The Mechanics of Deleveragings - And Where the Current One Fits In | Andy Constan

[00:00:00] [SPEAKER_02]: Welcome to Excess Returns, where we focus on what works over the long term in the markets.

[00:00:04] [SPEAKER_02]: Join us as we talk about the strategies and tactics that can help you become a better

[00:00:07] [SPEAKER_00]: long-term investment. Jack Forehand is a principal at Validia Capital Management.

[00:00:11] [SPEAKER_00]: The opinions expressed in this podcast do not necessarily reflect the opinions of Validia

[00:00:15] [SPEAKER_00]: Capital. No information on this podcast should be construed as investment advice.

[00:00:19] [SPEAKER_00]: Securities discussed in the podcast may be holdings of clients of Validia Capital.

[00:00:22] [SPEAKER_02]: Hey guys, this is Justin. In this episode of Excess Returns, Jack sits down with

[00:00:26] [SPEAKER_02]: Damp Spring founder Andy Constan. Andy is one of our favorite guests because he always offers a

[00:00:30] [SPEAKER_02]: balanced view and uses a very thoughtful approach to analyze markets. With everything going on in

[00:00:34] [SPEAKER_02]: the macro world and the recent volatility in markets, it was a perfect time to have Andy back

[00:00:37] [SPEAKER_02]: to help us make sense of it all. Jack and Andy discussed the recent market decline and the

[00:00:41] [SPEAKER_02]: driving forces behind it, the recent jobs report, the outlook for inflation, and a lot

[00:00:45] [SPEAKER_02]: more. Andy's unique perspective on the macro world was in full display during this

[00:00:48] [SPEAKER_02]: interview and we hope you learn as much from it as we did. As always thank you for listening,

[00:00:52] [SPEAKER_02]: please enjoy this discussion with Andy Constan. Andy, thank you for coming back on.

[00:00:56] [SPEAKER_03]: Pleasure to be here, Jack. As always. I think it's your fifth appearance in Excess Returns,

[00:01:01] [SPEAKER_03]: I believe. So we appreciate you continuing to say yes when I continue to email you about it.

[00:01:05] [SPEAKER_03]: Fantastic. I always enjoy the conversations. So we're going to cover a lot today. We're

[00:01:09] [SPEAKER_03]: going to cover inflation. We're going to cover the economy. We're going to cover what's

[00:01:11] [SPEAKER_03]: going on with the Fed. But I want to start out with what happened recently because

[00:01:14] [SPEAKER_03]: what happened last Monday was a very interesting event in that we hadn't seen

[00:01:18] [SPEAKER_03]: something like that in a long time and there's been a lot of people out there trying to

[00:01:21] [SPEAKER_03]: explain what went on and what's going on by the scenes and whether it's going to continue

[00:01:25] [SPEAKER_03]: and a lot of things. So I wanted to just start by getting your take on that.

[00:01:28] [SPEAKER_03]: What was your take on what happened last Monday and what's going on behind the scenes in the

[00:01:32] [SPEAKER_05]: market? Yeah, I mean, I think you have to step back and say that Monday was just an

[00:01:37] [SPEAKER_05]: outcome of what had been set up. And I think that basically is a classic

[00:01:48] [SPEAKER_05]: deleveraging that occurs periodically across markets. I just wrote a deaf spring report

[00:01:55] [SPEAKER_05]: that profiles about 13 of them. And it's fairly classic. They all start with a system

[00:02:04] [SPEAKER_05]: that is for whatever reason, a little over its skis in terms of leverage. It could be a lot

[00:02:11] [SPEAKER_05]: over its skis. It could be the whole financial system is overlevered or a single investor.

[00:02:20] [SPEAKER_05]: And whenever that happens, whenever there is leverage in the system, there are a couple

[00:02:30] [SPEAKER_05]: of things that can happen. I guess the first thing that people are focused on, which I think

[00:02:36] [SPEAKER_05]: is missing the point quite a bit, is the cost of your borrowing can go up. Meaning if you're

[00:02:43] [SPEAKER_05]: borrowing at the floating rate and buying long term assets with it, you're exposed to your

[00:02:50] [SPEAKER_05]: cost of a carry, which is the interest you pay every day to maintain your leverage.

[00:02:56] [SPEAKER_05]: And so rate hikes increase that leverage. But the problem is they work so slowly.

[00:03:03] [SPEAKER_05]: If you have, if you're paying 10 basis points in yen carry and they move it to 25 basis points,

[00:03:11] [SPEAKER_05]: that's 1,365 of 15 basis points per day that the trade begins to cost you. So that's not really

[00:03:22] [SPEAKER_05]: a motivation to unwind. Typically, leverage is unwound when there is a lender

[00:03:32] [SPEAKER_05]: who needs more collateral. You put 100 cents on the dock, you buy 100 cents worth of Nvidia stock,

[00:03:41] [SPEAKER_05]: you, your margin clerk posts 70 cents and you post 30. And they want more money when the equity

[00:03:51] [SPEAKER_05]: value, if it goes to 90, and your equity value is now only 20, they're going to want seven bucks.

[00:03:59] [SPEAKER_05]: And if you don't post that money, they're going to liquidate you. And that's a margin call. And

[00:04:06] [SPEAKER_05]: you notice what it starts with is the lender was perfectly happy to lend you money. They weren't

[00:04:13] [SPEAKER_05]: asking for it back. But the asset price fell. And so I think you have to always think about

[00:04:22] [SPEAKER_05]: a deleveraging from what's happening to asset prices, whether it's homes in 2007.

[00:04:32] [SPEAKER_05]: The tie bot in 1997, long term interest rates in 1994, you pick them, you're going to find

[00:04:44] [SPEAKER_05]: most delevergings occur when the thing that's being leveraged falls.

[00:04:51] [SPEAKER_05]: Japan and the Japanese carry trade is just the same as that, except you have to add another

[00:04:59] [SPEAKER_05]: potential catalyst for a forced unwind. Certainly the asset price falls. So if you bought Nvidia

[00:05:07] [SPEAKER_05]: on leverage, and the asset price falls, you may need to sell. Alternatively,

[00:05:13] [SPEAKER_05]: it on top of that, if you bought Nvidia on leverage, and you borrowed the money,

[00:05:20] [SPEAKER_05]: the dollars that you needed from denominated in yen, then you also have the potential that when

[00:05:28] [SPEAKER_05]: you go to sell that you need to come up with even more money to if the yen has appreciated

[00:05:36] [SPEAKER_05]: to pay back the yen you'll need. And so the yen carry trade is just another form of a leveraged

[00:05:42] [SPEAKER_05]: unwind, where both in this case both the asset and the denomination of the loan went against you.

[00:05:52] [SPEAKER_05]: And so that creates extra selling or more sensitive, more losses from levered positions.

