MAGGIE LAKE: Hi there, everyone. Welcome to the Real Vision Daily Briefing. It's Thursday, June 2nd, 2022. I'm Maggie Lake, here with Harry Melandri, advisor to MI 2. Hi there, Harry.
HARRY MELANDRI: Hi, Maggie, how are you?
MAGGIE LAKE: I'm doing okay. Listen, I'm camping out at the Real Vision studio today. I'm not in my usual spot. Who knows what's going to happen, but it's great to finally get back in the office. I think some people are creeping back in.
HARRY MELANDRI: I have no idea what getting back in the office would involve.
MAGGIE LAKE: I know. [?], there's no taxis in New York, but I got here. Let's talk a little bit about what's happening in the market. It feels like a little bit of a funny day. We've got equities going up again, but I feel like it's just part of this bigger picture. I don't know if you feel like any of the moves today have any legs, but just stretching it out a bit, perhaps beyond today, what do you think about what's going on lately? What does it feel like?
HARRY MELANDRI: It's not as if I'm always right. Everything I say is got to come with a health warning.
MAGGIE LAKE: Health disclaimer.
HARRY MELANDRI: Yeah, exactly. But the first observation I'd have is bear markets are always fiendishly difficult to trade. They're tough. And I remember my first boss, who was a fantastic guy, a guy called Bill [?], he said to me, the problem with bear markets is you got to have a certain amount of faith. You're selling it at a point when the thing looks like it will never ever go down.
My working hypothesis is we're in an equity bear. The problem I've got is I don't-- my boss, Julian, is absolutely convinced that inflation is going higher. And I'm sure he's right. Not going higher, but not coming down in an efficacious or in a prompt fashion, one which will rescue the Fed. Which means that we could get so much more from the Fed than they're currently expecting. Right now, the base assumption's got to be that the Fed heading to neutral and neutral somewhere between 2% and 2.5%. That's what they think it is. Whether neutral is actually there, that's another matter completely.
I got a friend of the firm acquaintance guy called Nick Lindemann, Nick was at Brevan Howard around the same time I was there. And he's a good friend of Julian. Nick claimed that at Davos, and I think Nick is probably in a better place than me to say, my invite to Davos got lost in the mail this year. Yeah, weird. Apparently, the chat at Davos with people were talking about the possibility of Fed Funds at 5%. And I have friends who do talk with central bankers still and still have good context of central banks, those guys are saying, roughly speaking, yeah, inflation is a priority for once, they really do have to deal with it. And it's whatever it takes.
It's by no means impossible that we can overshoot on rates way beyond what the market's currently thinking, and the way bond markets are trading, it doesn't-- I wanted to buy them. I wanted to buy those dips and play that positive carry from them, but it's not trading well.
MAGGIE LAKE: Why do you think that possibility is not being priced in?
HARRY MELANDRI: Well, it's so far away, and we're all used to a world in which inflation is not a problem. That's the last 30, 40 years. The last time inflation was a serious problem was like the mid-1980s. That's when we actually believed that inflation was a policy variable. These days, nobody believes it.
And that includes people who are not that sharp and people who are super sharp. I talked to David Rosenberg. David Rosenberg knows exactly what he's talking about. He thinks there's a recession next year. I can see his point. We don't see the recession now. And a recession can show up. Does a recession mean that inflation goes away? Back in the 1970s and 1980s, it didn't. It might not necessarily mean that now.
And there are really good reasons why inflation could-- there's no tradeoff between inflation and growth but there are terms of trade shifts, longer term tradeoff between inflation. We did a couple of things that would definitely tend to push inflation higher, one of which was we've excluded Russia from the global trading system. That means Russia's industrial capacity, the logistics are not in place to move that stuff around the world to places which can take it.
We don't have the refining capacity. We don't have the amount of coal we need to replace the oil product which is missing. We don't have the natural gas we need, and you see that everywhere. Tell you the truth, I think the biggest single problem is refining capacity. But who knows yet? We haven't yet seen the full effect of losing that commodity capacity and industrial capacity with Russia.
And then we had the lock downs in China. All of these things are pushing more inflation through the system at a time when inflation is already elevated. I'm not as confident as some people are that actually, the inflation will come down as much as it should do as base effects feed through, and that it doesn't then find a second leg up somewhere down the line.
MAGGIE LAKE: Yeah, that does seem to be the concern. We have the Fed Vice Chair Brainard today in a TV interview saying I can't really see a scenario where the Fed pauses, because I spoke to Christophe Ollari, that interview is dropping at some point if it hasn't already. And he said, everybody, he talks to investors, keep asking, when's the Fed pivot, because we've been so conditioned, to your point, to think they're going to pivot, and everyone's looking for it.
And that's a concern, he sees that as a risk, a certain amount of complacency. You can see why the Fed officials keep trying to put their hot coat on and jawbone the market by saying, no, no, this time, we're serious. But Ash caught up with Neal Berger, who had an interesting concept and argument suggesting that the Fed should be way more aggressive than they are right now. Let's take a listen to a clip of that.
