The Breakdown - Bitcoin, Bank Coins and Bonds, feat. George Goncalves

Episode Date: December 29, 2020

George Goncalves has been a macro analyst specializing in bonds for more than 20 years. In this conversation, he and NLW discuss the story bonds are telling the market and why central bank digital currencies are likely to have an important part of the macro conversation in 2021. Find our guest online: @bondstrategist  

Quite frankly, the Fed hasn't been in full control of the dollar-based system for the last 20, 30 years anyway. So using these big blunt tools and trying to make them sound as if they are super effective and really are going to move the needle, you know, only just conflates and actually confuses the matter, but people buy into it because the Fed operates really through expectations channels and their announcements of these big programs help move markets. But the markets themselves still do most of the heavy lifting. Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by crypto.com and nexo.io. And produced and distributed by CoinDesk.

What's going on, guys? It is Monday, December 28th, and today on the breakdown's end-of-year extravaganza, I am joined by George Goncalvez. George is a macro expert who is particularly known for his. his understanding of the bond markets, and even more specifically, for sharing the signals that bond markets are trying to tell us at any given time. I'm really excited to have George back to the show, so without any further ado, let's get to the conversation. All right, George, welcome back to the breakdown. It's great to have you here again. No, look, it's great. It's a great time of the year,

wrap things up, and it's been great to listen to all your podcasts. I really enjoyed it, and I learned a lot as well. Awesome, man. Well, so let's dive in. I think you're going to have a really great perspective on a lot of these questions. And to start off kind of at the biggest highest level, what in your opinion was the most important economic story of 2020? Well, you know, that's one that's really hard to kind of pin down. But I guess front center, obviously COVID and what it did and the fallout, both on the on the health side of things, as well as on the economy. But then what took place in parallel to that and was really like a, you know, in reaction to the sort of policy that was put in place by central banks and the fiscal,

the whole K recovery, this idea that like those that were, you know, close to financial assets or, you know, were still gainfully employed, were able to benefit tremendously from this massive, just really epic amount of response from central banks, you know, to a health crisis doing things that were much larger than what they did during the financial crisis. And then on the flip side, obviously those policies not really making their way down to many of the industries and locations in municipalities and towns and small businesses that were really suffering directly because of COVID. So the whole K recovery and the ironies and the tragedy really of what that really created, I think that's the biggest economic story that with all the valiant efforts of policymakers trying to. really help everyone, it really became a huge bottleneck and not only a few, well, a large portion benefit, but not those that really potentially needed it.

So one of the things that I've been reflecting on a lot is the bluntness of the Fed's instrument, right? So even if you are put on your non-cinical cap and are like, okay, these guys are genuine in their desire to, you know, they're really focused on this goal of kind of full unemployment, right? it's felt at various points throughout this year that effectively the message being telegraphed is if asset price inflation and by extension increased inequality are the cost of full employment, that's a cost we're willing to pay.

I mean, it's almost like the nature of the policy instrument is doomed to create or to exacerbate that sort of inequality. I mean, what do you think about this? I know you spent a lot of time thinking about this. No, look, I think that's spot on, but it's so layered and nested in different things that are influencing that. And quite frankly, the Fed hasn't been in full control of the dollar-based system for the last 20, 30 years anyway. So using these big blunt tools and trying to make them sound as if they are super effective and really are going to move the needle, you know, only just conflates and actually confuses the matter. but people buy into it because the Fed operates really through expectations channels and their

announcements of these big programs help move markets, but the markets themselves still do most of the heavy lifting. I mean, I think they suffer from the design of how things have evolved. And I agree with you that they do these things with best intentions to hit their mandates for both, you know, full employment and, you know, some sort of price stability. But, you know, the collateral damage along the way is that that you end up with, you know, creating and having to sustain, which is really what's happening now, having to sustain bubbles upon bubbles because they just can't really stomach to see the other side of what would happen if there was an actual repricing of financial assets back to more intrinsic values.

