1:55

And

2:00

what are you thinking the odds are that the Fed hikes? You're

2:04

exactly right, Jack. It's been a whirlwind. Up

2:06

until future vice chair Jefferson

2:09

spoke, I think the market was thinking we'd have another

2:11

hike in June. The market was

2:13

thinking that because we had some hawkish commentary

2:16

from Governor

2:18

Wallace. So Governor Wallace,

2:20

sorry. Governor Waller basically highlighted

2:22

three scenarios. He said that in June,

2:25

there are three ways this can go. One is

2:27

that we just pause here, Fed was done with the hikes,

2:29

and we're gonna keep rates where we are for

2:31

the rest of the year. Option

2:33

two, we're gonna hike. And option

2:36

three, we're going to skip. So

2:38

we won't hike in June, but we'll hike

2:40

in July. Now Governor Waller heavily

2:42

suggested that he was in favor for the latter

2:45

two. So he thinks that we're not done

2:47

yet, but he's not sure if we're gonna hike

2:49

in June. And that was king of the

2:51

market for somewhat

2:53

of a chance of, I think better than even chance

2:56

of a June hike. But then future

2:58

Vice Chair Jefferson spoke and he's like, I'm

3:00

all in on the skip. So he doesn't wanna hike

3:02

in June, he wants to hike in July. Well,

3:05

he's just saying that obviously he has no idea how things

3:07

would turn out. I think this will ultimately

3:09

hinge upon what happens with the non-form

3:11

payrolls, which report tomorrow, Friday.

3:14

If we get hot payrolls, I think we'll get a June

3:16

hike. If not, I think we are

3:18

not gonna get high. It's really just not

3:20

just gonna come down to what happens Friday.

3:23

Okay, so the June hike in your mind, Joseph, is still on

3:25

the table, even though we had, you know, our

3:27

friend Nick Timaros came out with the article today that said,

3:29

you know, that it's leaning

3:32

that it's gonna be more of a skip than a hike.

3:34

It depends on what happens Friday. I think unless

3:36

we get a really hot job support, I think we won't

3:39

hike. But it could be that

3:41

they already have a lot of strong indications of

3:43

what the job support would be. So they do get data

3:46

in advance, how far in advance. I'm

3:49

not super sure. I don't know if Jefferson knew about

3:51

it when he gave his speech a couple of days ago.

3:53

Got it. Alex, what are you making of this? Yeah,

3:56

I think similar to Joseph, although I think we've

3:58

been more in the...

3:59

the Fed can afford to

4:02

skip kind of camp. We've

4:06

obviously had issues in the banking system throughout

4:08

the spring that have tightened

4:10

financial conditions, even if they don't

4:12

show up in many common financial conditions

4:14

indices as such. So

4:18

they've already done a lot of tightening. Things

4:21

are moving in the right direction, maybe

4:23

not as quickly as they would like. And

4:25

so this is an opportunity for them to

4:28

revise their forecast for the remainder

4:29

of the year. We'll get new SEP

4:32

dots obviously in June.

4:35

And then they can sort of assess. We

4:37

obviously just had the resolution of the debt ceiling.

4:40

We have a deluge

4:43

of issuance that's gonna come forth

4:45

in the coming months. I think

4:47

Joseph's very well positioned to talk

4:49

to that. And so

4:52

there's some amount of tightening that could be done

4:54

on their behalf in

4:56

the coming weeks from

4:59

that draining of reserves that may take place.

5:01

So I think they can afford to skip, but I

5:03

think it is pretty much a toss up. The comments

5:06

were not just from Jefferson, but also from Harker. And

5:09

so it does seem like, we're

5:11

kind of heading into the blackout period.

5:13

And it seems like certainly some people

5:15

wanted to try and push the probability

5:19

back towards at least even odds, if

5:21

not less than 50%.

5:23

Joseph, I wanna ask you, how legit

5:26

is this idea of a skip?

5:28

And sort of a metaphor from life,

5:31

two people are dating and they're having problems. They

5:34

say, oh, we're gonna go on a break. But sometimes that break

5:37

is a euphemism for we're gonna break up,

5:39

right? It's like, we're probably not gonna get back together. So is

5:42

this skip a way of

5:44

sort of a euphemism for we're not

5:46

gonna hike in June and we may hike in July and then

5:49

up they don't hike in July. What do you

5:51

make of this?

5:52

That's a great point, Jack. It could

5:55

simply be that the Fed actually doesn't think

5:57

that they're done, but here's the

5:59

problem.

5:59

If they were to say that they were

6:02

done, I'm just a pause and hope

6:04

for the rest of the year, the market will aggressively

6:06

price in rate cuts. Now,

6:08

I don't think the Fed wants that. The Fed wants

6:11

the market to believe them that they're

6:13

going to hold rates around 5% for the rest

6:15

of the year, higher for longer, as it would say.

6:18

One way to quote unquote trick the market

6:20

into pricing this is to say that, yeah,

6:23

we won't hike in June, but don't price

6:25

in rate hikes. Don't price in rate cuts. We

6:27

might continue to hike later on. So

6:29

I don't know if it'll work or not, but that's one way

6:32

to do it. And I think Alex made a really good

6:34

point that this is a June meeting, so we're

6:36

going to get some SEP dots. The SEP

6:38

dots is the Fed's somewhat

6:41

of a forecast of where they're going to, where

6:44

rates will be and where GDP and inflation

6:46

will be for the next few years. That's

6:48

also an opportunity for them to emphasize

6:51

to the market that they want to stay higher

6:53

for longer. So they could, for example,

6:55

not hike in June, but in their SEP

6:58

dots show

6:59

slightly higher, slightly revised

7:02

higher rate path projection to kind of counterbalance

7:04

that. So there's a few ways they could communicate

7:06

that to influence markets.

7:09

And I would say it is my expectation

7:11

that the dots will move up in

7:14

June. So that'll be potentially

7:16

a way for them to sort of

7:18

try and pre-commit themselves to continuing

7:22

the relationship with rate hikes, as it were. Now

7:25

let's move on to your latest piece from FedDai.com,

7:28

which is called Back to 2019, which

7:30

is about a certain trade that

7:32

was very popular back in the day. It

7:34

didn't get popular because there was

7:37

a blow up, but now it's getting popular. So what

7:39

is the Treasury Cash Futures

7:42

Basis Trade and why is it significant?

7:44

And we have all your charts here so we can put them up.

7:47

Oh, great. The Cash

7:49

Futures Basis Trade is basically an

7:51

arbitrage trade where on the one hand,

7:54

you sell short treasury futures and

7:56

on the other hand, you own cash

7:59

treasuries.

8:00

Now, sometimes there's a disconnect,

8:03

this kind of a disconnect between the pricing or

8:05

the cash futures pricing

8:08

and the cash futures

8:10

pricing is off. And

8:13

so if you are a hedge fund, what you would do is

8:15

you would try to arbitrage that difference.

8:18

Now, this is important because

8:21

when you do this trade, you oftentimes do

8:23

it in size. So the basis

8:25

is the amount of money you can make on this is really

8:28

small. And so you have to lever yourself up to,

8:30

let's say, a few hundred billion dollars overall

8:32

to make it worth your while.

8:34

Before 2019, this

8:36

trade was huge. And you can see

8:39

in the block charts that I have there that heading

8:41

from 2018 to 2020, the

8:43

amount of long treasury exposures

8:46

the hedge fund community had and the short, big short,

8:49

uh, treasury futures positions

8:51

were rising. Now,

8:53

the funny thing is this basically

8:56

made the hedge fund community the marginal

8:58

buyer of cash treasuries heading

9:00

into 2020. So a lot of people talk

9:02

about, well, the treasury is issuing so

9:04

much debt, it's going to be one to $2 trillion

9:06

a year for forever. Who's going to buy all that

9:09

debt? Before 2020,

9:11

it was the hedge fund community from 2020 to 2022, it was the commercial

9:13

banks and of course

9:16

the Fed.

9:17

And now it looks like the hedge fund community

9:19

is back into this trade where

9:22

they're buying a lot. If you go down

9:24

a little bit, you can see the repo volume surge. So

9:27

when you are,

9:28

yeah, so you see that surge

9:30

in repo volumes. So when you're in this trade, you

9:32

have to buy cash treasuries and you finance that

9:34

in the repo market. And you see that surge there

9:36

over the past half year coincides

9:39

with also short treasury futures by

9:41

the hedge fund community. So you can see that

9:43

strongly suggests that this trade is back. And so

9:46

when people are worried about who's going to buy all those treasuries

9:48

that are coming, not that the debt ceiling is over,

9:51

it seems like it's going to be the hedge fund community

9:53

because they want to do this trade.

