The Derivative - Debt, Dollars, and Deficits with CME's Blu Putnam

Episode Date: August 13, 2020

It’s a job all in itself to be able to look at data – especially data that affects all of us on a daily basis – and be able to interpret that to make sense to yourself. Take that and have to turn it into something that makes sense to everyone else – well that’s a gift. And we’ve got the most gifted of them all joining us on The Derivative – CME Group’s Chief Economist Blu Putnam. We’re lucky enough to have Blu on today's episode breaking down all that’s going on in the craziness of what we’re living through in 2020.  We’re getting outside the charts and into the conversation surrounding sailing in the Chesapeake, the U.S. dollar trending, the future of technology and small businesses, inflation during and post-corona, fed funds rate to ZERO, effects of printing more money, “coordinated” monetary policy, the outlook on the remaining 2020 economy, gold rallies, the fed’s pandemic reaction, trading Bitcoin futures, signposts of inflation returning, and Blu’s favorite Chicago pizza – his wife’s. Follow along with Blu on Twitter and LinkedIn. And last but not least, don't forget to subscribe to The Derivative, and follow us on Twitter, or LinkedIn, and Facebook, and sign-up for our blog digest. Disclaimer: This podcast is provided for informational purposes only and should not be relied upon as legal, business, or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of RCM Alternatives, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed not to make specific trade recommendations, nor reference past or potential profits. And listeners are reminded that managed futures, commodity trading, and other alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors. For more information, visit www.rcmalternatives.com/disclaimer

Thanks for listening to The Derivative. This podcast is provided for informational purposes only and should not be relied upon as legal, business, investment, or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of RCM Alternatives, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed not to make specific trade recommendations nor reference past or potential profits, and listeners are reminded that managed futures, commodity trading, and other alternative investments are complex and carry a risk

of substantial losses. As such, they are not suitable for all investors. Welcome to The Derivative by RCM Alternatives, where we dive into what makes alternative investments go, analyze the strategies of unique hedge fund managers, and chat with interesting guests from across the investment world. The U.S. government threw money at the 2008 problem for exactly one year. They threw about a trillion extra dollars at it. But then they went into stalemate mode. They put the sequestration plans in place.

And we had very tight fiscal policy from 2010 to 2017. And you could argue that that tightness of fiscal policy perhaps made the economy recover from the Great Recession a little slower. But the Fed, of course, started the quantitative easing and just kept doing it for a while. So, you know, there's some different habits there. Hello and welcome back. Our intro music switch up today is in honor of our guest today, Mr. Blue Putnam. We've had him on a couple of different version of virtual webinars turned podcasts and whatnot before. But this is our first one on one with the chief economist and managing partner at CME Group. So welcome, Blue. Thank you.

Blue, you're known for explaining the happenings of the world simply with a couple of charts and some slides, giving a lowdown on the economic factors of the times that are helping or plaguing or confusing our world. And as we're well aware, between the coronavirus and everything else that's going on in the world today, the current state of the U.S. and world economies are in a bit of flux. So there's plenty to talk about. And to start with, you were just out sailing somewhere? Yes, I sail on the chesapeake bay beautiful place to sail yeah but you're here in chicago i'm back in chicago but usually you're in chicago right

yes so that's just a treat to get to go out to chesapeake bay and hit the water what what kind of boat uh it's a islander 36 all right very old boat it's like 40 years old or something but it's a great sailboat all right i used to do a bit of sailing myself i've never sailed in the chesapeake actually though so i have to put that on my list um and did you fly out there yes what what was that like no the plane was half empty and it felt safer than the grocery store. Really? What was, which airline? United. United. All right. I feel like Delta has been getting the props for the best at it and America in

the worst. So maybe United's in the middle. I guess so. It has the best route. So tell us a little bit, we've done in some of our other pods some of your background but can you give us a little cliff-noted version of how you got to the position you're in at CME? Yeah I'm chief economist at the CME I've been here almost 10 years and really enjoy it a great company. Prior to that, I was involved in a consulting venture aimed at managing macroeconomic portfolios for hedge funds. And before that, I actually ran some investment,

investment asset management business. And then before that, I was involved with a sell- side strategy on bonds. And my first job was the New York Federal Reserve Bank as an economist working on international issues. So that's kind of the background in reverse. Yeah, I like it. What year was that year at the Fed? That's confidential information. Before all their recent shenanigans, I bet that they couldn't have imagined. Well before.

Yeah, in those days that some of the tools they had in their toolbox. And what's going on at the CME these days? Seems like growing gangbusters as always and more and more people interested in futures markets. Yeah, there's definitely a lot of interest, particularly in some of the newer products. The micro equity products are really doing exceedingly well. People are excited about gold and some other products. So yeah, things are going well. What's it been like throughout your time with the CME?

Do you feel like you still have to explain derivatives and futures, or has it become a more standard tool in the toolbox, not to use that twice in two minutes, but has it become a more standard tool for investors these days? I think it's a more standard tool, or it's been a standard tool for me for a long time. I've always been interested in these markets, but there's a wide group of investors that lots of different kind of investors use futures and options on futures. So I don't have to get in the educational business too much. Right. What do you think is the most, confuses people the most about futures markets, either from institutional standpoint or down to the retail? Oh, I don't know. That's a hard question to answer as to what would be the issues. I mean, there are technical specifications for each product,

and they are different. Some products like the 10-year treasury note are a physically delivered product and others are cash delivered. But 99% of the traders don't hold a futures contract to a maturity anyway. So those differences don't really play a big role. Right. I just got into the weeds on Twitter last week debating the roll cost or roll yield embedded in futures and was kind of saying, well, people think it's the cost of having to roll to the new, more expensive contract, when in fact, it's actually just the decay of the current contract down to spot prices, if it's in contango. You got any thoughts on that? I guess it's technically correct, but we all seem to think like, no, you're rolling to the more expensive contract. No, I mean, that only happens in certain markets that have longer dated futures contracts and you can trade further out the maturity curve.

That would be true in natural gas, oil, corn, things like that. But like in the equities, the E-mini S&P, you just go from the most active contract is the nearby. And then when that matures, you're in the next one. And I have a side question for you. We were running some stats on running, just holding E-minis to replicate the S&P performance. It seems to trail by about 2.5% on average. Why is that?