And so, I mean, the irony of the whole situation ends up being that they are trying to create full employment. But in fact, each time they do that, we never regain the jobs that were really lost in the prior cycle and we get a lower and lower kind of participation rate amongst the population. And that's really the unfortunate part. I think they're not designed to really include financial assets into their modeling, although they keep telling us that financial conditions matter. They want to keep the wealth effect up there with the hope that trickles down. And it ends up getting, you know, stuck and it really doesn't help everyone. It's a fascinating challenge for sure,

but it's something's got to give. It feels like. And I guess maybe this gets into my next question, which is, you kind of answered this a little bit already, but what do you think is the most important economic story that people weren't paying enough attention to this year? Yeah, and I think we're kind of dancing around it a little bit, but, you know, really all this manifests itself in the huge, you know, income and wealth inequality that's really been growing for years now at levels that we haven't seen, you know, since really the French Revolution. That story has been underlying for quite some time, but it, it really took this pandemic and the response to it to really bring it to the surface,

although it's not talked about or discussed enough in all circles. I mean, you know, they don't even admit it that, oh, yeah, there's no income inequality. In reality, in wealth inequality, but all these policies, unfortunately, end up in that conclusion. So, you know, and it could be, you know, what led to political changes as well. We don't have to go into that. But I do think that, you know, the Trump tax cuts, in my humble opinion, should not have been done. I mean, it just put us further into debt at a point where we really needed to do other sort of policies that were more geared towards labor. So perhaps, like, you know, again, there might be a shift that's that has to happen at some point between capital and labor that, you know, that, you know, you have to start to increase wages and start to really have this, you know, wealth filtered down further into into, into all, you know, all citizens.

Yeah, I think that the challenging thing for so many is, Again, the vehicles we have for the transmission of change feel so ineffectual for the change needed, right? I mean, to your point, I think that you're right to identify that part of our political cycle has been a veering, right, between extremes in order to try to address these sort of shared fundamental conditions. And the question is whether, you know, the politics, since we have it set up, is able to deliver that. But that's probably way bigger than an end of year show to dive into. One thing that I wanted to ask you specifically, you know, I've heard from a number of the folks that I've had on the show that the zero interest rate kind of, you know, the persistent, you know, long duration, it seems like zero interest rate policies have had people reevaluating how they think about bonds. Bonds are obviously a place that you have enormous experience. You spend a ton of your time thinking about. How have you seen attitude shift around bonds this year? I mean, what are what are the stories that Bonds? bonds are telling us where do they fit in the market right now?

This is the upside down pyramid in starting with a zero is never a good starting point. And it has at least highlight in some countries in parts of the world. We're now at record negative interest rates. So forget about just having zero rates in the U.S. It forces people to make uneconomic decisions because they need to find yield somewhere. And then that then creates an environment that the central banks. are aware that there's a lot of other assets that have benefited from these low rates that if they were to go up, that it would expose that many companies are zombie companies that cannot

afford higher interest rates. And so it's worked its way through the credit as well as the investor psyche of how to evaluate risk and reward in a way that adulterated or changed in a way the notion of value. And what is value when rates are so close to zero? and when you have credit that has now interest rates that are sitting on top of inflation expectations, and really not much of a return prospect within the fixed income market. And that comes with a lot of issues because people usually view bonds as a hedge to their overall risk portfolio and profile. And now each time they do this, we're really taking away the benefit of what bonds provide as a buffering. offer for other asset classes. I mean, the worst case scenario, if we ever get to it, would be like

that risk markets are down and bonds don't give you the hedge. And actually, bonds can go down, too, for other reasons for either credit reasons. And so the forcing up into the credit spectrum away from government bonds because rates are so low, the, you're not beating inflation, making you know, feel like you need to chase risk assets. It's all part of the same story. And it, you, you know, It just compounds risks and really reduces the ability for the bar market to serve as a hedge as a traditional link that has. This episode is brought to you by Crypto.com, the Crypto Super app that lets you buy, earn, earn and spend crypto all in one place and earn up to 8.5% per year on your Bitcoin.

