Odd Lots - Viktor Shvets on How the Fed Has Become a Prisoner of Its Own Making

Episode Date: May 13, 2024

This week, we'll get fresh inflation data in the US, which will inevitably feed into the Federal Reserve's future decisions to raise, hold or lower benchmark interest rates. Meanwhile, the Biden administration is preparing to announce new tariffs aimed at curbing Chinese imports in key industries, including electric vehicles, batteries and solar cells. On this episode, we speak to Odd Lots favorite Viktor Shvets. The Macquarie strategist has a way of threading the needle between major global events and reaching back into history to provide context for our current macroeconomic moment. He describes the US central bank as a prisoner of its own policies, namely data dependency and the "dot plot." Meanwhile, China faces "massive" overcapacity problems as more and more countries put up barriers to its exports. We also talk about generational shifts and what they mean for investment.See omnystudio.com/listener for privacy information.

Bloomberg Audio Studios. Podcasts, Radio News. Hello and welcome to another episode of the Oddlots podcast. I'm Tracy Allaway. And I'm Joe Wisenthall. Joe, did you watch the FOMC presser recently? No, I did not because we were recording an episode of the Odd Lots podcast. What happened? So I know that you didn't watch it either. Unless you watched it on video afterwards, in which case you are a better journalist than I am. I didn't, just to clear that up. What I did was I read a bunch of,

of analysis of the Fed meeting and a bunch of news summaries of what happened. And I have to say there was one term that I really liked, one description. I think it was in the FT, and they sort of describe the Fed as a monument to stasis. I mean, that could be a good thing. First of all, by the way, plug, the other thing you can do if you miss a presser on the Bloomberg terminal. And I forget the code right now, but they produce transcripts very fast. And the transcripts aren't published of the press conferences. Like, they don't appear anywhere. So, plug for our terminal here. But yes, look, it's been a weird year for the Fed, right? Because, I mean, inflation continued at least through Q1 of the year, inflation harder than expected,

all these expectations of cuts, keep getting priced out, everyone's higher for longer. It's unclear whether the sort of simple models that we use, like, I mean, I think everyone sort of knows this. Nobody really knows how inflation works. But everything seems to be okay, right? I think one of the issues that the Fed might be facing is they put so much emphasis on data dependency, that it kind of means that like every monthly reading of CPI can generate a completely different response. So when CPI comes in stronger than expected, everyone starts panicking about a lack of rate cuts and maybe even you get a rate hike at some point. When it comes in weaker than expected, you know, as it was doing up until fairly recently, everyone gets

very excited and we get that kind of Goldilocks moment in equities. There does seem to be like this weird tension between, I know they don't use like formal forward guidance anymore, but in a way the dots sort of serve that purpose and sort of imply the fed so-called reaction function. And so we're supposed to sort of take all of these data point, plug them into this black box reaction function and then sort of implicitly see what that means for policy. But it does seem like things move a lot from data point to data point. So it becomes very present-oriented. Yes, that's a great way of putting it.

And then the other thing I would say is in addition to all the complexity around what's going on with the U.S. economy. And it's kind of phenomenal in many ways that we're still having intellectual arguments about what the impact of higher interest rates actually is and whether or not it actually does anything to bring down inflation. But beyond that, the other thing that's starting to happen is we are seeing international consequences, and we've been talking about them on the show, of the higher for longer stance. So the dollar has been rising. I think the spot dollar index is up almost 4 percent so far this year. And then against

specific currencies like the Japanese yen, it surged even more. And so we are seeing those tensions between strength in the U.S. economy, you know, ongoing inflationary pressures, higher rates for longer, potentially kind of meet emerging markets. and also developed economies in the wider world. Totally. You know, we had that interview recently with Hugh Hendry, extremely colorful character, to say the least. But one of the points that I found very interesting

was like, we're not really used to an environment in which it's the U.S. that's out, that's lapping everyone else, growing much faster than G7 or G10 or G whatever peers, sort of powering ahead, all this domestic investment. And so we get this upward pressure, higher rates, higher dollars, stress elsewhere. It's an interesting environment. G-whatever is a good term. They should have a G-whatever conference. Can I coin that? Because I know Ian Bremmer has the G-Zero. But like I don't, I like G-Whatever. The G-Whatever Summit. That should be a thing.