That's kind of the cost of money there embedded in it? That sounds like the dividend, but I'd have to do some research to tell you. Yeah. With the e-minis, you're only dealing with the price index. If you own the ETF or something like that, you're getting the dividends. Got it.

All right. Well, enough of my curiosities. Let's dig into the U.S. dollar. It's been kind of all over the headlines recently that we're, is this finally the dollar sell-off? Has the Fed gone too far? Is inflation coming? All this yada, yada, yada. So let's talk about the dollar. What are you seeing in terms of the dollar index? Well, there are a couple of things going on with the dollar, both in the U.S. and outside of the U.S. One of the main components in the dollar index is the euro. And the euro did some pretty exciting things in the last couple of weeks. One of the big problems with the euro that a lot of economists identify, at least, is that when the euro was created, they created a common currency and they created the European Central Bank, but there's no common fiscal policy. And in the last

couple of weeks, the European Union met, they agreed to issue bonds in euros for the credit risk of the whole European Union. And even more importantly, some of that money will go in grants to the country's hardest hit by the pandemic. So that was a huge first step toward a common fiscal policy or a united fiscal policy. And it really got a lot of traders excited about the future of the euro. On the other side of the Atlantic Ocean, in the U.S., the U.S. Treasury has been issuing, well, they issued $3.3 trillion worth of debt in the first half of the year. Is that a lot? That's a lot. And the Federal Reserve bought half of that, not quite half, 46%. The Federal Reserve bought almost half. And so what economists call that is a fusion of fiscal and monetary policy. And the theory it goes under is modern monetary theory or MMT.

And a lot of economists worry that you may be able to do that in a pandemic without any real consequences, and you probably should do it. So it's a good thing. But if you keep doing it after the economy recovers, then there's a big inflation risk down the road, you know, three, four, five years, we don't know. So if you're worried about the inflation risk, you buy gold and you sell the dollar. And both of those things have been happening. So the dollar story is, you know, got a got a US component and a euro dollar. And both of those things have been happening. So the dollar story has got a US component and a euro component, and it's a complicated story, but really you can boil it down to those two factors. Right. And the euro's 21% or something. I can't remember off the top of

my head of what it is of the dollar index, but it's the largest. It's a very good chunk. Yeah. And what else is in there? Do you know off the top? Sorry to put you on the spot, but it's a very good chunk yeah and what else is in there do you know if top sorry to put you on the spot but it's the yen well yes it's your you know it's the regular cast of characters uh the yen and the pound things like that swiss franc uh all make up part of that that basket and so people the euro side of that is people are betting the problems of not too long ago, even last year, right? The thinking was, we're just getting Germany's economic input with all the other problems of the euro built into this currency. And now you're kind of saying, okay, they're trying to figure that piece out. Yeah, that's right. You don't have to go back very far. And Europe was

stagnating. It wasn't growing very fast. Germany was leading. But then Angela Merkel kind of wasn't clear where she would be. And but now they've really you know, they've done something unusual. They've got a coordinated fiscal policy that they've never had before. And, you know, there's a lot more optimism about Europe doing well in 2021. Even with and where is their negative yielding debt come into all this? Well, you know, they do have a lot of negative yielding debt. And where, I don't know who buys it, of course, because I wouldn't be buying. But if you wanted to own, right, if you're

on this trade and you want to own euros, you're going to put it in, in theory, you're going to put it in some. It's going to be in cash, you know. But the monetary policies of countries are not all that different right now. The big countries, the big central banks are all doing quantitative easing. They're all buying assets, and they all have interest rates pretty close to zero. Maybe they're slightly negative in the case of the euro and pretty close to zero in the US, but those differences are small. They're all in the same bag. What is different is the fiscal policies are shaping up a little differently and that's showing up and the expected growth rates are being a little different now with Europe kind of maybe getting a little boost.

And that's unusual, by the way. So that's helped them out. So those are where the differences aren't really a monetary policy. So let's rewind back to the MMT here. And which side of the fence are you on there that that is going to cause problems? Or I was just hearing about that new book deficits don't matter stephanie something what's that book you heard of it yes uh she is the uh it's it's somewhere on the bookcase behind me stephanie kelton yeah yes stephanie kelton she's the the chief proponent of modern monetary theory it got involved in as a very political issue because it was always attached to what you wanted to spend the money on. So you would pick your issue, spend the money on that, and then the Fed would buy the debt that financed it.

But in reality, it's a set of ideas that have been around a long time, just brought together in a little bit of a different package. And when you're in an economic situation like the pandemic, where you're far from equilibrium, we've gone through what I call a network collapse. Doing something extraordinary makes a lot of sense. So the Fed actions and the fiscal policy actions are to be applauded here. What worries people is what happens three, four, five years down the road. The economy is growing again. And, you know, there are some people out there that don't trust politicians to stop spending. And there are some other people that don't trust the central banks to stop buying the debt. And so it's the cynics, if you will, that are worried about the inflation down the road.

But we'll see when we get there. You know, we'll have plenty of time once the economy is growing again to see if policy can dial back or not. And, you know, there's a pretty good chance the Fed will dial back. They understand these risks. But so it's not the concept of how are we going to pay for it? How are we going to pay for it? How are we going to pay it back? It's more of the concept of there's going to be too much money chasing too few assets and cause inflation. What really matters for the economy is the actual new spending that's occurring. Because that's what will get the demand for goods and services above the supply and create the inflation. The fact that it's debt financed is an issue, but it's not the inflation issue so much.

The debt financing of it makes the economy more fragile to any change in interest rates. So economies that have a lot of debt, an abundance of debt, more than typical economies, are much more likely to be reticent to raise interest rates, just because if you have a lot of debt and you raise interest rates, bad things can happen. So that's a part of the danger. Just popped in my head, do you think U.S. will ever move to like the hundred year bonds or something to solve that problem? They were talking about some very, very long term bonds at the U.S. Treasury, I think at least 50 years or something. And they got a lot of pushback from the bond community, if you will, the investment banks and bond dealers. So at this point, I don't see it. But, you know, things can change.

Right. What's what's the tenure right now? Like 50 pips or something? Yeah, it's a little over a half a percent. Yeah, 53, 56 pips. I feel like someone out there would be like, give me one and a half percent for 50 years and I'll take it. Well, 50 years is kind of a long time. And a long duration bond like that is going to have some interesting volatility, even if interest rates yields don't move very much at all. Right.

