The Pomp Podcast - #1391 Darius Dale | How Japan Broke Bitcoin and Stocks!

Episode Date: August 7, 2024

Darius Dale is the Founder & CEO of 42Macro. In this conversation, we talk about what is going on in Japan, how that affects US monetary policy, global impact of a weaker US dollar, inflation, global liquidity, and what you should be paying attention to as an investor.  ======================= CrossFi is the Apple Pay for Crypto. For the first time in history, anyone with a web 3 wallet like Metamask can spend crypto through a physical or virtual visa cards anywhere in the world where Visa is accepted. Be one of the first to get your hands on a CrossFi card and a prize pool of $3 Million Dollars by joining and participating in their testnet today: ⁠⁠⁠https://xfi.foundation/users⁠⁠⁠ ======================= Gemini is the safe and secure way to trade crypto. Gemini is offering eligible new users the opportunity to earn $100 in BTC when they trade $1000 in crypto within their first 30 days of signing up. Head over to https://www.gemini.com/partners/pomp and start trading crypto to earn $100 in BTC. ======================= Pomp writes a daily letter to over 265,000+ 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/ ======================= View 10k+ open startup jobs: ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠https://dreamstartupjob.com/⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠ Enroll in my Crypto Academy: https://www.thecryptoacademy.io/

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. 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. What's up, guys? Bang, bang. I've got a special treat for you today. We've got Darius Dale, founder and CEO of 42 Macro, is back. He had to take a couple of weeks off because he became

a father, but he is back in prime shape. Darius breaks down with extreme clarity what's going on in Japan, how that affects US monetary policy, what a weaker US dollar would mean for international commerce, and what you should be paying attention to as an investor in asset markets. Darius is one of the best people that I know at trying to unpack the data, pull out the insights and explain it in plain English. And today is a masterclass in what's going on in financial markets. So here is my episode with Darius Dale. Anthony Pompliano runs Pomp Investments. All views of him and the guests on his podcast are solely their opinions and do not reflect the opinions of Pomp Investments. 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. Today's episode is brought to you by CrossFi. CrossFi is the Apple pay for crypto. For the first time in history, anyone with a Web3 wallet like MetaMask can spend crypto through a physical or virtual Visa card anywhere in the world where Visa is accepted. No more exchanges or middlemen. Just link your wallet, get your card, and start spending today. CrossFide card transactions have already been successfully processed in New York, Los Angeles, London, Dubai, China, Japan, and over 20 other countries. Be one of the first to get your hands on a CrossFide card and a prize pool of up to $3 million by joining and participating in their testnet today.

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will give you $100 in Bitcoin. If you head over to Gemini.com slash partners slash pump and you trade $1,000 in crypto within the first 30 days. all right guys darius is back and i thought a great place to start is there's massive chaos and uncertainty in financial markets there's this carry trade going on in japan everyone seems to think japan is blowing up which means the rest of the world is going to fall suit what's going on and why are so many people worried about japan right now hey absolutely man well thank you for having me first and foremost it's great to be back it's great to be back as a dad joining you in the uh fraternity uh so we'll start with uh with chart one where we just show

uh the policy rates for the fed the ecb the bank of england the bank of japan and the swiss national bank and then we show what their respective money markets are pricing in with respect to either rate cuts or rate hikes over various durations and what we see in japan the reason why we're hearing about this unwind of the jpy carry trade of the yen carry trade is because many financial institutions globally have funded their levered positions in the jpy market because as you can see in the chart, Japanese yields have been significantly lower than the rest of the world's major central bank yields. And so it's been a lot easier to finance yourself in JPY, convert that to USD or to euros or whatever else you need in terms of the investments that you're

actually trying to make. And we're starting to see a little bit of an unwind of that. Now, we saw that the Bank of Japan came out and they started talking about what they're going to do on the monetary policy side. We also see some things in kind of the US dollar markets that is telling us what they believe the Fed should be doing. So how do you think about the recent BOJ comments, but also kind of what the market's telling the Fed to do? Well, the recent BOJ comments were very supportive for asset markets, and rightfully so. The Bank of Japan essentially came out and said, okay, we get it, we get it, we're going to back off. It wasn't our intention to create this kind of volatility with respect to their own policy normalization drive, which is

