The Pomp Podcast - #1200 Darius Dale On Debt Crisis, Recession, Central Banks, Global Liquidity

Episode Date: May 23, 2023

Darius Dale is the founder & CEO of 42Macro. In this conversation, we talk about global liquidity, debt limit crisis, treasury issuance potentially up-ticking, and what this all means for asset prices. ======================= Pomp writes a daily letter to over 235,000+ 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.

In this conversation, we talk about global liquidity, the debt limit crisis, the treasury issuance potentially upticking, and what exactly this all means for asset prices. I always enjoy talking to Darius, and I hope you guys enjoy these conversations as well. Once you get done listening, jump on Twitter and let us know what you agree with and what you disagree with. The feedback always helps us improve these episodes and these conversations. Here is my conversation with Darius Dale. Your summer travels deserve an upgrade. With select Chevrolet, Buick, GMC, and Cadillac vehicles connected by OnStar, you can stream, game, and more on the go.

Whether you're headed to a music festival or a cottage getaway, you can access hundreds of apps on Google Play right from your center display. Explore OnStar tech today at OnStar.ca and discover how to take your summer to the next level. OnStar. Better never stops. All right, guys. Bang, bang. Got Darius here with me. Darius, I thought a great place for us to start this conversation is probably in one of the most important charts in global finance,

which is global liquidity. We know that there's all sorts of nonsense that's going on. There's the debt limit crisis, there's inflation, there's the Fed's comments, there's interest rates, etc. But global liquidity seems to be driving a lot of asset market movement. And so what do you think is happening with this global liquidity right now? Yeah, absolutely. And thanks for having me back. Always a pleasure to be with your audience, man. So I'll start by saying we think the debt limit is sort of the ceiling, whatever you want to call it, crisis or lack thereof, is very much a sell the news event. And the reason we think it's a sell the news event is because the return of Uncle Sam, i.e. the federal U.S. government, back to international capital markets is likely to drain

a significant amount of liquidity from the global financial system. So in this first chart we put up here, we show in the blue line the statutory debt limit as approved by Congress here in the U.S. that number is currently at $31.381 trillion. It's funny. We throw the word T around like it used to be a B. But anyway, so that number is at $31.38 trillion. The red line shows the U.S. debt outstanding that is subject to that debt limit. And as you can see, the red line and blue line have had the same value for the better part of 2023. And so that's one reason why we've seen such positive asset market performance in the first half of this year is because we have not had to compete with Uncle Sam in terms of in terms of all that liquidity demand for all that

liquidity. And secondarily, if you look at the black line there in this chart, we show the Treasury General Account Balance, which has declined all the way from a right around a little bit, a little bit over 800 billion dollars, you know, a few months ago, all the way down to 61. Sorry, not a few months ago, a few quarters ago, all the way down to 61 billion. That has been a positive development for the global liquidity cycle and has certainly been a supportive factor for why asset markets have been taking this kind of debt ceiling crisis, if you will, like it's not really much, like it's a walk in the park. Explain what happens when all of a sudden there's an uptick in treasury bills, right?

When the federal government starts issuing these things and we see this thing just tick up, what exactly do you expect to happen? Yeah, so actually that's on the second chart we show. So in the second chart, the title of the chart is a significant uptick in T-bill issuance would actually sterilize the pending rebuild of the treasury general account balance. So I'm sure most people know this, but for those of you who may be new to our ecosystem and how we think about the world, you know, the Treasury General Account Balance is one of the factors we use in our adjusted net liquidity model that we're trying to kind of contextualize, you know, the ebbs and flows of liquidity stemming from the interplay between the public and private sector.

So the Treasury General Account Balance, the best way to think about that is sort of the Treasury, you know, the U.S. government, the federal government's checking account that it has on balance on the Fed's balance sheet. And so that number, when it goes down, it ultimately means the Treasury is taking money out of the Fed's balance sheet and putting it into the real economy, either, you know, sort of a retiring debt vis-a-vis principal and interest payments, or they're using that money to spend on services, et cetera, in the economy. And so it's basically a net increase in liquidity when the line goes down. The line is about to go up and go up in a major way in the coming months. If you look at the most recent guidance that we got from the from the Treasury Borrowing Advisory Committee suggesting that, you know, this not this red line could be at six hundred billion dollars by the end of September. You know, so that basically be bouncing off zero. You know, so you're talking about a significant increase in the amount of money that the Treasury is going to take from the private sector to refill its coffers on the Fed balance sheet.