9:55

Another thing that's really interesting is that,

9:57

you know, as our friend Andy Collins,

10:00

Johnson noted, for every long, there's

10:02

a short. Now why is there a

10:04

disallocation in the

10:06

treasury futures basis? It's because

10:09

it seems a lot of the real money investors,

10:11

they are gaining exposure in treasuries by

10:14

buying them. And so they seem to want

10:16

to have greater exposure to duration.

10:19

Maybe they're part of the low inflation or recession

10:22

trade, I'm not sure, but it's because

10:24

that they want to have more exposure, that

10:26

the basis widens until the hedge funds come in

10:28

and try to close it. So that kind

10:30

of, in my view, reveals some positioning

10:33

of the investor community in the market.

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11:10

Let's get back to the episode.

11:13

So I'm not an expert on this

11:15

at all, but I'm just going to break down how I see

11:17

it. So you want to go long bonds or

11:19

short bonds, there's at least two ways to

11:21

do it, two main ways to do it. There's

11:24

the cash bond market, where you actually take money that you

11:26

actually have and then you buy it.

11:29

And you can lever that up, I guess, via repo, but those

11:31

are real bonds. Whereas that's

11:33

different from futures, where it's a contract

11:36

through the CME Chicago Market

11:38

Child Exchange. It's the same way you'd go long

11:41

cattle futures or you'd go short oil

11:43

futures. It's a derivative.

11:45

It's a futures contract, so not cash bonds.

11:48

So there's the cash market and then there's the

11:50

futures market. And for various

11:53

reasons, I mean, I think in the piece, which

11:55

is called Back to 2019,

11:57

tax efficiency, if people want to go long.

11:59

and as well as just leverage ease of use, they

12:02

can go long, let's say a bunch of two-year future,

12:04

two-year note futures, and it will be a constant two-year

12:07

contract as opposed to they buy a two-year

12:09

cash bond, in six months

12:11

it's gonna turn into a one and a half year bond, which is kind of annoying.

12:14

So people who wanna get long, a

12:16

lot of them are doing that via the future. So

12:18

that pushes up the price of the futures relative

12:21

to the cash two-year note. So it's

12:23

gonna make it, if it's $100 on the futures

12:26

versus 99

12:29

and 0.98

12:30

or something on the cash bonds, that's the

12:32

price, the yield will be a

12:35

few basis points of difference. So they short

12:37

the futures and then buy the cash bonds

12:40

and they do that via repo and that's

12:43

actually one of the charts we'll put up right here is

12:46

just how this sort of trade works.

12:49

And then it's kind

12:51

of free money. So what can go wrong

12:55

with this Joseph? And now we'll actually move

12:57

on to this chart, which a lot of people

13:00

on Twitter posted and been impressed by

13:02

this, not this chart, but a chart that shows

13:04

the

13:05

bottom net line or something similar,

13:08

this is hedge fund net short position, but something

13:10

from the commitment of traders that shows speculative

13:12

positions are record short the bond markets. People

13:14

are saying, people are getting really into this bond market

13:17

short and they make the

13:19

contrarian trade deal. If everyone is short, then you

13:21

wanna be long. But as Andy

13:23

Carlson says, there's a net long for

13:25

every short. And some of those people, they're

13:27

not macro hedge funds who are making

13:30

a bet that rates will

13:32

continue to go up. A lot of them are just

13:35

what you were saying Joseph, doing this basis

13:37

straight. So they're short the futures, but they're also long

13:40

the cash bond. So it's not as if it's

13:43

not a directional trade, right? Exactly,

13:45

it's not a directional trade. So if you're thinking

13:48

that all the hedge funds are just short bonds

13:50

and they're gonna have to capitulate, that that's definitely

13:53

not what's happening because they're hedged,

13:55

right? They're short the futures, but they're long the cash bond

13:57

as you explained very well, Jack. So,

13:59

they're not in there for the directional exposure,

14:02

they're in there for the bases. And what

14:04

that means is that as the future contract

14:07

rolls toward expiration, see

14:09

the

14:10

futures price and the cash price converge

14:13

and the investor that harvests the bases.

14:15

So they're not really betting on

14:18

whether or not, let's say, treasury prices

14:20

go up or down, yields go up or down. They're just

14:22

doing this arbitrage trade. That's

14:24

all they're doing. And it went really, really

14:27

wrong in 2020 in March

14:29

where the bases usually will definitely

14:32

converge. But before it converges,

14:34

it can widen further. And in March 2020, it

14:36

widened significantly. And then

14:39

a lot of people got washed out and

14:40

people lost a lot of money. And it disappeared

14:43

for a couple years until

14:45

a few months ago. But

14:48

that doesn't seem like what's going to happen right now.

14:51

Basically, you're collecting pennies in front of steamroller. Got

14:54

it. And the steamroller, a lot of

14:56

people were flattened in September 2019.

14:59

I think that's why the Fed had to do

15:01

repo injections as well as March 2020. A lot

15:03

of flattenings happened. Alex, what

15:06

do you make of this as someone who follows

15:08

positioning really closely? Yeah,

15:10

so I'd say a couple of things. One,

15:12

as somebody attracts flows quite

15:15

closely, maybe just add a

15:17

little bit of perspective

15:19

on the long

15:21

cash bond position that we're seeing from

15:23

asset managers in the CFTC data. So the

15:25

first thing I would say there is that we've seen

15:28

pretty strong inflows into fixed income

15:31

funds this year. And so if you're

15:33

a bond manager and you're getting inflows, you

15:36

have to deploy that AUM somehow.

15:39

So you either need to buy cash bonds or

15:42

buy treasury futures to gain that exposure. So

15:45

they have to do something with it. The other thing

15:47

is, is we track some data that we collect looking

15:49

at the largest US bond

15:51

funds. And we look at their duration

15:53

position versus their benchmark. And

15:56

they basically have been short

15:59

for the last

15:59

several years, but actually

16:02

year to date and in recent months,

16:04

they have flipped to being modestly net long

16:07

duration relative to their benchmark. So I think

16:10

both of those data points do provide,

16:13

the CFTC data, as you say, for every

16:15

long there's a short, but

16:17

I think that those two data points that

16:20

are sort of from separate sources do add

16:22

some confidence

16:24

that maybe these asset managers are

16:26

in fact getting longer duration

16:29

and buying

16:29

bonds. So I just wanted to add that perspective.

16:32

It's the exact opposite of the chart

16:35

of the commitment of traders shorting futures.

16:38

The levered funds that Joseph was referring to doing the basis

16:40

trade, I defer to him on the

16:43

basis trade side of

16:46

that and the hedge fund activity, but I was just trying

16:48

to add perspective on the

16:50

asset managers that appear to have the

16:53

net long in treasury futures that

16:55

is the offset, the long that is offsetting

16:57

the hedge fund short. Just

17:00

adding some perspective that we are seeing inflows

17:02

to bond funds and we are seeing that bond funds

17:05

are increasing their duration relative

17:07

to their benchmark. And

17:09

so that provides some kind of evidence that

17:12

these asset managers, these bond funds

17:14

are in fact buying

17:17

bonds and futures and extending duration.

17:20

Got it. And that is a directional position. So the people who

17:22

are long are largely directional,

17:24

whereas the people who are short are, it's an ARB, they're

17:27

short against a cash position. So really,

17:30

based on Joseph, what you and Alex are saying,

17:33

putting it two and two together,

17:35

the case that is put by someone on

17:37

Twitter who says people are so short

17:39

bonds, therefore they must go up,

17:42

it's actually the exact opposite. Let's

17:44

go through the whole picture though too. What's

17:46

the perception? What's the sentiment? What's

17:48

the, well, people are worried about a recession,

17:51

it seems. And if you look at the path

17:53

of Fed policy that's being priced into short interest

17:55

rate futures, everyone's like either,

17:58

everyone's worried for downside risk.

17:59

That's why they're pricing in a lot of Fed

18:02

cuts later in the year. So that seems consistent

18:04

to me with people more afraid

18:06

of downside risk or lower inflation or something

18:09

like that.

18:11

I think that's right. And something certainly

18:13

that we've seen not just in US fixed

18:15

income this week, but kind of globally in fixed

18:18

income over the last week, we've had yields moving

18:20

lower in a lot of different jurisdictions.

18:23

Maybe the UK is, I mean, even there yields

18:26

have moved lower over the week. But the

18:28

inflation trajectories that we're seeing, the intent

18:31

that we saw in Europe, have people

18:33

kind of starting to second guess

18:35

or scale back their hiking expectations for the ECB.

18:38

As I said, the UK is a little bit of an outlier.