hiking interest rates in Japan versus our policy normalization drive, which are lowering interest rates in the U.S. And if you look at U.S. dollar money markets relative to what the Fed is sort of last guided to with respect to a stock plot, U.S. dollar rates markets are very much out in front of the Fed, which meaning the Fed is behind the curve with respect to the amount of policy rate easing that we're likely to see between now and December 2025. We're somewhere around 100 basis points priced into U.S. dollar money markets of rate cuts priced in through a year in 2024. And then I want let's say another, let's call it 125 basis points from there. And so when you get to the year in 2025, the market is essentially 100 to 125 basis points priced in more cuts than the Fed. It's

effectively begging the Fed to stop hurrying up and waiting and start cutting so that it can preserve the US business cycle. Now, if we were talking about this in 2021, interest rates were at zero, that'd be a big, big problem. We'd be going negative for sure. But the Fed, maybe the only thing they got right so far, or maybe kind of a blessing in disguise, is they have raised interest rates at a very aggressive pace. And so they have, you know, call it five and a half percent or so of interest rates to cut if they want to. You've got some analysis as to what they normally do in these easing cycles

and how much they cut. What is your kind of conclusion from that analysis end up being? Yeah. So going back to a great question, going back to last Friday, in our opinion, the reason we saw an acceleration in the unwind of the end carry trade and the by the spike in volatility that obviously Fed led over into Monday is because the rest of the world, the world investors got very concerned about the prospect of a U.S. recession. Recall that the rule was triggered in the July jobs report. And so investors got very spooked in terms of the

likelihood that we would see an accelerated policy rate cutting cycle, monetary easing cycle out of the Fed, which historically has been about 400 basis points in a recession and recessions caused by tight monetary policy, the Fed has cut rates by 475 basis points on a median level. And so that extra 200 basis points of rate cuts relative to what's already been priced into the forward rate curve got investors very spooked about the speed of the unwind of the end carry trade. If we're going to take rates, US dollar rates down 200 basis points more than what was already priced in, you're talking about a dollar that's going to get absolutely smoked. And again, that's going to rally sharply and cause a lot of those carry trades to unwind in a more forceful

manner. Now, the Treasury bond market also, I think, is kind of trading in this lockstep. What exactly is happening here? Yeah, absolutely. So we can see this chart just shows the December 2024 Fed funds rate yield minus the current Fed funds rate shows the 25 yield and then ROIS derived a Fed or Fed funds rate. And we can see that the both the bond market is evidenced by the 10-year yield and the currency market, the U.S. dollar, are moving in lockstep with the market implied path of the policy rate. And so it's actually it's helpful to know that this is the Federal Reserve that's being cajoled by financial markets to understand that to get rates lower here in a more expeditious manner. Now, these central banks don't act in a vacuum. Obviously, people in

the United States pay attention to the Federal Reserve. There's people in other countries that pay attention to their local central bank. But you can compare the relative decisions, right? If the Fed does something and maybe the ECB doesn't, et cetera, what is the market telling us in terms of what the Fed's going to do compared to everyone else around the world? Yeah, that's a great question. So in this next chart, we just show what the markets are pricing in for a policy rate easing relative over the next year for each of the Fed, the ECB, the Bank of England, the Bank of Japan, and the Swiss National Bank.

And we also show that relative to the Taylor rule spreads. So what we did in this chart, we show we take the 12-month bill yield for those respective economies. And then we subtract the baseline Taylor rule estimate for those potential, for those central banks, which is an estimation, which is a model implied policy rate estimate based on John Taylor's famous formula. And so what we see is that the Federal Reserve relative to its Taylor rule implied policy rate is much tighter than all the rest of the world's central banks. It's only 70, the current Fed funds rate is only 74 basis points lower than the implied Taylor estimate, not the Fed funds, but rather the 12-month T-bill yield. We're using 12-month

deal yields to actually contribute the influence of forward guidance to the analysis. And that minus 74 basis points compares to minus 439 basis points currently for the ECB, minus 322 basis points for the Bank of England, minus 441 basis points for the Bank of Japan, and minus 279 basis points for the Swiss National Bank. So the market is saying that the Fed is by far the most tight central bank right now. And as a function of that, when you look at current money market pricing, the market is saying the Fed is going to cut rates much faster than these peer central banks over the next year. And so right now, the overnight index swap market are pricing in 215 basis points of rate cuts by the Fed over the next year. That compares favorably to only 145 basis points of

