Forward Guidance

Danny Dayan: Reacceleration Risk Threatens Bond Market, Demographics In U.S. Are Inflationary (Not Deflationary)

Tue Feb 13 2024

macro viewrecessioninterest rateseconomic growthfinancial conditionsinflationdemographicshousing markettrade opportunitiesChina's economy

Description

This episode covers the balance of risks in the macro view, potential impacts of a second wave and overheating economy, indicators of economic activity and market performance, uncertainty in equities and interest rates, job market growth and the neutral rate, patterns of financial conditions and rate cuts, inflation, rate cuts, and two-sided risks, interest rates, demographics, and economic growth, demographics, inflation, and the global economy, inflation, interest rates, and wealth distribution, excess cash, interest rates, and trade opportunities, China's economic situation and housing market.

Insights

The probability of a recession is roughly the same as it always is, around 15%.

Despite talk of a recession, many people still own stocks and the stock market is at all-time highs.

The risk of overtightening exists if rates reach 7%, which could potentially break things in the economy.

Restrictiveness can be measured using market-traded rates such as five-year and ten-year yields.

The Federal Reserve currently sees risks on the left tail (recession), but there is concern about the right tail (re-acceleration in economic growth) leading to increased inflation.

Telegraphing rate cuts has backfired in the past as markets always anticipate rate cuts even when rates were being raised incrementally.

The US economy has healthy balance sheets and high household wealth compared to previous decades, suggesting it can withstand higher interest rates than before.

Demographics play a role in why higher rates are being handled better than expected.

The corporate sector is below average in terms of interest payments.

Trades the speaker likes include being long volatility on equity markets and short fixed income.

China's policy set, bad demographics, and balance sheet recession make it uninvestable according to the speaker.

Chinese bond yields going to zero for an extended period of time is a possible bet for institutional investors.

China should allow its currency to weaken to counter deflationary impulses, but they are concerned about social unrest and outflows.

The housing market in China has seen a decrease in completions and distressed developers, but there have been no reported loan impairments by banks.

Chapters

The Balance of Risks in the Macro View
Potential Impacts of Second Wave and Overheating Economy
Indicators of Economic Activity and Market Performance
Uncertainty in Equities and Interest Rates
Job Market Growth and Neutral Rate
Patterns of Financial Conditions and Rate Cuts
Inflation, Rate Cuts, and Two-Sided Risks
Interest Rates, Demographics, and Economic Growth
Demographics, Inflation, and Global Economy
Inflation, Interest Rates, and Wealth Distribution
Excess Cash, Interest Rates, and Trade Opportunities
China's Economic Situation and Housing Market

Summary

Transcript

The Balance of Risks in the Macro View

00:00 - 06:44

The guest, Danny Diane, discusses the balance of risks in the macro view.
He sees a left tail risk where rates are too high and a right tail risk that is more terrifying.
Danny believes that the probability of a recession is roughly the same as it always is, around 15%.
He thinks people are too focused on the left tail risk because there is still policy room to cut rates.
Danny points out that if a recession were to happen, equity market investors would likely sell their stocks and buy them again at lower prices.
He mentions that despite talk of a recession, many people still own stocks and the stock market is at all-time highs.
The right tail risk that keeps him up at night is the possibility of an overheating economy due to economic re-accelerations.
If an overheating economy occurs, he believes the Fed will have to react by cutting rates or taking other measures.

Potential Impacts of Second Wave and Overheating Economy

06:16 - 12:58

The possibility of a second wave of the pandemic could lead to an embedded psychological impact and require action from the Fed.
If the economy overheats, the Fed may have to react by bringing hikes back onto the table, which could result in a significant increase in interest rates.
Other central banks like the Bank of Canada and ECB may have justifiable reasons to cut rates due to weak growth.
In a worst-case scenario with rate hikes and liquidity being sucked out of the system, there could be a more severe recession than currently anticipated.
The risk of overtightening exists if rates reach 7%, which could potentially break things in the economy.
It is important to avoid this scenario as bad things would happen if rates stay at a high level.
Restrictiveness can be measured using market-traded rates such as five-year and ten-year yields, which are more important for economic activity than just the Fed funds rate.
Currently, these market-traded rates are less restrictive compared to previous periods when policy rates were higher.