Now, you asked the question about T-bill issuance. One thing that could actually make that process a little bit less onerous for markets is the fact that if the Treasury, if Janet Yellen, Secretary Yellen decides to issue a significant amount of T-bills, i.e. instead of notes and coupons, these are shorter-term Treasury debt securities that mature in less than a year, there's a lot of excess demand in that black line for those particular types of securities. There's about $2.3 trillion in the Fed's reverse repo facility balance. Now, this is going to get even more wonky and esoteric, but I'll just be quick. That's basically money market funds looking for T-bills, unable to find them, so they're parking that money on the Fed's balance sheet and earning right around 5.05% for that money. So there is excess demand for these securities, but she may choose not to issue T-bills, and there's a variety of reasons why we think that. So when you look at these easing financial conditions but inflation running hot, I think when it begs the question like what actually is inflation right now, right?

You look at trueflation, that's down around 3%. You look at the official CPI metric, that's like 4.9%. Then you have the question of like does that actually get incorporated into whether they're going to issue the T-bills or not? I think, as you point out in one of these charts, that Janet Yellen used to actually run the Fed. And so there's some thought process around monetary policy, along with this debt limit crisis and a depleting kind of balance for the Treasury. How do you see Janet Yellen kind of decision making playing out here with quantitative easing or some sort of financial easing given inflation? Yeah, that's a great question. So let's let's let's summarize that before we even unpack the inflation can. And if Janet Yellen decides to issue a significant amount of T-bills on the other side of the debt

selling, which sometime around June 1st to June 15th or so is likely when we're going to have to have that thing moved or at the bare minimum punted into the future, she can choose to replenish the coffers. And then also don't forget the government has a pretty significant budget deficit of around 7% of GDP that they also need to finance as well. If they issue a bunch of T-bills, they can drain the reverse repo facility balance down and tap into that excess liquidity and make that process somewhat smooth for asset markets. However, if they choose to issue a bunch of notes and coupons, these are interest-bearing securities that mature a year or more, up to 30 years currently, then that process is likely to be very onerous for asset markets because we, the private

sector, are going to have to come up with funds to support that debt issuance. We're going to have to sell stocks or sell other bonds or sell Bitcoin or something to capitalize the U.S. government, maybe not on a one-form basis, but certainly that's kind of how it impacts the broader private sector. So going back to your question on inflation, we sort of have to ask, put ourselves in Janet Yellen's seat to give a sense of why she might choose to go one down, one door or into door B. And we hypothesize that because inflation is still running at right around two to three X defense price stability target, particularly when you look at these measures of underlying inflation on a three-month annualized basis, that it doesn't make a lot of sense for her to support

an easing of financial conditions, which would coincide with the flooding of the market with T-bills. And so in this chart here on slide three, we show median CPI, trim mean CPI, median PC inflation, trim mean PC inflation, core PC inflation, which is the Fed's preferred inflation mandate, and then super core PC inflation. And all these numbers is at least two to three X the Fed's price stability target on a three-month annualized rate of change basis, which is super important because after you get past June, we're going to start to lose the kind of the steepening of the base effects that have been driven driving, you know, year over year in price time series down in terms of inflation. And we might actually start to see

a bottoming process emerge in inflation time series on a year over year basis as we head into the back half of the year. So it's very unlikely, in our opinion, that Yellen is incentivized to do anything that would support, you know, asset markets and S&P going up, et cetera, because ultimately what that just means is it's going to continue to fan the flames of inflation in the U.S. economy. Inverted yield curve throws a another curveball in here. What what do you think that does? Yeah. So going back to this discussion on inflation, you know, we don't think Yellen is sort of incentivized to be very kind to asset markets, you know, in the in the months and quarters following this debt ceiling increase, because ultimately it means if she's if she's