rate cuts by the ECB, only 129 basis points of rate cuts by the Bank of England, plus 17 basis points of rate hikes by the Bank of Japan, and minus 63 basis points of rate cuts by the Swiss National Bank. So if that actually occurs, if that's in the area code of correct, then we're going to see a downtrend in the U.S. dollar over the next 12 months as markets reprice, as some of these carry trades kind of reprice and the mismatch between dollar funding, yen funding, etc. starts to kind of unwind a bit and perhaps in a more less deleterious manner. Now, what's interesting about this is this weaker U.S. dollar has some implications. You've got two implications here, one with the PBOC, but also a kind of cross-border trade.

And so explain how you see a weaker U.S. dollar playing out. Yeah. So one of the things that we've been pounding the table on here is that the U.S. economy has been resilient. We've been talking about that here on this program for literally two years now. And so having authored that being back in the summer of 2022. And what we're trying to explain to investors is if we get a sustained downtrend in the U.S. dollar that is not moving with the speed that we've observed over the past few days,

i.e. is the speed that's causing a lot of the net volatility because it's causing funds to unwind positions in a more kind of risk manager kind of forceful manner. If we can just have a gradual unwind of those positions and a falling dollar, that would actually support global liquidity through the lens of the cross-border financing channel. So in this chart, we just show the net international investment positions of all the major capital exporting economies in the world with Japan, China, and Germany kind of all being up there at the top at around $3 trillion or a little bit over $3 trillion a piece. And so if we get a weak dollar, a sustained weak dollar, it's very likely that we actually see

it would be a lot easier for these economies to create cross-border lending vis-a-vis in the euro-dollar market and other forms and fashions that we typically see across the world. So this would be a very supportive dynamic if it happens a lot slower than what we observed the past kind of 72 hours. Now, I know that at 42 macro, you guys have these two models. There's a grid model and then you have this kind of weather model. Maybe you can give us an update on that. Like, what are you seeing with the grid model and what is it telling us? Yeah, great question. So our grid model is just showing that the U.S. economy is likely to go into bottom-up macro regime deflation here in the third quarter. That's growth decelerating and inflation decelerating

simultaneously. We're not overly concerned about that because, as you can see in the bottom left of the chart, we have our estimates for GDP growth are actually much higher than consensus estimates for GDP growth. And that's likely to remain the case over the next 12-month forecast horizon. We've been consistently ahead of consensus for the past roughly three-quarters now with respect to U.S. growth, and we don't expect that to change over the medium term Because again, we do our deep dive business cycle analysis, we come to the conclusion that there's very limited risk of a recession in the US economy over the medium term. Now that could change a financial market, you know, sort of force, force, you know, change the wealth effect and cause business investments slow, i.e. you have a negative wealth effect that kind of filters through the economy, but that's not our baseline expectation. Our baseline expectation is an economy that is slowing, but is likely to surprise consensus estimates to the upside throughout. We also have inflation slowing, you know, kind of bottoming in Q4 before starting to meander higher in the first half of 2025.

I do believe that's going to be a market risk for investors to have to deal with in 2025. But I don't think we have to price that in currently because we're still in a phase of accelerated shelter disinflation. And when you go to slide nine there, we show the grid model of progressions for not just the U.S. economy, but for all the economies in the world that we maintain grid models for. You go down, you look at the bottom, the world grid is actually different from the U.S. grid. So we have growth slowing in the U.S., but actually diverging globally where you see that the world economy is likely to be in Goldilocks through year end and then transitioning to kind of a reflation later in the year. And if you look at this on a mode basis, i.e. the highest frequency across all the economies in the model, the rest of the world is likely to remain in Goldilocks, which, again, is growth accelerating and inflation decelerating, which is obviously a very supportive backdrop for asset markets. That's the highest probability outcome for not just the world economy, but for the mode of all the economies in the sample right here. So that's a really positive, supportive dynamic for liquidity as well.