18:41

But overall, I think when

18:44

I look at markets, when we look at markets, sort of from a global

18:46

perspective, there's a lot of worry

18:49

out there

18:49

in recent

18:51

sessions about global

18:53

growth and about the growth outlook. I think a lot of that

18:56

stems from China. But I

18:58

think that there are, there's a sort of a real mix

19:00

of data points. You look at the ISM today was

19:02

very weak. We'll see what payrolls

19:05

does tomorrow, obviously, as Joseph mentioned. Right.

19:07

And so Alex, what are you seeing on the

19:09

global bond allocation

19:12

front, not just into particular

19:14

US Treasuries, but what are central

19:16

banks doing? Are they buying or selling bonds or letting them roll

19:19

off? What are reserve managers doing?

19:21

What are portfolio managers doing? In 2022,

19:24

the bid for the bond was

19:26

clearly not there. Bonds had a historically

19:29

horrible year in 2022.

19:31

What's your outlook for 2023 based

19:33

on the flows that you're seeing?

19:35

Yeah. So maybe I'll just step back and talk

19:37

about 2022 for a minute. From my perspective, tracking

19:43

global capital flows, 2022 was kind

19:45

of a banner year. We

19:47

had some really big stories and really big

19:49

flows and big shifts. So

19:52

we had the Eurozone gas crisis,

19:55

which led to the current account position

19:57

in the Eurozone deteriorating by 2020.

21:59

of oil. And so

22:02

those high energy prices were also weighing on

22:04

Japan's surplus. And

22:07

at the same time, you have sort

22:09

of the move in interest rates in the US

22:12

that really changes the calculus

22:15

for a lot of Japanese investors, some

22:18

of whom buy foreign fixed income

22:20

securities by Treasury securities or Eurozone

22:22

government bonds on a hedged basis,

22:25

and some of whom buy it on an unhedged basis.

22:27

And so given the change

22:30

in slope of the yield curve

22:33

in the US, those hedging costs became extremely

22:36

prohibitive. And so you had a lot of

22:39

Japanese fixed income investors kind of unwinding

22:42

or rolling off some of their

22:46

hedged global fixed income holdings. So

22:48

it was kind of a very complicated mix. I

22:50

think it was sort of encapsulated

22:53

by the mood that we had really, let's

22:56

say last September, October, if you

22:58

recall that

22:59

period, August through October roughly,

23:02

or we had Treasury

23:05

yields just kept grinding

23:07

higher, fixed income vol was really

23:09

elevated, energy prices

23:11

were super high. And

23:14

we had the Japanese Ministry

23:16

of Finance intervening in currency markets.

23:18

We had emerging markets

23:21

intervening in currency markets. And

23:23

so it was actually a pretty tense and

23:26

messy environment from

23:28

an international finance perspective.

23:32

It's very unusual for Japan to intervene

23:34

in currency markets. I think it's the first

23:36

time that they've sold in decades,

23:38

sold foreign currency in decades. So

23:41

when we had this sort of doom loop where they,

23:44

rising yields were causing them to sell

23:46

and then their selling was causing yields to rise

23:48

even further. So

23:51

we were in kind of a bad equilibrium

23:53

there. And then we got the relief

23:56

from the sort of peak

23:58

out in CPI. in November,

24:01

and the dollar really started to soften, and

24:03

the flows started to improve, and

24:06

intervention tapered off. So I think this year,

24:08

coming into this year, we were in a much

24:10

better place than where we came

24:12

from in 2022. Energy prices had come down, the

24:15

Eurozone

24:17

situation was more stable, fixed

24:19

income vol was kind

24:21

of moderating and going down. February,

24:24

we had a little bit of a return to

24:26

the dynamics of late 2022, and then we had

24:30

the banking issues in the US,

24:33

which really took US yields

24:36

and Fed hiking expectations down at least

24:38

for a time, and that also

24:40

provided some relief for these reserve managers

24:43

and others. But when we

24:45

look at the Japanese flows, the hedging

24:47

costs, the yield curve shape is really still

24:49

prohibitive for them to be

24:51

buying foreign fixed income on a hedged basis.

24:54

We still haven't yet had any adjustment to the BOJ's

24:57

yield curve control framework, which many

24:59

people expect to happen at some point in

25:02

the future and coming quarters. Interest

25:05

rates in the Eurozone are much

25:07

higher than they have been in

25:09

nominal terms in many, many decades.

25:13

And even though the current account surplus

25:15

in the Eurozone is recovering from the

25:17

energy shock last year, it's still

25:19

probably going to end up a little bit lower

25:21

than where it was prior to the Ukraine

25:24

conflict and the energy shock. So

25:27

when I look at global flows of this year, I think

25:30

the big question mark that's still out

25:32

there is how this structurally

25:34

higher interest rate environment globally

25:36

is going to play out in terms of the

25:39

traditional role of Japan and the

25:41

Eurozone as being

25:43

major buyers of

25:46

global fixed income. Thanks,

25:48

Alex. A few terms you said FX, that's

25:50

foreign exchange. So central banks sell in their own currencies.

25:53

EM, of course, refers to emerging markets. A

25:55

CPI, measure of inflation consumer price

25:57

index. So Alex, the main

25:59

driver or a very

26:02

large driver of the bond sell-off, the

26:04

horrible year in bonds in 2022. And

26:06

everyone knows is inflation was uncomfortably

26:09

high, fixed income securities.

26:12

There's no upside convexity. If interest rates

26:14

are 4%, you're only going to be paid 4%,

26:17

unlike stocks, which can pass on those higher

26:19

prices and their earnings will go up

26:22

too. So that's kind of the

26:24

macro broad, 10,000-foot

26:26

view, why bonds perform so poorly. Once

26:30

you go down into the nitty-gritty, it's

26:32

very, very complex. And that's why we're so

26:34

glad you're here. Can you tell us a little

26:36

bit more about

26:38

how the Federal Reserve's rate hikes in 2022,

26:41

going from 0% to 5%, quite extreme, quite fast.

26:45

How did that impact

26:47

and why did that impact the

26:49

foreign bid for treasuries? And you mentioned the

26:52

Japanese pension managers. So Japanese

26:54

pension managers, insurance funds, their

26:57

clients, they have needs that are denominated and yet

26:59

not dollars. So they buy US bonds, but

27:01

they hedge the currency risk. Why

27:03

is it that the Federal Reserve's rapid rate hikes

27:06

increased those hedging costs and made that unattractive?

27:09

Can you give us a little more color on that, please?

27:10

Yeah. So there's a couple of things. So

27:13

when you look at Japanese investors, they're not monolithic.

27:17

There's different institutional sectors and

27:19

players that have different incentives. So

27:22

for instance, the pension

27:24

fund, the government pension fund, which is kind

27:26

of

27:27

like a

27:29

privately managed but publicly

27:32

owned sovereign

27:35

wealth fund kind of, they have a mandate

27:37

where their target

27:42

allocation for their portfolio is essentially 25%

27:44

foreign equities, 25% foreign bonds, and then 25%

27:50

domestic equities, 25% domestic bonds. So

27:54

they have kind of a longer term strategic view

27:57

about what's the optimal asset allocation

27:59

for their policyholders and what's going

28:02

to get them the highest returns over

28:04

the long run, they tend

28:06

to invest on an unhedged basis. So they'll just

28:08

buy foreign bonds and foreign equities outright

28:11

and hold it. Then you have banks,

28:14

Japanese banks. Yields

28:17

have been historically low and the yield curve

28:19

incredibly flat in Japan for a long

28:22

time. And banks are

28:24

in the business of intermediation. They want

28:26

to

28:27

borrow short term, lend long term, and earn

28:29

a spread. And so they

28:31

typically like when there's an upward

28:34

slope to the yield curve because it means that you

28:36

can actually earn some spread

28:39

by engaging in that maturity transformation.

28:42

But in Japan, that's not really been a very

28:45

profitable

28:46

business for many decades.

28:49

And so they've engaged in other kinds of

28:52

investments whereby maybe they'll

28:55

borrow short term in dollars,

28:58

maybe in the repo market, and then

29:00

they'll buy treasury securities at

29:02

a 10-year point. And so they

29:04

now are FX hedged, but they

29:07

have a maturity mismatch in the sense

29:09

that they're borrowing short term and they're holding a

29:11

long duration asset. And the problem

29:13

is when the Fed aggressively

29:16

hiked interest

29:16

rates last year, the short

29:19

term interest rates rose much more than long term interest

29:21

rates. And so suddenly that kind of

29:23

arbitrage, that kind of curve trade is no longer

29:25

profitable. And then

29:27

there's a third set of investors, that's banks,

29:30

and then there's a third set of investors which are life insurers.