You'll have to survive to duration to see the effect of that. And I always come back to like Austria or someone issued a hundred year bonds, like they weren't even a country for a hundred year period, like a country. So there's some other outside risks there of having your money tied up. Well, you know, in the 1800s, the United Kingdom used to issue what they call consoles. And those are bonds that pay interest and they never mature. Really? All right. What were the rates on those? They were actually fairly low. I mean, you only issue these things when inflation is low and you're doing okay, you know.

So I don't know if I heard your answer. So which side of MMT are you on? That it's okay in a terrible situation, but not all the time? Oh yeah, you didn't really hear my answer because I dodged those kind of questions. I'm still doing a lot of research on MMT. I did write a research piece a couple of months back on it to try to really get my head into it and explain it. But I'm not on one side or the other. I think when you're far from equilibrium like we are now, it's an appropriate policy. And there'll be times later on where it's not appropriate. And we just have to see how carefully the politicians and the central bank deal with that when the time comes.

But what's different this time than 08? Nothing? We just weren't calling it necessarily MMT and 08? Oh, no, no, no. This is a lot different than 08. Mainly because of, well, two things. First, magnitude. In 2008, in the fourth quarter of 2008,

the Fed did buy a trillion dollars of securities, but it wasn't U.S. Treasury debt. It was to take the bad, toxic securities, if you will, out of the banking system. And it allowed our banking system to recover much faster. What we had, a second difference with 2008 is while 2008 was a financial crisis, that the financial system didn't work for a short period of time, and we then went through a deleveraging period, the pandemic is not a price event. It's a shutdown, a government mandated shutdown because of a health crisis. So it shut down the, you know, the restaurants and curtail flying and all of those, the tourist industry suffered. And so anytime an economy is not responding to price signals, because it can't, then you cannot analyze that with economics 101.

Okay? Because everything that we teach in economics at universities involves very important that agents and consumers and businesses respond to prices. And that's not what we're doing right now. We're responding to a health crisis and government orders and so forth. So it's totally different. And what would you say if it's, right, a lot of the critique is it's not a liquidity issue, it's a demand issue, right? And you can't print money to solve a demand issue. That's correct. And that came up back in the 1930s. The phrase pushing on a string was applied to central bank policy.

Because, you know, you had a severe demand drop in the depression. And we've had a severe demand drop from the pandemic, at least for certain types of goods, tourism, restaurants, air travel, things like that. And there's nothing the Federal Reserve is going to be able to do about that or the federal government, for that matter, except to try to solve the underlying problem. And the underlying problem, we're going to call a vaccine. When we get a vaccine and we're able to distribute it, then consumer behavior can change again. So that's not Federal Reserve policy. But I could argue that, but I still printed this $3 trillion, gave out this $3 trillion. That's not going to solve a lot of those solvency issues for those groups. Well, the Fed buying the debt of the Treasury allowed the spending that the Treasury was doing, the U.S. government was doing to help them with the pandemic, it allowed that to have less of an

impact on bond yields than it otherwise would have. So that probably helped the equities rally. I'm sure it did, because you have lower bond volatility, lower yields, so that's good for equities. So it had an impact on the asset price markets. And it allowed the treasury to get that money out there without impacting the asset prices as much as it might otherwise have. So I would argue it's appropriate policy.

What do you think the bond yields would have done if the Treasury hadn't bought those, or the Fed hadn't bought them? Well, we won't know. But there are two ways of looking at this. And one way is to look at the history of, say, the 10-year compared to inflation, historical and recent history of inflation. And since inflation peaked in the United States back in 1980, 81, 82, at around 12%, 13%, and there was a big gap. But over the time, as inflation came down in the 90s, the gap between inflation and bond yields narrowed. So bonds weren't offering as much of a premium. And more recently, in the last 10 years, bonds have really offered only a fairly small premium to inflation. And then when quantitative easing has become very aggressive,

sometimes that premium went away. So if you're looking at that theory, you would argue that the Fed maybe has lowered the 10 years, maybe a half a point, 50 basis points lower than it otherwise would have been. But that doesn't tell the whole story. If the Fed is buying 46% of the Treasury's new issued bonds, then the bond market itself, the yield curve is reflecting a combination, a complex combination of what private investors are doing, asset funds, hedge funds, whatever, and what the Fed is doing. And of course, the Fed isn't maximizing its profits. The Fed is trying to achieve an economic goal. So that means that the yield curve, the price discovery in the yield curve, doesn't mean the same thing it used to mean. And it probably is not telling you how easy monetary policy really is.

So you have to look to other markets that are inflation sensitive to get some idea that maybe the yield curve is not giving the same signal it used to give. And gold and the dollar are telling you that there's some inflation fear out there. And so that would tell you that that 50 basis points is an underestimate. But as to what the right number is, I don't have a clue. So let's dig back to the dollar a little bit in in our world of managed futures

and trend following across all sorts of different sectors or not even trend, but whatever your strategy is, right, the dollar most everything is priced in US dollars. So a downtrend there can cause uptrends absent any other price movement in some of these commodities. What are you seeing in terms of that effect playing out in the grown in the ground commodities and other financial commodities? Yeah, we are seeing some impact on the commodities. The metals are impacted, led by gold and then followed by silver the most. On the other extreme, the agricultural commodities are not really much affected by this at this point. They're being affected by the pandemic shutdown because restaurants are closed or not as open as they used to be, even though they're reopening.

