ALFONSO PECCATIELLO: Good evening from Europe and good afternoon to our US listeners. This is Alf speaking. Welcome to the Real Vision Daily Briefing. I'm here today, Wednesday 23rd of February 2022, with my good buddy, the founder and CEO of 42Macro, Darius Dale. How are you doing, Darius?

DARIUS DALE: I'm wonderful, Alf. It's great to be back on with you, my friend. Let's unpack.

ALFONSO PECCATIELLO: Hashtag the macro dream team. Well, actually, we named ourselves that. Let's see if we can deliver something decent for our audience today, there's a lot to talk about. We have equity indices across the board going into red, we have Treasurys not being able to rally. Interestingly, the curve is even steepening into this move.

And we have oil, gold, and anything else and Bitcoin trading sideways, choppy trading I would define that all over the place. And obviously, the headlines are all about Russia and Ukraine and the geopolitical tensions. Just as a broad first initial comment, Darius, what would you say about today's price action?

DARIUS DALE: Yeah, so the first thing I'll say is there's a complete bloodbath in the NASDAQ and tech stocks. Obviously, they don't like it when geopolitical tensions are accelerating. And you're not getting the benefit of a curve flattening at the long end of the Treasury curve. And this is something I had a conversation with one of our subscribers on Twitter this weekend or last week, and they're saying, hey, look, what would happen if they invaded? What happens if they go to war? Do you buy more bonds in that?

And I said maybe, maybe not, because war from this perspective, if you think about the reduction in labor supply that we have not just domestically, but abroad, could actually be more inflationary over the medium term in terms of putting on additional tax on the productive capacity of the economy, which itself is already really depressed.

ALFONSO PECCATIELLO: Pretty interesting initial comment. This Russia, Ukraine story is catching all the attention. And I want to talk about a couple of movers out there, people are also looking at that. And one of it is the CDS for pricing dollar for Russia as a sovereign. It actually spiked up to 400 basis points rather than 25 basis point, which is last seen, if I'm not mistaken, somewhere about 2015, 2016.

The last time that Russia was entering the recession, post the Crimea sanctions in 2014. And obviously also, Russian equities are dropping, and the ruble is trading pretty weak against the dollar. If you look at option markets, well, it's priced to-- there's a 50% chance to drop to the lows of 2014 against the dollar. Darius, do you think this situation can escalate to a point where it becomes systemically important, or is this more an idiosyncratic story?

DARIUS DALE: No, it's definitely not idiosyncratic in my opinion. We have some of the world's largest economies, if you think about the US, Germany, France, and Russia going tit for tat and escalating geopolitical tensions, I think it's very unlikely that it's contained. Now, again, I think we'd all be remiss to sit here and start making forecasts as if we have any incremental evidence or an ability or basis to do so, we're all at the mercy of the headline risk, which in our opinion, causes much more of a rush for near term protection than you otherwise would in a more traditional macro catalyst.

This is how you can get big spiky ball spikes. You go back to last Friday, last Friday was a one of the biggest [?] we've seen in recent months. We lost about 25% of the notional exposure in terms of put gamma, and so investors might have found themselves naked heading into this week. And this week could have obviously gone one of two ways, it's clearly starting to go one way, which is a way that leads to more geopolitical concerns.

ALFONSO PECCATIELLO: Darius, you're touching upon optionalities and the cost of insurance and gamma and all of that. My natural question as a former risk taker is how you would rather than advise, at least look from your perspective to trade choppy markets where the house is about to get on fire, so insurance is pretty expensive to start with, and implied vols and realized vols start to go up?

And at the same time, if you want to take the other side of the equation, and you were to sell volatility to monetize these premiums, which are larger than normal in these situations, you're facing unlimited downside effectively in case the tail risk realizes. What's your agenda actually, over the next month to trade around these choppy markets and to risk manage?

DARIUS DALE: Yeah, great question. Lot to unpack, so I'll break it up in pieces to be a little bit more cogent for our audience. I'll start by saying selling volatility in a growth slowing GRID regime, as you know, we think about the world through a regime segmentation lens. There's Goldilocks where's growth accelerating and inflation's decelerating, there's reflation where both growth and inflation are accelerating simultaneously, you could sell as much vol as you want in those regimes.

That's where volatility tends to be declining, not only low but declining in those environments. Where now, we're an environment that's characterized by growth's long on a turning basis as evidenced by the composite leading indicators. Right now, we're in what we call inflation, that's growth decelerating, inflation accelerating, there's also what we call deflation as well, which is both growth and inflation are decelerating simultaneously. Do not sell volatility in either inflation or deflation.

There's a central tendency for volatility to rise, for credit spreads to widen and for volatility just generally be almost an order of magnitude nearly double its average on a realized and implied basis relative to Goldilocks in reflation. That's number one, just as general rule of thought in terms of how to think about risk management based on where we are in the broader rate of change business cycle.

Number two, I think it's super critical and very important, and this is something you and I talk about all the time on this program, your background in professional money management, my background have a nice meeting with folks like you, which is your portfolio should not ever represent one bet. Even if we're talking about trading this choppy environment, it's not just that my whole entire portfolio has to start reflecting this trading this choppy environment.