[00:05:59] [SPEAKER_05]: And so I think that's happening. I think the yen has appreciated, that's certainly clear,

[00:06:05] [SPEAKER_05]: which indicates that people who are borrowing yen are chasing to buy back the yen they are short

[00:06:14] [SPEAKER_05]: and deliver it to the people that they borrowed from. But also mostly it's about asset prices

[00:06:21] [SPEAKER_03]: falling. How do these carry trades work in the real world? I mean, is it mostly people

[00:06:26] [SPEAKER_03]: borrowing in yen and then buying something like low risk, like Pbills? Or is this a lot of

[00:06:30] [SPEAKER_03]: like people borrowing yen and then they buy risky assets? Yeah, I mean, I think you have

[00:06:34] [SPEAKER_05]: to step back again and say, you know, there's some literally people that borrow yen

[00:06:42] [SPEAKER_05]: and invest and buy on leverage some other asset as a carry trade. And then there's the Japanese

[00:06:50] [SPEAKER_05]: in total, which have three and a half trillion dollars worth of market value of

[00:06:59] [SPEAKER_05]: the rest of the world portfolios. And so they have either bought hard assets like real estate,

[00:07:10] [SPEAKER_05]: bought financial assets like stocks or lent money to the rest of the world in a total

[00:07:15] [SPEAKER_05]: of around three and a half trillion dollars. And so that's all the lending that's going

[00:07:20] [SPEAKER_05]: out to foreigners. So that's a good ballpark quantity. But most of the lending is not for

[00:07:30] [SPEAKER_05]: speculative trades like you're describing. It's for, you know, longer term lending and

[00:07:37] [SPEAKER_05]: the Japanese themselves are buying assets. So I don't think that the literal people

[00:07:44] [SPEAKER_05]: that are borrowing in yen and buying something else are anywhere near the size that most

[00:07:51] [SPEAKER_05]: people have said. But the typical trade, and this is probably one of the first canaries in the coal

[00:07:58] [SPEAKER_05]: mine is a carry trade across currencies. And so one of the classic ones that has been working

[00:08:06] [SPEAKER_05]: so well has been borrowing in yen and investing in the Mexican peso. And that one really started

[00:08:18] [SPEAKER_05]: to unwind right after the election in Mexico. And in that case, you're buying a T bill,

[00:08:26] [SPEAKER_05]: they're buying short term paper in Mexico that pays a high interest rate denominated in pesos.

[00:08:31] [SPEAKER_05]: The pesos appreciating relative to the yen and the cost of interest on the yen loan is small.

[00:08:38] [SPEAKER_05]: And so that's the carry trade. Now you can buy any asset and people buy all sorts of assets,

[00:08:42] [SPEAKER_03]: but you know, that's one of them. So when we think about what happened Monday, I mean,

[00:08:47] [SPEAKER_03]: I think from what you're saying, you don't believe the end carry trade was the cause of

[00:08:51] [SPEAKER_03]: what happened Monday. But we'll always, all the news will always be telling us it was this or

[00:08:54] [SPEAKER_03]: is this or is this. Like what do you think when you look at something that happens like that,

[00:08:59] [SPEAKER_03]: that's maybe not a major decline in the long term, but something investors are definitely

[00:09:02] [SPEAKER_03]: worried about because it's something that kind of came out of nowhere. How do you think

[00:09:05] [SPEAKER_05]: about analyzing what went on? Right. So that's the big question. I don't know the answer

[00:09:11] [SPEAKER_05]: whether the deleveraging that occurred over the last call at month, you know, sort of since July

[00:09:17] [SPEAKER_05]: 11 stocks, risky assets have fallen. Short term interest rates have risen a lot. The yen has

[00:09:27] [SPEAKER_05]: appreciated it a lot and other things that are measures of deleveraging have occurred

[00:09:34] [SPEAKER_05]: like high volatility credit spreads expanding. It's clear a deleveraging is going on.

[00:09:40] [SPEAKER_05]: The question that everyone wants to know because, you know, the by the dip culture in the world is

[00:09:45] [SPEAKER_05]: very strong and very successful is when is it over? And so I just look at a framework for that. I

[00:09:54] [SPEAKER_05]: don't, you know, try to guess no one let me just be clear. No one knows. There are people

[00:10:00] [SPEAKER_05]: that are saying it's 75% over JP Morgan recently printed something about that. Everybody is guessing.

[00:10:09] [SPEAKER_05]: No one knows. So the question is, what do you want to know about deleveraging that can give you some

[00:10:18] [SPEAKER_05]: information that makes it and signs that it is in fact over? And so this is what my damp spring

[00:10:26] [SPEAKER_05]: report is about. And I'll just give you the high level. It's for clients. So I'll give you

[00:10:31] [SPEAKER_05]: the high level framework, which is who sell? That's an important piece of the information.

[00:10:40] [SPEAKER_05]: Is it one guy like in 1997 where a, you know, 15% drawdown occurred because one guy decide was

[00:10:50] [SPEAKER_05]: forced out of his puts because he was exposed to tie bot stocks? It doesn't seem like that

[00:10:56] [SPEAKER_05]: here. Is it systemic? That's the other extreme in which dealers, banks,

[00:11:07] [SPEAKER_05]: insurance schemes are being forced to unwind at large quantities. There's no sign of that as far

[00:11:16] [SPEAKER_05]: as I can tell. And so it falls somewhere in the middle. And I would describe the sell-off as

[00:11:21] [SPEAKER_05]: broad across many assets and impacting many different types of investors. And when I step back

[00:11:29] [SPEAKER_05]: and say what is the look prior to the deleveraging, what did I think the environment looked like?

[00:11:35] [SPEAKER_05]: I would say the following, which is assets were very well bid up. There was an expectation that

[00:11:41] [SPEAKER_05]: the central banks were on an easing path that, you know, even still earnings expectations were

[00:11:48] [SPEAKER_05]: extremely high for the next two years. Multiples were very high. Fixed income risk premium was very low.

[00:11:57] [SPEAKER_05]: Vol was very low. And all of those things are consistent with investors at a fairly high

[00:12:05] [SPEAKER_05]: level of leverage. And you can look at other forms of leverage, how much repo is being done?

[00:12:13] [SPEAKER_05]: What is the cost of repo that's seen in swap spreads? So how much demand for leverage is there?

[00:12:21] [SPEAKER_05]: Margin loans, existing margin loans. And what I would have described and what I have been describing

[00:12:27] [SPEAKER_05]: is that the system is pretty leveraged and asset prices are not very attractive.

[00:12:32] [SPEAKER_05]: And so that's a good circumstance for a broad deleveraging. And I'm not talking about a stock

[00:12:37] [SPEAKER_05]: market crash. I'm just talking about, you know, let's get some of the leverage out.

[00:12:43] [SPEAKER_05]: And it's important to note that it's not like when the system is leveraged, say the overall

[00:12:51] [SPEAKER_05]: system is leveraged two to one. And there's a deleveraging. A new investor that is buying

[00:13:07] [SPEAKER_05]: the positions that are being sold needs to lever. And they're not going to lever two to one,

[00:13:14] [SPEAKER_05]: if so, the market's price isn't going to change. They're going to want to lever, I don't know,

[00:13:19] [SPEAKER_05]: one and a half to one. And the only way to get that, meaning the leverage gets paid back by one

[00:13:24] [SPEAKER_05]: and new leverages created by another, the only way to deal with that is a price decline.

[00:13:31] [SPEAKER_05]: And so I'm just talking about a classic deleveraging correction. We saw it in 2018 when the Fed

[00:13:39] [SPEAKER_05]: was too tight. We saw it in 2022 when the, in the midst of the market sell-off when the UK

[00:13:47] [SPEAKER_05]: LDI scheme unwound, we saw it in the SVB situation. So those are recent cases. And obviously we saw

[00:13:56] [SPEAKER_05]: versions of that throughout history. And so that's what's happening. The next bit of,

[00:14:03] [SPEAKER_05]: so that's who's selling and why? And the answer is broad and asset prices are not particularly

[00:14:10] [SPEAKER_05]: attractive. And there's a high amount of leverage in the system. So that's who's selling. That tends

[00:14:17] [SPEAKER_05]: to mean that it lasts longer than if one or a few people are being delevered like Bill Wang, Huang,

[00:14:25] [SPEAKER_05]: or Victor Niederhofer, or some of these other cases where it was very narrow deleveraging.