They're being affected by the oil market because corn has an ethanol component. So the ag markets are kind of not in play, if you will. But the metals definitely are. And you go to energy, and like oil is 75% used in its refined state as a transportation fuel. And so you're looking at on the demand side, you know, air traffic is simply not back, although people are driving. So the demand for gasoline to fill up your car is there, but the demand for jet fuel and so forth is not there like it used to be. And then on the supply side, we're seeing a huge drops in supply in the Permian Basin and other shale oil in the US, but we're probably going to see some increases in production in Saudi Arabia and Russia and

parts of OPEC. So, you know, oil has been trading in a, you know, sitting around that low $40 range for WTI. It did get a boost from the tragic events in Lebanon, but that's temporary for that. What do you see in terms of the, right, so when oil went to negative 37 or whatnot, and you know, I don't know, end of day basis when it went to five bucks or something, and now all the way back to 40, as you said, is that a more result of basically them shutting in the supply of like, hey, we got to react quickly to this lack of demand, let's drastically reduce supply or increase in demand? Well, that was a very, very special one day case just before the expiration or maturity of the nearby oil contract. And oil is a physically delivered contract. And so if you get if you are an oil

trader that studies that market carefully, you understand the issues of storage, and where that oil is allowed to be stored to meet the contract specifications and so forth. If you're a retail investor or something, you know, you have no business being close to the expiration of that contract anyway. So that was a very one-off. But markets worked very well. I mean, the markets traded all the way up and down. Every contract got filled. There was a buyer and a seller. The market worked. Just some people didn't like the outcome. That's a different story. Right. But I would say ignoring that day, right, when oil went down, even if we say $10, right, it's rallied drastically off those loads. Yes, on the day that the nearby went negative, the second contract in oil was sitting, went as low as 10. So we've gone from, if you say,

we've gone from 10 back to 40. And, you know, that's really a partial reopening of the economies as well as the drop in production that's happening in the US shale play. And at least in part of that, the OPEC plus Russia dropped production for a while. So there's some pretty good supply and demand stories there. Plus some dollar weakness, right? And plus a little dollar weakness because oil is priced in dollars. And do you have any thoughts or concepts on how hedge fund strategies typically perform in a trending dollar versus non-trending dollar or a weak or strong dollar? Well, you know, not so much in the last 10 years, but the foreign exchange traders used to wear, you know, on their tie,

the trend is my friend. They no longer wear ties, and the trend hasn't been as friendly. But, you know, I think when you get a fairly large divergence in policy and you get a perception that things are changing in one of the key countries like the euro, there's a pretty good chance that people will find that trend and do well with it. And is that, do you feel like that's partly globalization and coordination of monetary policy across all the G7 or whatever currency countries of that's kind of suppressed volatility and suppressed trends in the dollar and the

resulting currencies? Yeah, once we had the Great Recession in 2008, and Japan, your ECB, the Federal Reserve, Bank of England, they all went to near zero rates. They all got on the conference call together, right? And said, all right, how are we going to fix this? I'm not sure they had a conference call, but they all ended up doing the same thing. They do talk to each other a lot. I wouldn't necessarily use the word coordinated. OK, but they all ended up in the same place. And so it took monetary policy out of the equation for a long time. I mean, the European Central Bank, the Bank of Japan, you know, they're still doing quantitative easing. Rates are still either zero or slightly negative. So, you know, what you have moving the currencies is either changes in risk perception or changes

in relative growth. And that's what we're kind of seeing that's changed with Europe in the last couple of, in the last month. So I think I'd speak on behalf of all the traders that they would welcome lack of coordinated, even if we don't use that word, monetary policy would be welcome to all the traders out there. Well, they've got it. They just don't have it in the majors. I mean, that's one of the interesting parts of the foreign exchange market is there are lots of opportunities for interest rate differentials and growth differentials and risk differentials

in the emerging market currencies. Very interesting things going on and that business is a growing business so there's there's plenty of things to do you just not necessarily in the majors. And where are we putting the renminbi or the Chinese currency in there as a non-major? It's a non-major until they loosen up their restrictions. Yes. But do you see any that they'll become the reserve currency of the world? Do you see any threat of that or truth to that? Well, you know, the dollar really has a pretty strong hold on being the primary reserve currency. But there are different issues with all of its competitors. So the biggest competitor to the dollar is portfolio diversification. So if you run a sovereign debt

fund or you're running a central bank around the world and you're feeling that the U.S. is riskier than it used to be and the U.S. maybe isn't coordinating with other countries as much as it used to, then you might say, okay, I'm going to change my currency mix. So I'll own a little less dollars, but I'm going to own more of a slice of everything else plus gold. So portfolio diversification right now is the challenger to the dollar, but not any specific currency. Okay, so I'm not going to get you to wade into the Chinese politics there. Let's go back to gold. So is the gold story all about this dollar sell-off and inflation expectations, or is anything else going on there? Well, the gold rallies had a couple of legs to it. And the first leg up was really the change in the Federal Reserve to not be raising rates. They were raising rates, you know, and then they stopped raising rates. Yeah. And then they started lowering rates. And then we got the pandemic and they really lowered rates to zero.

So every time the Federal Reserve moved to an easier policy stance, you had another leg up in the gold market. And now it's not interest rates, but now it's the back to our modern monetary theory. It's the Federal Reserve financing the fiscal policy and the fiscal policy become incredibly expansionary. And then the cynicism of the gold bugs is, wait a minute, once these guys learn how to spend, they may just keep spending. I don't know if that'll happen, but that's the way a gold bug thinks. And it feels like that from a way like, oh, we threw trillions at it. It worked. Let's do it again. Now, right. If one trillion work,

let's try three trillion. Well, that's true of the Fed, but not the threw trillions at it. It worked. Let's do it again. Now, right, if one trillion worked, let's try three trillion. Well, that's true of the Fed, but not the U.S. government. The U.S. government threw money at the 2008 problem for exactly one year. They threw about a trillion extra dollars at it. But then they went into stalemate mode. They put the sequestration plans in place. And we had very tight fiscal policy from 2010 to 2017. And you could argue that that tightness of fiscal policy perhaps made the economy recover from the great recession

a little slower. But the Fed of course started the quantitative easing and just kept doing it for a while. So you know there's there's some different habits there. And what are your thoughts? I've been reading a lot recently on it's actually very tight right now for small business lending, like almost impossible for small businesses to get a loan, right? If they have revenue and they have profits, they're saying, well, we're uncertain of the future. And the flip side is they lost their demand and they have no revenue or profits, so they're not going to get a loan. Are you seeing any of those stats?

No, that's correct. The issue here is the Federal Reserve can provide all the credit they want to banks, but the banks have to make profits. And in a highly uncertain environment where small businesses are struggling in many, many ways in many industries, those loans are going to be hard to get. And there's really, you know, the Federal Reserve wants banks to make good credit decisions. So and banks are regulated by the amount of capital they have and so forth. So the bankers are going to be very, very cautious in a highly uncertain environment like we're in about putting those loans out there. And that's where, you know, the fiscal policy, making some loans available to small businesses, the Main Street lending program, the Paycheck Protection Program.