Any country can come. Okay. But when we want to connect the dots between what's happening with central banks around the world between the U.S. economy and the Fed and the global macro-situations. there's one person that we like to call in particular. So today we are bringing back Victor Schwetz. He is, of course, a strategist over at McCory, and we love talking to him. So Victor, thank you so much for coming back on all thoughts. Thank you for having me. Remind us before we begin. It's not just us, right? The data dependency of the Fed, they have emphasized that a number of times. And to some extent, it seems like it is coming back to haunt them whenever there is a stronger than expected inflation print. And then we had payrolls since CPI, and payrolls came in, you know,

lower than expected for the first time in ages. And everyone got really excited about that. You're absolutely right, Tracy, that what essentially we have is a Federal Reserve as a prisoner of policies they start putting in a couple of years ago, which is essentially being extremely data dependent rather than forward-looking. There is another problem, and that's the dots, one of the most destructive instruments from Bernaki era. So it's not anything to do with Jay Powell. I think if he could, he would have got rid of dots today. The problem he has is that the volatility getting rid of dots probably will be greater than the volatility dots themselves are creating. So he's trying to denigrate it by arguing that dots degenerate almost immediately as soon as they are published.

So he's trying to take out tension away from dots. But as long as they are published, they are the materials. So you've got a data dependency on the one side, which is basically a dependency on a backward-looking or at best contemporaneous numbers that you have. You also have a lot of faulty numbers, whether it is how you determine shelter expenses or owner-equivalent rent, how do you relate secondhand car prices, how do you measure insurance policy or financial markets, but there is also major problems with Bureau of Labor Statistics. I mean, I'm glad that they've increased or revised hours work last week, which basically showed that productivity miracle wasn't really there.

So you have quite a faulty numbers, both from Bureau of Labor statistics on a labor market, you have mostly backward-looking or contemporaneous numbers in terms of inflation. And if you become data dependent, you're starting to create exceptional volatility because you're basically like a deer in a light. You're stuck. You are, you cannot move to the left. You cannot move to the right. Now, what I think Jerempal is doing quite well is trying to introduce some degree of forward guidance. So essentially what he's saying and what he said last week is that if I think of the shelter expenses, they're not quite as bad as a number's low. And he is absolutely right. If he talks about other service-oriented numbers, again, whether it's insurance or anything else, he kept emphasizing they're not as bad as what they appear, both in CPI and PCE. And he's been quite vocal that the labor market actually a lot loser than what Bureau of Labor Statistics highlights.

But the problem is, Tracy, if you are a prisoner of data dependency and dots, the chances of committing a policy error increases. And so one of the questions I struggle with whether, in fact, it matters if Federal Reserve does commit a policy error. I feel like we could have a whole episode just on the dots and the problem with this as a communication strategy. Maybe we will. But anyway, it's interesting. You said this. I guess it was either earlier today or yesterday, Minneapolis Fed, Neil Kesh Kari, ended his speech. The final section of his speech, shout out to our old colleague Lou Kawa for flagging this.

This is also a communication challenge for policymakers in my own summary of economic projections, CEP, the formal name for the dots. Submission, I have only modestly increased my longer run nominal neutral funds rate, blah, blah, blah. The step does not provide a simple way to communicate the policy

that the neutral rate might be at least temporarily elevated. DeCode that. What is the issue, as you see it, with the dots? Well, there are a couple of issues. One of them, dots work very well if everything is placid. Not a problem. Whenever you have a high degree of volatility, either externally or internally driven, dots really don't tell you anything because it's really a

personal opinion of several governors. Some are voting, some are not voting right now, and it's not linked to either federal policy. It's not vetted. It's not researched. There is nothing in it. So long as the line of sight is relatively stable, dots are absolutely fine. As soon as you can, get the volatility, they are not. And I think Philip Lowe, who retired as a governor of Reserve Bank of Australia late last year, put it the best way. He said central banks will never see again inflation contained in a narrow range. Now, what it basically means that this idea that you have relatively flatish outlook and you try to manage it on the margin is becoming irrelevant. So, for example, Federal Reserve, at the end of last year, on a number of variables, they went past their

mandate. In fact, they've overachieved their mandate. And if you look at subsequent three, four months, suddenly they're way ahead of their mandate. And that's what Philip Law was highlighting, that from now on, you're going to have a great deal of volatility of those numbers. And I think the dots by themselves magnify that volatility rather than creating a greater sort of clarity for market participants. So why do you say that a Fed policy error might not matter? And I should caveat this with, you know, Joe and I spend a lot of time online and going by some of the, you know, social media discourse. The world basically revolves around whether or not the Fed's going to make a policy error and the bias is always the Fed is doing something wrong in one way or another. But why do you

think it might not matter? Well, I usually say to people, look, we had terrific tightening. We had some withdrawal of liquidity. Could you explain to me how high yield spreads? Only about 3%, which is the lowest ever. How can you explain to me that double B debt is trading at only 2% spreads? How can you explain to me that despite a very significant rise in US dollar, which both of you have just highlighted, that basis swaps are only 5 bibs. They should be more like 50 bips or above. And so to me, the advantage of our era is that first of all, we have too much capital.

