The Pomp Podcast - #1186 Darius Dale on Bitcoin Rally, Interest Rates, Inflation, & Banking Crisis

Episode Date: April 12, 2023

Darius Dale is the founder & CEO of 42 Macro. He is one of my favorite people to talk to about the financial markets. In this conversation, we talk about interest rates, inflation, bitcoin rally, stocks, cash, and what the Fed has to do moving forward. ======================= Pomp writes a daily letter to over 200,000+ investors about business, technology, and finance. He breaks down complex topics into easy-to-understand language while sharing opinions on various aspects of each industry. You can subscribe at https://pomp.substack.com/

What's up everyone? This is Anthony Pompliano. Many of you know me as Pomp. You're listening to the Pomp Podcast, which is my effort to find the most interesting people in the world and sit with them for hours while I ask questions in an effort to learn. We have no advertisers on this podcast, so it would mean the world to me if you would subscribe to the show on your favorite audio platform, watch episodes on YouTube, and tell your friends and family about the podcast. My goal is to help millions learn from the world's most interesting people. So let's get into today's episode. Darius Dale is the founder and CEO of 42 Macro.

He's one of my favorite people to talk to about financial markets. In this conversation, we talk about interest rates, inflation, why Bitcoin has performed so well to start the year, how he's thinking about stocks, cash, and what the Fed's got to do moving forward. I always enjoy talking to Darius, and I hope you guys enjoy this one as well. Here's my conversation with Darius Dale. This episode is brought to you by Accenture. When your advertising operations fall out of sync, everything else follows.

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You should not treat any opinion expressed by Pomp or his guests as a specific inducement to make a particular investment or follow a particular strategy, but only as an expression of his personal opinion. This podcast is for informational purposes only. All right, guys. Bang, bang.

Darius is back. Darius, Bitcoin, $30,000. now, two times off the bottom, 100% appreciation since the bottom. What exactly is going on? How are you evaluating what's going on with Bitcoin? Yeah, no, great question, man. I think it's a hat tip to anyone who made that call, specifically looking at my boy here over here, rocking the New York hat, I have to join you. But there's a couple of things going on in this market. And I think all of which are appropriate for where we are in this particular phase. And so we'll start with the market pricing in of the Fed pause pivot. Historically speaking, when we go back and we sequence, we've done a big study on bear markets through the lens of the S&P, whether it be through the lens of the inflation cycle, the growth cycle, but most importantly, the liquidity cycle.

And what we found is that a couple of things. Markets tend to bottom right around when the Fed inflexes liquidity cycle, either with rate cuts or pausing or panic rate cuts, et cetera, or doing QE, obviously, in the post-crisis era. But another thing that we've learned in that study is that historically speaking, pause pivots tend to be the most bullish pivots. And the reason I think that is the case, again, the data is speaking to me, is I believe the market, when the Fed pauses, looks forward and reflates soft landing expectations. They go, the coast is clear. Things are fine. You know, the Fed didn't break anything. It did not overtighten us into a draconian economic scenario. Therefore, investors feel a lot more comfortable taking risks. So I think that's part of what's going on here is the market is clearly sniffing out the Fed eventually getting to this pause pivot. We happen to think it's probably more likely to be the June meeting, but that's neither here nor there. It's obviously April. Markets are forward looking.

The second thing I think is happening in the cryptocurrency market, and this is broader markets in general, is the inflection in the Chinese both growth cycle and the Chinese liquidity cycle. And this is something that's had a pretty significant influence on global, you know, sort of assets, you know, really since October. You know, we've seen Chinese growth bottom and really start to re-accelerate, particularly coming out of the end of their zero COVID policy. And then more importantly, we're starting to see, we're not starting to see, we have seen a pretty significant acceleration in the size and growth of the PBOC's balance sheet. It's grown by roughly about, you know, 1.5 trillion yuan, which is somewhere around, let's call it 350, 370 billion U.S. dollars in the last three months. So that's very clearly been very positive in terms of supporting assets that the Chinese themselves like to speculate in, namely Bitcoin. So I think those confluence of factors are really contributing to what you're seeing on your screens here. What's fascinating to me is this idea of global liquidity. So a lot of people have been focused on the U.S. central bank balance sheet and obviously looking at, you know, it's going down, it's going down.