being kind asset markets, she's ultimately being very kind to the real economy, which would be very counter to the Fed's stated objective of slowing the economy, causing pain in the economy so that we can get inflation back under control. The yield curve, this inversion in the yield curve, and it's a pretty significant inversion, one of the deepest inversions we've seen, you know, going back to the early 80s. This deep inversion in the yield curve

further disincentivizes her from flooding the market with T-bills. Because again, T-bills, which are the shorter maturity treasuries that, you know, mature up to one year, these have the highest yields currently. Whereas if you look at notes and bonds, you know, down there,

kind of that's what this green line shows in this chart here on slide four, the kind of the interest rate across the curve from bills to the left, all the way to the bonds and notes and bonds all the way to the right. And as you can see, she sort of incentivized at this particular juncture to lock in lower coupons if you kind of issue kind of in the belly of the curve, somewhere right around three to 10 years. And so the reality is just from a cash, just from a budgeting management standpoint, because obviously the treasury has to pay interest on all this debt. Just from a budgeting management standpoint, it does not behoove her to concentrate

a significant amount of issuance, which we think, according to our math, could easily be somewhere between $1 trillion and $1.4 trillion in the two quarters following the debt ceiling. Tons of issuance, a massive amount of issuance that we have to digest as from a market possessiveness standpoint. If she concentrates that issuance at the top left of the chart right here on slide four, they were going to have a problem as it relates to the U.S. government's kind of ballooning and urgent interest payments. So that's going to be another issue from the perspective of asset markets as well, because again, we don't think inflation or the yield curve is incentivizing her to make this rebuild of the TGA and just general return of debt issuance and debt deductions to

support the budget deficit to be a kind of a row walk in the park kind of process. When central banks are injecting all this liquidity into the market, I think a lot of times because we're so U.S. centric, we think so much about the Federal Reserve. We kind of think that everyone's doing the same thing. But obviously, we've seen Q4, Q1 that at the same time that the Fed was pulling all this liquidity out of the market, we saw other central banks, most notably in Japan and China, they were pumping tons of liquidity into the market. You've got a chart here that shows that now actually they may be done putting that liquidity into the market. Are they just running out of kind of dry powder? Are they changing their stance? What's happening?

And why do you think that's such a big deal? Yeah, great question. So I'll start by just just saying what is, and then we'll talk about why that may be. So to your point, yes, so what I'm showing in this chart here are the balance sheets of the ECB here in slide five, the Bank of England, the Bank of Japan, the People's Bank of China, and the Swiss National Bank. These are the kind of G2 through six central bank balance sheets that kind of amalgamate into our global central bank balance sheet metric, which also includes the Fed, obviously. And that metric itself feeds directly into our broader model for global liquidity, which ultimately includes global narrow money supply as well as global foreign exchange reserves. But just focusing specifically

on the central bank balance sheet aspect of that, particularly through the lens of the PBOC and the BLJ, we see that there's been a significant inflection in these balance sheets. What I'm showing there in the bottom panel of these charts is the three-month impulse, the trailing three-month momentum in each of these indicators. And as you can see in terms of the black bars and the red bars, we had a pretty significant swing higher from kind of the lows of late 2022 through the highs of 2023 in both of those indicators. At the highs of January of 2023, on a trailing three-month basis, the Bank of Japan's balance sheet was expanding by plus $953 billion, almost a trillion US dollars on a trailing three-month impulse basis. That number is now

minus $173 billion. PBOC, we had a pretty significant impulse, positive impulse in terms of its contribution to global liquidity, kind of in the early part of Q1 as well. That number peaked at plus $853 billion on a trailing three-month basis. It's now minus $277 billion on a trailing three-month basis as well. So these numbers take time to kind of flow through financial markets with a little bit of a kind of a lag. But the reality is both of these central banks, if you go back and you look at the reasons why they were so aggressive with their monetary easing kind of a couple of quarters ago, it was because A, the Bank of Japan was very much kind of defending yield curve control. There's a lot of speculative attacks in terms of the market,