In other words, the idea of scarcity of capital that underlines things like DCF calculation or underlines most of the investment decision do not apply when you have too much capital. Now, it is not evenly or fairly distributed by any means, but there is plenty of capital. And the way you can measure it is essentially what is the value of all your financial instruments globally against real underlying economies. And what you find, depending how you do of balance, balance, your commitments, how you do derivatives, you could be looking five to ten times larger than the underlying economies. So we have plench of capital.

What it basically means, no matter what Federal Reserve does, it's very hard to tighten because that capital just keeps circulating, looking for diminishing returns. The second thing we have, and Bloomberg plays a great role in it, is that we have instantaneous repricing. So anybody, any word in the market, it instantaneously gets reprised. And the third thing we have is that central banks are rolling out policies in an incredible speed. They don't even debating what is the outcome of those policies.

or what are the implications of what we're doing? Usually something happens on Thursday and Friday, and by Monday, it's all fixed. And so are we going to have new policies for private capital, private debt, equivalent to what we have for Silicon Valley Bank? Are we going to have special policies for parity trade, basis trade, from some of the niches in a high-yield market? Of course we are. So if you have too much capital, if you're repricing instantaneously, and if central banks

are willing and prepared to plug the holes almost instantaneously. This is a world of no risk. In other words, the way I put it, if the risk is everywhere, the risk is nowhere. And if the risk is nowhere, then you can explain speculation. You can explain the gold price of Bitcoin. You can explain why high yields will be trading at only 3% spreads, because there is no risk. And the reason central banks are doing it, not because they're greedy for power or anything else. There is no shadow you know, deep state or anything like that. The reason they're doing it is because of the dangers of not doing it. If you think of dot com, that was only one asset price going wrong. If you think of GFC, that's really a bigger asset, but only one. Today, you know, landmines are everywhere.

And those landmines, each one of them could be bigger than the original GFC. Wow. And so the result is central banks really don't have a choice. So even if Federal Reserve does commit a policy error, as possible, they can unwind it in split second. The way I describe it in my notes is to say, let's assume you get up, get in the morning, say, oh my God, it's going to be terrible day. By lunchtime, I don't know it's okay. And by evening, let's have a dinner. And the whole thing just evaporated. Now, the key question, however, to ask, what price do we pay for it? And the price we pay for it is this volatility of inflation rates. Is this volatility, it is volatility of the neutral rates. In other words, the way I describe it, risk does not

disappear. It just migrates. So if you keep the market placid, which is what we're doing, risks simply migrate somewhere else. It migrates into politics. It migrates into social sphere. It migrates into geopolitics. And so we do pay a price. We do pay a price for this. But to argue that central bank is committing an error, furniture must be broken, is wrong. Even if they commit the error, which is possible, they can unwind it in 30 seconds. I want to get into maybe migrate the conversations, geopolitics and this migration of risks, because you write a lot very well on that. But just sort of real quickly before we do that, in your view, you describe this world of like so much capital relative to GDP.

You know, and people, you know, they blame QE for stuff like this or whatever. Is there like an original policy sin? And I don't even know if it's a sin. Paul Walker. Okay, explain. So what is this sort of original sin that created this world? of a bundle capital. Well, if you're saying Paul Walker, he's mostly known, of course, for squashing inflation. But if you go back in time, I think his much bigger legacy is creating that system of global recycling of capital and addiction to debt and addiction to asset prices. Prior to 90, well, essentially what happened, we've deregulated the financial sphere.

We've deregulated the regulating capital flow. The idea was that United States will take the money from other people and stimulate consumption. Those other people will be buying treasury bonds, for example, in order to get returns to lower the cost for U.S. consumers, but also to reduce their currency and make themselves more competitive. Now, Paul Walker was expecting that currency eventually will recalibrate this process, but they never did because nobody ever wanted to have an appreciating currency. And so we're stuck in the world of accumulating, I guess, disparities between savings

and spending. In other words, US and the UK consistently net spender, Germany, Netherlands, China, Korea, Japan consistently net sabre. And we've never really rebalanced it properly. So one of the side effects of that was that it become easier and easier to borrow, easy and easier to bring future consumption to the present to maintain your lifestyle. It became easy and easier to multiply credit. Instead of having one instrument per asset, we can now have five instrument per assets, 10. And each one of those instruments can be leveraged yet again and yet again. And so all of that created massive amount of capital. I mean, if you think of the Financial Stability Board, they try to calculate the overall level of financialization. They're usually behind time. They only have