29:32

So they have primarily yen denominated

29:35

liabilities to their policyholders, but

29:37

they're looking for long

29:40

dated liability driven investors. They want long

29:42

duration, assets

29:47

to match their long duration liabilities.

29:50

But there's a limited supply in Japan's

29:53

case, because the BOJ has

29:55

bought so many of the outstanding

29:58

Japanese government bonds or JGBs.

29:59

So, they've also looked for

30:03

investment opportunities abroad and they

30:05

do some of it unhedged like the pensions

30:07

where they'll just buy treasuries outright. And

30:10

then they do other parts of it that are hedged,

30:13

currency hedged. And

30:15

the thing is, is currency hedging,

30:18

the cost of currency hedging is really

30:20

a function of the relative

30:22

slopes of different yield curves in

30:26

the different currencies. And so again,

30:28

when the US yield curve inverts,

30:30

that tends to raise the cost of

30:33

essentially hedging on a three-month

30:36

basis to hold your 10-year

30:38

treasury bond. So, you're earning your 10-year

30:40

treasury bond yield, but then you're having to

30:42

roll over every three months in the currency

30:45

forward market, your

30:47

foreign currency hedge. And as

30:49

US short-term interest rates rise, the cost

30:52

of rolling over that three-month hedge

30:54

goes up and so it becomes harder to earn

30:57

that spread.

30:58

Joseph, that trade now is a very

31:01

unprofitable trade because you'd be borrowing at 5% to buy

31:03

a 10-year treasury that yields 3.7%. So,

31:06

what are the people who are doing that carry trade,

31:09

presumably they still work the same fund? Like

31:11

what do they do? Are they just at the beach? What are

31:13

they doing out there? Or are they doing the remotes? They're shorting

31:15

10-year treasury bond.

31:16

So, I'll just review very

31:18

basically. So like Alex mentioned,

31:21

if you are a Japanese investor or any foreign investor

31:23

and you want to buy something in another currency,

31:25

say dollars, there's a couple of ways you can do this. One

31:28

is that you just go and you borrow in

31:30

the repo market with dollars and then you buy

31:32

a 10-year, boom. Your currency is

31:34

hedged because your liability is

31:37

dollar repo and your asset is dollar treasuries.

31:40

Another way that people would do it would be, let's

31:42

say you borrow it in the FX swap

31:45

market. So, what you would do

31:47

is you would, you start with yen and you swap that yen for

31:50

dollars. So you borrow dollars against that

31:52

yen and then take those dollars and

31:54

buy treasuries. And like Alex described

31:56

and like you just mentioned, both those

31:58

borrowing rates are

31:59

basically short-term rates. So

32:02

when the curve is inverted, that trade doesn't

32:04

make sense because you're borrowing

32:06

at a higher interest rate than you're receiving on

32:09

your asset side. So it all disappears. And

32:11

so

32:12

Alex had a really good piece just

32:15

a few months ago on this where Japan

32:17

used to be a very big buyer of, let's

32:19

say agency MBS and treasuries. And

32:22

partially because of

32:23

the shape of the curve, it doesn't make as

32:26

much sense for them anymore. You

32:28

could still buy dollar assets unhedged.

32:32

In that case, you would be kind of like betting on the

32:34

currency. So betting with the dollar would

32:36

appreciate against the yen, which actually has

32:38

been a pretty good bet for the past few

32:41

months. So even though they didn't

32:43

make that much money on their interest rates,

32:45

they could have made a lot of money on the ethics flight. Although

32:47

that's really risky, right? Alex, I don't think they want to

32:49

do that. Yeah, yeah. So I

32:51

mean, obviously the pension

32:53

funds last year, the

32:56

yen depreciated a lot in 2022 against

32:58

the dollar. And so those

33:00

unhedged

33:02

dollar holdings became much more valuable

33:04

in yen terms. So

33:08

now the question is, is whether you think the yen,

33:11

it went from 110

33:13

to 150 last year

33:15

at the peak roughly. Now

33:17

we're right around 138, 139, something like that. If

33:22

you think that the yen is gonna go to 170, then

33:26

also it makes sense to, you're

33:28

gonna get a lot on

33:31

your foreign bond in yen terms. But

33:34

if the yen is gonna go to 120, then

33:36

you lose money that way, right? So the unhedged

33:39

position comes with that risk that

33:41

you're taking the currency risk, right? It

33:43

could go either way. There are some

33:46

institutions in Japan that also

33:48

are like a

33:50

postal bank and some other kind of cooperative

33:53

banks that have deposits

33:55

and those ones, those institutions,

33:57

they typically put their money.

33:59

into essentially an investment fund. They sort

34:02

of outsourced the asset management to an investment

34:04

fund and then those investment funds buy foreign

34:06

bonds. And it's a little unclear

34:08

how much hedging they do, but

34:10

that's another key class of

34:12

investors that we have to watch a little

34:15

bit more opaque, but that we

34:17

have to watch for these global

34:19

fixed income flows.

34:21

Alex, from your perspective, so if

34:24

these foreign bonds are less attractive

34:26

to the Japanese

34:28

investors, are they staying whole or are they

34:30

going up to the risk spectrum, maybe buying

34:32

other stuff like corporate debt or equities or something

34:34

like that? And also if the Japanese

34:37

investors are not buying, let's say, agency and VSC

34:39

in the same size that they used to, have you

34:41

detected a new investor

34:44

class to take their place?

34:49

The pensions continue to kind

34:51

of just, I think,

34:54

manage the currency risk and try and time

34:57

when they buy things, buy

35:01

foreign bonds or treasuries, for instance. The

35:04

life insurers primarily, they're

35:07

doing kind of a mixture of, the

35:09

problem is that they don't wanna

35:12

just sell all of their negative carry

35:14

positions immediately. One, because

35:16

the bonds prices have fallen because

35:18

interest rates have gone up so much. So you'd actually

35:21

have to then realize the losses on

35:23

the bond portfolio. So you have

35:24

kind of a dilemma there if you're

35:26

one of these hedged insurers where do

35:29

you wanna just get out of the position

35:31

immediately and realize the

35:33

loss on the bonds? Or

35:35

do you wanna pay some negative carry because, oh,

35:38

the bond's gonna mature in

35:39

six months time anyways. And

35:43

then you don't have to realize that loss. So

35:46

what we think has been happening is they mostly have

35:48

been allowing the portfolio to roll

35:51

off and mature. And then

35:53

they take some portion of that and

35:55

they'll roll it into

35:57

higher yielding assets.

37:55

essentially

38:00

sort of like a survey of primary dealers looking

38:03

at what the sort of modal expectations

38:05

for when the yield curve control may be changed.

38:08

And it actually, the latest survey

38:11

shifted that expectation sort of from Q2

38:13

of this

38:14

year to Q3 of this year. So there has

38:17

been some further,

38:20

you know, I think the new governor of the BOJ has

38:23

been successful in getting

38:25

across that he's a patient, he's going to take a

38:27

patient approach to altering the yield curve

38:29

control framework.

38:31

Right. And for more insight

38:33

on that, people definitely need to check out Weston

38:36

Nakamura's work who's a trader

38:38

at Base2Japan, who's an analyst for Blockworks

38:40

Macro. His videos are on Blockworks Macro and his podcast

38:43

is called Market Depth. So people

38:45

should check that out. So

38:47

Alex, let's move on from the world of bonds.

38:49

Let's go into flows.

38:51

What's going on in the stock

38:53

markets when it comes to flows? Are

38:56

people

38:57

putting money into the stock market? They're taking it out. You know,

38:59

you look at the stock market, particularly technology,

39:01

AI stocks, they are on an absolute

39:04

tear. And I mean, I just

39:06

talked to a buddy of mine who's shared some fantastic,

39:08

some fascinating statistics just on the

39:10

deciles based on market cap of

39:12

just how narrow this rally is. But

39:15

what do you say equity flows? What

39:17

are you, what are you, what are you, how do you define an

39:19

equity flow different from the price? What is the

39:22

insight that is different? And then, yeah, what

39:24

are you seeing there? So we

39:26

track a couple of different types of equity

39:28

flows. One is cross border. So like

39:31

all the things I just talked about, about, you

39:33

know, Japanese investors buying US

39:35

Treasuries

39:36

could be Japanese investors buying US

39:38

equities as well. But we also

39:41

track domestic flows. So these would be primarily

39:43

flows into mutual funds and ETFs.

39:47

So those are you and I, when we

39:49

go and we buy our SPY, right,

39:53

then that's an inflow into the SPY

39:56

fund, the AUM of the fund goes up.

