ASH BENNINGTON: Welcome to the Real Vision Daily Briefing. It's Wednesday, February 16th, 2022. I'm Ash Benington joined today by Darius Dale, founder and CEO of 42Macro. Lots to talk about today with Darius. Looking out across US equity markets, essentially flat here on the day, not a ton of movement, but lots of news flow to talk about. We're going to talk about yesterday's January PPI print, retail sales, and of course, the FOMC minutes.

But before we get into that, important note here on Ukraine, Russia says it is continuing to pull back troops from the Ukrainian border, US Secretary of State Antony Blinken says that the US essentially cannot independently confirm that that troop pullback is taking place. With that said, Darius, lots to talk about here with markets and macro. Darius, what's on your screen right now?

DARIUS DALE: Oh, there's a lot on our screens right now. I'll start with the Fed minutes, that was the topic du jour of today or at least of this afternoon, and they're pretty boring. They certainly weren't as exciting as the Fed minutes in terms of giving us an incremental update on the Fed's monetary policy normalization agenda. I think probably the biggest takeaway, or the biggest takeaway is that it did provide any incremental evidence, but the secondary takeaway is that the Fed officials see that the median Fed official believes QT is likely to commence in the third quarter of this year.

Again, the meeting was before we got the January CPI data last week, and so you can think about pulling that forward at least into the second half of the second quarter. Although we do believe that certainly by April or May, we're likely to be engaged in quantitative tightening.

ASH BENNINGTON: Hey, Darius, for folks who are not eyebrow deep in this like you are, give us a sense of what the significance of that is that you see this median forecast being for tightening for Q3?

DARIUS DALE: Well, I'll go and say I'm probably scuba diving here, which I love the eyebrow deep. I'm probably too close to this stuff to begin with. What we ultimately mean is, obviously, the Fed has outlined the guidelines and principles for its balance sheet reduction, which largely consists of letting principal repayments roll off, particularly in the mortgage-backed security space.

There were some talks about potentially accelerating that via sales of mortgage-backed securities, but it's unclear whether or not they've seen enough to prepare to actually sign off on that at this current juncture. But the reality is, we've already gotten the guidance we needed out of Jay Powell, which is quantitative tightening is likely to start fairly quickly after they got the liftoff, which obviously is going to be in a month or so. I believe in exactly one month's time.

ASH BENNINGTON: Yeah. Darius, let's talk a little bit about some of the drivers of this. I'm talking about inflation, of course. Some new numbers out yesterday, January PPI, this is Producer Price Index, generally doesn't get as much attention as CPI, Consumer Price Index, but we got a really hot print on this. 1% month over month seasonally adjusted. Big change. I think it's 1.1% non-seasonally adjusted. These are big movements for the Producer Price Index. What does it mean? What's the significance? And what are your thoughts?

DARIUS DALE: The significance is that we still saw a pretty elevated rate of sequential momentum in the time series. But the year-over-year started to decline. And again, this is the first month where we see base effects actually start to impact reported inflation statistics. And that's going to be something that'll persist all throughout 2022. We did see the price pressure on a year-over-year basis eased, not only just in the US PPI statistics, we also got PPI data out of China and the UK which eased as well, and so this continues to lean in credence to our view that the world reversed peak supply chain disruptions in Q4 of this year.

And as those disruptions ameliorate on balance throughout the first half of this year, really throughout the balance of this year, it's very unlikely that that sequential momentum in the inflation time series will start to wane. At the same time, the base effects themselves are steepening into it and through the latter half of this year. That's a cocktail for much lower inflation prints hat we recurrently are dealing with. But it's not necessarily a cocktail for target, at or below target inflation prints anytime soon. That's why the Fed is very much likely to continue tightening monetary policy into a simultaneous slowdown in both inflation and growth.

ASH BENNINGTON: This is a really interesting view. And I should say, an important point here, you're talking about the second derivative, the rate of change, getting a sense of where this is going in the future. That's why you're saying you see this beginning to moderate, but we should point out, when you talk about this on a year over year basis, it looks like a 6.9% print, nearly 7% inflation. That's pretty close in line with what we're seeing in CPI.

Those are still significant numbers. You're suggesting that you believe that it's past the peak of acceleration that we're going to see a deceleration in the rate of change on this, but still, obviously quite significant, quite material, and principally the driver of precisely what you were mentioning earlier, which is the monetary tightening expected to come out of the Fed in 2022.

DARIUS DALE: Yeah, you're spot on. Markets function or rate of change. The markets care about what the current state is, and the direction and magnitude of the change in these critical economic variables. They also care about the pace, direction and tightening and direction of easing or tightening and the magnitude of the change with respect to monetary and fiscal policy as well.

But let's not forget, the Fed is an academic institution, largely, that cares about markets, but generally is much more concerned about inflation dynamics and employment dynamics, and then use this financial stability or financial conditions as a third stool or a weak third stool relative to its broader mandate. The Fed is a levels-based institution, the Fed cares about the level of inflation. These are the persistency of staying above target, the persistency of wage pressures in the economy, and all those things that certainly have some Fed officials spooked.