22 numbers. But essentially what they were showing about $500 trillion, and that's based on the net derivatives, and not including any of balance sheet commitments or major ones. And so that effectively was five times global GDP. So that's what started. So if you were to ask one person or one time when that happened, it's really Paul Walker who created our debt and asset-based culture. Now, Greenspan in late 80s, all he did, he took Walker's idea and brought it to logical conclusion. And that was a Greenspan put, which Bernarck and Yellen subsequently maintained. Yeah, it is interesting. I think I might have written a little bit about this in the odd lots newsletter or kind of thought out loud about it. It feels like

we're internalizing the idea that the supply of credit can expand even as the cost of money goes up via benchmark rates, which might not necessarily be a new dynamic, as you just described, but like one that was probably underappreciated. Unintuitive. Yeah, unintuitive and underappreciated until this very moment in time. I want to ask one more thing on the U.S. economy and the Fed before we maybe broaden out the conversation to geopolitics and pressures in other parts of the world. But I remember one of the things I really liked about your framing of the post-pandemic period was unlike a lot of other pundits, you did not go back to the 1970s as your preferred historical analogy. You went back to the 1918 Spanish flu, which resulted in a big run-up in inflation, but then a pretty

rapid deflationary bust. And I'm curious, you know, here we are. in 2024, inflation is still relatively strong. We haven't seen interest rate cuts at all. And as expected, maybe back in late 2022, going into 2023, there were a lot of people who predicted we'd see cuts and recessions. And I think you might have been one of them. But have you been surprised by, I guess, the stubbornness of inflation and the higher for longer scenario in the U.S. And how is that stacking up against that 1918 parallel? Well, the way I look at it, my argument was there will be no recessions in the U.S. There will be no recession globally.

Because we don't have recession, there is nothing to recover from. So don't expect any significant recovery. That's why my global gross rates always pitched at around 2, 2.5%, which is at least 75 basis points less than what we used to have at the previous decade and about 100 basis points less than what we used to have in the past. My view, as you correctly said, that as you have sort of misallocation of demand and supply curves, as we have destabilization of demand of supply curves, gradually winds down, inflation should come out, no need for recession, no need for unemployment, but there is a price we pay, and the price we pay,

there will be no recovery, and there will be more or less a circular stagnation argument globally. Some countries will grow a little bit faster than others, and that will be primarily driven by primary deficits. Because overall deficits don't matter. Primary deficits do. And the U.S. happen to have the highest deficits. U.S. is now running about 3, 3.5% of GDP primary deficits. Europe is less than one. Japan is less than two. So if you have a higher primary deficits, you push up your neutral rates higher compared to, for example, European Monetary Union or Japan. Now, this inflationary trend in the global is still continuing. Now, if you think of our GF, GF, CPI, for example. When we were here last time in late 22, early 23, the number was 5%. In March,

it was 2.4. Now, 2.4, it's only 2030 bibs higher than it was over the previous 25 years. But the leadership changed. If you think of the second half of 23, disinflation in the US was extremely strong. But inflation in Europe, UK and Japan actually was climbing, not down. What you saw over the last four months? Is it inflation? Start breaking in the UK, start breaking in Eurozone, start breaking in Japan. Decentflation got stronger in China as we progress. But in the US, it's stuck and actually gone up a bit. Now, the question is whether that's something unique to United States, or whether, in fact,

in the second half of 24, we're going to relieve what we had in the second half of 23, and the United States will join the rest of the world in a disinflationary trend. That's my base case. Now, what underpins it is neutral rates and productivity. Now, my view is that neutral rate has not changed. Neutral rate is a long-term process. That's why almost all models are still showing that neutral rates in the US are 50 to 100 basis points real, which means policy rate should be closer to three, not five and a half on that basis. But in a short term, you can have a spike in those neutral rates. Now, I do think neutral rate spike, despite the fact that models don't show it. I

seeing it did spike. Now the question is whether it's already coming off or whether somehow we can keep neutral rate at a much high level. One of the key elements there is productivity. Now, I'm not a buyer that there will be any productivity improvements. In other words, labor productivity or multi-factor productivity is not going to recover for at least 10 years, possibly even 20 years. Now, if you take a view that productivity is not going to drive it, then either you have to have much higher primary deficits continuing, or you have to have some other form of shocks in the system in order to drive it up. So if I'm correct that neutral rates have not changed, and it's still 50 to 100 base points real,

then it must be coming up. As it comes off, deflator comes up. Nominal GDP drops from, in the US, it's already down from 12% to 5.4. As it start dropping towards 4%, you can't keep policy rates at 5.5. unless you want to have a recession. That's the only reason to have it. So I'm still in the same camp except as desynchronized or going back to Reserve Bank of Australia.

It's violent, how it moves. Also, one more point, in the US inflation is really in pockets. In 22 or 21, even in early 23, it was all over the place. Right now is just in pockets. So all you need to do is to bring those pockets down to a low level.