39:59

The fund has a

39:59

a mandate or

40:02

in the case of an ETF is benchmarked to

40:04

a certain index and is going to go out and

40:07

buy those stocks. So that

40:09

inflow into the fund management industry

40:12

itself is the other

40:14

form of flow that we look closely

40:16

at. There

40:18

I would say it's actually a little

40:21

bit of

40:24

similar to what I was describing about 2022

40:26

and then this year like we had a couple

40:29

of years during the pandemic where

40:31

equity flows

40:33

into equity funds were

40:36

unprecedentedly massive.

40:40

I mean we had more flows

40:42

into US equity funds in 2020,

40:45

2021 than we had over the

40:48

previous decade. So

40:50

people

40:51

just took their stimmies

40:54

or their excess savings or however you

40:56

want to think about it and they

40:59

deployed it into different

41:01

assets and equities was a key asset

41:03

that they deployed it into. So

41:05

we were already coming from a very, very

41:08

high level of flows over the

41:10

last couple of years and what we've seen is that actually

41:13

the inflows into US equities have

41:15

kind of tapered off and I think

41:19

obviously there are people who follow the

41:21

equity markets on a day in day out basis

41:24

much more closely than I do and

41:27

who are looking at every intraday

41:29

move and tick but

41:32

the equity markets kind of been

41:34

trading

41:35

sideways with added ups

41:38

and downs but it's kind of still below

41:40

its prior peak. So I do

41:42

think that the period in which we had

41:45

extraordinary inflows was a period

41:47

in which equities performed very strongly and

41:49

I think the period in which equities

41:52

have kind of moved a little bit more sideways

41:54

have been a period in which equity inflows

41:57

have been relatively weaker.

41:59

argue the causality could go either way,

42:02

that the inflows follow the

42:04

performance or that the performance

42:06

follows the flows. And that's

42:08

a philosophical debate. But I would

42:11

just say that stepping back from

42:13

a multi-year perspective, we

42:15

see that there's substantially less

42:18

inflows into equities than

42:20

there were over the last several years. So

42:23

it doesn't mean that there's outflows

42:26

every day or every week or anything like that.

42:29

But sometimes it's the change in momentum

42:31

of those flows can be as important as the absolute

42:33

level of them. With

42:35

respect to tech stocks specifically, so obviously,

42:38

we exchanged

42:40

some notes on, but it's very

42:43

difficult to track these

42:45

kinds of flows into single-name stocks.

42:49

So if there are specific, if

42:51

everybody goes out and buys Nvidia, that's

42:54

not a flow that I can observe in

42:56

the data that I look at. But I do

42:58

look at

42:59

sector flows, so flows into the

43:01

information technology sector versus the materials

43:04

sector, for instance. And

43:07

it's also not obvious from

43:09

that sector-level

43:11

view that there's particularly

43:14

strong inflows into information technology.

43:18

Like I said, it could be the case, though, that that's just

43:20

a too aggregate a level to look at

43:23

what are flows into AI-specific

43:26

stocks, single names, or into AI-focused

43:29

ETFs or mutual

43:31

funds. I

43:33

think to Alex's point, broadly speaking,

43:35

most stocks aren't doing that well. It's really just a

43:38

very narrow set. So that

43:41

seems to be supporting some of the broader

43:43

indexes.

43:44

Yes, and- It doesn't make sense.

43:48

Hey there, sorry to interrupt. A lot

43:50

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43:52

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43:55

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44:46

The rally is very narrow and it's counting on

44:48

a handful of stocks. That definitely is a sign,

44:51

not a great sign. But Alex,

44:54

it sounds like the flows haven't been coming in into

44:56

the big

44:57

flows and yet the shares go up

45:00

of Apple, of Microsoft. Those are

45:02

such a big percentage of the S&P 500.

45:05

Some people are saying it's a new bear

45:07

market. It really is quite

45:10

remarkable. I think if you look at market

45:12

cap, the top 10% decile

45:15

of market cap for the Nasdaq is up 60%

45:18

year-to-date.

45:19

It really

45:22

is just these giant stocks and these AI stocks

45:24

that are leading in higher. You said there isn't

45:26

that many flows into the AI funds.

45:29

Maybe as you said, that's because AI as

45:31

a category hasn't been

45:33

marketed to the

45:35

public in terms of selling stocks. So why are

45:37

the shares up then? Well,

45:40

the shares can go up, prices can change aside

45:43

from flows as well.

45:47

One reason why tech stocks

45:50

are doing better this year,

45:52

I'm just using tech stocks as a shorthand, is

45:55

because they did really poorly last year.

45:59

one of the reasons why they did really poorly last year

46:02

is because interest rates and inflation were just going

46:04

up and up and up and they're seen as

46:06

being sensitive to a change in the interest rate

46:09

environment. And interest

46:11

rates have also kind of gone sideways

46:14

over the recent period. So

46:16

there's a little bit of just a, I

46:19

think, a stabilization in

46:21

the expectations about the path

46:24

of interest rates over coming

46:26

years that has benefited them.

46:29

And I think that

46:29

was probably particularly

46:32

evident. I'd have to go back and look at it. But

46:34

when we had really large moves in

46:36

US interest rates down in March in response

46:39

to the banking tension, I would

46:41

be willing to bet that probably there was some

46:43

outperformance. Some of that 60% year-to-date

46:46

performance may have been

46:49

particularly in that period. I don't

46:52

want to hang my hat on that without having

46:54

looked at it further. But my point being

46:56

that I think that these stocks

46:59

are also sensitive to other things other

47:01

than flows. So interest rates, earnings,

47:04

they've all undertaken substantial

47:06

restructurings, cost-cutting. So

47:10

the earnings outlook has also factored

47:13

into why they performed. The earnings have been

47:15

resilient.

47:18

Hey, everyone. Jack here. Just want to provide

47:20

an update. The conversation

47:23

that you were having, you're listening to, Joseph,

47:26

Alex, and I had it on the 1st

47:28

of June, which was a

47:31

Thursday. And at that date,

47:33

the flows into US equities,

47:35

the official data, it still

47:37

was showing not a lot of influence. And that's what Alex

47:40

was talking about. However, the

47:42

following day on the 2nd, the new data

47:44

got released, or shortly after, new

47:47

data got released, showing quite significant

47:49

inflows to US equities, around 20

47:53

billion inflows for

47:57

all of USA, and close to half of that.

47:59

not quite half of that was into the

48:02

IT sector, information technology stocks. So

48:04

just want to say that the data there has

48:06

actually changed so we could flash this

48:08

data up here. You'll see that the

48:11

gray and blue bar combined showing

48:14

close to $20 billion of inflows and

48:16

that

48:17

blue bar is nearly half

48:19

of that 20 billion of inflows are technology

48:21

stocks.

48:24

And we'll show on this chart

48:26

that in the dark orange, you'll see that

48:30

in the most recently, there's a big

48:33

pickup into information technology

48:35

stocks. So just want to provide that update to

48:37

the data now that the

48:39

data has been released after we shortly filmed

48:42

our conversation. All right, thanks. Let's get back

48:44

to the interview.

48:45

Yeah, and Joseph, I know better than to

48:48

ask you, what's your S&P 500 target? Don't

48:52

ask me either. Yeah, Joseph,

48:54

we've known each other, we've done a lot of interviews together. How

48:56

are you thinking about this

48:58

rally in stocks? Which is definitely

49:00

taking me by surprise. Probably not you, you've

49:03

done a lot more questions. No, I am surprised as well

49:05

so I would not have expected this. So when

49:07

I take a look at the macro landscape, first

49:10

of all, I note that there

49:12

seems to be a lot of pessimism, seems

49:14

to be that market persistently, persistently

49:17

thinks that the Fed is going to be cutting rates soon. I

49:19

know that the 10-year has

49:22

basically been stock around 3.5% for some time.

49:26

My best guess is that there's

49:29

a lot of people out there thinking that we're

49:31

trying to get ahead of basically what they perceive

49:33

to be the end of the rate hike cycle. So

49:37

I think a lot of people think that once that

49:39

inflation is getting under control, soon the Fed

49:41

is gonna cut rates because the Fed wants to

49:43

protect growth. And if break

49:46

rate cuts are there, maybe not

49:48

too far afterwards, we could have something like Kiwi.

49:51

And we all know that in that old world

49:55

where there are rate cuts and there's a

49:57

lot of easy monetary policy, tech

49:59

stocks. do well and bonds do well. I

50:02

think a whole lot of people are just trying to get

50:04

ahead of that trade. They

50:07

could be right or we could be in a different world

50:09

where the Fed actually does stay higher for longer. I

50:12

guess we'll find out. The I thing,

50:15

though, I think it's legitimate that there is a lot of real

50:17

interest in that,

50:18

just like there was real interest in crypto as

50:21

a very interesting technology that could have big ramifications.

