SAMUEL BURKE: Welcome to the Real Vision Daily Briefing for Wednesday, July 7th, 2021. I'm Samuel Burke joined by my co-host Jack Farley and Daily Briefing fan favorite, Darius Dale, founder and CEO of 42Macro. Darius, we just wanted to give you a little preview of what we're going to be putting to you today, starting with those Fed notes that are out, they see progress toward tapering, which is why it's confounding for some that you see 10-year US Treasurys dipping below 1.3% today, maybe not confounding for you, Darius. Jack, what's on your radar?
JACK FARLEY: Well, as you say, 10 Year below 1.30, that's a five-month low, and that is lifting gold higher for the fifth day in a row, at the same time, dragging oil down with Western Texas Intermediate crude trading below $72. Samuel?
SAMUEL BURKE: Jack, as much as you're a gold man, you know that I'm a tech man. I was thrilled to see my Amazon stock hit an all-time high at one point today. Then equally as disappointed when we saw the Chinese tech stocks do exactly the opposite. More news coming out of China, looks like they're going to close a loophole that allowed Chinese tech companies to IPO overseas. Darius has some great context for us to put this all into perspective. Let's get right to that big story, Darius.
Here, on the one hand, you have a lot of factors that would make you think that bonds would be doing something very different. You've got the Fed, as we just mentioned, seeing progress toward tapering, you've got expectations of inflation, not by all but by many. Then of course, you expect interest rates going up at some point. In your view, why are the yields moving the way that they're moving?
DARIUS DALE: Yeah, thank you, Samuel. It's great to be back. Thanks, everyone, for joining us. The number one driver from my perspective of this bond yield move is the decay in the terminal Fed Funds Rate for what this business cycle is likely to produce. If you look at something like 5 Year 5 Year forward overnight index swap spreads, they've declined 90 basis points since the end of March from 2.4% to 1.5%. My interpretation of that because I think there's a lot of different interpretations, my primary interpretation of that is that the bond market and really, credit investors broadly have really shifted to understanding that this Federal Reserve is unlikely to be as willing to have a participant in this what I would consider to be an inevitable march towards MMT.
What I mean by that is that the Federal Reserve is unlikely to let inflation get out of hand on a realized basis for an extended period of time. More importantly, they're unlikely to allow inflation expectations that have been priced into the long end of [?] both in the US and broadly to really seep into the US into the real economy. I think you just have a much tighter Fed on expectations basis on a three- to five-year forward basis. That, to me, is really why you're seeing the decline in inflation premiums in certain yield curves.
JACK FARLEY: Yeah. That 5 Year 5 Year is what the market is pricing, the five-year yield will be in five years, a little bit complex. That's why we like having you here, Darius. My question is, why is that the case? What has the Federal Reserve done that signals to investors that it is taking inflation more seriously, perhaps than they were before? Is it just the dot-plot? Was it some sort of incantation that Jerome Powell gave?
DARIUS DALE: Yeah, I think it's a combination of the dot-plot, and also Powell's unwillingness to provide very dovish commentary around that dot-plot hawkish revision. I think it was very purposeful. I think what they've done is they've effectively hiked interest rates without actually hiking interest rates. This is how far down this rabbit hole, this dangerous path of never ending, ever increasing fiscal and monetary largess that we're on. They can hike interest rates and crater inflation expectations and break down long term inflation expectations with just a change of a dot-plot or some commentary. I think that's where we are. That's how wired markets are to monetary policy and the changes therein.
SAMUEL BURKE: I'm just curious, you've laid out very clearly your thoughts about deflation while everybody's talking about inflation right here on the Daily Briefing.
DARIUS DALE: Sound like an idiot back a month ago.
SAMUEL BURKE: Feel free to lay that out again, and I just want to know how today's Fed notes, again, progress toward tapering, and what you see with these 10 Year US Treasury yields. Does that affect your thinking about deflation in any way whatsoever?
DARIUS DALE: Yeah. According to macro, we started pivoting our portfolio construction at the margin towards a we called deflation back at the beginning of May, not outright deflation. I feel like I have to constantly remind our viewers of this but what we mean by deflation is a state where the economy is decelerating on growth and inflation simultaneously. Historically, that's obviously argued for defensive posture and equity and credit markets, but it's also argued for outsized excess returns in the long end of sovereign yield curve.
From my perspective, everything is going according to plan if you consider the fact that inflation has likely peaked in the month of May, and growth has likely peaked in the month of April. Now, we're not talking about slowing precipitously from those levels, but certainly a persistent deceleration into very elevated growth and earnings expectations that could really catalyze a sense of disappointment for an extended period of time. The problem with that, as it relates to risk assets, or if you're short bonds here, the big problem with that is that everyone's got to change their positioning.