I mean, we could also just talk for an hour about why it'll take 20 years before we see a productivity boom. But let's talk a little geopolitics. So this idea, risk has been taken out of the financial system and it migrates elsewhere, maybe to politics, maybe to geopolitics. We're obviously in a moment and you're going to see it by all the trips. People in the administration take trips to China where there's a significant amount of anxiety about China, geopolitically, military to military communication, cooling the temperature, coupled with industrial anxiety, are they going to own the EV market for the entire world, etc.

Draw that line for us. Maybe we'll start there. Draw that line for us between the sort of taking out of financial risk and that migration and how that fits into the China thesis. Sure. Well, one of the things I disagreed with almost everyone over the last two or three years. Remember, the beer was that China is running out of people, and so China will be exporting inflation. Now, my argument all along was China cannot export inflation, their major export of disinflation.

And the reason for that is very simple. China, just like Japan's 70s, 80s has a very high national saving rates. They're running at about 45%. Just like Japan in 70s 80s could have put policies in place to consume it, but they didn't. Neither have China. And so the result is they must invest at least 42, 43% of GDP. Think of the numbers. That's an equivalent of 90%.

to $10 trillion invested every year. It's double of GDP of Japan invested every single year. Now, if you're investing that sort of money, it doesn't really matter what you invest in. You create massive overcapacities. And if you go into niches, things like what Chishaping calls productive forces, things like electric vehicles, robotics, automation, solar industry, if you go into smaller niches, you almost automatically create three times global demand. if not more. Now, at that point, they have very limited choices. Either they change their pivot, pivot their policies dramatically, send checks to people instead of building another factory. You know, raise a social safety net. Yeah, raise universal basic income. They already have universal

basic income in China, just raise it and equalize it across the country. So you either do that, but if you're not willing to do that, which they're not, then the only way you can do it is except that you lost the capital and closed the factories, and we will discover China potentially is much smaller country than what we thought it was, or the other alternative dump that access capacity onto other countries. But given the amounts of money involved, there is not much you can dump on Kazakhstan. So there is only UK, European monetary union or EU, United States, Japan, there's very few places that can take that sort of capacity. And so what's happening, countries are putting up barriers. Now, the reason they're putting up barriers is that China also

wants to change the world. They want to redesign everything, whether it's human rights, information, whether it's a role of state versus individual, whether it's role of state subsidies, trade rules, they want to change everything. So if China did not try to change the world, I think the extent to which the barriers would have come up, would not have been as aggressive. But now China has a catch 22, barriers will come up, which means it's harder to sell that excess capacity. You don't want to recognize the loss of the capital. And what you're trying to do is to go on a charm offensive. That's why a Chinese president is in Europe right now. From a U.S. perspective, what U.S. is trying to do is gradually grind China out of the Western system, but without dislocating

refrigerator prices or without dislocating things that housewives are using. And the way you do it is starting from the top, starting from the high tag, and just keep moving and slowly grinding them out, slowly retarding their gross rates, at least relative to what you can do, but without triggering a real conflict. So to me, that's a cold war. You're walking at Tritrop between degrading as much as you can your opponent without triggering something really nasty. And I think so far, to be fair, whether it's Janet Yellen, whether it's Blinken, whether it's Sullivan, I think they've done pretty good job of actually achieving that balance. Whether that can be maintained, however, depends extent to which Chinese economy and society

perform, to some extent. I mean, it also depends what happens in the US, of course, but if you just look at China, it depends on that. Because remember, nominal GDP in China already fallen from 10% to 4. Now, in other words, as you create more disinflation, as you saw in Japan, it is really nominal GDP that tells you the extent of the pressure. Now, if economy and society are geared towards a double-digit nominal GDP, if you can't raise it, inevitably pressure starts rising. And so the question is, extent to which the pressure rises, what is China's response, both in terms of

in terms of geopolitics, in terms of politics, but also in terms of economic policies and how are you going to change them? Well, this is kind of what I don't get. And this came up in the episode we did with Hugh Hendry recently as well, where he was talking about the old traditional Chinese export model for reasons that you just laid out as well just isn't going to work anymore because, you know, Europe is not going to accept a flood of cheap electric vehicles coming in from China. And so I guess I'm a little bit confused exactly what China is planning here because the resistance from the rest of the world seems so glaringly obvious. When China first started talking about, building up, you know, technological independence in things like semiconductors or strategically

important technologies. I was under the impression that, like, some of the idea there was to sell it into the domestic population so that you don't have to worry about the U.S. suddenly cutting you off from important chips. You would have your own supply, and then you could do with it what you will. But as you laid out, like, boosting domestic consumption doesn't actually seem to be a priority right now. They still seem to be very focused on exports. So I guess I just don't get it, because to me the problem with that strategy seems so obvious. One of the ways I describe it is the way I look at Xi Jinping and the way I look at Chinese leadership right now, it's sort of a mixture of very stern paternalistic attitude, you know,

being soft is bad, suffering is good, that's one side of it. The other side of it is very classical economics and Marxist economics, they effectively harping back to the day of Quincy, David Riccada, Adam Smith, Karl Marx. And those people were not thinking of prices. They were thinking of value. Now, since late 19th century, economists abundant value. So we only look at the prices. So if you're billionaire, you must have added value because price is telling us you have.