Obviously, we've heard from Bullard last week, we're going to hear from Bullard again tomorrow, and then I believe there's some policy kumbaya on Friday as well. The reality is, until the levels of these factors change, we can't expect the Fed to do a real about face. To me, this is the critical call for 2022. Oh, sorry, I just want to say that inflation movement, that level will not decline fast enough to cause the Fed to pivot dovishly, the wage pressure in the US economy will not abate fast enough to cause the Fed to pivot dovishly.

The only signal that the Federal Reserve can get in order to tell it that it's overtightened and it's done too much from a monetary policy standpoint, tightening standpoint, is through the lens of financial conditions. And that's a problem.

ASH BENNINGTON: Yeah, you said something very important at the beginning of that conversation, which is effectively that markets are pricing the rate of change. This is probably a key insight for people who are thinking about these types of issues for relatively early in their investing career for the first-time. The important point, what we're seeing prices, the rate of change, the new information coming into the market, and how that's being perceived in terms of relative strength or weakness to a trend.

I should also say precisely on that road, I'm curious to get your insights about what's happening in bond markets, US 10 Year Yield obviously over 2% right now. What are your thoughts about US Treasurys?

DARIUS DALE: The US Treasury market, there's two sides of the trade discussion. One, there's the yield curve flattening and the yield curve flattening whether you look at 10s, 2s, the 5s, 30s, or rates markets, they're obviously on a path to inversion in certain pockets of the market. If you look particularly forward, markets are already signaling inversion.

That's telling you that the Fed, which is extremely behind the curve, not only relative to where markets are pricing, rates markets are pricing policy tightening, but also with respect to where we are in the broader business cycle is really still the level of unemployment and the tightness of the labor market from a wage perspective. It's still the yield curve is saying, hey, look, the Fed's going to tighten us into a slowdown.

But if you actually look at just the level and the trending momentum in bond yields and things of that nature, they're continuing to sing a song that the economy is fine, if you will. There's a couple things that are continuing to sing a song that the economy is fine for now. One, we wouldn't be having increased duration risk, i.e., bonds going down in price if we didn't have a growth expectation in the market that we're likely to rebound off of this overcrowding driven weakness that we saw in late Q4 and into early Q1.

We're also getting that signal confirmed through our dispersion analysis as well. One thing we track at 42Macro are the month-on-month Sharpe ratios across 50, 60 US equity sectors style factors as a proxy for institutional flows. In fact, if you can put that chart up, Chart 32, we update this every day for our subscribers, but what we're trying to look at in this analysis, the chart on the right shows the composition of the upper quintile of that cohort, of that population sample relative to the lower quintile, and ultimately trying to identify how that composition is changing, because it's really instructive in terms of identifying the behavior of your pod shop style hedge funds.

These are your multimanager platform shops. These are massive hedge funds. They control anywhere between 60%, 70%, 80% of equity market turnover in any given day. And so, what we're trying to do is track their behavior and that behavior continues to signal that the economy is doing fine if you think about relaying what energy leadership, airlines leadership, leisure and hospitality leadership imply for the near-term direction of the economy. In my opinion, this post-Omicron bounce dynamic is having a market impact both in terms of leadership within the market, but also in terms of the direction of travel for bond yields.

ASH BENNINGTON: Talking of bond yields, I want to talk a little bit internationally here. I believe we've got a piece of tape from Real Vision's Weston Nakamura talking about what's happening in Chinese bond markets, Chinese sovereigns. Let's take a look at that clip if we have it.

WESTON NAKAMURA: Hey, guys, so the G20 central banks and finance ministers meeting is being held virtually this week. It's being hosted by Indonesia this year. And I just want to highlight the opening remarks from the governor of the PBOC. He's spent a good amount of time promoting bilateral renminbi currency swaps among Asian nations as a way to alleviate dollar strength, which I personally thought was a smart and opportunistic move to further advance the yuan and offer an alternative shift away from USD dependency.

But then he went on to explicitly state the following, "throughout the entire process, the PBOC has worked to improve supporting measures and to reduce cross border restrictions on the use of local currencies to make sure that market forces always stay the key driver." Market forces, from the governor of the People's Bank of China. Now meanwhile, in commodities, let me also highlight the iron ore market in China, which has been getting hammered down about 10% in the last two days as officials have been taking measures to clamp down on certain prices once again.

And at the same time, you have CEOs of both BHP and Fortescue coming out and saying that iron ore prices will be strong because of demand from China. And ultimately, supply and demand are going to determine prices of iron ore and not Chinese authorities. And now, I'm not like accusing hypocrisy by China for touting free market forces on one side, and then hammering commodity markets on the other, frankly, they're no different from everybody else.

My point is that what's happening with the iron ore battle is a perfect microcosm of this year's very strange G20 meeting and the usual challenges that they face as a group because at the end of this, they're going to have to sign a communique and somehow all coalesce around cooperation, right as we're on the cusp of splintering global policy divergences as each economy and country is being affected by inflation in different ways to differing degrees and certainly, different policy prescriptions. Ultimately, forget speeches, forget interviews, forget communiques, just watch actions, and price action to get a read on what's going on. Alright, thanks.