[00:14:31] [SPEAKER_05]: So it's broad and that's the first part of the framework. The second part is,

[00:14:37] [SPEAKER_05]: you know, how are financial institutes doing? Because there's only been one major situation where

[00:14:44] [SPEAKER_05]: the financial system had all of the same positions as the private sector. And

[00:14:51] [SPEAKER_05]: they were forced to delever and they were unable to offer credit. In fact,

[00:14:57] [SPEAKER_05]: they had to take away credit from their existing clients. And that was the GFC. Now there have

[00:15:04] [SPEAKER_05]: been other times where for whatever reason, these banks are either in the same position, 1998 is

[00:15:12] [SPEAKER_05]: a fairly good example of that, or are constrained in some way in terms of how much leverage

[00:15:19] [SPEAKER_05]: they can have, but they're not contributing. So that's a metric. How are financial institutions

[00:15:24] [SPEAKER_05]: and the better shape they are, and the least exposed they are to the deleveraging, the shorter

[00:15:30] [SPEAKER_05]: it's going, the shallower it's going to be, and the shorter it's going to last. And right now,

[00:15:35] [SPEAKER_05]: they're in great shape. So that would be a signal that that that would be a circumstance where one

[00:15:41] [SPEAKER_05]: would expect a deleveraging to be shallower and quicker. And then you have set the impact on the

[00:15:52] [SPEAKER_05]: economy. And you know, when you look at deleverings, whether it's 2000 or 1998, or COVID, or, or the

[00:16:07] [SPEAKER_05]: ones that didn't have impact on the economy, some of these deleverings can be a causal to a economic

[00:16:15] [SPEAKER_05]: slowdown. And, you know, that has an impact on the when there is an economic slowdown that is

[00:16:22] [SPEAKER_05]: caused by the deleveraging. It takes a long time for the bottom to get to be in a deleveraging.

[00:16:32] [SPEAKER_05]: And then the last thing is what are the central banks do? What are policymakers do and, you know,

[00:16:38] [SPEAKER_05]: now we're in a world in which part of the policymaking can be fiscal spending,

[00:16:42] [SPEAKER_05]: which we saw in COVID, handled to a little medium extent, what we saw in the SVB crisis.

[00:16:54] [SPEAKER_05]: The whether the central bank or fiscal does anything is an important criteria in terms of

[00:17:01] [SPEAKER_05]: whether there's going to be a bounce. The strength of their response will obviously have

[00:17:08] [SPEAKER_05]: a meaningful impact on those things. You know, if you look at the COVID crisis, which,

[00:17:13] [SPEAKER_05]: you know, is exogenous, the market corrected one month made its low in one month. And I think it was

[00:17:22] [SPEAKER_05]: 120 days later was back to its all time to its all time high. That's because of the strength

[00:17:30] [SPEAKER_05]: of the response. And so it's super important to judge whether this will elicit what whether

[00:17:39] [SPEAKER_05]: it'll affect the economy and whether it'll elicit a Fed reaction. And, you know, Jeremy

[00:17:46] [SPEAKER_05]: single called for 75 basis points cuts it on Monday. You know, that was an incredibly stupid

[00:17:51] [SPEAKER_05]: thing to say emergency cuts. He since retracted that as the market stopped panicking. But there's

[00:17:59] [SPEAKER_05]: it's interesting to note that in 1987, and in the long term, long term capital crisis,

[00:18:07] [SPEAKER_05]: the entire cuts that occurred in the greatest stock market crash in history, and the biggest

[00:18:12] [SPEAKER_05]: hedge fund unwind in history in which equities fell 20% in two months. The Fed cut 75 basis

[00:18:19] [SPEAKER_05]: points in total. So you have to judge whether there's going to be a bazooka like response.

[00:18:30] [SPEAKER_05]: I would look at the SVB crisis and it was short and and sweet because

[00:18:36] [SPEAKER_05]: the response was over the top. Whereas I'd look at the

[00:18:42] [SPEAKER_05]: and but the but it was a meaningful, a meaningful event. I'd look at the LDI crisis and say,

[00:18:49] [SPEAKER_05]: you know, the BOE had a rifle shot right to where it was needed. They walked some bonds back,

[00:18:57] [SPEAKER_05]: they redid QE but immediately after and that's off the problem. Now, of course,

[00:19:05] [SPEAKER_05]: trust being kicked out really was the problem. But from a financial standpoint, that problem

[00:19:11] [SPEAKER_05]: was solved very quickly. And then the stimulus was removed. Whereas in the SVB crisis, we're

[00:19:19] [SPEAKER_05]: still living with the $106 billion worth of BT up P that doesn't expire for another year.

[00:19:26] [SPEAKER_05]: And so that's easier than and probably disproportionate to what was happening back

[00:19:33] [SPEAKER_05]: then back then. So anyway, that's the overall framework for those who selling how the bank's

[00:19:39] [SPEAKER_05]: doing, what's the economy going to do? And what are the central bankers going to do?

[00:19:45] [SPEAKER_05]: And you have to judge for yourself where we are in that framework and what the likely

[00:19:49] [SPEAKER_03]: outcome will be. I want to ask you more about some of the stuff you said about

[00:19:53] [SPEAKER_03]: the economy. But first, I want to ask you about the VIX because people like me are kind of

[00:19:56] [SPEAKER_03]: outside of that world and your average investor too saw a huge spike in the VIX to

[00:19:59] [SPEAKER_03]: inferior at least over 60 on Monday. And we're worried about is there something going on?

[00:20:04] [SPEAKER_03]: Because if you look at previous episodes where the VIX spiked to 60, there was a major event

[00:20:08] [SPEAKER_03]: tied to it and someone had a chart going around on Twitter with this, like all these

[00:20:11] [SPEAKER_03]: major events and then this one which seemed like it wasn't tied to much of anything

[00:20:14] [SPEAKER_03]: and the VIX went above 60. So what do you make of that?

[00:20:19] [SPEAKER_05]: Well, I am willing to get technical about it but I don't know whether it's

[00:20:26] [SPEAKER_05]: useful. I'll start with the following. The VIX is a calculation. It represents the prices

[00:20:38] [SPEAKER_05]: of a series of options that expire within the next month and those options change through time

[00:20:46] [SPEAKER_05]: meaning it's not the same option every day. Each day there's a new option, well each

[00:20:51] [SPEAKER_05]: period of time, every few days there's a new option that comes on that's included in the

[00:20:57] [SPEAKER_05]: calculation and it's lots of options. It's not just one, it's a series of options

[00:21:03] [SPEAKER_05]: and it's a calculation and it's not tradable. There are no products that can trade the VIX

[00:21:11] [SPEAKER_05]: except VIX options which are even harder to necessarily explain to your viewers.

[00:21:17] [SPEAKER_05]: What does trade and so represents the true expectations for a vol is VIX futures

[00:21:26] [SPEAKER_05]: and those didn't spike. They went up a lot. They went up to 35 if I'm not mistaken but they didn't

[00:21:32] [SPEAKER_05]: spike anywhere near what the VIX did. Why did the VIX spike? There are people,

[00:21:42] [SPEAKER_05]: Dean Karnit who runs Alpha Exchange, who's a phenomenal derivatives person,

[00:21:48] [SPEAKER_05]: did an analysis of every single thing that was used in the calculation for the VIX at that time

[00:21:56] [SPEAKER_05]: and found an option that was the most meaningful contributor to that

[00:22:06] [SPEAKER_05]: calculation for that at that moment that was clearly mispriced relative to any other option.

[00:22:13] [SPEAKER_05]: And really so what does it mean to be mispriced? Well every moment that these

[00:22:18] [SPEAKER_05]: calculations are done someone is bidding and someone is offering and they take the mid-price of

[00:22:24] [SPEAKER_05]: that and that's what they do. Now I don't know if you or any of your viewers tried to

[00:22:30] [SPEAKER_05]: trade options on Monday but the bid offer spreads were astoundingly large. Now does that mean the

[00:22:37] [SPEAKER_05]: mid is accurate? It could conceptually the bid offer spread could be perfectly wide around the

[00:22:47] [SPEAKER_05]: mid being the price but it's unlike... but that's true and so the price that was used that generated

[00:22:57] [SPEAKER_05]: a 65 VIX was simply not an accurate price. Not something that could have been traded at was

[00:23:02] [SPEAKER_05]: not the mid market of what could have been traded and so but that's the calculation. They

[00:23:08] [SPEAKER_05]: follow the rules and the VIX printed 65. That's true but so what? You couldn't trade it.

