The Market Huddle

Lost Control of Financial Conditions (Guest: Danny Dayan)

Sat Apr 20 2024

Federal ReserveFinancial ConditionsCareer JourneyQuantitative EasingInterest Rate MarketsEconomic PredictionsResilience of the EconomyR Star and Neutral RatesFed's Approach CriticismSticky Inflation RisksMarket OptimismCanada's EconomyPessimism about Canada's Economic SituationGeopolitical RisksLong-Term Market Views

Description

This episode covers various topics including the guest's background, the Federal Reserve's control of financial conditions, career journeys, quantitative easing, interest rate markets, economic predictions, resilience of the economy, impact of R star and neutral rates, criticism of the Fed's approach, risks and implications of sticky inflation, market optimism, Canada's economy, pessimism about Canada's economic situation, geopolitical risks, long-term market views, and an anecdote about dumpling bets.

Insights

The Fed has lost control of financial conditions and predicts higher inflation than the market expects.

The guest discusses how the Fed has lost control of financial conditions and predicts higher inflation than the market expects.

There is concern about potential financial conditions tightening and loss of control by the Fed.

QE did not lead to hyperinflation as feared due to deleveraging and deflationary demographics.

The speaker accurately predicted an economic re-acceleration in 2023 based on financial conditions and saw signs of recovery in housing and consumer confidence.

Demographic changes are leading to structurally higher R star, impacting debates on neutral rates and economic resilience.

The speaker criticizes the Fed for not understanding the importance of ten-year yields in achieving their objectives.

The Federal Reserve is facing a risky situation with sticky inflation and a strong economy.

Market optimism was high due to anticipated growth re-acceleration, but concerns arose during earnings season when companies did not match price gains with earnings.

The central bank of Canada is not indicating willingness to tolerate higher inflation, leading to meager growth prospects.

President Xi in China has prioritized Taiwan, creating uncertainty about potential moves by China towards Taiwan.

Chapters

Guest Background and Fed Control
Career Journey and Macro Economics
Quantitative Easing (QE) and Interest Rate Markets
Career Transition and Launching a Hedge Fund
Economic Predictions and Financial Conditions
Resilience of the Economy and Demographic Changes
Impact of R Star and Neutral Rates
Criticism of Fed's Approach and Concerns
Risks and Implications of Sticky Inflation
Market Optimism, Interest Rates, and Canada's Economy
Pessimism about Canada's Economic Situation
Geopolitical Risks and Long-Term Market Views
Anecdote and Contact Information

Summary

Transcript

Guest Background and Fed Control

00:04 - 07:39

The guest, Danny Diane, discusses his upbringing in Montreal and his background as a competitive tennis player.
Danny Diane transitioned from studying business to working in derivatives after falling in love with them during a course.
He worked at a risk management software firm in New York consulting with large institutional clients on hedging exotic option portfolios.
The guest discusses how the Fed has lost control of financial conditions and predicts higher inflation than the market expects.
The guest shares a way to hedge a portfolio for outlier risks that are concerning.

Career Journey and Macro Economics

07:20 - 14:48

The speaker gravitated towards their clients' work during the financial crisis, learning from experts and Nobel Prize winners at University of Chicago.
Attending University of Chicago was influential in the speaker's career, providing diverse classes and exposure to renowned professors.
The speaker preferred living in Chicago over New York due to its laid-back atmosphere and beautiful infrastructure.
After graduation, the speaker chose a job in rate sales over trading to focus on macroeconomics and became known for making big picture calls that made money for clients.
The speaker left the sell side due to political issues and resource cuts during regulatory changes like Basel 3 and Dodd Frank.

Quantitative Easing (QE) and Interest Rate Markets

14:31 - 22:09

QE did not lead to hyperinflation as feared due to deleveraging and deflationary demographics.
Understanding the demographic and deleveraging angles provided an edge in interest rate markets during the cycle.
Structuring trades using derivative markets offered better staying power for longer-term themes.
QE did not cause inflation but rather asset inflation by compressing risk premiums.
Excess reserves from QE stayed within the banking system and did not reach the real economy, preventing inflation.
Insight into central banking operations from University of Chicago classes helped in understanding why QE wouldn't create inflation.

Career Transition and Launching a Hedge Fund

21:40 - 28:29

Reserves held by the central bank were not permanent and could be called back, which raised questions about their ability to stimulate economic activity.
The interviewee transitioned from working at Credit Suisse to joining Dean Kurnut's team at Macro Risk Advisors, focusing on rates and FX business.
The interviewee later joined Mike Green's fund as head of trading and risk, where they outperformed the macro community but faced challenges with fundraising.
After Mike Green moved on, the interviewee realized the importance of managing the business side of a fund and decided to launch their own hedge fund with a different fee structure.