Everyone was levered long reflation going back a month ago, certainly in the commodity space and two months ago in the equity space, and now, you're just seeing that unwind. I got a couple steps for you. You look at the S&P 500 constituent. It's actually down 0.2% since the May 7th peak in the S&P 500, whereas the S&P 500 itself is up 3%. That's a telling sign in terms of the lack of breath, but even when you look at the commodities market, the CRB index peaked on June 11th. Oil is up 1.5% from that, but if you look at ags, it's down 6.5%, base metals are down 3.2%, and precious metals are down 4.6%, so you're seeing a real narrowness of breadth that tends to be a real feature of topping processes in and around asset markets.
JACK FARLEY: Darius, do you think that the baton will fully be passed from the reflationary names, the small cap miners, the homebuilders and the like to the large cap, big tech stocks like NVIDIA. One thing, but also, the mainstream FANG names, Samuel earlier alluded that Amazon was up something like 4.5% yesterday, which for a huge cap stock is just tremendous. Do you think that you will see that leadership continue to consolidate in the FANG names, Apple, Microsoft, Amazon, Google and the like?
DARIUS DALE: Yeah, that's a very appropriate market response to again, going into this deflation macro regime in the second half of the year that we have, and our model is starting in August. Yes, I do agree and to be fair to the market participants that have already taken advantage of that, it started three or four weeks ago. We started actually calling that out in terms of secular and style factor dispersion is really starting to creep towards defensive and up until this this most recent week, it hadn't really gotten fully defensive.
It was defensive from the perspective of, okay, let me go by least shorted debt, least shorted growth names, tech names, work from home names, but you didn't quite see the composition at the lower quantiles of dispersion that would indicate the market was ready for a risk-off moment, but you're now actually starting to see that this week.
JACK FARLEY: Darius, I've got a question for you, which I'm going to read from your morning note today from 42Macro, you had a very interesting--
DARIUS DALE: Those things are a mouthful.
JACK FARLEY: All told, the stock market does not crash when everyone is positioned for a crash. It crashes when hedge fund consensus is forced by fundamental catalysts and/or systemic risk management rules to cover high. What does that mean?
DARIUS DALE: Yeah, so that note though, that particular note is in context or relation to what we've been tracking, and this is what other investors particularly in the vol space have been highlighting on Twitter is that you just have a massive amount of implied vol premium to the flip side across not only the US equity indices, but a lot of the different sectors and style factors in the indices. A lot of people were really nervous about a potential Fed taper here in this month of July and certainly by Jackson Hole, so you have a lot of investors putting on protection and getting nervous about the reflation trade into that.
Well, the problem with that is whenever one has the same hedge, it typically tends not to work. What's likely to happen or at least in my opinion, I think what's more likely to happen is that you see a decay of those hedges, dealers have to buy back their short gamma exposure. Then ultimately, as we go through earnings season, you hit your final last gasp higher in a lot of these reflation plays and a lot of the mega cap tech names. I think you could see a broadening of breadth into earnings season, but beyond that, after people are forced, again, by those catalysts and potentially forced by, obviously, the price action to take off those hedges, that's when the bottom, in my opinion, could and should drop out of the equity market. If it happens sooner, obviously, we're going to have to adjust.
SAMUEL BURKE: I know that Jack has a sound bite that he wants to pay, but just to close up one part of inflation before he gets there, I'm very focused on labor inflation, wage inflation, so I just want to know where you see that in the context of what you've been talking about in terms of deflation.
DARIUS DALE: Yeah. If you think about the labor market, I try to parse it into three different categories, employment growth or the lack of employment growth, wages and hours worked. Wages are obviously accelerating and making new highs as a function of the lack of supply in the near record demand to pick your indicator. Employment is obviously improving on that lag or improving on a lag but it's certainly not improving at a pace that I would consider most investors-- well, we just learned at 2 PM today that the Fed would consider a substantial further progress in the labor market.
In fact, I think one of the keys telling statistics from last week's jobs report is the fact that unemployment actually ticked up if you look at household surveys. We're clearly not out of the woods yet. I think we all want the pandemic to be over, we want to get back to normal, but the reality is, we're just not quite there yet, which again, is giving me confidence to say that I think ultimately, goldilocks can persist over at least over the next few weeks. But beyond that, I don't think that's like [?] jobs.
Sorry, just really quickly. When you think about average hourly earnings, it's actually moving in the wrong direction, both for blue-collar work and white-collar work. That to me was a pretty telling statistic, if you look at the composition of the report that again, the labor market is not necessarily ready for the Fed to taper. Sorry about that.
JACK FARLEY: That's really interesting you say that, Darius. I remember, in March and April of 2020, the only positive statistic in the labor market was a rise in hourly wages. Of course, that was because the lowest paid workers were the ones who were losing their jobs, most vulnerable to lose. I wonder if you say it's a bad statistic that wages are going down, if that actually represents the people going back to work, perhaps?
DARIUS DALE: Yeah, it certainly does but again, the labor market is extremely robust and tight in the non-COVID affected areas, what I would consider to be-- I parse it from white-collar industries relative to blue-collar industries, it's very tight. You're seeing wage inflation in accelerating wage inflation in that cohort, as well. You're also obviously seeing it in the blue-collar workers and the most effective industries. That's obviously the function of the tight supply and demand, but also just a function of the economy is growing extremely fast at the current juncture.