Now, in the weather model, what is that telling us? Yeah, so the weather model, so we use those two models to assess the probability of regime change in asset markets. The grid model gives us a medium to long-term time horizon look. That's anything between three and 12 months. And the weather model gives us a short to medium-term time horizon look into the probability of regime change in asset markets. And that's anything from one to three months in terms of our risk management nomenclature. And what we find right now in the weather model, we're seeing a neutral signal for the stock market and a neutral signal for Bitcoin, which it tells you that investors should be expecting baseline type returns in

those asset classes over the next three months. I'll give you that without going down each of these indicators, the things that are contributing to a relatively sanguine outlook from a short to medium term time horizon perspective, an uptrend in global liquidity right now. That's probably the biggest factor there. We have rate cuts priced in, in terms of the two-year nominee yield benchmark policy rate spread. We also have the unemployment rate is projected to decline from here over the next 12 months. You may factor in consensus estimates. We also have other supportive dynamics as well. And so how this model works is what it's trying to do is now cast current trends across all these principal components of macro, starting with the real economy cycles on the left

and the financial economy cycles on the right. And each of those trends contributes independently to the rolling three-month forward return projection that you're seeing for the various asset classes. And so we're relatively sanguine here. We understand that growth is slowing. So we're probably going to have defensive leadership in asset markets when you think about this from a factor standpoint, types of sectors and factors within the equity markets and credit markets that are likely to lead. But we're relatively sanguine on the actual beta of those asset classes from a medium to longer term perspective, because we just don't see the kind of economic risk here in the U.S. that would cause the Fed to slash rates much deeper and much faster than what's currently

priced in, which would obviously cause the unwind of the end carry trade to accelerate in a more deleterious manner. Now, you mentioned that you think that inflation is going to kind of continue to slow and then it will start meandering up. What is really driving that, especially kind of around the turn of the year? Yeah, absolutely. So base effects are the primary driver of that. We're going to start to kind of lap the easy compares in inflation starting in Q1 of next year. And in our opinion, not in our opinion, according to our research, we've done a tremendous amount of work on understanding all the dynamics within the context of the business cycle. And the thing we found, one of the more

important salient takeaways from our deep dive business cycle study is that inflation is the most lagging indicator of the business cycle. It typically only breaks down below trend 12 to 15 months after a recession has started. So without a recession projected to start, at least according to our forecast and according to how the current compendium of persistent leading indicators are aligned, since we don't see a recession, it's very likely that we just hit the bottom and start to cycle higher again in inflation, which has historically always happened. There's never been a business cycle in the history of the post-war U.S. economy that saw inflation return durably to trend in the absence of a recession. So we're not betting on that to be the first time here.

It may happen. We may be wrong in that expectation. But we ultimately think that as long as we do avoid recession over this kind of next 12-month forecast horizon, then it is very likely, based on how the business cycle is historically performed, that inflation will start to bottom and accelerate from a level that is inconsistent with the Fed's 2% target. But as you and I have talked about on the program, we know the Fed doesn't want 2%. They probably want 3%. They're just pretending like they want 2% for credibility's sake. How important is who wins the presidential election in November to all of this kind of economic analysis? Does it matter? Oh, it's very important in my opinion. So as you go back to

that grid model, you see where we are most divergent from consensus with respect to our bottom-up macro regime projections up there in the top right is that we are expecting a bottom-up macro regime inflation to persist for, you know, kind of starting in a little bit in Q4, really, not really, you won't notice it from a data standpoint, but you really start to notice it, in our opinion, once we get into the first half of 2025. And the reason we bring that up with respect to the election is, if you think about the Kamala Harris winning the election, it's probably just more of the same from an economic agenda standpoint. Maybe there's, you know, tinkers there, tinkers there, flip a lever here, flip a lever there. But the reality is, we're probably

going to see a lot more of the same with respect to Biden's industrial policy. The big difference, in our opinion, with respect to the economy, is if we saw a Donald Trump, a new Donald Trump administration, because if you go back to the Republican National Congress or whatever they did last month, they outlined two day one policy initiatives by a new Trump presidency. And number one would be mass deportation, which would obviously be a negative supply shock to the labor market. Recall that immigration has been a positive supply shock to the labor market, allowing the growth, the labor market to grow in terms of total employment, while also emitting downward pressure on wages. That was obviously a really positive dynamic.