Those were very welcome provisions because the banks wouldn't have necessarily done that on their own even if you gave them the money to do it but in this case that that the other thing on small business or any business if you take on an extra loan that helps you get to the other side of the problem but it doesn't make you grow faster when the economy comes back because you're more indebted. You've got to be more conservative with your cash and with your business plans. So, you know, this is a complex issue, but, you know, fiscal policy stepped in to try to help that, but, you know, it's a huge problem. Right. And are bonds and gold, besides the interest rate differential and the fear of inflation, they're also pricing in a little bit of like, maybe this is a depression era, deflationary

environment based on all these small businesses not being able to grow and kind of a permanent lack of demand moving forward. Yeah, the jury is very much out on what's going to happen to inflation over the next couple of months. We've had some types of markets that have clearly been saturated with supply and their prices have gone down. But we've had other markets where because of disruptions to the supply side, they were hard to get and prices went up. So it's not clear how much of a deflationary situation we're in, but we're definitely in a situation with much less aggregate global demand. So you're not worried about inflation at all right now. And the possibility of a little bit of deflation is out there. It's definitely a possibility. And what are your thoughts on the you know we just keep having this further dichotomy

between the the biggest winner take all tech companies in the rest of the world even the right i think the five largest in the s&p are up 35 or something and the other 495 are basically flat or down something so do you see that as a problem long term? Not in their stock performance, but just if those, if the largest companies just keep generating more and more monopoly, I'd be hesitant to use that word, but more power in terms of demand and customer interest, right? If we have the rest of the companies have no interest, where does that leave us? Well, the pandemic has put us all working from home, or many of us. And so it's made technology a premium. So technology is one of those industrial sectors, which is a winner, if you will, or has opportunities to take advantage of

with the pandemic situation. But competition tends to come out of the woodwork on these things too, so. But even the technology, right? It's the largest of the large are the winners versus the whole sector. I think that's a bigger issue. Yeah, the largest of the large have gotten larger

because they've been very well positioned to provide the services that we needed during the pandemic. And, you know, a lot of the mainline traditional businesses, building cars, building airplanes, things like that, are, you know, they're on the other side of that coin. Unless you're building electric cars. And your name's Tesla, right? And just while we're on these big tech titans, what's the logic in the Fed buying the bonds of Apple, for instance, who have $190-some billion in cash and don't need anyone? Well, I think the Federal Reserve decided to throw the kitchen sink at issues, the problem. And they,

in particular, did not want credit spreads to get too wide. They felt that keeping credit spreads on, so they instituted a variety of buying programs that they had never done before. They'd never bought corporate credit. They'd never been involved in municipal bonds. They're not involved to a great deal of money compared to what they do in treasury. Treasury is measured in trillions. These corporate credit municipal bond programs are 30, 40, 50 billion at most. However, the announcement effect was huge. All the Fed had to do is say, we're thinking about buying some of these things and poof, the spread moved in. I feel like Apple's spread wouldn't have moved down to begin with. So it's a little bit odd to put in some of those names.

No, that's right. But, you know, on the flip side, they've also, the Federal Reserve is holding some not so good credits that have already been downgraded. Okay, true. And what happens to that money? Is that accrue for the benefit of the U.S. taxpayer? Well, we don't know. The Federal Reserve has never done this before. They've created some special purpose vehicles to buy these bonds. And now they're going to be on credit committees and things like that. And this is, excuse me, this is territory,

this brand new territory for the fed yeah and i think they're going to probably reach you know they're going to have some challenges but that includes the uh the purchases of the treasuries so they're that 46 percent of the treasuries that they're buying that's that goes into this slush fund as well i wouldn't use that word. Excuse me. The Fed has a really big portfolio. They're at $7 trillion. They were at $4 trillion on February 26. So it didn't take them long to get to $7 trillion. Treasuries make up a huge component of that portfolio.

Mortgages are next. And then these other things are pretty small. The Fed actually stopped increasing its assets on June 10th, or the week of June 10th. But they have been redeploying assets. So at the early stage of the pandemic, the Fed made a lot of loans, or we call them swap lines to foreign central banks because the dollar was strong at that point. Now that the dollar is weaker, foreign central banks don't need that money.

They've been sending it back to the Fed. And the Fed's been using it to buy intermediate and longer term bonds. In the initial part of the pandemic, the Fed was buying a lot of treasury bills and a lot of repo activity to make sure the overnight funding markets worked really well. That's the SOFR, futures and things like that. They work just fine. There are no issues there. So the Fed hasn't bought a T-bill in six or eight weeks. They're more in the intermediate, longer into the curve. So the Fed has, you know, what it was doing in March and April, it's reassessed that and it's adjusting its strategy as it goes along. So they're making, you know, their portfolio decisions based on what they're seeing, which markets they think need help to function properly. But, and can they just wipe that, some of those trillions off the balance sheet,

so to speak, or does it actually have to be sold to someone else and become a real world asset? You can't wipe it off. They, you know, the Fed actually, I mean, I bet they'll try, someone will try. You know, they bought something, so they own a bond. So it's going to be, we're going to see how, what they do to unwind this if they ever decide to unwind it. It is a little bit habit forming. So it'll be interesting to see what the Federal Reserve is doing in 2024 when presumably the economy is in

much better shape. But in theory, if they sell those holdings back to another party, that's not neither here nor there, right? That's not going to really cause an issue one way or the other. No, I mean, after the Great Recession and when the Fed bought that trillion dollars of very different kinds of distressed securities. A couple of years later, they auctioned them off and made money on it. And where did that money go? That back into the treasury? Ah, the Fed took the money in and bought mortgages and treasuries with it.