[00:23:18] [SPEAKER_05]: Nothing priced off of that thing. It was just a signal that people and

[00:23:25] [SPEAKER_05]: mainstream media puts on the front page and then you see those charts and all those sort of things.

[00:23:30] [SPEAKER_05]: But if you look at the VIX futures which have traded for a long time as well in none of those

[00:23:38] [SPEAKER_05]: events that this was I think it was two events 2020 and sorry 2000 and

[00:23:48] [SPEAKER_05]: and GFC and COVID where the VIX had spiked to this level and then this one.

[00:23:57] [SPEAKER_05]: The VIX futures spiked like on those two crazy days, crazy periods but the VIX futures really

[00:24:07] [SPEAKER_05]: didn't do anything and moved a lot but it wasn't unusually large and so I guess what

[00:24:13] [SPEAKER_05]: I would say to your viewers is particularly on days like that it's most it's better to use things

[00:24:22] [SPEAKER_05]: that are actively trading that represent what you care about which is oh you know is the

[00:24:27] [SPEAKER_03]: fear gauge work the triggering. You mentioned the wide option spread on Monday and that gets

[00:24:33] [SPEAKER_03]: an issue a lot of people are worried about right now which is you'll hear all the time on Twitter

[00:24:37] [SPEAKER_03]: liquidity beneath the surface is horrible and so people worry well if we had an event like

[00:24:41] [SPEAKER_03]: this and we had what we had what happens if we have a major event is that something you're

[00:24:45] [SPEAKER_03]: concerned about that liquidity is drying up or it's very bad beneath the surface.

[00:24:49] [SPEAKER_05]: You know I the way I think about liquidity is probably different than most

[00:24:56] [SPEAKER_05]: that are that are discussing it in the way you just did.

[00:25:00] [SPEAKER_05]: You know liquidity to me is when it is what is necessary for a

[00:25:06] [SPEAKER_05]: a meaningful player to move a meaningful amount of risk and what sort of impact are they going

[00:25:13] [SPEAKER_05]: to have and they're dealing with it doing that they're dealing with large scale liquidity

[00:25:19] [SPEAKER_05]: providers and large scale potential counter parties who are taking the opposite side

[00:25:27] [SPEAKER_05]: of their trade and so you know that's when I think about liquidity and now that isn't perfect

[00:25:32] [SPEAKER_05]: either and you know you should expect some high costs in trading during times of stress

[00:25:41] [SPEAKER_05]: if you're moving large amounts of risk but I think what most people are talking about

[00:25:45] [SPEAKER_05]: is very short term liquidity for a relatively small size like you know your viewers are

[00:25:50] [SPEAKER_05]: probably transacting in and I actually am pretty optimistic about liquidity most of the time

[00:25:58] [SPEAKER_05]: you know compared to you know years past the cost of trading is extraordinarily low

[00:26:05] [SPEAKER_05]: for everyone and you know that's a good thing but it's also true that trading during a period

[00:26:14] [SPEAKER_05]: of time when big participants are moving risk or there's great uncertainty is anyways much

[00:26:24] [SPEAKER_05]: much more expensive and I just discourage it I just would you know my my thinking generally

[00:26:30] [SPEAKER_05]: about well about trading in general and investing in particular is you shouldn't ever be in a

[00:26:40] [SPEAKER_05]: position where you have to trade on a big day you know a big day in which you have to trade

[00:26:48] [SPEAKER_05]: now we may want to trade because we're making all this money and we want to realize that

[00:26:52] [SPEAKER_05]: that's wanting to trade having to trade is when you're being forced to trade because you are losing

[00:27:00] [SPEAKER_05]: and are going to be pushed out of your positions and for me the times if you're if you work if

[00:27:09] [SPEAKER_05]: you have to trade and it's when you are you're the way you're set up in your investing is that

[00:27:18] [SPEAKER_05]: that's going you're going to have to trade on a very bad day for markets you're setting yourself up to

[00:27:25] [SPEAKER_05]: fail and so I just wouldn't ever put myself in a position where I'm going to be forced out of a

[00:27:32] [SPEAKER_05]: trade in the worst possible time to be forced out of I just wouldn't take that risk and I

[00:27:39] [SPEAKER_05]: just so the point being always position yourself so that you can withstand difficult markets you know

[00:27:52] [SPEAKER_05]: if you were forced out on Monday you're looking really foolish today so don't put yourself in a

[00:27:58] [SPEAKER_05]: position to be forced out on Monday so you don't see anything in terms of like a systemic risk

[00:28:02] [SPEAKER_03]: to the market like if everybody's trying to get out the door on the same day and something

[00:28:04] [SPEAKER_03]: major happens that we have you know much less liquidity behind the scenes for them to do

[00:28:08] [SPEAKER_03]: that than they've had then we've had in the past there's never enough liquidity when everyone

[00:28:11] [SPEAKER_05]: wants to go out the door it never is there never will be there never is but you know when the

[00:28:16] [SPEAKER_05]: when the way turns in such a way that everyone needs to get out are you are you going to be

[00:28:22] [SPEAKER_05]: the opposite side of that I'm not yeah definitely not right you know that's the problem with

[00:28:28] [SPEAKER_05]: crowded trades and that's the problem with markets in general which is

[00:28:34] [SPEAKER_05]: when things radically change the price is going to change you're not going to get out

[00:28:41] [SPEAKER_05]: before the price changes you may think you are going to get out before the price changes

[00:28:47] [SPEAKER_05]: but the people that are on the other side of that are not stupid so I don't consider

[00:28:52] [SPEAKER_05]: that's not what I consider liquidity I consider liquidity is all the information is out

[00:28:58] [SPEAKER_05]: and now you just want to transact can you transact at a fair bit off or spread

[00:29:03] [SPEAKER_05]: and the chances are no during times of uncertainty and so I wouldn't put myself in the position to

[00:29:09] [SPEAKER_05]: do that now that's not going to protect you when everybody decides they need to sell something

[00:29:14] [SPEAKER_05]: it's just not going to do it you're just not you're not going to beat anybody to the market

[00:29:20] [SPEAKER_05]: and the market's going to move whether there's a transaction or not

[00:29:25] [SPEAKER_05]: I just consider that different than liquidity maybe well it makes sense

[00:29:29] [SPEAKER_03]: yeah for the second half I want to switch the economy because last time we talked to you was

[00:29:33] [SPEAKER_03]: April 30th on our live stream and I believe your boat was out at sea you were resisting soft

[00:29:38] [SPEAKER_03]: landing island you weren't sure where you're going to go can you just update us on where you are now

[00:29:42] [SPEAKER_05]: yeah it's still unclear to me um I think the the what what happened I think

[00:29:49] [SPEAKER_05]: sometime in June maybe or far like June sorry early June is we started getting weak data

[00:29:55] [SPEAKER_05]: um inflation data's had been coming down it continued to come down and wasn't as hot as it

[00:30:03] [SPEAKER_05]: had been in the early part of the year that gave you know that was good that good for markets

[00:30:12] [SPEAKER_05]: good for the economy etc but we started getting weak growth numbers and that by and large has

[00:30:20] [SPEAKER_05]: continued you know there's been some good numbers and some bad numbers the most recent

[00:30:24] [SPEAKER_05]: number was last Friday which caught the market sorry Friday before last which caught the market um