You want to spread out your bets across multiple iterations, and so right now, you can think about trying to monetize some put exposure in the near term, or certainly trying to think about playing for a bounce, selling things on as bounce, shorting things on a bounce. And that some portion of your capital is allocated to that near term, while some portion of your capital is allocated to the medium- and longer-term views.

Obviously, we've been quite, quite pretty explicit in our belief that both growth and inflation will likely trend lower throughout the balance of 2022. I've been very explicit on our view, our work that suggests that we're very much likely to underperform consensus expectations throughout that process on growth in particular, and we're more than likely to outperform consensus expectations on inflation throughout that process as well, both domestically and abroad.

You net out those two factors, we're talking about a widening risk premium risk assets particularly led by higher beta risk assets. And ultimately, we're talking about more narrow risk premia, more flattening in the Treasury yield curve, and so that's where our medium-term views tend to be focused.

ALFONSO PECCATIELLO: What a great answer. I want to unpack for our listeners a couple of very important things that you said. It really hits an open nerve when you talk about positions reflecting one probabilistic outcome that you have in mind, it might be your base case but having a portfolio totally skewed to that is one of the typical mistakes that risk takers tend to make. And I'm looking at my own global macro long/short positions published on The Macro Compass, where I am up here today, I'm trading pretty okay, but I'm wondering if my trades today reflect too much conviction on my base case as basically, I have a flattener in the US, I have a short Russell trade, then a put on high yield bonds, and then basically short Bitcoin as well. And the only thing which is against this regime is long Chinese real estate.

You tend to ask yourself, am I pumping too much into one base case scenario? What you just said reflects this consideration that people that manage money professionally, or that they're able to advise people professionally are always having on top of their head, how much am I plugging my consensus probabilistic scenario into my trades without considering the tails? That's one.

And the other thing that you mentioned as well is selling volatility or being long volatility according to different macro regimes, which is very important and one of the characteristics of this macro regime and I want your opinion on that, Darius, is credit spreads. Credit spreads have started to widen, they're reflected both in corporate bond spreads widening, there has been no high yield deal, primary deal, syndicated deal over the last 13 trading days, if I'm not mistaken, which means they're drying up, which means that when investment bank syndicates go around and ask people like me or the past me a few months ago, would you be interested in that bond? The answer is a firm no, and therefore, they have to postpone their issuance calendar.

But it's also being reflected in mortgages. We're seeing 30-year mortgage rates at 4%. And today, we got the news that mortgage applications dropped to the lowest level in over two years. I want your opinion on the housing market. What do you make of that in 2022, and whether you see potential spillovers as well to the consumer confidence side of the equation?

DARIUS DALE: Yeah. We already certainly are seeing this spillover to consumer confidence, although I'm not quite sure it's coming from housing at this particular juncture. We're still continuing to see elevated levels of demand, existing home sales, new home sales, the only issue in the housing market really has obviously been unaffordability and the inability of builders to meet rising demand. We've seen building permits, I want to say, hit a 15-, 16-year high on the most recent month, whereas new starts, like the actual starts continue to slow on a trending basis.

There's a divergence there. I think people just aren't getting what they want, and that may be causing some angst with the [?], in my opinion, is being caused by the decline in real disposable personal income. Now, it's something we talked about in the program as well with if you look at on a per capita basis, most recent month we got was December, we'll get the January data, the PCE data on Friday, I believe, and the most recent update was minus 3% on annualized basis.

That's a deep contraction in real disposable personal income per capita and that's leading to pretty depressed measures of consumer confidence. Obviously, the Michigan survey where we're getting the consumer buying and conditions for things like vehicles, houses, 20-, 30-, 40-year lows, pick your indicator, where we're getting consumer assessment of their financial situations, whether it be a one year look back, that's the lowest we've seen since 2013, or one year forward, that's the lowest index level we've seen since 2011.

But to me, of all the consumer confidence data points we've gotten in recent weeks, and really in recent months thus far in this expansion, the most important number we've seen thus far is the consumer confidence labor differential for the month of January, or sorry, yeah, for the month of January that came out for the Conference Board. This month of February, my apologies on getting my months mixed up. But for the month of February, the consumer confidence labor differential, and it finally ticked off its cycle peak, which it had been huddling at for several months.

And the reason that's important is because this indicator pretty much tracks the labor cycle, the broader business cycle, pretty much like a glove. And we've seen nine cycle peaks in this indicator going back to the mid-1960s and the median decline from the peak of this indicator in the S&P 500 point terms is minus 36%. You typically see a minus 36% drawdown on the median basis. For each of those nine times, we've seen the business cycle unravel through the lens of this indicator. That's a real scary data point, one of the more scary data points we've received in recent months.

ALFONSO PECCATIELLO: And actually, as you said, the fact that real disposable incomes have been shrinking for over a year now to the base of about 3% year on year makes a potential marginal borrower that buys a house at a mortgage effectively, as mortgage rates have gone up and as real disposable income has gone down, less likely to be able to afford houses at the same price as it was affording them last year, for example. We might see perhaps a slowdown coming this year.