you know, market participants speculating that they may change the framework at some point in the near future. And ultimately, those attacks have kind of gone by the wayside in recent months as we got Kazuo Ueda, the new Bank of Japan governor, has come in and pretty much doubled down on yield curve control. Now, I happen to think he's only doing that because he's setting up markets up to surprise them later on this year. But the reality is those speculative attacks have gone away. And as those speculative tax have gone away, we've seen the Bank of Japan's willingness or even need to supply the market with a ton of liquidity has gone away as well. Looking at the PBOC, obviously, you go back to late fall, China was real struggling to get off

the ground as a function of zero COVID, finally got the relaxation of that regulatory policy. And ultimately, we saw the PBOC really kind of step its foot on the gas pedal to get that recovery started, particularly in the context of what ultimately turned out to be very muted fiscal support in China. So it's pretty clear from our perspective that A, the signals that we're seeing from the fiscal authorities in China, i.e. very limited fiscal support, and also in terms of the growth target that they announced back in March for a full year of 2023, that it's unlikely that we need to see the PBOC very aggressively supporting the Chinese economy over the near term. Now, that may change if their recovery starts to wobble, as we think it already has

started to in the coming months. But certainly, it's unlikely we're going to see anything like what we saw, you know, kind of heading into the early part of this year. So if global liquidity, specifically coming from the central banks, is not linear, there's variation to it. Sometimes one or two of them are pumping liquidity. Sometimes others are draining it. Sometimes even the same central banks, as we're talking about here, can go from pumping in liquidity through taking it out uh why are asset prices trading i think as you point out as if global liquidity has now kind of bottomed and we're just going to go up and there's going to be more and more liquidity in this linear fashion yeah well that's that i think that's part of the narrative

machine right you know we certainly uh live in a kind of a narrative driven world you know as connected as ever been and there is this sort of narrative out there that you know liquidity is going to continue ubiquitously improving now i don't i did i very much agree with that narrative on a longer term time horizon you know 18 months from now global liquidity be way higher than it is currently maybe even 12 months from now but i think inside of 12 months from now you have to consider the path that it's going to take to get there and the reality is asset markets are currently pricing a very linear path to getting global liquidity much higher 12 18 24 months from now so what i'm showing in this chart here on slide six is our global liquidity proxy as i

mentioned that is the sum of the global central bank balance sheet which includes the fed the ECB, the Bank of England, Bank of Japan, People's Bank of China, and Swiss National Bank. That also includes global narrow money supply, which is the sum of the narrow money supply in each of those economies, as well as global FX reserves minus gold. And so when we're tracking, we amalgamate those three statistics, that's the blue line in the top panel there. The blue line in the second panel just shows the one year Z score of that particular indicator. And as you can see, it's a minus 0.7 sigma. So that's kind of where we are in terms of on a normalized basis in terms of global liquidity in terms of looking at it on a trailing one-year look back. When you apply that

same study to global equity market cap, which is the red line in the chart, or Bitcoin, for instance, which is the black line of the chart, we see that those one-year Z-scores for those two indicators are plus 1.1 and plus 1.2, respectively. And so very clearly, we've seen the recovery in asset markets outpace the recovery in global liquidity. Now, that may be the case that asset markets just got a little bit ahead of themselves and global liquidity is about to catch up. Or it could be the case that asset markets got a lot ahead of themselves on this sort of hope and expectation that the blue line was going to, you know, literally continue improving without even considering, you know, some of these post-debt ceiling dynamics that

we're talking about in the U.S. and some of these other central bank balance sheet dynamics that we talk about in Asia with people like China and Bank of Japan. When you see kind of the United States debt limit talk, let's bring this all the way back home um and it seems like all the attention is there the inflation number headline at least is coming down do you anticipate that we will get recession that we will get quantitative easing that we will get a pause like how do you look at the monetary policy and the actions of the federal reserve over the next let's call it uh 90 days or so in light of kind of the air being sucked out of the room on this whole debt limit thing isn't really a monetary policy thing right it's not

it's not something that the Fed is actively involved in or should be involved in. And so it seems like you ever seen the meme where there's the three people and it's like the Fed's in the background and then the person's looking at the treasury, right? Like that's literally what's happening right now. It's like, what's going on in the back? What's going on with the other person, right? What's the Fed going to do over the next 90 days in your opinion? Yeah, great question, man. Look, and this is why we talk about all this stuff all at once, you know, it's, you know, trying to, you know, one, this whole concept of global liquidity is a very kind of squishy concept. So you need to, you know, I think what we do at 42 Macro is try