Okay. So it never is going to go back into the treasury. The Fed did shrink its balance sheet a little bit uh a couple of years back but uh it didn't last too long let me go back to uh we mentioned gold and silver a little bit. What's the dynamic on why silver delayed there and then played catch up really quickly? Any thoughts on that? Well, you know, gold is the go-to currency when you're thinking about international troubles, when you're thinking about inflation risk. So gold was the first out of the block, if you will. But the gold price, gold to silver ratio got kind of out of the block uh if you will but the gold price gold to silver ratio got got kind of

out of whack yeah and when gold was powering up people were saying wait wait a minute gold's gotten pretty far ahead of itself so what we're seeing now is really a catch-up to bring us the gold silver ratio more back into line which is typically what i don't know off the top of my head like neither do i 100 to 1 or something 80 to 1 no i don't know that ratio but essentially you're saying hey it should be rather standard through history of like well i mean it's changed through history but uh because silver used to have more industrial uses. I mean, you might have been a photographer at one point and you develop film and you needed silver. We don't need that anymore. Okay, so silver has adjusted to a different ratio, because it's lost some industrial demand. But that happened 15 years ago. So that's already done. And then let's talk Bitcoin for a sec. So it's been rallying as if it were gold, you know, as kind of an inflationary. Well, what are your thoughts? Is that rallying like as a gold proxy or is it rallying as a speculative asset?

Well, it's rallying, I think, in part because interest rates are zero. People are looking around and saying, where can I get some yield? Where can I get some money? So it's what we call a search for yield. It takes you into riskier things or more volatile things. And Bitcoin is not particularly related to the fundamentals that might affect other markets. So, you know, there are players in that market that do see value in adding that to their portfolio in these times. And what are your overall thoughts on Bitcoin? Did you ever think you'd be alive to see the day of the virtual currency? Do you feel it's a currency or what?

I don't know what I would put the category. I, you know, I put it in the category of a futures product. Yeah. And, you know, it's a futures product because the demand for trading it is out there. You know, you know, the exchange is agnostic. If people want to trade something and then if enough people want to trade it then we might offer a platform for that with what we did with with Bitcoin you know but I want you guys to do a box office receipt futures I feel like I'd be a great trader on that selling some of these new movies short buying other ones that'd be good Cantner fits jail tried that like two dozen years ago and i don't think it got approved but no i mean there there's there's a a large number of really great ideas for futures products that haven't worked i mean uh we we if you look over the history of

the hundred year plus history of futures exchanges uh they're they're littered with product projects that thought they were going to work and they just didn't. And that even when you do the research and you talk to people, they say, yeah, we'll trade that. But then they don't. But I have to say, CME Group, we're getting better at designing products. We've had, you know, the micro equity products have been a big success. You know, some of filling some of the gaps in the treasury yield curve with the ultra 10. And

more recently, the three year have been great ideas. So I think we're getting better at it. And what what is that ultra bond one? There's a what's the ultra 40? Fifth? What is that? That's essentially a 30. Okay. And and what happened you've got the the ultra bond you've got the bond which is closer to a average duration of 20 or 17 or something then you've got the the uh the treasury note which is like a 10 year but you can deliver a seven or eight year into it and then you've got the ultra 10 which is a closer window of delivery. So it gives people, you know, traders, risk managers, a really good look at the yield curve and they can position exactly where they want to be on it or run their risk management on the shape of the curve. And then you mentioned the Fed putting

overnight money for currencies. Have you seen the Turkish lira the last two days? What's going on there? It's like a 800% overnight funding rate or something? Well, you know, anytime a country has a lot of debt, particularly some debt not denominated in their own currency, and they have some political issues going on, and they're not growing. If they wanna control, if they wanna stop the weakness of the currency, rates could just go sky high for a little bit.

So, what are those places? Just a way to protect their currency without going into the open market, so to speak? Well, it makes the cost of shorting the currency very, very high. Yeah. And so that's the theory. And it can work for some period of time, but it hurts the economy. So there's a trade-off. And how do they do that? They're basically just not loaning out any currency. Yeah. Well, it's kind of like the Fed setting the Fed funds rate, just pop that rate up there. So, I mean, and when you're dealing with emerging market currencies, the interest rate differentials play a huge role,

and they're much more volatile differentials than they are with the major currencies, which aren't volatile at all right now. So you get to, you get some really nice moves in those interest rates, and then you'll get a big move in the currency and so it's a you know you've got to do your homework for that those kind of trades yeah no thanks and so let's let's circle back to the Fed funds rate that you just mentioned how long which I know you don't know the answer but let's discuss like how long are we gonna be at zero can we ever not be at zero right part of me is just in my real world of seeing friends in real estate and lending and whatnot, I feel like there's no way you can ever go back to 14% or something of these mortgages

that used to be in the 70s and 80s. I know we've talked before, I've never said never, but it seems to me that the world's addicted to low rates massively now. It'll be a big ask to go back. Well, it's true that the major countries are very much addicted to debt, which makes you addicted to low rates. But what can change, and we have no idea if it will or not, is the inflation environment. Inflation is very hard to start if you don't have any, and it's very hard to stop once you get a lot of it. Right.

See Japan for the first one and see Argentina for the second one. Right. You know, and the U.S. had creeping inflation in the 60s. It started picking up in the 70s. And then when the U.S. tried to stop it, it took a long time. And it took 20% interest rates to stop 10% inflation. Whereas, you know, so really, the inflation is going to be the key for whether rates stay very, very low. If we stay in a very subdued inflation environment, rates are going to stay low. But if inflation starts to pick up, then there'll be people that

get worried about that they'll have to protect themselves against the inflation risk and you will start to see action on rates eventually. property taxes, Chicago private school bills, and healthcare, like those are all growing at five to 10% a year. So there's huge inflation there that doesn't kind of make its way into monetary policy or theory. How do you square that? No, well, that doesn't square very easily. I mean, when we talk about inflation, we're talking about the average of the whole country. And you know, we're talking... not Jeff Malik's personal inflation. Yeah. I mean, you know, like, you know, you got your head in the oven and your feet in the freezer and you're fine on average. That doesn't work. Yeah. And, you know, so the average is definitely obscure. A lot of interesting things that are going on. But that shows up with different sectors

performing better. It shows up with the stock market maybe looking at one sector versus another. It shows up in people migrating to one state or leaving another. A lot of those things end up coming into play, but not interest rates. I just had that debate with someone the other day of whether it's ethical or moral to have, or wise to have inside the United States, basically competing, different states competing for citizens by offering essentially tax breaks and no state income tax here,

some income tax there. I think his argument would seem a more fair society if it was equal across the board in every state. Well, we're definitely a collection of states that have quite a bit of discretion in their taxation policies and are quite different one from the other. And that's their choice under our system. So I don't think that's going to change. And what do you do you have any thoughts or theories on whether right if all these people are moving to Austin, moving

to Nashville from high-tech states like Illinois, eventually it seems like they'll have to increase their taxes somewhere to pay for all that inflow, right? To pay for infrastructure and whatnot. So do they do it via, you know, maybe they don't add a state income tax, but you're going to be paying for it somewhere. Yeah, I mean, the states have to raise money somehow or another. And, you know, like your example of Tennessee and Nashville is kind of an interesting one, because they've really acquired literally, some pretty amazing musical talent from different places around the world, including Detroit and places, you know, like 10 or 15, 20 years ago, because Tennessee doesn't have an income tax, but it does have sales tax, and it does have property taxes, and you know, it just depends on your own

circumstances, whether it makes sense or not. And what some people I know down there say, now they have a traffic tax, not an actual tax, but the traffic is 10 times worse than it was a few years ago. Yeah, I mean, I think you can definitely say that places like LA and Atlanta also have traffic taxes. Yeah, and Chicago, except if you're like me and live in the city and work in the city, you don't experience it all that much.