[00:30:31] [SPEAKER_05]: and long and caused a sell-off which then followed through on Monday was the NFP which was soft

[00:30:39] [SPEAKER_04]: and so the economy is heading toward some sort of landing

[00:30:50] [SPEAKER_05]: and I'm not sure what kind it'll be um and I'm not sure that inflation is necessarily

[00:30:58] [SPEAKER_05]: going to allow the the Fed and policymakers in general to cut as much as they would

[00:31:06] [SPEAKER_05]: in the face of a weakening economy but and I think this is the most important thing

[00:31:11] [SPEAKER_05]: um for months now we've been focusing on the second decimal place of inflation data

[00:31:17] [SPEAKER_05]: um it's not it's not important whether you know it comes in at consensus of point two

[00:31:24] [SPEAKER_05]: or not it matters if it's point one eight rounded to point two or point two two rounded to point

[00:31:31] [SPEAKER_05]: two up or down that tells you that people are done talking about inflation so we have CPI

[00:31:39] [SPEAKER_05]: on Wednesday and PPI tomorrow um I think that the the narrative around inflation has shifted

[00:31:49] [SPEAKER_05]: to it's not a big deal anymore now I could possibly have consequences but

[00:31:55] [SPEAKER_05]: the more important thing is what's been put in its place and that is weakening jobs because the

[00:32:01] [SPEAKER_05]: Fed's mandate is a jobs uh you know full employment and stable prices and they've told

[00:32:07] [SPEAKER_05]: us that they're certainly Powell has told us but many other on the Dover side Fed members

[00:32:13] [SPEAKER_05]: have told us that you know they're uh um balanced they see the economy is balanced and there are

[00:32:20] [SPEAKER_05]: risks to the downside regarding um jobs and they are paying a lot of attention to the employment

[00:32:26] [SPEAKER_05]: situation now that seems right that seems to be the thing that could be next um

[00:32:38] [SPEAKER_05]: how's the market reacted the markets reacted to immediately pricing in uh 50 percent chance of

[00:32:46] [SPEAKER_05]: a 50 basis point cut on in September and a total of 125 basis points cuts um in 2024 which the Fed

[00:32:55] [SPEAKER_05]: based on data they had in June was saying there was only going to be a single cut

[00:33:02] [SPEAKER_05]: so the market has headed to recession island it's it's on the on island um and so I don't know

[00:33:10] [SPEAKER_05]: what to expand but yet equity prices haven't really corrected much so I don't know what to expect for

[00:33:16] [SPEAKER_05]: the you know my outlook for the economy is it's probably not as bad as people are pricing in

[00:33:22] [SPEAKER_05]: terms of the fixed income market um there is a reasonable pop pop possibility that inflation

[00:33:29] [SPEAKER_05]: continuing to go down won't move markets but inflation bouncing will in a negative sense

[00:33:37] [SPEAKER_05]: to bond market and so I'm worried about a hot inflation print and for that matter I'm worried

[00:33:45] [SPEAKER_05]: about a you know not worried I think it'll be good that the economy will be stronger than

[00:33:50] [SPEAKER_05]: people are pricing and so um that's how I'm positioning which is two year notes anticipate a recession

[00:34:02] [SPEAKER_05]: um a significant cutting cycle and stocks anticipate a soft landing um and there's still a possibility

[00:34:13] [SPEAKER_05]: that inflation isn't dead and so to me being short both stocks and and um two year notes is the best

[00:34:20] [SPEAKER_05]: risk award at this stage whether we're in the midst of the deleveraging whether the deleveraging

[00:34:26] [SPEAKER_05]: is done whatever that seems to be the best bet and we seem to have been trapped in this cycle where

[00:34:32] [SPEAKER_03]: you know we get bad news they price in more cuts things get a little bit better and then the

[00:34:37] [SPEAKER_03]: cut the cuts go away it seems like this just keeps happening over and over again yeah I mean

[00:34:40] [SPEAKER_05]: it's unclear to me whether you know so 10 year notes are below 4% they were at 5% and on Halloween

[00:34:47] [SPEAKER_05]: uh they rallied from five to four then they rallied from then they moved from four to

[00:34:54] [SPEAKER_05]: 4.8 now they're back to four okay that has an impact on the economy that doesn't lag very much

[00:35:01] [SPEAKER_05]: and so part of the reason why I'm more optimistic short term on the economy

[00:35:06] [SPEAKER_05]: and why I don't think we're heading to a imminent recession is the easing that has occurred

[00:35:13] [SPEAKER_05]: mortgage rates I saw mortgage rates broke broke 6% um some form of mortgage broke 6% today um

[00:35:23] [SPEAKER_05]: that's going to unlock some housing activity I suspect so you know I'm not willing to say

[00:35:29] [SPEAKER_05]: that we're heading to a recession and I'm certainly not willing to trade based on it

[00:35:33] [SPEAKER_05]: because except for being short stocks there's no opportunity in the bond market in the

[00:35:41] [SPEAKER_05]: treasury market to bet on a recession it's already priced did you think there was an overreaction to

[00:35:47] [SPEAKER_03]: that jobs report um I mean it seemed like some of the stuff might have been temporary do you think

[00:35:50] [SPEAKER_05]: the market maybe priced too much in after that so I think the big point is that um we're in the

[00:35:56] [SPEAKER_05]: midst of a deleveraging and positioning was off sides for a world that could either be

[00:36:02] [SPEAKER_05]: a recessionary on the stock side um and what happened in a deleveraging what happens in

[00:36:09] [SPEAKER_05]: a deleveraging is people who are long stocks and say I don't want to be long stocks anymore

[00:36:16] [SPEAKER_05]: whether they're leveraged or not have to sell and have to buy something they can't just say well

[00:36:25] [SPEAKER_05]: I'm going to take bills like like literal money hard money to um but as receipt or I'm going to

[00:36:33] [SPEAKER_05]: either take a bank deposit or I'm going to buy bills or I'm going to buy two-year notes

[00:36:37] [SPEAKER_05]: I'm going to buy something and so I think the squeeze on the front end was entirely people

[00:36:43] [SPEAKER_05]: just rushing to cash not having a um not pairing so much about what they were pricing in like think

[00:36:53] [SPEAKER_05]: about real dudes who are selling their stocks and need something to put it in are they really

[00:36:58] [SPEAKER_05]: focusing on the the dime they would they would should say that would price the um the two-year note

[00:37:09] [SPEAKER_05]: more like the the appropriate fed path or are they saying just give me the two-year note it's

[00:37:16] [SPEAKER_05]: you know it doesn't matter to me what it what price I buy it at I'm just gonna buy it and

[00:37:21] [SPEAKER_05]: so I think there was a completely inelastic bid for short-term interest rates that

[00:37:27] [SPEAKER_05]: you know those who bet on the fed's path in a leveraged way are saying fine you know if you

[00:37:35] [SPEAKER_05]: want to pay up great they they've begun selling and it's now come back in a little bit but

[00:37:41] [SPEAKER_05]: um the market is in the deleveraging and you're going to still continue into

[00:37:46] [SPEAKER_05]: see demand for two-year notes even if they're 50 basis points wrong in price because

[00:37:53] [SPEAKER_05]: 50 basis points wrong is nothing when you're thinking about getting out of a stock that's down 10%

[00:38:02] [SPEAKER_03]: going back to inflation one of the things I've learned from you which I think is really great

[00:38:06] [SPEAKER_03]: is your script for killing inflation and how that process will work out can you just talk

[00:38:10] [SPEAKER_03]: about what that script is and maybe where we are in it right now yeah so my expectation was

[00:38:14] [SPEAKER_05]: and it so far it hasn't played out um as I expected you know when I wrote that it was

[00:38:20] [SPEAKER_05]: over a year ago and it was into what I thought needed to happen and what I thought needed to