NEAL BERGER: My first foray in the market was Greenspan, but even from Greenspan on, central banks are somewhat sensitive to trying to prepare the market for their moves and make sure that what they do is not going to cause a crash in the market. And then they go down as the Fed Chairman that caused a crash.
I think they're trying to prepare the market for what they want to do. But this particular Fed, and I certainly wouldn't be able to do personally do a better job, I don't really know what to do, so I'm not looking to criticize anybody. But I think the market perception is that they're a little bit overdoing it. Like we all know interest rates going up, just do it already. You know what I mean? It's not going to be a shocking surprise.
In other words, if they raise rates 100 basis points tomorrow, I do not think the market would crash. In fact, I think it's possible the market might rally on that, because the perception would be okay, finally, the Fed is getting more aggressive and understands the severity of this inflation and is getting ahead of it and is willing to be aggressive towards fighting it.
MAGGIE LAKE: Controversial. By the way, that full interview is available on the website today to across all of our tier members, Essential, Plus and Pro. Harry, that's a provocative statement to make. There have been people saying, listen, I wish they would front load it, that would be the best thing to do while they have this opportunity. Haven't heard that exactly. But could the market even handle something like that?
HARRY MELANDRI: I'm a huge fan of people speaking off the cuff, but that was definitely a little-- I have problems. I have questions. For one, there's a reason why the Fed is transparent. And the transparency is there to minimize shocks to the system. Now, I suspect there's too much transparency these days, because how much visibility does the Fed itself had? They didn't see this inflation coming.
And now, they're telling us, we're going to hike to wherever, we're going to be tough with inflation, tough on the causes of inflation. Well, they need to deal with that risk, but they lose credibility, because they've been so egregiously wrong. But if you start say, if the markets priced in a whole series of hikes, we've got a series of prices on the Eurodollar contracts and interest rate futures across the board. If you accelerate that, and double the pace, people are going to get destroyed.
Bond positions are going to get kicked out, liquidated rapidly and the market will have to recalibrate, equity volume will increase, stuff is bad enough already. In an attempt to minimize that vol, I get what he's saying, he thinks, okay, we were already pricing 3% rates or higher down the line in about 12 months, 15 months' time, something like that. Why not get there quicker? Fine, but you got to communicate that to markets because markets are expecting you to communicate it.
And if you just short circuit that process and just go, you know what, there you go, 100 basis points. How are you left? The people will ask themselves, what is it the Fed just saw that they did not see before? What changed? What do we have to worry about? What is it we don't know? Maybe they should accelerate the process but that's a language change--
MAGGIE LAKE: This brings up all sorts of counterparty issues. Back in the financial crisis, there were a lot of people who are saying in a vacuum theoretically for moral hazard, let this firm fail, let this happen. And then when those dominoes came down, there were unintended consequences that we all know what happened there. By the way, this is also a time when we have the President of Goldman Sachs as well as Jamie Dimon.
Jamie Dimon talking about a hurricane, the President of Goldman Sachs talking about the fact that he's never seen this confluence of shocks hit the market at the same time, just speaking to the difficulty of navigating this right now. And the fact that lots of folks are flying without a real guide on what to do here. I think lots of danger all around.
But if we talk about the Fed, Harry, this is all timing, isn't it? Because if they are aggressive, and they hike, and they destroy demand, they spark a recession or a downturn, or at least withdraw the demand side of the economy, they can't do anything to the supply side, these more structural issues with underinvestment in energy, do they keep hiking even if inflation is elevated, if they've already addressed the part of the economy that they theoretically, and I know there's a debate about this, have the ability to impact? Why keep going when they don't have any control over that part of the economy?
HARRY MELANDRI: Well, you could argue real rates is the reason why they have to keep going. Because if they don't hike, if you've got 8% inflation and 3% rates, even though you're already going into recession, and even though you can't do much to the supply side, real rates are negative by five points. And negative 5% rates is bound to encourage risk taking, you haven't really tightened monetary policy at all, you can make that case anyway.
In practice, overall financial conditions, they're not just interest rates, stock prices, credit spreads, volatility, everything feeds into overall financial conditions. And the other thing is the US economy, the whole thing about transferring investment risk from the companies and pension fund to the individuals, now everyone is their own CIO. Well, that means everyone is embedded in the financial economy as well as the real economy.
If you retire at the wrong time, you can see your living standard drop dramatically if you get these trades wrong. It's difficult, I can easily see how 3% rates might not be sufficient, might not be particularly tight in a monetary policy terms because of overall financial conditions. On the other hand, if stocks drop 20%, 30%, 3% rates might be plenty tight enough. Julian makes his point all the time, he's banging the table. Julian likes banging tables a lot. But he's banging the table-- yeah, you've seen him in a bar, you've seen him banging tables.
Right. Exactly. And he's right about this, which is, if the Fed raises rates and stocks don't fall, did it really make a sound? Did we really tighten policy? I would argue, yeah, if we need to tighten monetary conditions, and stocks are not going down, we're probably going to have to tighten them some more.