Classical economy says, no, this guy just captured somebody else's value. He didn't create value. And so if you take that mindset, who is creating value? who is destroying value. If you ask David Ricardo, does he sing financial markets or capital markets value creative? The answer would have been no.

The best thing you can argue they're relocated, but they don't create it. Who is creating value? And so for Ricardo or Adam Smith or even Quincy before that, the argument people who produce stuff, whether it was agriculture early on, whether it's manufacturing, whether it's technology, and so the emphasis seemed to be much more on supply.

The emphasis seemed to be much more productive, The emphasis is to start to strengthen, as Chishaping calls it, productive forces, which is a classic Marxist argument, productive versus unproductive. Strengthen then, put obstacle in front of people who you don't regard us productive, and they're incredibly suspicious of capital markets and finance. Right, so curb the disorderly expansion of capital. That's right. What Karl Marx used to call fictitious capital, capital that multiplies for its own sake, without doing anything good to anybody else, And so if you take that mindset, and that is not the mindset of Western economists, but if you take that mindset, this sort of stern paternalistic attitude

and the emphasis of what he described productive forces, you understand why they're reluctant to actually do anything about it. Now, eventually, as I said early on, the pressures has to rise, and they will have to pivot. And we saw with COVID in late October, early in November 22, that he can pivot very, very quickly. That's why there was a disorderly opening after COVID. And so there is a possibility that there will be that moment when you actually will have the change.

But the longer he waits, the worse it gets. And the reason is very simple. China is not Japan. Japan had an open capital account and fluctuating currency and convertible currency. So when Japan run into the wall, they just collapse overnight. China has close capital account. Currency is not convertible. Central Bank is not independent.

Actually lost all the power pretty much. Commercial banks are not commercial, and private sector is not really private. So when you're operating behind the wall garden, you can't have Minsky moments. You can't just hit the wall and collapse. But what you can do, you can basically have increasing headwinds as you keep going. So if Japan operated Chinese system in 1990, they didn't have to go down. They could have survived until 96 or 97. But the longer you go with that, the worse it gets.

And so they need to recalibrate. So recalibration, which is needed, change your policy settings quite dramatically. Number two, change your geopolitical stance quite dramatically, in a sense, stop trying to rebuild the world and change the world, and change domestic politics. In other words, give a little bit of freedom for people, both businesses and consumers and households. If there is this pivot change, you still have to pay a price because one of the things I highlight is capital stock.

IMF calculates it. And if you think of 2004, China had capital stock of, I forgot, like, $4 trillion, India had one. In 2008, they will have $105 trillion. A U.S., for example, will have $70, $705. India will only have six. So China absorbed over $100 trillion of depreciated capital in a couple of decades. When you absorb so much capital, which is entire world GDP, when you absorb so much capital so quickly, inevitably you have an indigestion period. So that indigestion period will be with you

even if you make a policy pivot today. But what will happen if they do that, risk premium will improve because China is the only market in the world and the only asset in the world where risk premium over the last several years have gone up. Almost everywhere, risk premium actually fall. I want to push on two specific things you said. So one is you're talking. You're talking about talked about Chinese dumping. And I sort of understand conceptually the idea of dumping in a commodity like steel, or they're, you know, you produce a bunch and you can't use it all at home, or maybe even like solar or something like that. But a lot of the Chinese export success seems to be in making high-quality non-commodities that are just very competitive for cost

reasons. And in some arguably quality reasons, one example would be people saying that the The Xiaomi phone now has a better camera, say, than the iPhone. So that's one thing. And then the other thing is you say you credit Yellen and Blinking for maintaining something reasonably well, this attempt to degrade China but not necessarily provoke something stronger. What have they actually done substantively? Because I see the trips and I see the talk and the anxiety and the, you know, the FT columns

about dumping and all that stuff. But I don't really understand or can't quite internalize what substantively they have accomplished. Well, what do you need to avoid is very dramatic moves. So, in other words, the last thing you want is to stop slapping tariffs on very primitive products. But remember, China mostly actually does low-grade stuff. People focus on cameras, et cetera, but a lot of China is basic chemicals, it's toys,

it's that sort of stuff. So try to avoid displacing that trade as much as possible. try to focus on the areas that are important for you strategically. And that's what Trump started to do, but very chaotically, and what Biden administration have done very systematically over the last four years. Now, accept that China trade will get rerouted. Now, the fact that suddenly Mexico and Vietnam became major partners of the United States have very little to do with capacity of those countries to actually produce it.