[00:38:24] [SPEAKER_05]: happen is that long-term interest rates the curve needed to bear steep now it turned out it did for

[00:38:30] [SPEAKER_05]: three months and equity started to fall and I was fairly confident that we were going to

[00:38:36] [SPEAKER_05]: kill inflation the way you kill inflation is asset prices fall enough so that you no

[00:38:43] [SPEAKER_05]: longer have cheap financing for corporations to build for homeowners to buy new homes for consumers

[00:38:53] [SPEAKER_05]: to spend cash when they can um sorry borrow cat borrow to consume and people's wealth is down

[00:39:02] [SPEAKER_05]: because all asset prices have fallen that tends to kill demand and we were on that path

[00:39:09] [SPEAKER_05]: leading into Halloween and at that point both the treasury and the fed got very concerned about the bond

[00:39:17] [SPEAKER_05]: market sell off and the the data that had started to be impacted by this um these higher rates

[00:39:26] [SPEAKER_05]: and pivoted and so the script was thrown back to day one where it was unclear when the

[00:39:36] [SPEAKER_05]: recession would come when inflation would be dead when demand would be uh would decline

[00:39:43] [SPEAKER_05]: and I'm still not sure it's there you know I look at um financial conditions they are very easy

[00:39:49] [SPEAKER_05]: which should support the economy and keep inflation sticky but I might be wrong um and so

[00:39:57] [SPEAKER_05]: what I'm looking for is to know that the script has not yet played out and inflation is not

[00:40:02] [SPEAKER_05]: dead I need to see inflation not being dead yet and so that's what I'm I it could be over inflation

[00:40:09] [SPEAKER_05]: couldn't be over I don't think it is but if it is that's very bearish for the economy the uh

[00:40:17] [SPEAKER_05]: and in particular very bearish for the stock market not so bearish for the economy sorry

[00:40:23] [SPEAKER_05]: I misspoke fine for the economy but bearish for the stock market because they've been counting

[00:40:27] [SPEAKER_05]: on significant nominal growth and without inflation and with slow growth you don't get the sort of

[00:40:34] [SPEAKER_05]: earnings expectations that are built into stock prices this is one of the things I learned talking

[00:40:39] [SPEAKER_03]: to you and and to other people we've had in the podcast is this idea of the importance of

[00:40:42] [SPEAKER_03]: thinking in probabilities um you're you're not saying inflation you know people want to say

[00:40:46] [SPEAKER_03]: inflation's dead or where I have a recession tomorrow like so much of this is just probabilities

[00:40:50] [SPEAKER_03]: of what might happen and you know trying to figure those out and try to figure out what

[00:40:54] [SPEAKER_03]: the most likely probabilities are and then positioning for that right and the best part

[00:40:57] [SPEAKER_05]: about it is the market tells you what they think the probability is and so you when you trade your

[00:41:05] [SPEAKER_05]: um and before in a market timing alpha sort of way betting sort of way you get the market

[00:41:11] [SPEAKER_05]: odds and you compare them to what you think the real odds are if you're investing in any other

[00:41:17] [SPEAKER_05]: way how are you thinking about your investment the market is telling you the odds of various

[00:41:24] [SPEAKER_05]: outcomes in its price and either you have to bet that someone else is going to make the bet

[00:41:33] [SPEAKER_05]: you're betting at worse odds meaning the price you got in is good and they're gonna pay you

[00:41:40] [SPEAKER_05]: a higher price and you're gonna get out or the odds of the thing that you're betting on

[00:41:46] [SPEAKER_05]: is um higher than the market's paying and to me that's what investing is about

[00:41:54] [SPEAKER_03]: and when you when you think about the islands in that framework I mean do you think about

[00:41:57] [SPEAKER_03]: like the probabilities of each of we've got the soft landing island we've got higher for

[00:42:01] [SPEAKER_03]: longer island we've got recession island do you think of those being fairly equal right

[00:42:04] [SPEAKER_05]: now or do you think one is is the leading candidate um so again what I think versus what's

[00:42:12] [SPEAKER_05]: priced at what's priced in is zero essentially a zero probability of significant rate hikes

[00:42:20] [SPEAKER_05]: because inflation isn't dead that would be or even a long pause we're expecting 200 basis

[00:42:26] [SPEAKER_05]: points of cuts in the next 12 months there's nothing priced for higher for longer so the

[00:42:33] [SPEAKER_05]: probability is zero I think it's higher than zero um recession

[00:42:41] [SPEAKER_05]: you know I think we're priced at about a 50% odds of a recession uh imminently maybe it's not that

[00:42:48] [SPEAKER_05]: high maybe it's 35 40 but high imminent recession and I think the odds of that are much lower

[00:42:56] [SPEAKER_05]: what's the number I don't know 20 25 percent um you know that leaves the soft landing and

[00:43:08] [SPEAKER_05]: I think there's I I know these probabilities won't add up I don't think there's a chance

[00:43:14] [SPEAKER_05]: that we end up having a soft landing so what the way I think about it is market pricing

[00:43:19] [SPEAKER_05]: may stay at a soft landing until it deviates and so betting against a soft landing is

[00:43:26] [SPEAKER_05]: there's a pretty high odds bet but you know the market's really placing a high probability of a soft

[00:43:33] [SPEAKER_05]: landing and it's pricing I think that probability is very low and will look like a soft landing

[00:43:40] [SPEAKER_03]: until it's not or we're talking about the Fed and what's priced in in terms of what they might do

[00:43:44] [SPEAKER_03]: I'm just wondering what you think they should do like if you were in their position right now

[00:43:48] [SPEAKER_03]: it seems like the data is a little bit uncertain as to what we're seeing you know they did

[00:43:52] [SPEAKER_03]: have there's been significant rate hikes over time I mean is there a case to be made to try to

[00:43:56] [SPEAKER_03]: slowly bring things back down to minimize the risk of recession or how do you think about that

[00:44:00] [SPEAKER_05]: yeah I mean it's I think it's what they should do what they should do is follow that look at the

[00:44:05] [SPEAKER_05]: data and think about it in a appropriate way and I think mostly they do that um what I think

[00:44:12] [SPEAKER_05]: they should do is pay a bit more attention than what they do pay attention to and that is

[00:44:19] [SPEAKER_05]: the effect of long-term interest rates versus the effect versus the short-term interest rate mechanism

[00:44:29] [SPEAKER_05]: and so that's what I think they should do they should pay attention to the potential

[00:44:35] [SPEAKER_05]: that low long-term interest rates makes a big difference and high long-term interest rates

[00:44:43] [SPEAKER_05]: makes a big difference to the economy whereas in this economy where bank deposits are sticky

[00:44:54] [SPEAKER_05]: and don't respond to big shifts in the front end and in which most borrowing is done longer turn

[00:45:02] [SPEAKER_05]: and in which most private sector investors borrowers are flush with money from wages

[00:45:09] [SPEAKER_05]: or asset appreciation you know in out of macro sense obviously some people are doing having very

[00:45:14] [SPEAKER_05]: difficult times short-term rates just don't matter much and I think they overemphasize that so

[00:45:21] [SPEAKER_05]: that's what I think they should do and then they should focus on the data but if you took

[00:45:27] [SPEAKER_05]: so they will focus on the data and we'll see how it plays out we've got a couple of CPIs

[00:45:33] [SPEAKER_05]: and a couple and an NFP between now and the next Fed meeting we have Jackson Hole we'll see what they do

[00:45:44] [SPEAKER_05]: but I would like to see them focus more on the influence on the economy of long-term interest

[00:45:50] [SPEAKER_05]: rates and then if they begin to see that that's an important factor take policy steps to

[00:46:01] [SPEAKER_03]: address that factor so that would be more QT right then playing around with short-term interest