50:24

You can always get ahead of yourself in that

50:26

sense, we could be ahead of ourselves.

50:29

I mean, nothing goes straight up, right? We've

50:31

seen what happens with these skills straight up. But

50:34

I think there is something interesting in that

50:37

field.

50:38

I just don't know what

50:40

the right price is for it. Yeah.

50:42

And Alex, when you say money

50:45

isn't flowing into AI stocks,

50:47

that sounds a little, or AI

50:49

funds, it sounds bearish, but actually from a

50:51

contrarian sense, it's a little bullish. Why

50:54

are they going up if no one's flooding into it?

50:57

If no money was flooding into ARKK,

50:59

but Tesla was doubling every six months, that

51:01

would be very bullish. It's when everyone

51:04

starts knowing about it and the money does flow in, then

51:06

that becomes mainstream and there's no one. So

51:08

we're going to, some money's working on AI ETF

51:11

right now. It's going to come any moment. I'm sure that we

51:13

can start tracking it. Well, there already is

51:16

a stock whose

51:17

ticker is AI. And on

51:19

the fundamentals of the stock, I'm not particularly

51:22

favorable, but just based on the fact that its ticker

51:24

was, I was like, should I get into the stock

51:26

or something? I ended up not doing it. And

51:29

it's up, it's actually down today, but it's

51:31

just probably up 300% this year.

51:34

There's a Bloomberg story on that stock

51:36

as well. The guy who owns that company

51:38

is a master marketer. I think he

51:40

used to label himself an energy company back

51:42

when energy was big. And then he changed to the

51:45

internet of things when internet of things is big. And

51:48

he

51:49

thinks of himself as an AI guy now.

51:52

Yeah. And he pretty much is a consulting company

51:54

as something like, you know, 70, 80% of the clients

51:56

are oil and gas companies, but

51:58

he see marks himself as like an AI company.

51:59

ESG company, even though I read this on his

52:02

Wikipedia page, so it could be true, false, but

52:04

I think it's true, is that he

52:06

emits more via

52:08

private plane than like anyone in the world. That's

52:11

just a little tidbit on that

52:14

stock.

52:16

Okay, so that's the stock

52:18

market.

52:19

Should we move on to the

52:21

plumbing? Alex, you

52:24

read Joseph's work on FedGuy.com

52:28

very, very frequently. I know

52:31

you've got a lot of questions for

52:33

him, particularly about his last piece, his

52:35

penultimate piece about the lowest common

52:38

level of reserves. Do you

52:40

want to ask a question for Joseph? Yeah, so first

52:42

I just say, yeah, I read as much of Joseph's

52:44

stuff as I can. I bought his book

52:46

when it came out. I was an early adopter, I'd like

52:48

to say, and I've learned a ton from

52:51

reading your stuff, Joseph, so thank you.

52:53

Yeah, I mean, I think

52:55

for me, some of the questions would be, you

52:59

know, we kind of understand some

53:01

of the basics of some of the basic

53:04

mechanics, but do you see

53:06

this as being, you know, I get a lot of questions.

53:08

I see a lot of people out there

53:10

speculating that there's really

53:12

sort of two broader implications, and I'm curious

53:14

where you kind of come down on them. One is, does

53:17

this hasten the end of QT,

53:21

because we're getting to that level of lowest,

53:24

you know,

53:25

comfortable level of reserves? And two,

53:28

maybe more immediately, you know, we have been through

53:30

this turmoil in the banking

53:32

system in the last few months

53:34

that has been partly driven by outflows

53:37

from bank deposits, and

53:39

so does this bring those concerns back

53:42

to the fore? Are we going to see, you know,

53:44

speaking of equities, are we going to see KRE

53:48

taking another big leg down

53:50

in response to this kind of a thing?

53:52

Great question. So yeah, KRE is the banking

53:54

ETF, a lot of bank stocks, and then, but

53:57

you said, does this impact QT?

53:59

Yeah, you're referring to, I think, the lowest

54:02

comfortable level of reserves. So reserves

54:04

in the bank system have gone down,

54:06

but they may approach the lowest comfortable level

54:09

of reserves, which Joseph will tell us all about. Yeah,

54:12

just curious if the TGA,

54:15

the need to issue bills is going to accelerate

54:17

the end of quantitative tightening. Oh,

54:19

TGA, not. Yeah, that's a really good

54:21

question. I think a lot of people are really interested in this.

54:24

I certainly see it on Twitter. So I

54:26

think at a high level, what people are concerned about

54:28

is that now that the debt ceiling is over,

54:31

the US government is going to have to refill

54:33

their checking account at the Fed. That

54:36

account is called the Treasury General account. Right

54:39

now it's really low, but they actually tell

54:41

us

54:41

what their target is. They want to fill it up

54:43

to about $550 billion by the end of June and $600 billion by the end

54:50

of September. These are targets.

54:52

They're not legally binding, but there's an

54:55

indication of what the Treasury wants to

54:57

do.

54:58

Now, the way the Treasury refills its TGA

55:00

is it goes and it buys a whole lot of money, issues

55:02

bills, issues coupons, and

55:05

that that money then goes

55:07

into the TGA account. Now, the money

55:09

can come out of

55:10

two places. One is it can

55:12

come out of the banking sector. So

55:15

for example, if I have a bank

55:17

account and then I want to go and buy a newly issued

55:19

Treasury,

55:20

then I withdraw money out of the bank and then I

55:22

buy a Treasury. Through some

55:25

plumbing, money goes out of the bank system

55:27

and into the TGA account.

55:30

What's lost is reserves. Reserves

55:32

go out of the bank system. Exactly.

55:35

Reserves are the liabilities of the Fed and the

55:37

assets of banks.

55:39

Yeah, so they're basically cash. So

55:42

if you're a commercial bank, you have a

55:44

checking account at the Fed and you keep your

55:46

cash there. It's called reserve. So

55:49

that's how that would work. Another way that

55:51

the TGA could be refilled is if

55:55

money market funds withdraw money

55:57

out of the reverse repo facility and

55:59

take that money to buy a treasury of bills. Now

56:02

that then would drain money out of the RFP

56:05

and put that money into the Treasury General

56:07

Account. Now if that happens,

56:10

the banks don't lose any liquidity and the RFP,

56:13

I think of it as just this huge wad of excess

56:15

liquidity in the financial system. And so it's

56:18

going to be really harmless. Now the

56:20

question is that let's say that the

56:22

Treasury issues all this debt

56:24

and

56:25

it ends up not being purchased by money

56:27

market funds, but by investors who bank

56:29

with commercial banks. If that happens,

56:32

then you could see the reserves in the banking

56:34

system drop really quickly by

56:36

a few hundred billion dollars. And you

56:38

know that could scare the Fed because

56:41

the Fed thinks that commercial banks

56:43

need a certain amount of liquidity to

56:45

function properly.

56:47

So I think Alex has a

56:49

really good question is that, you know, how

56:51

close are we to this lowest comfortable reserves?

56:54

And if we hit that,

56:55

does the Fed stop QT or what will

56:57

it do? There's a lot of, I've read

56:59

a lot of people have comments on this. So

57:02

I don't think

57:04

that, so

57:05

eventually I think we're going to hit the lowest comfortable

57:08

level of reserves. I think within a

57:10

few months, part of it is because of

57:12

the TGA rebuild. Part of it is because

57:14

we have a lot more money going into money

57:17

market funds. And I suspect that the money

57:19

market funds will reinvest at in the RFP.

57:22

And so the overall level of reserves will

57:24

gradually drain because of that.

57:27

Some people think that the Fed could easily

57:30

push money out of the reverse repo facility

57:32

back into the banking sector by poggling parameters

57:35

of it, like counterparty limits and stuff like that.

57:37

But that's definitely something that they will do.

57:39

The RFP is there to control

57:42

interest rates to provide a floor. They don't want

57:44

to mess with it.

57:45

I don't think it would stop QT either

57:48

because that's part of their monetary policy

57:50

on autopilot. Inflation is at 5%

57:52

to stop QT, really, really bad

57:54

signal. If

57:57

there was an emergency procedure that they would

57:59

do. to try to put liquidity back in the

58:01

banking sector, it would

58:04

be to do the same thing that they did, I think,

58:06

you know, in September

58:08

and October of 2019, that is to buy

58:10

treasury bills from the Fed's perspective.

58:13

That's a really, really neutral thing to

58:15

do. They're issuing reserves, which

58:17

are short duration assets and using it to purchase

58:19

treasury bills, which are also short duration assets.

58:22

So that doesn't really, from their perspective,

58:25

that's not stimulative because they're not taking duration

58:27

out of the financial system.

58:29

I think they would do that.