Economic Predictions and Financial Conditions

28:05 - 35:11

The speaker tried to create a fund with unique features like no management fee and a different capital structure, but found it too complicated and not competitive in the changing market.
After leaving the fund, the speaker joined Twitter and started sharing their views on economic topics, preferring long-form discussions over tweets.
The speaker accurately predicted an economic re-acceleration in 2023 based on financial conditions and saw signs of recovery in housing and consumer confidence.
The Silicon Valley bank crisis was initially a liquidity issue that was resolved by the creation of a facility for banks to access liquidity, but it led to increased funding costs for banks.

Resilience of the Economy and Demographic Changes

34:49 - 42:22

The speaker predicted a re-acceleration in the economy, which was followed by an 8% nominal GDP quarter in Q3.
There was a term premium tantrum as the back end of the curve started to shift without influence from the Fed.
The economy's resilience to interest rate increases is attributed to factors like healthy household and corporate balance sheets and demographic changes.
Demographic shifts, particularly baby boomers retiring earlier than expected, have led to lower aggregate savings and increased demand for durable goods and housing.
The speaker highlights that millennials entering peak productivity and family formation phases have contributed to higher demand for goods and services.

Impact of R Star and Neutral Rates

41:55 - 48:48

Demographic changes are leading to structurally higher R star, impacting debates on neutral rates and economic resilience.
Federal Reserve economists' views on R star and neutral rates influence consensus among portfolio managers, especially bond managers.
Realization of a higher R star could impact the long end of the bond market and potentially cause a backup.
The Fed's messaging regarding rate cuts and economic conditions has influenced market reactions and expectations.

Criticism of Fed's Approach and Concerns

48:21 - 55:29

The speaker criticizes the Fed for not understanding the importance of ten-year yields in achieving their objectives.
They believe that the Fed's policy mistake was not using Quantitative Tightening (QT) more effectively.
The speaker suggests that implementing a yield curve floor could have been a better approach for the Fed.
There is concern about potential financial conditions tightening and loss of control by the Fed.
The upcoming June FOMC meeting is seen as crucial due to sticky inflation, a strong economy, and potential risks.

Risks and Implications of Sticky Inflation

55:05 - 1:02:29

The Federal Reserve is facing a risky situation with sticky inflation and a strong economy.
Potential risks include geopolitical events leading to supply shocks and increased lending causing a second wave of inflation.
The Fed may need to hike rates if inflation remains high by December, but their messaging needs to be clear to impact financial conditions.
Persistently high inflation could lead to changes in psychology where companies and households become more comfortable with higher prices and wages, potentially requiring a deeper recession to correct.
Higher rates could impact equity markets, with potential implications for stock valuations.

Market Optimism, Interest Rates, and Canada's Economy

1:02:07 - 1:09:14

Market optimism was high due to anticipated growth re-acceleration, but concerns arose during earnings season when companies did not match price gains with earnings.
The speaker was initially bullish in late 2018 but turned bearish in April, selling rallies and expressing discomfort with the equity market.
Higher interest rates may not significantly impact the corporate sector as they have managed debt well and can live with higher rates.
Canada's economy is a concern due to elevated debt levels across government, corporate, and household sectors, surpassing pre-COVID healthy debt-to-GDP ratios.
Bank of Canada faces challenges with high debt levels as inflation or default are unattractive options, potentially leading to significant rate cuts.

Pessimism about Canada's Economic Situation

1:08:57 - 1:16:15

The central bank of Canada is not indicating willingness to tolerate higher inflation, leading to meager growth prospects.
The speaker predicts that the dollar CAD exchange rate may reach 145 due to structural factors and differences in interest rates between Canada and the US.
Canada's economy faces challenges with increasing rates despite justification for cuts, potentially worsening economic conditions.
The speaker is pessimistic about Canada's economic situation, highlighting lack of recognition by government officials and potential long-term negative impacts.
Investing based on future developments rather than current events is emphasized, drawing parallels with geopolitical situations like Russia-Ukraine and China-Taiwan.

Geopolitical Risks and Long-Term Market Views

1:15:54 - 1:22:41

President Xi in China has prioritized Taiwan, creating uncertainty about potential moves by China towards Taiwan.
Preparing for a potential conflict involving Taiwan is challenging due to the unpredictability and speed of China's military actions.
There is a suggestion to consider investing in dollar Taiwan out-of-the-money calls as a form of insurance in case of geopolitical events impacting the market.
Long-term views on markets can be expressed through option markets or structured trades, incorporating staying power and positive carry.
Harley Basman's approach to expressing long-term views in markets through option markets has been influential for the speaker.

Anecdote and Contact Information

1:22:12 - 1:24:18

A group of people in New York City made bets on how many huge dumplings someone could eat from a food cart.
The person eating the dumplings had to go home early because he couldn't finish them all.
The guest, Danny, shared his Twitter handle and Substack link for those interested in macro topics like demographics and trade ideas.