[00:46:07] [SPEAKER_05]: rates well I actually think what they what they there are two things that I let me just say exactly

[00:46:12] [SPEAKER_05]: what I think they should do I think they should stop reinvesting the proceeds of their

[00:46:19] [SPEAKER_05]: balance sheet runoff in anything but bills which means they stop adding on 10 years stop

[00:46:28] [SPEAKER_05]: adding on 30 years and that would force the treasury if presuming they still want to sell as many 10s and

[00:46:35] [SPEAKER_05]: 30s to sell more to the private sector which would have an influence on the this curve that is still

[00:46:42] [SPEAKER_05]: disin that would disinvert the curve it wouldn't have any impact on reserves because that's

[00:46:49] [SPEAKER_05]: reinvestment and then to the extent that it's not working and inflation stays sticky at that point

[00:46:58] [SPEAKER_05]: they could and this is not QT it's what we call a twist they could because QT reduces bank reserves

[00:47:06] [SPEAKER_05]: and you know bank reserves are still very ample but they could get you know over the next year

[00:47:11] [SPEAKER_05]: they will get tight and in order to continue to wind down their balance sheet and affect

[00:47:18] [SPEAKER_05]: long-term interest rates the treasury could the Fed could sell some of their long-term bonds

[00:47:25] [SPEAKER_05]: and particularly their mortgages which they've said they don't want to own

[00:47:29] [SPEAKER_05]: and reinvest the proceeds in bills and if they were to do that that would have no impact on

[00:47:36] [SPEAKER_05]: bank reserves so those are a couple of ideas it's essentially reducing the duration of the

[00:47:44] [SPEAKER_05]: treasury of the Fed without cutting reserves and that's what I think they should do will they

[00:47:51] [SPEAKER_05]: do it they don't believe that the long end they they are unwilling except in one for one

[00:47:57] [SPEAKER_05]: month in October to even acknowledge the impact of long-term interest rates on the economy

[00:48:06] [SPEAKER_03]: when you think about inflation long term you know outside of this episode we're dealing with

[00:48:10] [SPEAKER_03]: right now like how do you think about that now like I think you know from from my own

[00:48:13] [SPEAKER_03]: perspective coming into this before we had any inflation I was thinking about you know

[00:48:17] [SPEAKER_03]: technology and demographics and globalization as these trends that were putting downward

[00:48:21] [SPEAKER_03]: pressure on inflation but I assume that world is over and globalization is definitely going

[00:48:25] [SPEAKER_03]: the other way so how do you think about like where inflation goes long return

[00:48:30] [SPEAKER_05]: I think of it the same way my framework for inflation is pretty straightforward it comes

[00:48:34] [SPEAKER_05]: in from three different places supply of goods and services demand for goods and services

[00:48:41] [SPEAKER_05]: and what I call monetary inflation which is the creation of money and credit and the last one

[00:48:48] [SPEAKER_05]: when money and credit is created that is and handed to the economy that is generally inflationary

[00:48:57] [SPEAKER_05]: because there's more money to buy the same amount of goods and services so the price goes up

[00:49:04] [SPEAKER_05]: then there's demand which to me is you know you mentioned demographics that's certainly one

[00:49:09] [SPEAKER_05]: thing but you know that can shift based on taste you know certain economies are profligate

[00:49:17] [SPEAKER_05]: spenders and other economies are spendthrift spendthrift is I think that might be the wrong

[00:49:24] [SPEAKER_05]: usage I think so anyway cheap don't want to spend their money and you know Japan is a good

[00:49:32] [SPEAKER_05]: example of an economy that is just savers they're just savers by nature now you've add in

[00:49:40] [SPEAKER_05]: the government as a spender and you can get demand side inflation which just people decide to

[00:49:50] [SPEAKER_05]: dissape and spend and then there's the supply side which is you know what how much output can the

[00:49:59] [SPEAKER_05]: humans and their machines generate and in a in globalization and automation

[00:50:07] [SPEAKER_05]: you had an environment where people that were not productive were able to make socks

[00:50:14] [SPEAKER_05]: and that created a huge benefit for the sock industry and socks got cheap and

[00:50:22] [SPEAKER_05]: depleted because we've got all our socks in China a lot of that is played through

[00:50:30] [SPEAKER_05]: and so now you're in a world in which we have allies that we can't and this is the

[00:50:36] [SPEAKER_05]: deglobalization idea and I don't think it's actually happening much but at any point in time we could have a

[00:50:44] [SPEAKER_05]: deglobalization supply chain constraint and that can be inflationary but I think the

[00:50:51] [SPEAKER_05]: one you're the thing that we're not discussing is obviously AI which has the potential of reducing

[00:50:59] [SPEAKER_05]: the amount of humans you need to create the same amount of output or increasing the amount of

[00:51:05] [SPEAKER_05]: output for the same number of humans and the same costs you know that's deflationary so you know I just

[00:51:11] [SPEAKER_05]: look at each of those things and say the future could be one in which AI productivity creates a

[00:51:22] [SPEAKER_05]: strong enough anti-inflationary worse on the supply side despite monetary money creation inflation

[00:51:30] [SPEAKER_05]: and despite government spending we could see aggregate disinflation or low inflation

[00:51:41] [SPEAKER_05]: but right now we're not getting any of that productivity and so I don't see the supply side

[00:51:50] [SPEAKER_05]: disinflationary impulse as being very long-lasting at this stage.

[00:51:55] [SPEAKER_03]: Yeah AI is something I have a hard time thinking about because I think back to the

[00:52:02] [SPEAKER_03]: very different things and it's going to be the same thing here with AI like I don't think any of us

[00:52:05] [SPEAKER_03]: understand exactly what it's going to be but trying to think about that in terms of inflation I

[00:52:09] [SPEAKER_03]: think is it's tough thing to do because we just don't know at this point it's obviously I don't

[00:52:13] [SPEAKER_03]: know if you've used it a lot I've used it a lot it's a pretty incredible technology but

[00:52:16] [SPEAKER_03]: what it means for the economy I have no idea. Yeah I mean I've been using

[00:52:22] [SPEAKER_05]: computers to do analysis systematically for many decades and this is a leveling up of that sort of

[00:52:33] [SPEAKER_05]: thing from and part of that is the compute power has leveled up. I don't I have no idea I have no

[00:52:42] [SPEAKER_05]: idea how what the five-year impact on disinflation and productivity will be. I do know that there is a

[00:52:51] [SPEAKER_05]: tremendous amount of money being spent which is inflationary today on chips, on servers, on racks,

[00:53:04] [SPEAKER_05]: on everything that on people who can help in the development of AI so wages for certain people

[00:53:12] [SPEAKER_05]: and that's creating an inflationary pulse without yet a significant with no productivity increase

[00:53:22] [SPEAKER_05]: of any meaning. And so I just look at it for now we can spec I'm not a futurist

[00:53:28] [SPEAKER_05]: though I love engaging in futurism and thinking about what the future could be.

[00:53:35] [SPEAKER_05]: I don't place any value at all in them for either my accuracy and certainly not for my investment

[00:53:41] [SPEAKER_03]: strategies. I'm just curious are you finding like in your everyday life or in your business

[00:53:45] [SPEAKER_03]: that you're using things like chat GBT a lot? Not really you know I've tested a more like

[00:53:50] [SPEAKER_05]: tested Claude chat GBT, perplexity, half a dozen others and you know to me the large language model is

[00:53:59] [SPEAKER_05]: not a particularly interesting usage of what I do usage for productivity enhancement.