MAGGIE LAKE: We've got some great questions coming in. I want to try to cycle some of them in. Paul E. on The Exchange and I think this is speaking to the shocks we're dealing with. At Davos, Bill Ackman said inflation is out of control, inflation expectations are out of control. Hell is coming. And George Soros said the Ukraine invasion may have been the beginning of the third world war and our civilization may not survive. With the disruption of supply chains, global inflation is liable to turn into depression. Your thoughts on those two rather gloomy outlooks.
HARRY MELANDRI: Well, I'm the gloomy guy so I sympathize with-- Bill Ackman's point is the most arguable, which is depressing, I hope that third world war was the most arguable point, but no, Bill Ackman's point's the most arguable. If inflation expectations are out of control, why are breakevens not out of control? Why is 5Y5Y forward breakeven so low? They're still bounded.
You'll get people like Loretta Mester, a sharp cookie. She'll come on and she'll give you a speech and she'll point out the 5Y5Y breakevens are actually well behaved. I don't think inflation expectations are out of control. If anything, the thing that surprises me is how well-behaved measures of inflation expectations are.
Now, it's quite possible that market inflation expectations don't really reflect what people really think. I've got a great friend over in London who I chat to occasionally because we both have the most sixth sense, terrible sense of humor, you know about this. And he pointed out to me that even if you've got negative 2%, 3% breakevens, where else are you going to get a hedge against inflation as a retail investor?
You might as well buy inflation linked bonds, doesn't matter if they're negative or free. There's a Fed product, sorry, a Treasury product, Treasury direct product, I think it's the I bond. That gives you a yield of 9% or nine something percent. Problem with that piece of paper is it's got a maximum amount of $10,000 per year you can put into it. You cannot get 9% anywhere else. Why does it give you that they calculate it based on the inflation rate? That's why it's so hard, actual inflation is 8%.
The question for me is why are inflation expectations so well behaved? And maybe they're not, maybe people know that there's worse inflation coming. But all the market driven indicators and inflation expectations are well behaved at the moment, breakevens are well behaved, forward breakevens are well behaved.
Third world war. Well, that's not cheerful, is it? Yeah, this is the thing that I can't get my head around. You asked me a question. I'm weird. Why would anyone listen to me? I have no idea. People who know me have no idea.
But we have a conflict between a proxy war between the US and Russia. So far in that proxy war, the Russians have been relatively calm. My sneaking suspicion, I expect eggs to be thrown at the screen at this point, is that because they're pretty sure they're going to win. If they were going to lose, I'm not sure where things go. Every time this thing escalates, I get nervous and look at real estate in New Hampshire and Argentina, and places like that.
For me, it's all very dangerous, but ignoring the danger because, hey, that's not my day job. I know people in Washington that focus on this as their day job. The supply chain issue is enormous. It's not a one- or two-year thing, where you rejigged supply chains away from one supplier to others, that whole supply chain for say noble inert gases, helium, argon, all those things that are used in semiconductor production, semiconductor lasers.
That has to be rebuilt. It gets rebuilt from steel. The reason they specialize in doing it is because they have blast furnaces still. I think it's a byproduct of blast furnace production. Where the hell are we going to get those inert gases to a semiconductor? And I just read, I think this morning, that the Russians had imposed export restrictions on those gases. All the supply chains have to get rejigged to reflect the fact that something what just happened looks like the return of the Iron Curtain.
I make this speculation all the time to my colleagues. But I'm not sure China will end up in the same trading bloc as us. And if that's the case, boy, are we going to see much more inflation. They're going to see deflation, by the way, you're going to see inflation.
MAGGIE LAKE: I think that's a great point. And this is the debate, not only how long do supply chains take to rebuild, how do you rebuild around without a key player like Russia, or China? But also, this larger debate about is globalization over? And do we see regionalization? And what does that look like, and which countries benefit and don't?
I sat down with Peter Zeihan, who talks and thinks a lot about this. We had another conversation that's going to come out on Friday, heads up on that, and he has very strong views on that, very interesting things to say. For anyone who's interested in those topics, I encourage you to check that out when it comes out. It takes me a while to recover from conversations with him, as you can imagine. But they're really thought provoking. These are the big questions that people are asking.
We have some more questions coming in for us, Harry, and James on The Exchange, ask Harry if he was to buy along the yield curve, would he choose the short end over the long end now to buy and hold for the next one and a half years? Thank you for including a timeframe on that, James. It's always super critical when asking this because your investment horizon matters a lot, but Harry, thoughts on that?
HARRY MELANDRI: Yeah, so James, I've already lost money on this trade. I had tried to buy five-year futures, and I'm underwater on that trade. I did that because I believed equities were breaking. Once we get a significant break down in risk assets, it will give the Fed pause. Even if I'm right about longer-term inflation, even if I'm right about the fact inflation won't be put under control, the Fed won't know that. And what we will see is all sorts of negative data on real economy, on embracing unemployment.
With those factors there, we will anticipate rate cuts and that trade