to do a very, you know, institutional level job of trying to amalgamate this stuff and keep track of it, you know, in the way that you would if you were sitting in a buy side chair. And so, you know, you're going back to answer your question specifically as it relates to the Fed. The Fed is, in our opinion, very much engaged in the monetary policy pause as it relates to its interest rate policy. One thing that we have not talked about at all because it hasn't been relevant in 2023 is their balance sheet. Because the federal government has not been issuing debt on a net basis, particularly coupon debt, which kind of drains out more liquidity from the private sector than T-bills, given the reverse ruble facility balance. Because we've not been issuing

that coupon debt for basically since January, quantitative tightening has had no bite. It has not drained bank reserves. Those securities have just rolled off the Fed's balance sheet. And we, the private sector, did not have to fund the next round of issuance from the Treasury because there was no next round of issuance. We've been at the statutory debt limit since January. Once we get past the statutory debt limit, i.e. either it's moved or it's punted into the future in terms of the continuum resolution, we're going to, not we, the Treasury will start to issue debt again. And so that ultimately means that that quantitative tightening process that we expect the Fed to continue to be engaged in, at least into the recession, is very clear and evident

in the labor market, just given the kind of dynamics that we expect to see in inflation over the next few quarters, until the return of this debt issuance is going to cause quantitative tightening to start draining bank reserves from the global financial system again, which ultimately means the asset markets, from a liquidity perspective, when you tie in the Fed back to the Treasury and ultimately layer on some of these foreign central banks, et cetera, some of the moves that we're seeing there, it's very likely that we go back to liquidity conditions that look very much like 2022. Now, will they be as bad or as negative as they were in 2022? That's unlikely. However, you know, from this particular starting point,

from a, you know, very rapidly forming investor consensus around this kind of ubiquitous expectation for, you know, kind of a linear recovery in global liquidity, I think you're, you know, we're probably setting up for at least two, perhaps as long as four to six months of, you know, kind of, you know, 2022 like, you know, liquidity conditions, which are obviously not very good. As we look into debt limit crisis kind of off of the cliff, if you will, are you doing anything different in your portfolio? Debt limit? No. I mean, we're pretty de-risk. As you know, we run a systematic risk management process in terms of our portfolio construction ideas and pivots. And so that process is north of 50% cash, very limited exposure to fixed income markets. In fact, the asset class that we have the most exposure to currently is in the equities, but it's still kind of de minimis relative to its min and max range.

So I don't think you need to be trading as an investor the debt ceiling itself. I think the bigger trade, the more structural overhang on our asset markets is what we've been talking about for the last 20 minutes, which is we're going to go from this very, very positive six-month period in liquidity conditions to, at the bare minimum, a somewhat bad period over the next, let's call it two, perhaps four months. That somewhat bad period could be very bad depending on the composition of debt and the speed of debt issuance that the Treasury Department elects to pursue in the coming months. So it's not going to be a good summer from our perspective, from the perspective of taking risk in asset markets. Is this the beginning of the big bang that we've expected, you know, kind of as it relates to the U.S. recession process that, in our opinion, is likely to spill over to the global economy? I don't think so. I think we're probably going to get, you know, a nasty set of market conditions over the next few months. Markets will probably find some low there, rally towards, you know, Q4, maybe even into year end. And that's probably it for this market cycle.

Where can we send people to find you or find out more about 42 Macro? I appreciate you, Pomp. So definitely come check us out at 42 Macro. Obviously, we tend to cater to professional investors, institutional investors with our research, but we also have plenty of research products and services for retail investors, crypto investors. I like to think that what we're trying to do is help regular everyday investors weaponize their risk management with the same kind of information that we use. you know, we, you know, we, we can, you know, we contribute to, um, to, to the breast and brightest institutions on global wall street. I always appreciate talking to you. And I learned something, I think every single time today, I learned multiple things, which means it's a great

day. So I appreciate you coming on and, uh, and doing this and we'll do it again in the future. Absolutely, brother. I appreciate you.