So we touched on that a little bit of basically you're just saying they'll come off zero when there's a threat of inflation. Actually, they won't come off zero when there's a threat of inflation. They'll come off zero after the inflation has happened. Which might be too late. And they've actually, Chairman Powell has been very clear about that, that they're going

to let inflation overshoot their targets before they get worried about it. And so where will you see, what will be some of the signposts there to see when inflation has come back? You just watch the inflation data. When people start talking about it in the newspaper, when your taxi driver starts complaining about it, when your Uber driver complains about it, when your long lost cousin is complaining about it, then it's back. But in terms of real world, it'd be like, I can't afford to buy a house. It would be like San Francisco real estate right now. Like an average household can't afford to buy a two bedroom home or something like that. Yeah. When there's going to be a, we call it a narrative, but when the narrative takes over that the inflation is back

is when that'll be when the conversation starts at the Fed. And they will they will watch the data. But they you know, it is there. They you know, they were unable to get inflation as high as they wanted it. They couldn't get it to two or three percent. So if it ever gets to two or three percent, they're going to let it go to four because, and then they'll see what they want to do. But that's what they've told us. And the flip side of that is they can never get it back, right? And then you're Japan and you have, what are the issues on that side of the equation? Well, you know, countries that are aging and that are, have an old demographic tend to have

less inflation. So Japan is one of the older countries in the world. Average age is about 47. The U.S. will turn 40 in the next couple of years. But Western Europe, the U.S., Japan, and China, by the way, are all pretty older countries. And so, you know, that dampens the growth in demand over time. And so you just don't sense this, you know, that the inflation pressure is going to come back in that kind of situation. But absent that you'd see depressed stock market prices. What would the deflationary period look like for stocks, bonds, other asset prices?

If it's only one or 2% deflation, you're not going to see much reaction in stocks. But like in the Great Depression, prices declined about 10% to 15% on average. And that is a whole different game. That's a ball of wax. But we're not in that ball of wax. And that's why the Fed and the US government are spending so much money is they don't want to be in that. wax. And that's why the Fed and the US government are spending so much money is they don't want to

be in that. I mean, 1932 was three years after the recession, almost depression had started. And both presidential candidates ran on a platform of balanced budgets, they were going to be fiscally disciplined. But it didn't take Roosevelt won the election. And it was like only a few weeks later that he felt like this is not going to work. And, you know, he went after spending a lot more money and putting works programs in place because once you're in power, you realize it's going to take something special when you're in that kind of depression situation. The pandemic shutdown, you know, clearly called out the need for extraordinary fiscal policy. Any other thoughts that you have on what we got going on in the economy here? Well, I'll leave you with the thing that I'm doing the most.

I'm getting out of the prediction business, and I'm into what we call the now casting business. If you don't know where you are now, how are you going to figure out even where to go? And so as an economist, what we're doing is we're really, and I mean this in my peer group as well, we are studying a lot of data we never used to look at. Like I check every day now, I have it automated on my computer systems, but I check the number of people that go through security checkpoints at airports. I want to know if we're flying and I can get that data for free every day. Which we just-

Open table, you know, the restaurant group- 700,000. Yeah. Open table makes restaurant seatings available. I check that. Are we going back to eat or not? I'm actually looking at the data from New York City on how many people go through Times Square subway station every day, because that'll be my leading indicator, among others, of when the work from home starts to ease off. I'm looking at transit, you know, how much the commuter rail ridership is. And again, this is all public data that a typical economist wouldn't have looked at, you know, five years ago, two years ago. Yeah, it sounds more like the alternative data that hedge funds are using to get a jump on an economic number. But I'm using all of this data just so I know where we are today.

Yeah. Because that's what changes the narrative that, you know, generates market expectations. Is if we get a change in this higher frequency data that tells us the economy is coming back, well, you know, we'll get another leg in the stock market and things like that. And we're using different data and we're using it to just tell us where are we now? Look out the window. Is it raining or what? So tell us where are we now? What do all those numbers look like? If 100% is all the way back, what gives us a rough percentage based on all those indicators? Restaurants are about 45% back, give or take. Airlines are not there. They're in the more the 30% category, depending on the airline. Tourism is definitely even not as far back as that. So, you know, those kind of the hardest

hit sectors are not back to 50 percent. Some of them are not back to 30 some odd percent yet. On the other hand, the numbers on the pandemic cases, the surge that was going on in the Sunbelt states, that's starting to come down in places like Florida and Georgia and so forth. So we are getting some better numbers every day on some of the pandemic statistics. And then we didn't even talk about employment. So all those restaurants and commuting ties in with the employment picture. Where, what are your thoughts on the employment picture? Are those jobs gone forever or they'll be tied to those statistics coming back?

Well, part of what drove me to alternative data was the confusion in the employment data. Okay. You know, we, we started looking at the weekly new unemployment claims and then we realized that a lot of states were two or three weeks behind in processing that stuff. So that's not so good. We don't know what's going on.

We know it's not. There's still a million people applying for those claims every week, according to the data. But, you know, they're lagged. And then we looked at the employment, the monthly employment data, and we discovered in the unemployment data that some people were misclassified, as the Bureau of Labor Statistics told us. And so, and all of that data has lagged, at least a couple of weeks in the case of claims, but maybe more because of the processing slowdowns. And, you know, the employment, the jobs report has lagged a month, and it's only a snapshot from the middle of the month. So I think we're all going, in my peer group, we're all looking at any kind of data that's got a higher frequency on it that can tell us more. So the jobs data is not as important to me as it used to be, because by the time it comes out, I already know the story's changed.