We're losing, you know, hundreds of billions of dollars off of that balance sheet. Quantitative tightening is happening. Oh, are they going to pivot? And we saw with the banking crisis, there was some liquidity added back. And is that QE? Is it not? But actually, since really the start of the year, we have seen a net growth of global liquidity, mainly because, as you point out, there's a ton of inflows happening in Asian countries. And so when we go ahead and we see that occurring, is that something that it's a simple look at the top 10 or top 20 global central banks and simply say, if it's net positive, asset prices go up.

If it's net negative and there's tightening going on on a global basis, asset prices are going down. Like, can we just boil it down to that simple equation? Yeah, that is actually true. I've done a tremendous amount of work on this and the correlations are very tight. They continue to be very tight. And this is across digital assets. this is called stratify assets both stocks and bonds you can very clearly see that tight correlation particularly on a levels basis in what we you know if you sort of aggregate what we would

we do here 42 macros we aggregate the top five central banks once you get beyond the top five you know there's really you're hardly talking about any share um so when you aggregate their their total balance sheet their size in u.s dollar terms what you see is global equity market cap is very correlated to that global fixed income market cap is very correlated to that and obviously in in the post-crisis era, digital asset market cap is all very correlated to that. So I don't think it's as simple as aggregating it because again, by the time you aggregate it, it's a coincident indicator. It's our job as investors to anticipate inflections and trends in the indicator as opposed to just acknowledging that it's gone up or gone down because by then it's obviously again,

too late to do anything about it in asset terms. It's our view for a variety of reasons that we're sort of getting, I wouldn't say to the end of the global liquidity cycle in terms of the inflection that we've seen, but we're certainly starting to see it peter out and stall out. And it's our view that by the time we get into the second half of the year, a lot of the positive dynamics that we've seen out of the Bank of Japan balance sheet and some of the positive dynamics that we've seen out of the PBOC balance sheet are likely to start to dissipate, which would ultimately give way to what we think is still ongoing, which is the balance sheet contraction here in the US vis-a-vis the Federal Reserve. So when we see this playing out, one of the pieces that I keep coming back to

is the United States Federal Reserve. They went ahead and they jacked interest rates from zero to 5% and they dropped a couple hundred billion dollars off of their balance sheet. We never got the official inflation number below 6% when they did all of that. At the same time in 2023, we have seen inflation month over month actually accelerating in what seems to be a little bit of a scary situation. And so if we are now talking about pausing of interest rate hikes and inflation has not come back down to 2%, should we just buckle up and expect 8%, 10%, 12% inflation? Or is there some other dynamic at play that will keep inflation down even if they return back to some level of a loose monetary policy? That's a phenomenal question. One of the

best questions I've gotten all year, because I think the underlying question within the question is, is this a Federal Reserve that is serious about its price stability mandate? Because I think that's the, if you have a, depending on what your answer is to that question, that really dictates what you're doing here in financial markets. We happen to believe that they are serious about their price stability mandate, and there's a couple of reasons why. One, it's very clearly that so many people in the United States of America live paycheck to paycheck, and so it's very clear from our perspective that under a democratic regime, democratic administration, you know, you have the left, you know, kind of pushing and leaning on the Fed,

Liz Warren being a prime example of that. We do believe that the Fed is sort of more focused, would be more focused on achieving inflation outcomes than it would be otherwise. But that's, I think that's less of an issue. I think the bigger issue is with respect to the Fed policy and its desire to get the inflation genie back in the bottle. I think it has a lot more to do with, you know, the financing in the treasury market. You know, if you go and you look at, you know, kind of, you know, you decompose the treasury market, you know, us, us private sector participants, we now own just shy of 40% of the treasury market, and that's up from like 30% in recent quarters. And, you know, part of the reason for that, obviously, we've seen

foreign central banks, you know, divest their treasury holdings. We've obviously seen the Fed divest its treasury holdings vis-a-vis QE. And obviously, you know, commercial banks, you know, are looking around and divesting their treasury holdings as well. Signature Bank, Silicon Valley Bank being, you know, two banks that have gone by the wayside because they didn't do it fast enough. You know, this is a real big issue. We're losing a lot of the sort of core components of the treasury demand curve. And the more we push the, you know, sort of the incremental kind of supply upon the private sector, the more the greater the probability is that we have higher and higher interest rates that we need to use to capitalize the U.S. government. And I think,