Indicators of Economic Activity and Market Performance

12:36 - 19:15

In October, the bond curve was over 5% and core inflation by CPI was about 4%, indicating a restrictive monetary policy.
The tenure (interest rate) is currently 180 basis points below nominal GDP, suggesting that the economy is not at risk of tipping into a recession.
The Fed funds rate has minimal impact on the economy as it mainly affects other rates in the market, not economic activity as a whole.
Mortgage purchase applications have been increasing since rates came down sharply in November, indicating some growth in housing activity.
The household savings rate is at multi-decade lows, suggesting that consumers are not reducing consumption to save more.
The corporate sector has shown positive earnings growth in Q3 and Q4, with companies taking advantage of lower rates to issue bonds and finance their businesses.
Credit markets have opened up since the Powell pivot, with high-yield issuance reaching its highest level since November 2021.
Despite concerns about an overheating economy and inflationary pressures, stocks may outperform bonds due to strong nominal growth and demand for equities.
Bond yields are considered too low and shorting them could be profitable. Equities may experience a correction but could also continue to rise if the economy overheats.

Uncertainty in Equities and Interest Rates

18:56 - 25:31

The speaker believes that equities may not be prepared for a significant increase in bond yields, and the next move is uncertain.
They think equities will either experience a "melt up" or a correction of 5 to 10 percent.
The speaker employs a strategy involving long straddles or strangles to profit from significant movements in the market.
They consider Bitcoin as a macro asset that can hedge against government devaluation of currency.
The US economy is perceived as strong, but there are arguments for a potential slowdown or recession.
The Federal Reserve's interest rate decisions are discussed, with the speaker emphasizing the importance of the ten-year rate over the Fed funds rate.
Arguments for cutting interest rates are questioned, considering factors such as nominal GDP growth and loan growth.
The job market is acknowledged to be slowing, but recent revisions have shown improvements.

Job Market Growth and Neutral Rate

25:10 - 32:14

The job market in the economy has shown substantial growth, with upward revisions to previous months' numbers and over 300,000 jobs added in December.
Despite claims of slowing, the economy is still far from reaching the replacement rate of job creation, which is 50 to 80,000 jobs per month.
There is no need for rate cuts when the economy is showing strong growth and resilience.
The neutral rate, which is neither stimulative nor restrictive for the economy, is estimated to be around 2.5% by the Federal Reserve.
Demographics have changed substantially and may indicate that the neutral rate is higher than it was in previous cycles.
Financial conditions have tended to be easier in this economy compared to previous cycles where they were tighter.
The equity market has consistently reacted negatively to various events in previous cycles, leading to tighter financial conditions and liquidity injections by the Fed. However, in this current economy, financial conditions have tended to be easier overall.

Patterns of Financial Conditions and Rate Cuts

31:49 - 39:20

The speaker discusses the pattern of tightening followed by a massive easing in the economy, which leads to re-acceleration within two to three months.
They emphasize the importance of looking at multiple metrics of financial conditions easing, such as bond yields, equities, and the value of the dollar.
The speaker mentions their accurate predictions of previous accelerations in the economy based on these financial conditions.
They highlight that SVB initially started as a liquidity crisis but later turned into a solvency issue due to funding costs for banks.
The Fed's focus on financial conditions has shifted over time, causing market volatility and increased animal spirits.
The speaker suggests that the Fed should study these patterns and concludes that there is currently no basis for rate cuts.
They discuss potential concerns regarding falling core PCE rates, nominal growth rates, and rising delinquencies in credit.
The speaker acknowledges the reliance on rate of change data but cautions against overreliance in macro investing.
They mention similarities between current delinquency rates and those seen before the 2007-2008 financial crisis.
The response agrees with the importance of observing trends but states that current levels are not problematic yet.

Inflation, Rate Cuts, and Two-Sided Risks

38:54 - 45:39

If inflation decreases but real GDP and nominal GDP remain the same, it suggests that productivity or supply side factors are stronger than expected.
If inflation continues to decrease and nominal GDP also decreases, it indicates a need for rate cuts.
Some metrics on inflation, such as the ISM services index and small business wage plans, show signs of increasing.
The goods sector may be improving, potentially leading to a shift from goods deflation to goods inflation while services inflation remains sticky.
There are two-sided risks in the economy, including commercial real estate market implications and credit card delinquencies.
The Federal Reserve currently sees risks on the left tail (recession), but there is concern about the right tail (re-acceleration in economic growth) leading to increased inflation.
It is important for the Fed to telegraph rate hikes to avoid abrupt tightening that impairs their ability to conduct policy.
Telegraphing rate cuts has backfired in the past as markets always anticipate rate cuts even when rates were being raised incrementally.
Staying at current levels of restrictiveness for three to six months could have weakened the economy and justified rate cuts, but mentioning rate cuts prematurely brought about negative consequences.