The long-term trend of real estate is actually something different, determined as well by different dynamics. I just published an article on The Macro Compass about that, but it's important for people to understand that if you increase borrowing costs for the private sector, and you reduce the real disposable income, then at some point, it becomes pretty difficult for them to access credit cheap enough to sustain asset prices at the level where they are. And these has some second-round effects or might have some second-round effects, and the datapoint you're talking about is an indication of that.

Real estate, though, according to people, Darius, and analysts as well also as a large reflection in CPI through basically the rent component. We were talking before the show about your views on inflation and what the Fed expects inflation to be and the median projection for 2022, which you disagree on. Do you want to give the audience the reason why you disagree on the inflation projections?

DARIUS DALE: Yeah, it's not that we disagree on the direction of travel, or even really the magnitude of travel to some degree, although it's the levels that every interval throughout the year, particularly at these intervals with the economic projections, Fed meetings, where they might actually provide incremental guidance on quantitative tightening and things of that nature.

To me, that's the scary part because our forecast for inflation are persistently higher over the next 12-month time forecast horizon than both of the Fed and the consensus, Bloomberg consensus. We have the direction of travel going down, it's just not going down fast enough to get the Fed, at least on the inflation front, enough air cover to pivot back in a dovish manner that could support risk assets from [?] levels.

ALFONSO PECCATIELLO: Yeah. Darius, can I ask you top of your head, what your core PCE forecast for the end of the year?

DARIUS DALE: Yeah, I think it's 2.8%. But don't quote me on that. I'll tweet that out.

ALFONSO PECCATIELLO: Sure, that's fine. But the Federal Reserve median projection for core PCE at the end of the year is 2.6%. Darius is saying, and I think is paramount important is that the bond market has priced the reaction function of the Federal Reserve to be seven hikes in 2022 as the median outcome despite let's say even with their core PCE projections being only "2.6%", which means that inflation will be by far, the most watched macro data coming over the next few months.

It doesn't take one single blip or one single underperformance of PCE or CPI numbers against expectations for the Fed to turn. But for the Fed to turn much more dovish, inflation needs to go on as low in direction pretty quick and way below their 2.6% core PCE, which according to Darius is already relatively dovish as a stance, so it's not going to be that easy for the Fed to turn dovish. Is that the case, Darius?

DARIUS DALE: 100%, exactly. The Fed expects inflation to go down and they're telling you that there is a risk that they'll hike at every meeting, there's a big hurdle for them to pivot dovishly based on inflation. We have to get core PCE well below 2.6% by the end of the year for them to have any air cover through the lens of their inflation mandate to pivot dovishly. And this is part of our central base case bear thesis for 2022, which is there's three areas of feedback that financial markets can send information to the Fed or the financial markets in the real economy.

One there's the labor market, what's obviously this headline unemployment is all these wonky academic statistics that we won't bore you with today, we'll wait for the next jobs report to bore you with those. It's very unlikely that we see an unraveling just based on where we are in the broader credit cycle, unraveling quick enough in the labor cycle this year to make the Fed pivot dovishly. We just talked about inflation not only in terms of the direction of travel, but the levels relative to the Fed forecast, very unlikely they get a signal anytime soon within several quarters to the inflation front that they need to pivot in a dovish manner.

That leaves the only leg of that stool left, three-legged stool with financial conditions. That's the only signal that the Fed is likely to receive this year that they've gone too far with respect to their policy normalization drive. And to me, that is the risk to financial markets, which is the markets themselves are going to have to tell the Fed they've done too much. And that's not exactly a place you want to be as a buy the dip bull or someone who's overly levered to high beta risk assets. This is a very, very growth setup.

ALFONSO PECCATIELLO: We discussed that in December, I think, at Real Vision Daily Briefing.

DARIUS DALE: It was like November, man, it was November.

ALFONSO PECCATIELLO: Talking about financial conditions and the time not to be long high beta, but actually financial conditions are the release valve, as you say, are the mechanism under which the markets might send messages to the Fed. And look at the components of this financial condition index, real interest rates, they've gone up. Curve had flattened. Equity markets, of course, have repriced the bid, risk premium as well, and credit spreads are now widening.

The cocktail doesn't look extremely good. Of course, we start from extremely loose level, so financial conditions. But the direction of travel has been very clear. And the market has been already sending signals to the Federal Reserve. I want to circle back for a second on inflation because it will be the macro data to watch in 2022. And at Real Vision, there was a very interesting interview between Larry MacDonald and David Einhorn, where David had some interesting views on inflation going forward. Let's take a listen.

DAVID EINHORN: One of the things you said a moment ago was that everybody agrees that the inflation is going to come down. And I would say that that may be where the consensus view is, but it's not obvious to me that that's how this has to play itself out. I think there's a range of outcomes, and certainly, one of the outcomes is the one that you outlined. But I think there's much more uncertainty