first and foremost, one, the Fed doesn't want that to happen to begin with because it's part of their mandate. If people think the Fed has a dual mandate, it doesn't have a dual mandate. It has three mandates, price stability, maximum employment, and moderate and long-term interest rates. And the moderate and long-term interest rate piece comes into play when you think about if you don't put the inflation genie back in the bottle, going back to your question, where are our long-term interest rates supposed to be over the long term? I happen to think the bond market thinks the Fed is going to put the inflation genie back in the bottle. That's why we still see interest rates with a three handle on the 10-year, et cetera. But ultimately, if the

bond market is wrong on that expectation, then we need a significant repricing higher across the entire interest rate curve to account for that. Ultimately, that's going to be extremely bullish for asset markets, right? You're talking about a Fed that's just going to be perpetually easy. But I think the process of going from point A to point B could be a little bit challenging. So I always like to dumb things down for myself to make sure that I understand. And one of the kind of ideas that I have or frameworks is, you know, when you're in high school and every weekend there's a party and you go to the party and they're like, you know, B plus, A minus parties. And you go every week and you see your same friends. You guys have a good time. But then

every once in a while, like maybe once a year, there's an absolute banger. Like there's just a party that you will talk about for 30 years. And it's usually because there's a bigger crowd. It's crazier. It's more fun. There's more alcohol. Obviously no one drinks in high school. It's just this awesome thing. Right. And when you think about that party, you basically spend the next couple of years trying to recreate the magic of like that one night, right? If you think of financial markets, 2020 and 2021 were the banger. Emergency interest rate cuts to zero, quantitative easing like the world had never seen before, and asset prices skyrocketed to the moon. It was awesome. We were all drunk and we had a blast. I think that an entire generation of investors

are going to be begging for a recreation of that time period? Will we see 0% interest rates and trillions of dollars of quantitative easing again in the next three, five, 10 years? Like, how do you think about the potential to recreate that type of environment versus like, no, maybe we'll just be in a more moderate kind of normal interest rate,

normal loose monetary policy type of environment? That's a phenomenal question again. That's all I do. That's all I do here. That's all you do is exit on the questions, man. I appreciate you, bro. So the answer is yes, but not to the same degree. I do believe we're headed for what we call, you know, recession, what most people call recession, what we call a phase two credit cycle downturn. Same, same thing. And in that process, the Fed is going to likely be concerned about ultimately the level of unemployment, et cetera, and will ultimately have to respond to asset markets telling it to do those things. Now, are we going to cut from five back to zero? Are we going to go back to $120 billion a month of QE?

I don't think so. I think what we saw on COVID was a pretty unique and extraordinary circumstance that, in my opinion, going back to this kind of chasing the banger of the party analogy, I think it sort of trapped a lot of investors in a regime that thinks monetary policy, the Fed reaction function, and the reaction function of policymakers globally is going to get easier and easier and easier. We happen to think the opposite is true. It's actually at every subsequent market cycle and business cycle, it's probably going to be slightly less easy than it was in the previous cycle. And I think this is going to be a classic example of that. And part of the reason for that is the underlying structural trend in inflation is transposing itself higher.

You know, we have a pretty sophisticated dynamic factor model that we built that is specifically designed to project a longer run trend of inflation, not just what inflation is doing on the next six month, next 12 month basis, but the underlying trend of the time series and that model suggesting that the underlying trend in time series is practically doubled, almost doubled from where it was trending at prior to COVID. And so that doesn't really sound like a lot, but not only is that doubling process a lot in Delta terms, but it's also, we're now talking about an underlying trend of core PC inflation, you know, underlying, you know, measures of underlying inflation, like trim means PC each median PC, you know, these are, these are kind

of your more wonky measures of inflation, we're talking about levels that are closer to three as opposed to below two. And when you have a level, let's not, let's remember the Fed's inflation target is 2%. And I think it's going to be 2% for quite a while until we get that employment rate high enough for them to have political cover to take it higher than two. But until we get to that point, it's very likely that this is a Federal Reserve that has to sort of, I don't want to say sit on its hands, but it's certainly going to be a lot more gun shy relative to the kegger that we just described, this banger of a party. Because again, inflation is a congressionally mandated mandate. As long as the treasury market's not malfunctioning, as long as the jobs market is