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Stay on top of your investment game with nexo.io. And remember, it's your your crypto, your credit, your choice. Get started at nexo.io. This is kind of taking it into a different area, but in the context, I guess, of this idea of the tools that the Fed has available and central banks in general have available and what they might try next. I know an area that you've been spending more time looking at this year is central bank digital currencies. What got you to come over and kind of spend more time looking at that? And what is your thinking? Where is your head as we head into 2021 around the significance of CBDCs? Well, I mean, we're definitely getting a lot more headlines now about central banks exploring

the idea of digital currencies. And I'm intrigued by both the significance for monetary policy options, but also what it means vis-à-vis the established crypto space, which I think will coexist in the future with whatever central banks will eventually unfold. But it was a curiosity around understanding a lot of the problems that we briefly touched on at the start of this is that there's ineffective tools. And so there's a legacy of so many different layers between repo markets, the euro dollar system, the way the banking system has evolved, the significance of the dollar. I mean, there's so many layers of this that you can't unpackage it or expect it to. you know, cleanly reset, as some would like to see. It's really going to require the evolution of

both the digital side of, you know, banking with central banks somehow, you know, obviously being a key part of that, as well as, you know, the private sector's version of crypto coming online and taking a bigger piece of overall the banking system itself and in providing alternatives for savers and investors. So I thought about it from a lot of different angles, and you can't rebuild the system overnight. It's going to have to evolve. And the old system has to somehow unwind itself at the same time. Meanwhile, you know, the central banks are, again, with these ineffective tools and politicians and policymakers on the fiscal side, really don't have super effective ways of getting stimulus into the hands of those that need it. So that the idea of

of a payment system overhaul and the ability to actually inject stimulus where it's needed and not just have it getting bottled up, I think it's a really valiant effort and it would be an elegant solution to some of the problems that we were discussing before. It's just, you know, it's complicated. It's hard. You know, I think we're very early on. I think some, you know, some countries probably have to go at it much quicker than the Fed. I think, you know, the Fed hasn't really said that they're, you know, actively pursuing it, but

obviously they're studying it. I think part of the concern around what happens when the U.S. goes to a digital currency, there's a legacy system that really has been with us since the late 90s after the Asia financial crisis where, you know, because of being mostly exporting nations, these countries built up as well as other countries around the world because of commodities and stuff like that have built up, you know, tremendous dollar reserves to help manage the, their own financial systems and payments, if we get to a world where, you know, it's really, you know, instantaneously payment type systems around the world where, you know, there's baskets

of currencies underlying these various digital schemes, then, you know, these global actors really don't need to hold as many dollars as possible as they have now. And I think that's one of the reasons why the Fed does want to, like, does one like Rush headlong into it? needs to really think this through because the power, you know, that the dollar affords the U.S. is massive. And so like this idea of, you know, other central banks around the world will start to potentially roll this out. The Fed will watch it in parallel and then see how this thing works. And, you know, there's, so there's that element, like the payment system, the role of the dollar and like how digital central banks would have to operate with each other in terms of the,

cross-border activity. And then there's, you know, the monetary policy. aspect of it in the fiscal policy, which I was starting to talk about, which is, you know, how do you get this money into the system? Because, you know, the Fed's balancing, if you know, how it works, you know, it's funded by, you know, actual, there's still a lot of paper currency in the system, you know, over, you know, over $2 trillion, which nearly two-thirds, if not more, are overseas, by the way, and the dollar still is a huge medium of exchange in the actual paper dollars are still a medium exchange around the world. So, you know, if we're going to go to an e-dollar type system or e-cash, then the currency and circulation that helps fund the Fed's

balance sheet and allows it to do its monetary policy, you know, has to become a new tool. And so they have to really know how to execute that in a way where it doesn't like, you know, create, you know, runaway inflation and just things like that, right? So I think it's going to be a monetary policy tool that's going to have to be put in place. It's going to have both a, you know, private sector and a wholesale sector function, CBDC aspect. of how it operates through the banking system. And it's probably over time going to slowly take away some of the dominance of the dollar's role. Meanwhile, I think all central banks, not just the Fed, have to be careful of not cannibalizing the private sector commercial banks,

which are the real true creators of credit and dollars in the system or currency in the system, and making sure that you preserve the private sector function, give them incentives to actually lend and make money. you. So it's super complicated. I just spent, I don't know how long trying to explain that part. But that's what got me super excited about what I'm seeing happening in fintech and in crypto space. And then trying to like, you know, compare or contrast to my knowledge of the plumbing and the banking side and the Fed and see like where we're going. So, I mean, it's super interesting. Just based on kind of the, the, that answer and, you know, your interest in this space, like it feels like your sense, your base case.

is that we are in the midst of some pretty significant shifts in how things work. I guess, you know, a lot of people right now are trying to figure out how much we're going back, you know, in the vaccine phase of COVID-19 to something like the old normal versus a fundamentally new period. And, you know, in markets, economics, et cetera, what's your kind of base case on what next year looks like? Are we going to see just a rip-up of demand? Is it going to be kind of all systems go? Are we going to see some pretty significant demand changes? Or central bank's going to be more tax than ever?