Interest Rates, Demographics, and Economic Growth

45:24 - 52:32

The speaker believes that interest rates could go up by a hundred basis points if certain conditions are met.
They think there is a possibility of two rate cuts, but the Federal Reserve may be cautious and slow to implement them.
The speaker sees the Federal Reserve as too dovish and focused on inflation rather than economic growth.
Demographic changes have occurred, leading to a shift in savings patterns, consumption patterns, and productivity in the economy.
Baby boomers transitioning into retirement become dis-savers, which affects the economy.
Aggregate productivity increases as baby boomers leave the workforce.
Consumption patterns change in retirement, with less spending on certain items like dining out and more spending on healthcare.
Millennials entering their peak family formation phase create demand for housing.

Demographics, Inflation, and Global Economy

52:11 - 59:22

Demand for housing is sticky because people buy houses based on their family circumstances and peak productivity in their lives.
The savings rate is substantially lower, leading to less demand for fixed income and inflationary pressures.
Millennials entering peak family formation phase is bullish for the economy as it leads to increased demand for houses and a shortage of housing.
The common narrative that older people spend less may not hold true in the US due to different dynamics compared to Japan's aging population.
A low savings rate is bad for bonds and good for stocks, but demographics alone cannot explain everything that happens in the economy.
In Japan, deflation was caused by factors such as the collapse in aggregate demand, blowups in housing and equities, and companies being unable to pass on cost increases. Aging demographics alone would have led to higher inflation if not for these factors.

Inflation, Interest Rates, and Wealth Distribution

58:58 - 1:05:56

The dynamics in Japan, such as deflationary bust and conservative companies, have led to higher inflation.
In the US, when baby boomers retire and start spending their wealth, it decreases the savings rate and increases demand for fixed income, which is inflationary.
Millennials in the US have a high demand for expensive tangible goods, leading to inflation in housing prices.
Europe's aging population has coincided with low inflation and low growth, but this correlation does not imply causation.
China is going through a balance sheet recession and a confidence crisis similar to Japan. A demographic bust in China could be deflationary for its economy.
Demographics alone do not determine inflation levels. Other factors like central bank policies and fiscal spending also impact inflation.
Labor shortages can lead to higher wage demands and structurally higher inflation.
The US economy has healthy balance sheets and high household wealth compared to previous decades, suggesting it can withstand higher interest rates than before.
Rates at current levels were historically not problematic for the US economy. The anomaly may have been the Global Financial Crisis (GFC).
Misjudging the economic situation by assuming we are back at 2019 could lead to thinking that rates are restrictive when they are not.
Demographics play a role in why higher rates are being handled better than expected.
Refinancing in the US has resulted in losses borne by debt owners rather than borrowers. This is different from other regions like Europe or Canada.
Wealthier cohorts in the US have excess cash and can earn interest income on it. Household interest payments as a percentage of disposable income are currently at very low levels.

Excess Cash, Interest Rates, and Trade Opportunities

1:05:33 - 1:12:34

The wealthier cohorts in the economy have excess cash and are earning interest income.
Household interest payments as a percentage of disposable income are at very low levels.
The corporate sector is also below average in terms of interest payments.
There is no shortage of cash, but the challenge is finding ways to invest it effectively.
The speaker believes that cutting rates would not be necessary because the economy is not restrictive.
Trades the speaker likes include being long volatility on equity markets and short fixed income.
In Canada, there is high household debt and bonds are correlated with the US market.
The Eurozone needs to stimulate exports by weakening the Euro currency.
Shorting the Euro is a trade opportunity for the speaker.
Sweden's manufacturing cycle can be a good indicator for the global economy's deflationary impulse.
China's policy set, bad demographics, and balance sheet recession make it uninvestable according to the speaker.
Chinese bond yields going to zero for an extended period of time is a possible bet for institutional investors.
China should allow its currency to weaken to counter deflationary impulses, but they are concerned about social unrest and outflows.

China's Economic Situation and Housing Market

1:12:06 - 1:17:15

China is concerned about money leaving the country and not coming back, which could lead to a long-term economic situation similar to Japan.
The housing market in China has seen a decrease in completions and distressed developers, but there have been no reported loan impairments by banks.
Recognizing losses early allows for growth, but China's control system is preventing this from happening.
The interviewee is considering returning to the institutional side of trading and exploring ways to engage responsibly on social media.
The podcast episode concludes with gratitude for the guest and reminders about other episodes and resources.