reasonably robust, they have to turn their attention to this congressionally mandated mandate. And it's unfortunate because we all know how this party ends, right? It's going to end with the cops coming and we're all climbing over the fence and running in the alleyway, we've been there. It's funny you say that, because that's exactly what my next question was gonna be, is it feels like the banking crisis where we saw the second and third largest bank failures

in U.S. history was kind of like when the cops show up and everyone's like, oh shit. And they just run to someone else's house and they try to get away, right? Like, is that part of it? God, I literally have so many great memories right now. this is so good i never did any of this by the way this is all hypothetical i read about it in books and watched some youtube videos but is that kind of what's going on is like hey we had the

party and then the cops are showing up and that's why there's bank failures and pain and people trying to figure out how the hell we're going to get through this without more things breaking you know i i wouldn't say it's the cops yet because i think the cops is the actual business cycle the cops are the hey look you did too much not only did you just cause a couple banks to go bust, you're actually causing a broader credit crunch in the U.S. economy, which I think is already underway. We can already see it in the C&I or in the small business lending data that we get on a weekly basis in the H-8 survey. But going back to the analogy, I think what Signature Bank and Silicon Valley Bank and the other bank that went with bust, this is what happens when

go bust people forget you um the so what i think is the more appropriate analogy for this moment in time is the nosy neighbor the nosy neighbor is knocking on the door say hey can you turn the music down or i'm going to call the cops and you know so you turn the music down you put everybody inside you pull the kegs inside and you know everyone's partying inside but eventually you know there's too many people there to keep the keep the party um keep the party going unnoticed for an extended period of time. So eventually, that nosy neighbor will call the cops. And ultimately, that calling the cops process, in our view, is the recession that, in our opinion, has yet to be priced in. So what are you paying attention to moving forward? Are there specific

metrics or data points that you're looking for that will tell you all is clear or brace for more kind of pain ahead? What specifically are you looking at? Yeah, great question. So there's never going to be an all clear signal, in my opinion. Financial markets never say, hey, sell here and buy here. That's just not how the process works, right? You have to fight through a lot of confirmation bias whenever you're making these inflection type calls at the lows or at the highs in financial markets. And we certainly have some great experience doing that. I think what you need to do is have a more robust process to understand, hey, look, there are some cycles that, you know, going back hundreds and hundreds of years of market history that need to get priced

in. We're talking about the employment cycle. We're talking about the growth cycle, the inflation cycle has yet to come come fully um you know fully uh get to where it needs to go and ultimately the liquidity cycle in our opinion has yet to meaningfully inflect so you know there's some you know with respect to i think the liquidity cycle is probably the most important one going back to that study we did on bear markets uh that suggests that markets tend to bottom right around that inflection liquidity cycle and the fed liquidity cycle because again dollar liquidity is the more important most important uh feature of that global liquidity system um you know when When we're looking at the dollar liquidity cycle, I think what's happening right now

that I think not enough investors are paying attention to is the destruction of private sector liquidity. We have M1 growth contracting at one of the fastest rates it's ever contracted. M1 is narrow money growth. This is the monetary base plus all the checkable deposits in the banking sector. And that money is effectively leaving the banking sector and chasing money market fund exposure, of which 83% is sort of treasury government style money market fund exposure. And as a function of not having enough T-bill supply, a lot of that money is winding up in

itself in the reverse loophole facility. So I don't see a real reason for that to stop until the Fed cuts interest rates. We're talking about a hundred percentile spread between what money market government, money market funds are paying investors at around, let's call it four and a half percent versus the 49 basis points that banks are paying on average across the country. And so that 100 percentile spread, in our opinion, was just the Silicon Valley Bank signature bank. That was the wake up call for investors to realize, hey, look, I press a few buttons and get a decent amount of money on my cash. And I think a lot of investors, it's very clear in the data that a lot of investors are doing that. And more importantly, it's very clear in the data that this is causing small banks, small regional banks.