And so if you reverse that, you're going to see a reversal of that in the economic statistics. And then number two, in terms of the day one policy priorities for the Trump administration are tariffs, hiking tariffs, you know, positionally broadly and very aggressively against China. So in our opinion, we already projected to have bottom up macro regime deflation, you know, really starting to hit the tape in the first half of next year, which is growth slowing and inflation accelerating. And obviously, if we saw a Trump 2.0 administration, then I would just exacerbate that with respect to the day one policy initiatives that they already outlined. Now, everything that you're talking about, I think is kind of directionally based on there

not being any sort of catastrophic external, you know, surprise, black swan, etc. One of the things that I found interesting is Wharton's Jeremy Siegel was on CNBC earlier this week, and he called for a 75 basis point emergency rate cut, and then another 75 basis point rate cut in September. Those emergency rate cuts, I mean, we did get them in 2020. I think we had two of them that brought us down to the 0% interest rate. What would have to be true for the Fed to cut rates in an emergency fashion before the September meeting, do you think? Oh, that's a great question. So we would need to see a freezing up of the credit and repo markets. And that's obviously not been the case thus far, at least.

So when we talk freezing up of the credit markets, that just means the primary, the market for primary credit issuance, companies borrowing money from investors, that market closes up like we saw in December of 2018. And we would likely need to see a freezing up of the repo market in the sense that you're seeing very aggressive collateral haircuts, the hypothecation in the repo market starts to contract and we get less and less leverage being extended to borrowers in the repo market. which is what happened in the summer of 2019. We would have to see some type of dynamics. One or both of those dynamics would need to occur to cause the Fed to pivot. Recall that the Fed pivoted

early January of 2019 after the Christmas blow up when the credit market froze up. The Fed pivoted in the summer of 2019 and started doing stealth QE after the repo market kind of seized up back then. And obviously, we saw emergency cuts and very aggressive alphabet super monetary policy initiatives in March of 2020 with COVID. So there's a playbook for this. We're not expecting that kind of deterioration, because ultimately, we don't see the economic outlook as supportive of that. Now, we could be wrong, because again, what we're more concerned about right now, which is the thing that's harder to forecast, and I would argue it's probably impossible to forecast, is the endogenous risk, the market risk. We've been talking about this all the time,

about exogenous risk, what's happening with policy, what's happening with growth, what's happening with inflation. In Dodger's market risk is what's happening within the players of the market and how they are impacting each other. And so the thing that I'm most concerned about over the medium term as an investor is continued unwind to the carry trade in terms of risk managers at various firms, forcing investors out of positions, forcing portfolio managers out of positions. And that is the kind of thing that could feed on itself. We're not forecasting it to feed on itself, but nobody can credibly forecast that kind of the dynamic. And what that ultimately would result in is if fund A blows up and has to unwind all

of its positions, and it'll impact fund B's positions, and then fund B blows up and impacts fund C and so on and so forth. That is a legitimate material risk. And I don't want to mince words and sound overly Pollyannish and overly optimistic right now. We're cautiously optimistic right now because we understand that the exogenous market risks aren't nearly as onerous as they were kind of felt to be over this weekend. But we do believe the endogenous market risk has not necessarily subsided. And until we get more quantitative confirmation vis-a-vis our risk management signals, then I think investors should be proceeding with caution until we get those kind of all clear signals over the coming days and weeks.

You know, Darius, you now are a dad and some people, they become a dad and they lose their kind of sharp edge. They start to degrade away. That didn't happen to you. I think you've gotten better since you became a dad. So I appreciate you coming on and kind of walking us through this. I think there's a lot of people saying, hey, there's this chaos, this uncertainty that's kind of playing out, trying to wrap their head around it. Where can we send people to find information at 42 Macro

if they want to subscribe there? Look, I appreciate you, man. You've been a wonderful role model as a father. So I just want to say thank you for all that you've shown me and taught me over the past few years. Obviously, investors that want to have the opportunity to invest with confidence and clarity in these volatile times,

that's exactly what we do for our clients here at 42 Macro. So definitely come check us out. Obviously, we have an institutional field to our research in terms of our core client base, but obviously we have thousands of retail investor clients around the world that are benefiting from our clear and actionable signals as well. So we just appreciate everyone for joining us and come check us out, 42macro.com. Amazing. We'll definitely do this again next month. So I appreciate the time and hope everyone learned something today. I appreciate you, Bob, and thank you very much.