Are they going to have kind of pulled it off again? I mean, when you look at 2021, how do you see kind of your, what do you see playing out on a core level? Well, we got, you know, roughly two weeks or so to go until we turn the corner into 21. And I think traditionally, you know, just the way investors act and behave, they start putting on trades for 21. in the year before. So a lot of the movements that we're seeing, you know, sector rotations and even what's going on in crypto space.

I mean, there's probably a lot of pre-placement of trays that are, you know, trying to anticipate the benefits of what the vaccine will do with the growth rebound and, you know, the pent-up demand that's out there. The problem I have is, okay, that's all fine and good.

You know, how much of that is priced in? Because, like, many of the, you know, the valuation metrics on risk assets are at nosebleed territories. we already know that central banks have our back, and they have been super accommodative all throughout. Are they going to up the ante? I mean, what we heard from the Fed at its last meeting, they're perfectly fine with the current

level of accommodation, and perhaps they have to do more if there is a need from the fiscal side to help finance a bigger stimulus package in the year ahead. But either way, I think they've done a lot. And a lot of it has been priced in. And the euphoria is super high right now. And sentiment metrics and all valuation metrics are at the extremes that can carry into the first year. But I'm just worried about a repeat of like what we saw in like 2011. What we saw even in 2017 and 18, super high enthusiasm.

Then we had the Vol explosion in 2018 with the VIX going bananas with those. And then, of course, we had last year with the COVID crisis really bringing to surface the length of this economic cycle, which got a temporary reset, in my humble opinion. But we never really allowed the insolvency or the cleaning up of bad credits within the capital market side. Unfortunately, there's been a lot of small businesses that have really, you know, nothing to do with finance directly or the financialization of the economy. they're the ones that are really taking the brunt of the hit right now. Meanwhile, because of all of the stimulus measures are more targeted towards those that have access to capital markets, they've done fine. I think all of that is going to come to ahead next year, and it's going to really prove, is this a sustainable recovery? Or was it just buying time to kind of reshuffle the decks a little bit so that we can then figure out who's really the strong hands out there?

So the enthusiasm carries into the beginning of the year. I don't think COVID, you know, unless it gets materially worse from here, it's going to change that narrative. I think we're going to be let down that, you know, the vaccines won't really completely fix everything. And we priced in a lot of good news. This is, I think, maybe the big question and the big thing that everyone's kind of betting on is to what extent, you know, how many, how many times can we reshuffle those chairs, right, on the deck to use that phrase? So this is a super fun conversation. There's a lot more that we could dig into. But I guess just to wrap us up, I want to close with the question I've been asking everyone,

which is what's one prediction that only you have? There's not really one prediction per se, but there are a number of inconsistencies that I think need to be exposed. And that's going to be, can we actually see a handoff from the central bank to the private sector and the banking system actually starting to grow again. And are they going to be willing to continue to offer as much credit that was put out there this past year? And the markets that I'm really kind of watching closely, you know, are they like the leverage loan markets, the shadow banking type lending, the private capital markets, you know, are they still

going to be the recipients of all this capital that, you know, really, you know, were coming from displacement from investors looking for yield. I'm worried about that. And then the housing market and how it's had an amazing run and how critical the housing market is in terms of collateral that it serves for the underpinnings of the very same banking system that we hope to see lending expand upon. If any of these don't work out or start to show cracks, I think that's where I'd be different than, you know, the consensus that, you know, the combination of housing and alternative forms of credit availability, if they dry up, then I think then all the other capital markets pieces start to, you know, suffer and really expose the reality.

I think we're going to have to do another show in a few months about what we've learned, what's been exposed, what hasn't, what we're still watching, because there's so much to to unpack and think about. I really appreciate you taking some time tonight to give us your thoughts on that. And always fun talking, George. So we'll definitely have to have you back again soon. Yeah, likewise. Thanks for having me.