And I say small with air quotes because the Fed defines small banks as any bank outside the top 25 in total assets. Well, these things are meaningful shares of the economy. They're about 40% of all loans and leases. They're about 30% of total bank deposits. So we have a serious problem in small banks. It's going to be a serious problem for the large US economy. And so I'm watching the destruction of private sector money and seeing how that is or is not being offset by the reflation of public sector money. It's clearly not being offset by public sector money reflation here in the U.S., but it has been offset by public sector money reflation in China and Japan. So what I'm most intently focused on is when that sort of crosses, you know, when we still have this public sector money or private sector money deflation here in America that, again, is not being commensurately offset by any central bank in the world. That's when I think we're going to start to run into problems in asset market terms again. And I think that's probably sometime in Q3, maybe early Q4. As we continue to watch this play out, Jerome Powell is going to have some tough decisions to make here. Are investors just watching him? Or do you think that investors will start trying to front run what they believe he will do? Do you see there being some other strategy for investors? It seems like a lot of people are sitting in cash or treasuries. They're trying to kind of figure out what to do. Real estate, there's almost like no deals happening, right? We've seen massive drop off because the cost of capital has spiked so significantly.

We've seen a lot of stocks fall. Many of them have not yet recovered. Bitcoin seems to be one of the unique ones where it fell and it's recovered pretty significantly, but it's still down 50% or so from its all-time high. What are investors going to do? What do you think they should be doing in this type of scenario? Yeah, in our view, because again, we have the view that there's going to come a time where that private sector money deflation is not being offset by the public sector money reflation.

It will eventually. But I think there's going to be a window of time that could be multiple quarters where that is not the case, where that public sector money reflation is not offsetting the private sector money deflation. This is happening globally, by the way. If you look at narrow money growth globally on a world PPP-weighted basis, it's actually declining for the first time ever, the time series, on a year-over-year basis. And so we have considerable private sector money deflation on us. Right now, it's just being offset for now. So in terms of what I think markets are doing, I think they're front-running the Fed. Markets are always trying to front run and game the Fed. Right. You know, if you look at the bond market, particularly the shorter end of the bond market, the money market curves, you know, they're pricing in some pretty significant rate cuts over the next 12 to 18 months.

In fact, if you look at the euro dollar curve, we're talking about three full rate cuts by the end of the year. So that's a pretty significant move. And I think that pricing in markets is effectively allowing investors to sort of buttress risk assets in the context of not seeing more private sector money deflation. That might be the theme of this interview. Right. You know, in the context of markets being able to say, well, we know the Fed's about to be easy so I can speculate. That's totally fine. And I think that's a very appropriate thing to do at this phase of the market cycle. I think as you roll the clock forward and maybe one, perhaps two quarters, I think the actual private sector money deflation will be too great for investors to speculate with. You're going to actually need that offsetting private public sector money reflation. And so I think the most appropriate thing to do as an investor, from our perspective, is to be reducing your risk at certain price levels. You know, we actually had a 30K price target on Bitcoin a few weeks ago, said, hey, look, it's probably going to go to 30K.

I think I would be selling it at 30K. Obviously, this is not the program to tell people to sell Bitcoin. But, you know, that's our, you know, that's our view for, you know, institutional investors, folks who are actually, you know, trying to risk manage the capital market cycle. So broadly speaking, equities, I think equities have a lot more downside in delta just terms and volatility just in terms than Bitcoin, because I think Bitcoin is actually undergoing what could potentially be a regime change. It's actually becoming the digital gold that it was marketed as for a long period of time, but technically wasn't. It was really just a high beta speculative risk asset, and it's now actually pulling forward some of these digital gold transitive properties. And so ultimately, I think that probably will insulate its downside, again, on a volatility-adjusted basis. It's a high-beta asset, so it's going to go down more if the S&P goes down a lot. But again, I don't think you need to be overly concerned about Bitcoin retesting its lows in a way that I do think you need to be concerned about the stock market retesting its lows.