It's a lot of Chinese trade gets rerouted through those places. And accept that, because you're getting some of the benefit of. of that, including sometimes better quality, low prices that consumers and businesses in the United States can benefit from. At the same time, what you're trying to do is reestablish as much contacts as you possibly can, because as the Defense Secretary was saying back in Singapore, when Chinese refused to talk to him 18 months ago, he said, with the Soviets, we never agreed on anything, but we talked. And the same is here. You need to maintain the lines of conversation. So that you know how far you can go, where you cannot go, how far you can push, how far you can bring it back.

So what you try to avoid is a chaos, what you try to avoid just slapping stuff all over the place, trying to avoid pushing China too far, and at the same time gradually, as I said, degrading it. Now, there is a possibility, and it is a small possibility right now, but there is a possibility that something horrible is going to happen either in Russia, Ukraine, or something horrible might happen across. Taiwan's trades, and the whole thing will start escalating beyond what you're trying to do. And at that point, we could potentially see zeroing out even of Chinese and Hong Kong assets. You can even see US Department of Treasury arguing that they don't recognize, for example, the currency, Hong Kong dollar. So in extreme, you can have a very extreme outcomes, which I think are not likely, so long as there is no, as I said, disasters occurring along the way. So we just have a few minutes left, and I want to go back to what you said earlier, where you were talking about the idea of financial risks migrating into, I guess, the real world, into the political sphere in one way or another. And you are actually the only cell side analyst I know of who has mentioned the Columbia protests specifically. We're here in New York. Columbia is not that far from us. Talk to us a little bit about how that kind of political discontent.

plays out in your world, in the world of, you know, investment and macro and things like that. Why is that on your radar? Well, usually when you have generational replacement and everything is fine, like economies are fine, finances, fine, technology is fine, there is no displacement politically or geopolitically. Then one generation just slips into another, almost unnoticed. That's what happened to baby boomers, an ex-generation. But whenever you have... As an X generation, we never, we slipped out before we were even in.

You're not X. Are you elder millennial? No, no, I'm 80. I'm X. Anyway, go on. But whenever you have a major technological financial disruption, what happens is that you have, or whenever circumstances change massively, for the better, for the worst, one generation cannot sleep into another generation.

That's what happened to baby boomers compared to a cyber. and GI generation, the baby boomers could not relate to their parents or to their grandparents. They had a radically different views what they wanted to do. And so the younger generation, anybody born sort of after sort of early 80s onwards, have a very different view of the world. And the reason they have very different view of the world because they did not experience a world where jobs were plentiful, where you've gone to college, you automatically had a good job. They found that your jobs degrade. They found the professional lives degrade. They found that technology gives you many tools, but it also degrades both your pricing power and marginal pricing power.

They found that politics become disoriented as that occurs. They found that democratic policies cannot solve the problem, extreme polarization. So they're in the mixture of technological, financial and political revolution. And when you have that change, that generation sinks very differently, and eventually they become a very large cohort. And when they become a large cohort, they demand a change. Now, what baby boomers were asking for is not what this generation is asking for, but they're asking for change. In my view, the change, all the surveys that come out, the change they're asking is very much

community-based, is very much community of equals, is very much government-supported. In other words, harping to their grand-grandparents who lived in 1940s and 1950s rather than to their parents and grandparents. And so usually it starts with those types of demonstration. It doesn't really matter what the excuse is, whether it's a civil rights, whether it's a Cold War, whether it's Vietnam War, whether it's inequalities, whatever that is, something triggers it. But then as they get big and bigger part of the population, they really drive the policy.

So today, late millennians in Z are already almost 50% of the population, but they're only about 39% of the adults. They're only 25% of the voters in the US. Mathematically, by 28, 29, there will be majority of adults. And by earlier to mid-2030s, there will be absolute majority of both voting and the adults. And so the question is, what type of policies, economic policies, political, social policies would they demand? Baby boomers wanted freedom, free enterprise, personal responsibility, you give me the rope,

and I can hang myself with it or I can succeed. These guys are asking for something else. And so how would all of those policies change? And I think they're going to bring us back to 1950s. That probably will be more likely outcome rather than sort of 1990s to thousands. I like how conceptually we've sort of come full circle because we're back to, I guess, demographic changes driving potentially higher deficits over the long-term fueling U.S. exceptionalism in some ways.

Maybe. Yeah, let's take it. Victor Schwetz, thank you so much for coming back on all thoughts. Thank you. I appreciate it. That was great. Yeah, that was really good. Joe, I feel like any mention of generations always leads to debate over the cutoff points.