Got it. And that would be the critique for your peer group and economists in general, right? If you're dealing with a lag, you know, famously people say no better than a weatherman in terms of predictive power. But what are your thoughts on those critiques? Well, you know, weathermen have gotten a lot better in the last 30 or 40 years. True. And, you know, with some satellite power behind them. Yes, with a lot of satellite power. And I do dabble in weather forecasting when I need to, particularly like, say, for spring flooding or not and harvesting the corn and soybean crops. Or when you're going out on Chesapeake Bay sailing. Exactly. So I have a lot more respect

for the weather forecasters than some people do. Exactly. So I have a lot more respect for the weather forecasters than some people do. And so when I get compared to a weather forecaster, I take it as a compliment. All right, done. And then one other thing you just brought up there, which I think is interesting, you're talking about the narrative, right? And you talked about that with inflation too. It seems the narrative matters more than the reality, right? Yes. There's a lot of debate about how expectations get formed. And a lot of economists do very detailed quantitative studies based on historical data to try to figure out expectations. But many of us believe that what the narrative, the prevailing narrative is way more important. And it can get out of line with reality, but then reality catches up and the narrative changes and it bounces back.

And so the proponent of this is Bob Schiller, Robert Schiller, a Nobel Prize winner, and he's written some great, a great book on narrative economics. But yeah, I think understanding how the narrative is going to change helps you understand how expectations will change. And then that's how the market's going to follow those expectations. And then it's not just the, right, there's competing narratives too, right? There's the actual narrative of all the investors and traders, but then you have the governments of the world trying to shape that narrative to make you believe what they want you to believe in terms of the data, right? Yes, and when you get competing narratives or sometimes we call them conflicting narratives,

you can get some very interesting risk profile probability distributions because if one narrative wins, you go one way, if another narrative wins, you go the other way. And so what that means is that the market today is pricing the average of the two narratives, and you know you're not going to stay there. You're going to go whichever one controls the narrative down the road. And so those are probably the most interesting risk events to watch. Yeah, it feels like in your brain you you think they might bounce each other out. But it seems if it's 51-49 one way, that narrative takes control and the market moves entirely that direction. If it flips 49-51 the other way, it flies in the other direction.

Well, to some extent, that's right. But what I'm really worried about is when it resolves. Like, say it's 50-50 or 60-40. And then you get some information that says okay the 60% narrative was right the 40% it goes to 100 yeah you know that's what happened with brexit I mean that's the classic you know do I stay or do I go and then you know after the the results come out you know you're gonna go and so the pound drops 7% on the day um anytime you get election risk

uh or policy risk or opec decision risk you can get people arguing one way or the other and then you find out the answer and markets move instantly quickly so now i was going to wrap up and now we brought up election risk so we got to talk about November. The VIX is pricing in a volatile period. You know, it's curve is in backwardation and then pops in October there. So what are your thoughts? Is it going to be volatile? Is it going to be one of these binary events?

Yeah, I mean, I'm in the camp that thinks we're going to have some pretty volatile markets around the election and in a couple of weeks afterwards. Yeah. And what do you believe the narrative is right now? That that'll be a Biden win or a Trump win? The narrative isn't focused as much on the president anymore. Okay. It's shifted to the Senate. Okay. If you read the stories every day in the newspapers and different kinds of social media, there's a lot more discussion that the Senate might be in play. And that, you know, we're pretty sure that the House of Representatives will remain Democratic. But the, you know, we're totally unsure about the Senate.

And I think that's the interesting debate, if you will, conflicting narrative, because if the Democrats have both houses of Congress, they will have a different kind of control. But if the Republicans have the Senate and the Democrats have the House, then you end up with a little more of a gridlock situation. So that is, you know, very interesting things to follow. But that, you know, you typically get election speculation, if you will, or prognostication after Labor Day. People really get focused. So we're in the last month where we can tune this out, and then we're going to have to get serious. Okay, I'm ready. Let's get focused. So we're in the last month where we can tune this out and then we're going to have to get serious. Okay, I'm ready. Let's get serious.

All right, let's finish it up with a few of your favorites we'd like to do. And thanks again for being here today. Favorite investing book, or I'll let you do economics book as well. My favorite investing book is Graham and Dodd. It's from the 30s. I think you can reread that as many times as you want and learn something. Okay. What's one good takeaway out of there? You really have to do your homework. You have to think about risk very, very carefully before putting on anything, and you have to calibrate that. So it's a very risk-based approach to investing. Favorite Chicago pizza spot? I'm afraid that would be my wife's pizza. Oh, she makes it homemade?

She can do it all, yes. All right, okay. You're gonna have to have me over for one of those. Favorite sailing spot, Chesapeake Bay, or have you been others? Oh, I've sailed a lot of places, and the Chesapeake Bay is my favorite. One of the things on the Chesapeake, there are a lot of restaurants when they're open that you can sail to and dock and have a nice meal, so it's destination sailing. The other thing is the Chesapeake Bay has a muddy bottom, sandy, muddy bottom. So when you accidentally go aground, there's no damage. If you're on the Long Island, if you're on the North Shore of the Long Island and you go aground, that means you've hit a rock and you've got a big bill coming your way. Yeah, I've hit rocks before. Off Florida, you hit the reef and yeah, it doesn't,

leaves a mark. And you're a tennis player too, right? Yes. Favorite tennis pro of all time. Oh, wow. You know, I would have to say Arthur Ashe. I go back a little bit, but he was just really amazing. But I also like Rafi

and uh how he plays I I you know I grew up playing on clay so I I do like that so Nadal yeah it's the man there he's only worth a couple hundred million these days so right um and then rounded out favorite Star Wars character? Definitely Pizza the Hut. All right, I'll take it. Thanks so much, Blue. This has been fun. Hopefully we'll get to see each other in person one of these days in the next couple months or years or whenever we're off lockdown. All right, sounds good. All right, thanks again. Thank you. You've been listening to The Derivative. Links from this episode will be in the episode description of this channel. Follow us on Twitter at RCM Alts and visit our website to read our blog or subscribe to our newsletter at RCMAlts.com. If you liked our show, introduce a friend and show them how to subscribe.

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