Because again, the stock market has not only these liquidity dynamics and these growth dynamics to contend with, it also has earnings. We're about to go on to potentially be a very deep earnings recession. At the bare minimum, I think we're going to get a pretty deep earnings recession. And not only will it be deep in delta terms, it's also going to be deep in expectations terms. You look, if you pull a Bloomberg consensus earnings estimates, they're talking about earnings are going to be growing 10% in Q4 year over year. They could be down 30. Seriously, I mean, our model suggests the recession is likely to commence in the fourth quarter of this year. So, I mean, they could easily be down 30.

So, I mean, in our opinion, I think the stock market is probably the most dangerous asset class here. you know, gun to my head, I'd rather be long Bitcoin here than the stock market. But the reality is I'd probably be selling both. When you see a recession on the horizon, is it possible that some of these asset prices could continue to increase even in that recessionary period? So use Bitcoin as maybe the example. Is there a world where, you know, recession comes, we have to get some easing and that drives the asset prices up. And so we're in this weird world where like investment assets are going up, but the quote unquote average citizen is being hurt with a recessionary-type period, and so it's leading to layoffs and contraction

in revenues of companies and things like that? Or are these things more likely to move lockstep, and if we get the recession, then asset prices will go down? Great question. So the answer is yes, you could easily see asset markets rising, particularly once you get into the recessionary phase. And this is usually going back to that bear market study that we did with respect to the liquidity cycle. Markets tend to bottom around the inflection liquidity cycle whether that's the beginning of the recession or the end of the recession i happen to think it's going to be towards not necessarily the end of the recession but it will be well into the recession this time around and part of the reason for that is twofold one we still

have structurally elevated inflation if you look at core pce the fed's preferred inflation metric is compounding three month annualized at 4.8 percent and the reason i say compounding three month annualized is because we know core pce is going to go down on a year-over-year basis partially because mostly because the base effects are steepening as we progress throughout the year the issue with that is if you roll the clock forward long enough in time and you don't stop the compounding from compounding at five percent eventually you're going to bottom at five percent and start to re-accelerate from there on a year-over-year basis and that's why i'm so concerned and i think partially reasoned i think jay powell is so concerned about the inflation

dynamics so that's one reason why i think the fed's reaction function to the recession will be delayed in this particular cycle the number two reason which is probably should have been number one, which is I think the Fed is implicitly forecasting a recession. If you look at their summary of economic projections, they're calling for the unemployment rate, the headline unemployment rate to rise from 3.5% to 4.5% by the end of the year, so over the next nine months. There's never been 100 basis point increase in the unemployment rate without a recession in the history of the time series going back to 1940-something. Every time the unemployment rate is up 150, 100 basis points, you are in a recession. If I can figure this out, certainly

the PhD economists at the Fed can figure this out. And so I think implicitly they're targeting for some pretty, you know, meaningful increase in labor market slack that I think they're not going to be overly responsive to at the beginning of the downturn. They're going to say, yeah, we actually thought this would happen. They're not going to say, oh my God, the unemployment rates rise and we got to cut interest rates and do QE. And so that to me, that's very worrisome in the context of, you know, this broader deflation of private sector liquidity. It's like they need to be doing something now, in my opinion, if they want to ensure that we have a mild recession and asset markets can really survive that without being scaved too materially. I think they're going to

be way too damn late, to be honest with you. And that way too damn late is going to cause, in our opinion, a lot of problems in the second half of the year, most likely concentrated in Q4. Where can we send people to find you on the internet? You drop bombs on the show every time you come on. I always learn a ton from you. Where can we send people to find you? I appreciate you, brother. We drop bombs on the show, my friend. I appreciate you. So anyway, And come check us out, 42Macro.com. I'm on Twitter, 42MacroWeather. We have our private Twitter account, 42MacroIsWhere as well.

So, you know, we try to do our best to help the community, man. I think there's a lot of knowledge to be given away, you know, because as you know, you know this, I spent my career in institutional finance. And the reality is we all need this information. It's not just the hallowed halls of, you know, Parker Avenue and Wall Street and all this other, go to Boston and Congress Avenue. It's not, no. London and Canary Wharf, we all need this information, you know. And so that's what 42 Macro is here, is to democratize the world-class

institutional macro research. I think you're doing a fantastic job. Again, I learn something every single time we talk. So anyone who hasn't checked out 42 Macro, I highly suggest you do that. And we will definitely do this again in the future, my friend. Appreciate it. Thank you, man.

Appreciate you so much, though.