Well, I may have said, I don't know if I've ever said on air. So I'll just say that I have a very simple test for the dividing line. between X and millennial, because some people say 79 or 81 or 80. Yeah, I've heard 1980 and above. Yeah, I've heard that too. But I think there's a very simple test to do it, which is did you have Facebook in college? Because that gets you in that ballpark automatically. Yeah. But also, that's generationally transformative. Social media is like clearly a dividing line. I did not have Facebook when I was in college. I got my first account, I don't know, like 20, it was after I graduated by a couple of years. You apparently did. So I'm X. You're a

millennial. That makes a lot of sense. Thank you. I think it's like, I think it's a test. And apparently, I guess it's probably rolled out to people on Harvard earlier. The implication is that people at Harvard became millennial before the rest of everyone else. Well, yeah, I was at LSE and I think we were one of the first international universities to get it. I have to say, part of me kind of misses the college era of Facebook where like we just spent an inordinate amount of time, like poking each other. I don't know if you remember that. Anyway, back to macro. There's so much to pull out. of that conversation. It's always great talking to Victor. I guess one of the things that strikes me is, you know, he highlighted the, I guess, unexpectedly loose financial conditions.

And to me, it does feel like that is a key part of what's happening in markets right now. And it kind of goes back to that point I was making earlier where I don't think anyone expected the cost of money to go up so much vis-b benchmark rates and the Fed's rate hikes while the supply of credit continues to expand. And that to me is sort of like the key to a lot of what's going on in asset prices, why we haven't seen that huge default cycle that people were predicting, why we haven't necessarily seen as many layoffs as a lot of people were predicting and things like that. Yeah, totally. Like we can easily point to a few different categories, like aspects of real estate in which. Sure. But no, it's totally true that it's sort of a puzzle. And I don't

think anyone is a great answer for why, you know, people talk about. about refinancing and everyone has a third year fixed. Maybe that has something to do with that. Still, it's not entirely intuitive why that hasn't had a larger compressing effect on asset prices. You know, there's so much to pull out of that conversation and every conversation with Victor, like I said, we could have talked for like an hour on the problem with the dots. And maybe we should do that because it does seem like that's getting more attention to sort of being handcuffed by the dots, perhaps. You know, obviously, and we'll do more China episodes, but is it really possible?

And I guess I have my doubts, but what do I know? Like to degrade China's cutting-edge capacity in such a way that doesn't provoke actual geopolitical conflict, something more mild. Big questions there. Dot seems so innocuous to me. It's so, it's funny that we're talking about them as like... Wait, can I give a confession?

And I always do my confessions at the end, because I hope that... No one's listening. No one's listening. Turn off odd lots right now. Turn off odd lots right here. I always forget whether the dots are what the individual FOMC member thinks should be the optimal path of monetary policy going forward versus what that FOMC member thinks the policy will be going forward. And I like, I know there's a right answer in one, but I always forget which is which.

Oh, I hate stuff like this because it makes me, it's one of those things like you just talk about kind of naturally without thinking about what you're actually looking at. but I think it might be what they think appropriate monetary policy should be. No, you're right. I just, as I was saying it, I also pulled up the Bloomberg Dots Explanter. Anyway, which, I mean, also, you would expect it to be that, right? Yeah, right. Well, I mean, yeah. Bring back the BEOE fan charts.

That's what I say. Let go of the dots. And let's just do a range of probabilities for interest rates. And we can have either fan charts or those hair charts, the hairy charts, the Medusa charts, which I love. Or just go back to the dots. the old days where they don't even tell you what rate that they sent and the market has to figure it out because the overnight rate, that would probably be fine too. I don't think we need all this communication. I appreciate it. I like the speeches are interesting, but we don't even, we went for years without that.

It would be very interesting to Victor's point about sort of real-time repricing to see what a system like that would mean for financial markets right now. Maybe it would be better. Let's all slow down. I think it's possible. All right. Shall we leave it there? Let's leave it there. This has been another episode of the Oddlots podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway. And I'm Joe Wisenthall. You can follow me at the stalwart.

Follow our producers, Carmen Rodriguez, at Carmen Erman. Dashel Bennett at Dashbot and Kel Brooks at Kel Brooks. Thank you to our producer, Moses Andam. For more Odd Lots content, go to Bloomberg.com slash Oddlot, where we have transcripts, a blog, and a newsletter. It comes out every Friday. And you can chat with fellow listeners in our Discord chat room 24-7.

talk about all these topics. Discord.g.g. slash oddlots. And if you enjoy oddlots, if you like it when we try to figure out what the dot plot actually is, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely add free. All you need to do is connect your Bloomberg account with Apple Podcasts. Thanks for listening.