58:31

There's also a view,

58:34

I think, that like Alex mentioned, that something

58:36

like this could hurt the smaller commercial banks,

58:38

because if you're withdrawing liquidity out of the banking

58:41

system, what if the banks that lose

58:43

that liquidity are the smaller or medium-sized

58:45

banks? And some

58:47

people perceive them to be fragile, right? So if they

58:49

lose liquidity, maybe it's not good for them. I

58:52

don't worry about that. My sense is that

58:54

it'll come largely out of the G-Cibs. One

58:57

way to think about this is who buys

58:59

treasury coupons? Well,

59:02

odds are they're not banking at Springfield Community

59:04

Bank. They're probably some kind of

59:06

institutional investor who has a lot of money

59:09

who banks with the G-Cib. So

59:12

I suspect that the drain

59:15

when it comes will be focused on

59:17

the larger banks. Right,

59:20

so reserves are used to

59:22

settle accounts between banks and they

59:24

have a wide- And the Fed as well, yeah. Yeah,

59:27

and the Fed, and not a wide range. I'm sorry,

59:29

and the Treasury, and the Treasury. And the Treasury, yes, thank

59:31

you. And they're

59:34

very important, whereas reverse

59:37

repo facility and $1 in the RRP is

59:39

the same as a dollar as a reserve, but

59:41

it's very narrow

59:43

usage. But almost by definition, it's an excess thing.

59:45

So I think they could drain the sort of quote, useless

59:48

dollars out and

59:50

use those to fund the Treasury

59:52

general account for the Treasury to fund itself.

59:55

That would be preferable to draining

59:57

the banking system reserves, where the banking system-

1:00:00

The system arguably needs a lot of

1:00:02

reserves, or at least that's what the federal reserve thinks.

1:00:04

And I think I'm looking at the right chart. So, you

1:00:07

know, before 2007, the reserves in the banking system were

1:00:09

tiny, like 45 billion. Peaked

1:00:12

in the summer of 2021 at 4.2 trillion. Now

1:00:16

they're at 3.2 trillion. And the Fed estimates

1:00:19

that the lowest comfortable level of reserves

1:00:21

is 2.2 trillion. So we do have a trillion

1:00:24

buffer. But does

1:00:26

the Fed worry once it

1:00:28

hits that 2.2 trillion, or are they going to start worrying before

1:00:31

if it continues to go down and down?

1:00:33

Yeah, so I think there's two

1:00:35

ways to think about this. Governor

1:00:37

Waller thinks that when he thinks about bank reserves,

1:00:40

he adds RFP balances into it. So

1:00:43

from his perspective, even if we go

1:00:45

to 2.2 trillion

1:00:46

in bank reserves, if we still have a large RFP,

1:00:49

you know, it doesn't matter. I

1:00:51

don't know if everyone else on the Fed

1:00:53

thinks that way. I suspect there are people in

1:00:56

the Fed who just narrowly look at bank

1:00:58

reserves and they would get nervous. I

1:01:00

just don't know how influential they are.

1:01:04

How do you think about how

1:01:08

does the overnight RFP get drained?

1:01:10

And how does that interact with the timing

1:01:12

of the end of quantitative

1:01:15

tightening?

1:01:17

So from the

1:01:19

Waller perspective, you know, having a large

1:01:22

RFP gives you plenty of runway to

1:01:25

run QT for a long time. The

1:01:27

thinking being that if you are a bank, you're

1:01:29

low in liquidity, you can go and find

1:01:32

ways to take money out of the RFP. You

1:01:34

could, one, go to your depositors,

1:01:37

offer them high deposit rates so they won't take money

1:01:39

and put it in a money market fund. Or

1:01:41

you can go and borrow from a home loan bank who

1:01:43

turns around and borrows from a money market

1:01:46

fund. So that's one way to think

1:01:48

about it. Large RFP, tremendous

1:01:50

runway for quantitative tightening. Now

1:01:53

if you don't subscribe to that view, if

1:01:55

you believe that you should just focus on bank

1:01:58

reserves, then it can be.

1:01:59

a problem because you are likely going to

1:02:02

be in a situation where bank reserves drop really

1:02:04

low really quickly.

1:02:07

So in that camp, you

1:02:09

know, you could again just do reserve

1:02:11

management purchases. But

1:02:14

in terms of the broader theme of when

1:02:17

QT will stop, I've

1:02:20

heard Fed people being asked about this.

1:02:23

They're basically all on the same page. It's

1:02:25

going to be on autopilot for

1:02:27

the foreseeable future. I

1:02:31

think that when inflation is where it is now

1:02:33

and you'd want to have a message of higher

1:02:35

for longer, I don't think they

1:02:37

really want to change that,

1:02:40

change the sense of the balance sheet at all.

1:02:43

Right. So the overnight repo facility was

1:02:45

basically at zero in 2020. It

1:02:48

peaked out at 2.2 trillion, 2.3 trillion.

1:02:52

Now we're at 2.1 trillion. So quantitative easing has

1:02:54

been going on, excuse me, quantitative tightening, the

1:02:56

Fed's reduction of its balance sheet has been

1:02:58

going on for over a year. And

1:03:00

the reverse repo facility hasn't been drained

1:03:03

at all,

1:03:04

which is interesting. And

1:03:06

then the reason is a little higher. What

1:03:08

do you say? It's a little, yeah. I

1:03:10

think it will go higher. You think it will go higher? Okay. Why

1:03:13

is that? Just another thing to Alex's

1:03:15

point. As time goes on,

1:03:18

the level of bill issuance will gradually

1:03:20

increase and that will help to draw some money

1:03:22

out as well. It's

1:03:25

hard to know exactly how what the

1:03:27

level of issuance will be. It's going to be very large.

1:03:30

In the next few months, it's going to be about a trillion.

1:03:33

Is that enough? I don't know. I

1:03:35

think it's enough

1:03:36

to have some impact, but

1:03:39

it's also hard to know because from

1:03:42

my work, I think that there's just a lot of demand

1:03:44

for bills from not money

1:03:46

market funds, but I would

1:03:49

say private wealth managers or family offices and things

1:03:51

like that over the past few months,

1:03:53

those people are the marginal buyers. Money

1:03:56

market funds have really not been buying any bills. So

1:03:59

if you will.

1:03:59

want to have, let's say, money

1:04:02

funds take money out of the RFP and buy bills,

1:04:05

you need to keep issuing a lot of bills until

1:04:07

bill yields become attractive enough. So

1:04:10

let's say trading above the RFP. It's

1:04:12

hard to know how much issuance

1:04:15

that requires, but eventually you'll get there simply

1:04:17

because the deficit grows infinitely,

1:04:20

it seems. So eventually you're

1:04:22

going to get enough bills to do that. So

1:04:24

that's another way that if we can get through

1:04:27

this, what I perceive to be

1:04:29

a temporary drop in reserves, then as bill

1:04:31

issuance gradually ramps up, you

1:04:33

could see the RFP come down and reserves go back

1:04:35

up as well. That's another path.

1:04:38

Why do you think the RFP will go up, Joseph?

1:04:40

Historically, okay, this is how this works. So

1:04:42

Fed hikes rates, nobody

1:04:44

puts money into a money

1:04:45

market fund, nobody cares. About a year

1:04:47

afterwards, people begin to care and

1:04:50

they begin to move money into money market funds.

1:04:52

And money market funds then begin to invest

1:04:54

in a reverse repo facility. We saw this the last

1:04:56

two hyphen cycles as well. It really

1:04:59

takes about a year for money to start for

1:05:02

people to be

1:05:04

interested in investing into money market funds. So

1:05:07

from what I see in weekly money market

1:05:09

fund data,

1:05:10

the inflows have been picking up every week.

1:05:13

And so as the money market funds get more inflows,

1:05:15

they're going to have to have somewhere

1:05:18

to invest in. And right now it

1:05:20

seems like it's going to be the RFP. So

1:05:22

let's say every week we get say $30 billion in

1:05:25

inflows, $100 billion a month.

1:05:27

Well, that money has to go somewhere. It

1:05:30

could just end up in the RFP. I

1:05:32

think the flow work that you do is really interesting. And

1:05:35

I know that it's very hard to know the causal relationship

1:05:37

between flows and prices, but

1:05:39

just looking around at

1:05:40

macro variables, do you see any relationship

1:05:43

between, let's say, GDP

1:05:45

or employment with flows? I mean, one

1:05:47

of my sense of just listening to people

1:05:50

was that a lot of people talk about how when we have a lot

1:05:52

of jobs of people because

1:05:54

of, let's say, target day funds, they get through their

1:05:56

employers. If they have jobs,

1:05:58

money goes there.