[00:54:11] [SPEAKER_05]: And like a lot of things that I've seen they look pretty damn cool for people who are not subject

[00:54:20] [SPEAKER_05]: matter experts and subject matter experts are like holy moly these things are so wrong so often

[00:54:28] [SPEAKER_05]: that they're essentially useless for subject matter expert. Yeah, I feel like just like you

[00:54:33] [SPEAKER_03]: said I mean stuff like that it probably does not work but day to day stuff like for instance

[00:54:37] [SPEAKER_03]: the summary of this podcast for YouTube will be done by Claude because Claude does a really good

[00:54:41] [SPEAKER_03]: job of it actually and then I make some minor changes or like the time stamps on YouTube

[00:54:45] [SPEAKER_03]: can be done by Claude so those aren't things that are revolutionized the economy but they

[00:54:48] [SPEAKER_03]: are things that took me a bunch of time before and these things are getting better and better

[00:54:52] [SPEAKER_03]: and better at doing that. I think that is fantastic. I even like the movie stuff you know that

[00:54:58] [SPEAKER_05]: the deep fakes and the you know the creative stuff that what was the thing that

[00:55:06] [SPEAKER_05]: chat that open AI created anyway Ergo or I don't remember anyway the thing that makes videos you

[00:55:16] [SPEAKER_05]: know I think the creative you know let me just say this I think you would have done

[00:55:24] [SPEAKER_05]: I think you still do a better job than chat GPT done then Claude does in summarizing this episode

[00:55:30] [SPEAKER_03]: I think that's right um yeah so I still have to tweak it a little bit but it's relative to

[00:55:34] [SPEAKER_03]: like and I could probably do the time stamps a little bit better too but relative to you know

[00:55:38] [SPEAKER_03]: it can get me 90% of the way there I think that's when you when you put the human together with

[00:55:42] [SPEAKER_03]: it I think that's probably where it's at its best. Yeah I agree with that completely.

[00:55:46] [SPEAKER_05]: I don't use it because I can't afford to have

[00:55:51] [SPEAKER_03]: mistakes in that type of stuff but if I go put a summary of your podcast up there and

[00:55:55] [SPEAKER_03]: makes up some place you worked in the past like I can't let that be in there so obviously I still

[00:55:59] [SPEAKER_03]: have to read all of this stuff and I have to supplement all of this stuff but it it probably

[00:56:03] [SPEAKER_03]: reduces the work by you know 80% that's who doing those things so that to that from that

[00:56:08] [SPEAKER_03]: perspective it's an advantage. Yep absolutely. Just one more you've been very generous giving us

[00:56:12] [SPEAKER_03]: an hour your time here I just wanted to ask you one more because I it was going on on Twitter

[00:56:15] [SPEAKER_03]: recently I want to ask you about market analogs because we see this a lot we see people looking

[00:56:20] [SPEAKER_03]: at certain periods in the market in the past and saying you know what can I learn from that

[00:56:24] [SPEAKER_03]: and you know obviously at the extreme people say it's just going to repeat itself which isn't right but

[00:56:28] [SPEAKER_03]: it's more on the other side of like what can I learn from this what can I take from this and one

[00:56:32] [SPEAKER_03]: of the ones we saw recently was this 1998 example and I was wondering if you could talk about that

[00:56:36] [SPEAKER_03]: a little bit about that a little bit like how do you think there's a comparison in 1998 with

[00:56:39] [SPEAKER_03]: what we're seeing right now do you think there's something we can learn from that.

[00:56:45] [SPEAKER_05]: So I use I use history to build frameworks what mattered to things that are generally common

[00:56:56] [SPEAKER_05]: it I gave you my framework for deleverages and the way you come up with that framework is you say

[00:57:05] [SPEAKER_05]: what mattered and you know how does each one of these examples differ and in what way and that

[00:57:16] [SPEAKER_04]: creates a framework and then you can but at the so once you have a framework that's about

[00:57:26] [SPEAKER_05]: as much as you can draw from it you can think about what happened and why and how things are

[00:57:33] [SPEAKER_05]: similar and different but you know things like fractals and charts that look the same

[00:57:42] [SPEAKER_05]: I don't get much value out of that and the statistical probability of any analog being

[00:57:53] [SPEAKER_05]: predictive of a future is very low so I like to just say we don't know anything and the market

[00:58:02] [SPEAKER_05]: will definitely the markets in the economy will definitely behave differently but you know what is

[00:58:07] [SPEAKER_05]: going on what is going on and in 1998 what was going on was a large hedge fund unwinding

[00:58:24] [SPEAKER_05]: other hedge funds having similar positions unwinding some of them unwinding early

[00:58:33] [SPEAKER_05]: before LTCM did some still in the midst of drawdowns from 1997's currency issues in Asia

[00:58:43] [SPEAKER_05]: and others very recently in the midst of drawdowns in Russia and so but one poster child who had

[00:58:53] [SPEAKER_05]: the biggest most leveraged positions unwinding and when that happens certain deleveraging things occur

[00:59:04] [SPEAKER_05]: including typically an equity drawdown and so we saw that and then was it impactful to the economy

[00:59:13] [SPEAKER_05]: almost no zero for no way was it impactful to the economy so from my framework there

[00:59:19] [SPEAKER_05]: didn't require central bank action and yet the central bank took aggressive action including a

[00:59:26] [SPEAKER_05]: surprise cut and the total of 75 basis points of cuts and arranged the bailout of LTCM

[00:59:37] [SPEAKER_05]: forcing 14 banks to pony up three and a half billion dollars and that was a fairly for

[00:59:49] [SPEAKER_05]: was that the drawdown was relatively short and the impact on the economy was actually pretty

[00:59:59] [SPEAKER_05]: long lasting in that they probably overstimulated and contributed to what was happening in the next

[01:00:05] [SPEAKER_05]: two years so similarly so what's the similarities and differences I don't see any similarities to

[01:00:14] [SPEAKER_05]: today pretty much across the board unless there's some whale that's getting killed in the last few

[01:00:24] [SPEAKER_05]: weeks that is very concentrated and needs to be bailed out and has positions that are

[01:00:33] [SPEAKER_05]: and banks have positions that are similar there's just nothing like that going on

[01:00:39] [SPEAKER_05]: and and yet if the central banks if Japan really does decide to let monetary policy

[01:00:49] [SPEAKER_05]: go on pause despite data that gets hot which I don't think they will but if they were to and

[01:00:57] [SPEAKER_05]: the US cut 50 basis points for each meeting for the next three meetings

[01:01:03] [SPEAKER_05]: and the other two things yeah we're gonna equity markets are gonna rip gold's gonna rip you know bonds

[01:01:09] [SPEAKER_05]: aren't gonna do great but you know they're gonna be dragged down by the front end and it's gonna

[01:01:14] [SPEAKER_05]: be an asset rally so you know I'm gonna I don't think the Fed will do any of those things I don't

[01:01:19] [SPEAKER_05]: think any central bank will react to what's happened the last few weeks but you know that's

[01:01:27] [SPEAKER_05]: the thing to look for you look for was the problem taken care of check was the problem systemic

[01:01:38] [SPEAKER_05]: a little bit but you know mostly it was taken care of and how strong was the response despite an

[01:01:45] [SPEAKER_05]: economy that had really that had no effect very high and if you look at 98 and you see that

[01:01:52] [SPEAKER_05]: the actions are similar to what the actions of central banks were in 98 you know what to do we're

[01:01:58] [SPEAKER_03]: going into a hyper bubble well any thank you this has been awesome if people want to find out more

[01:02:04] [SPEAKER_03]: about you and damp spring where can they go damp spring dot com and on twitter great thank

[01:02:10] [SPEAKER_01]: you so much I really appreciate it all right jack anytime this is just an again thanks so much

[01:02:14] [SPEAKER_01]: for tuning into this episode of excess returns you can follow jack on twitter at practical

[01:02:19] [SPEAKER_01]: quant and follow me on twitter at JJ carpenter if you found this discussion interesting and valuable

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