ASH BENNINGTON: Well, there it is. Weston Nakamura coming to us from Tokyo, our man in Asia covering these markets. I think it's interesting. The irony, of course of Weston talking about market-based mechanisms setting rates in China. I'm curious, Darius, maybe we can bring that framework back to the US a bit. Tell us a little bit about what you're seeing in bond markets. We were talking a little bit during the break of 2s, 10s curve. What are you seeing in terms of market-based mechanisms here in the US pricing these rate hikes and pricing inflation in bond markets right now?

DARIUS DALE: Yeah, so I think the most interesting dynamic, it's not even really with respect to bond markets, just within the broader fixed income universe and looking at rates markets, in particular, you're starting to see a material amount of inversion in OIS forward curves, and these overnight index swaps forwards on those contracts.

ASH BENNINGTON: Darius, why don't you give a hack for people who may not be familiar with overnight index swaps, what the significance of those swaps are, and what they price.

DARIUS DALE: Yeah, absolutely. That swap is you paying a fixed rate for floating rate exchange that's priced on the benchmark monetary policy rate in any given economy. Obviously, these would be priced on Fed funds. We're seeing is we have OIS in terms of what they're pricing in relative to the current Fed funds rate, anywhere between 175 to 200 basis points, pick your tenor between 18 months and two years in terms of the terminal Fed funds rate or the terminal amount of monetary tightening we're going to see from the policy rate.

But then beyond that, the curve starts to actually invert. That's the market signaling that somewhere between 18 months and two years' time, the Fed will actually be cutting interest rates and that in our opinion is a pretty clear signal from the rates market that the Fed is, A, going to do what it does best when it comes to tightening monetary policy, which is overdo it and push us into recession.

ASH BENNINGTON: By the way, talking about inflation, I wanted to take a look at another piece of tape here at Real Vision. This is a conversation today on Real Vision Essential Plus and Pro called, Is Gold Still the Best Hedge Against Inflation and Instability? It's a conversation with Rick Rule and George Milling-Stanley. People who are following these markets know that both of them are extremely well known in the precious metal space, in the gold community. Let's take a look at this clip because there's some insights here that I think are very interesting.

GEORGE MILLING-STANLEY: I believe that inflation will gradually come down. I'm not an economist either, Rick, but that fully modern languages is my academic background. I'm certainly not going to bring the word transitory back into the vocabulary of people talking about rates of inflation, I think that got rather devalued towards the end of last year when both Jerome Powell and Janet Yellen decided to remove it from the vocabulary.

I think they're absolutely right to do so in the face of six months of rising inflation, rising CPI, they had to remove it. But I still believe what we were told at the time which is that some of the very high inflation rates that we're experiencing currently have to do with supply disruptions that are COVID related. All of those container ships moored off of the Port of Long Beach in California, for example, I think a lot of them are still there.

People are talking about the fact that these supply disruptions will gradually dissipate, but they're still talking about them in the future tense. When they talk about them in the present tense, then I'll believe that they are actually dissipating. But until then, I won't. I think that there are a number of factors behind those high inflation rates that we see currently that suggests to me that they may turn out to be temporary. Transitory, no, but they will not necessarily be with us forever.

ASH BENNINGTON: Here's what I think is interesting about that, Darius. Two guys with a lot of experience in the gold space, looking at these markets in very different ways than you are, looking at macro in very different ways than you are, and yet they reached the same conclusion, a view of moderating inflation, talk of supply chain disruptions, and the view that they are dissipating, which has been consistent with your view of essentially being past peak supply chain disruptions. A view you've articulated here on Real Vision before.

DARIUS DALE: We altered that call going back to the fall last year, I wanted to say September, October, I said that I think this is probably the peak of supply chain disruptions and all the incremental data we've gotten both from PMIs, if you look at the ISM metrics in terms of supplier delivery times, or if you look at the companies themselves, going back to GM, Apple, all these major international corporations telling us that, hey, look, we are moving past the worst of it all.

And moving past the worst of it all just started to put some pressure, downward pressure on inflation momentum. But again, we're not going to go from 7.5% headline CPI to 2% headline CPI in a matter of months. It's going to take several quarters, and obviously core PCE being where it is, it's going to take several quarters to get that under control as well.

At the end of the day, this is the problem with forward guidance, and I think the Fed is going to riddle me this, I believe a few years from now, when they look back at this episode, they're going to realize that they forward guided themselves into potentially tightening the economy into a recession. Because this is a Federal Reserve that we know, this Jay Powell Fed that does not want to surprise, does not want to spook markets, wants to be very clear and cogent about its plans and ultimately executing upon those plans.

And there's a lot of plans to execute upon. You're talking about roughly seven rate hikes priced into OIS markets over the next year or so. That's a lot. But to me, the rate hikes are the sideshow. I've always thought of them being the sideshow. The real market risks, particularly for high beta risk assets, comes when the Fed is doing quantitative tightening.

This is something I talked about on the program as well.