1:05:59

money goes every two weeks from

1:06:03

their employer to the target they fund and that keeps

1:06:06

flows steady. Is that a variable

1:06:08

or are there other things that could potentially

1:06:11

be predictive of flows? Yeah,

1:06:14

so that's a great question, Joseph. And

1:06:17

it's one that arguably we should do

1:06:19

more work on at Exante. We

1:06:21

do, you know, our traditional

1:06:23

focus is on currency, you

1:06:25

know, foreign currency strategy. And

1:06:28

so we've historically focused more

1:06:29

on cross-border and cross-currency

1:06:33

flows for that very reason. But

1:06:36

it is probably analytically,

1:06:39

conceptually more rigorous and

1:06:43

correct to take a more

1:06:45

holistic view of flows,

1:06:49

where cross-border flows are just

1:06:51

one sub-component of

1:06:53

a broader set of intersectoral

1:06:57

flows. So that's more of the flow

1:06:59

funds type analysis

1:07:01

that you would see. You

1:07:03

know, there's other people who specialize

1:07:05

in this as well. And we do an increasing

1:07:07

amount of that.

1:07:08

I guess I would say it's

1:07:12

very hard to model what

1:07:17

you're describing. There are data sources that

1:07:19

we look at and that one can look at to try and

1:07:21

track those kinds of flows. But

1:07:24

the hardest thing to model

1:07:27

is really

1:07:30

what savings

1:07:32

are ultimately going to be. Like that is the

1:07:35

genesis of where

1:07:37

these financial flows really come from. It's

1:07:39

the difference between income and expenditure.

1:07:43

Right? So you can assume a certain path

1:07:45

for how much you're going to earn this year and how much

1:07:47

you're going to spend this year. And the difference is going to

1:07:49

be

1:07:50

your savings. Right? And

1:07:52

then once you have that savings, first it goes into

1:07:55

your checking account. And then you decide, okay,

1:07:57

now I'm going to take it from my checking account. I'm going to put...

1:07:59

60% of it in the equity

1:08:02

market and 40% of it in the bond market

1:08:04

or something like that. So coming

1:08:06

up with that asset allocation sort

1:08:09

of

1:08:10

rule or strategy is

1:08:12

in some sense is the easier part relative

1:08:15

to being able to know exactly

1:08:17

how people's incomes and their spending

1:08:19

is going to behave and therefore what the

1:08:22

savings flow is going to be. But

1:08:25

that's kind of one of the things that we try and

1:08:27

do when we take a longer term perspective

1:08:30

on global flows is where do

1:08:33

we think, how is demographic aging

1:08:35

going to impact Japan's overall

1:08:38

growth and their income

1:08:40

growth and then their savings and how

1:08:42

much they're going to then invest abroad versus

1:08:45

domestically. So when you start to get into modeling

1:08:47

those things, you're very familiar with the T-tables and

1:08:52

the interlocking balance sheets, but it

1:08:54

gets pretty complicated pretty

1:08:57

quickly when you're talking about all those interlocking balance

1:08:59

sheets. Right.

1:09:01

And so, Alex, when

1:09:04

people are making a lot of money, when the unemployment

1:09:06

rate is very low, almost

1:09:08

everyone who wants a job has one.

1:09:10

So they're getting money every two weeks.

1:09:13

And as such,

1:09:14

banks can't, they're going to be spending more money.

1:09:17

Banks can comfortably lend to them because they know you're

1:09:19

in the Obero and I think that they're going to default.

1:09:22

And that's exactly what we've seen. Defaults have been at record

1:09:24

low. The delinquency is record low in 2020, 2021.

1:09:27

We're picking up from very low levels.

1:09:30

How do you see this playing out? Because

1:09:33

I know that many people have so many different measures

1:09:35

of excess savings. There's a ton, a glut

1:09:37

of savings from the stimulus of 2020, 2021. The

1:09:40

Federal Reserve, of course, helped as well.

1:09:44

And that savings rate, you know, say people are going

1:09:46

down and real income, I believe, is negative.

1:09:49

In other words, people's income is going up by less than

1:09:51

inflation, or at least it was when the price of oil

1:09:53

is going wild. But yeah, I

1:09:55

mean, how do you see this affecting the economy

1:09:58

over the next year or so?

1:09:59

Yeah, so I mean, I think,

1:10:03

again, just I'll try and let

1:10:05

the data that I

1:10:07

follow speak for itself, right? So

1:10:10

we've seen a lot of inflows into fixed income

1:10:13

funds. We've seen a lot of inflows

1:10:16

into money market funds. We've

1:10:18

seen outflows from deposits, and

1:10:20

we have seen generally weaker flows into equities.

1:10:23

So if you kind of just, those are the sort

1:10:25

of four big places that you can think

1:10:27

about putting money, like there's obviously there's alternatives,

1:10:29

there's gold, there's crypto, there's

1:10:32

many more asset classes than that. But

1:10:35

in the sort of the highest level,

1:10:37

I think of the system like

1:10:39

that, right? I earn income

1:10:40

and I can either leave it in my checking account, I

1:10:43

can take it from my checking account and

1:10:45

put it into a money market fund, or

1:10:48

I can decide to allocate to something that

1:10:50

maybe has a bit more duration risk, or

1:10:52

that has a bit more credit risk associated with

1:10:55

it, a bit more volatility associated with it. So

1:10:57

those would be things like corporate bonds,

1:11:01

or equities, or

1:11:04

foreign equities, or something like that. So

1:11:07

when I look at the flow data,

1:11:09

what I'm seeing right now is the

1:11:12

savings rate is

1:11:15

low. So the flow

1:11:18

of new savings that's coming in every month

1:11:20

is lower than what it was in the recent

1:11:23

past where we had excess savings.

1:11:26

And then if you look at how people are deploying across

1:11:30

different asset classes, those savings,

1:11:32

it tends to be

1:11:33

out of deposits, but still

1:11:36

into something that's very liquid and money like. People

1:11:39

really want to hide out and because of the shape

1:11:41

of the curve in

1:11:43

very low duration assets that are

1:11:45

in the highest possible yield. And

1:11:47

they're hesitant to kind of

1:11:50

go down the credit spectrum, because

1:11:52

of the concerns about where we are in the economic

1:11:55

cycle. And I think they're hesitant to take

1:11:57

on duration risk. That's kind

1:11:59

of, I guess.

1:11:59

That's the big picture of what I would say on those

1:12:03

sort of savings flows. Got it.

1:12:06

Thanks, guys. We'll leave it there. Thanks

1:12:08

so much for coming on. Alex, your work

1:12:10

at Xanti Data, you work, of course,

1:12:12

with Jens Nordvig, who I recently interviewed.

1:12:15

And I've seen Xanti's work,

1:12:17

which you fortunately shared with me, and

1:12:19

it is excellent. So if there are any institutional

1:12:22

investors watching, they should definitely check

1:12:24

that out.

1:12:26

And Alex also has a great blog as well.

1:12:29

An accessible blog for its kind of... You

1:12:32

can also, yeah, we have a public blog or

1:12:35

a sub stack called Money Inside

1:12:37

and Out. Jens actually just put out a great

1:12:39

note on the hatred

1:12:42

for the dollar, his two

1:12:45

decades of wisdom on dollar

1:12:48

cycles and why

1:12:51

everybody's talking about de-dollarization right now. So

1:12:53

you should check it out. Money Inside and Out

1:12:55

on sub stack.

1:12:56

Yes. And of course, Joseph, you are

1:12:58

on Twitter at FedGuy12, your book, Central

1:13:01

Banking 101,

1:13:02

number two on Amazon for finance.

1:13:05

Well deserved. And

1:13:07

your blog, FedGuy.com is just absolutely

1:13:09

excellent. There's

1:13:11

so much insight per word, like not a

1:13:13

wasted word. You write in a very

1:13:14

lawyerly fashion. And

1:13:17

for the entire existence of FedGuy.com,

1:13:20

Joseph, people have been getting all this value,

1:13:22

but they haven't been paying at all.

1:13:24

FedGuy.com has been free. I think in the last

1:13:27

piece you hinted that you might

1:13:28

soon be transitioning to a paid

1:13:31

service, which it's

1:13:33

understandable. Will there be any more free posts

1:13:35

or is this sort of the free

1:13:37

time is over

1:13:39

very soon? Yeah, I

1:13:41

think I also have free posts every now and then, but

1:13:44

like you mentioned, Jack, I think I'm going

1:13:46

to

1:13:47

change the business model a little

1:13:49

bit going forward. Got it. That

1:13:52

makes sense. People should check that

1:13:54

out. Well, thank you both so much and thank you

1:13:56

everyone for watching.

1:13:59

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