You'd have estimates between 10% and 12% for the second quarter GDP. Obviously, we're looking at somewhere close to 4% or 5%, 6% for the third quarter. This is a perfectly normal reaction function for the labor market. Just from a level's perspective, however, we just don't think we've achieved substantial further progress in terms of putting a Fed tapering event on the calendar for the end of this month.
JACK FARLEY: Going back to the bond market, Darius, there's a clip I want to play, which is from an interview that we did with Alfonso Peccatiello, who's a macro investor focused on the bond market, and he is defying the consensus among bond investors that inflation is going to run red hot. He actually agrees with the Federal Reserve that it will prove transitory, and he has some interesting reasons why. Let's take a look at the clip.
ALFONSO PECCATIELLO: When the crisis hit or when the economy's slowing down, as we discussed before, long term forward nominal growth spikes down and therefore nominal yields tend to drop. I also tend to think that there are structurally deflationary forces out there that are mostly demographics, you'll see the chart on labor supply before, starting productivity overleveraged, misallocation of capital, technology, [?] force, those forces are very, very, very strong and short term sugar rush driven credit impulse can only symbolically give us the feeling for [?] that we are living in a regime change, there is no regime change.
JACK FARLEY: Darius, that interview, which is available for all Real Vision essential members on the Essential tier. He's basically saying that we've had a sugar rush in credit creation over the past year, but going forward, that sugar rush will be much less important than the deflationary forces on the horizon, like your allocation of capital, like technological improvement. What do you make of the rolling over of the credit impulse? Can you describe what that means?
DARIUS DALE: Yeah, impulse is just simply the change in credit in the economy. People like to do it on a credit to GDP ratio. I myself like to look at the three-year Z score of private financial sector credit growth. That's a mouthful for TV, but anyway, when you look at obviously, the US economy, but most economies in the world we track, we build models form, every OECD in major emerging market economy. They're all on the right side of the chart. I'll send you guys the chart I posted to Twitter.
What I mean by that is that credit growth has been massively accelerated all throughout the developed and emerging market world, and you're seeing that response. And so, the reality is to perpetuate an economic cycle from here, you got to do something else. There's naturally going to be a slowdown off of that sugar rush unless you bring forth more fiscal easing, more monetary easing, and obviously, where we are with most inflation sine curves globally, it's very unlikely to be the case in this period that we're highlighting, i.e., the second half of 2021.
We're going to have to cool off as a function of that. Again, I'm not concerned about cooling off towards a recession or slowing down to something that's below trend from a growth perspective, but I do think it's so good in terms of characterizing that with the positioning associated with everyone being max on reflation as recently as three to four weeks ago to having to put on a defensive portfolio for that. I think that's certainly why you're seeing bonds rally so sharply, why we're seeing gold back from the dead, and obviously, why you're seeing the crowding in the defensive exposures within the equity market.
JACK FARLEY: Darius, I want to get to gold in a second, but really quickly. Can you explain to us why it is the rate of change that is important because credit creation is extremely high right now, but it is so high that the only way to sustain growth is to go even higher? We are likely doomed to go slightly lower. Can you explain why that's important in rate of change terms?
DARIUS DALE: Yeah. One, calculus is a secret to the universe. Let's all start every conversation and every conversation with that. Secondarily, it's the market's function on rate of change. It's the second derivative. It's the gamma that really impacts financial markets and forces positioning and exposures to change hands among investors. Price is set at the margin, and the margin is dictated by what's happening at the margin in the economy. The rate of change is what got us here from the lows of last spring to the highs of this spring and the reflation trades and bond yields, and the rate of change is what's going to get us from these highs in bond yields, or from those highs on bond yields and reflation exposures to some higher low at some point in the back half of the year.
Again, it's not necessarily saying oh, we're at the beginning of this massive secular bear market or bonds or the 10 Year Treasury yield's going to go back to 0.5%. I don't really see the need to make that call. Because quite frankly, you're going to make money no matter where you wind up. It's really about the timing and the sequence of putting the trades on and exiting the trades.
JACK FARLEY: Darius, how does gold fit within that regime? Because I know you said gold has roared back to life. You're absolutely right. I think it's up for the sixth straight day in a row. That, of course, has happened as real yields have continued to sink. Can you explain how you're thinking about gold? nd why does gold trade so inversely with real rates? Why is that correlation so perfect?
DARIUS DALE: Yeah. Obviously, gold's up six days in a row but in this week, week to date, in particular, we've seen what we call a classic deflation move from a market regime perspective. What I mean by that is gold has historically been one of the best performing assets when the market regime is pricing in deflation from a bottom-up perspective. You're seeing gold actually rise in the face of a rising dollar. That is a clean cut deflation signal, and obviously, you're seeing a widening of the dispersion between defensive equity sectors and style factors and cyclical equity sectors and style factors here. And obviously, those [?] bond yields.
The market is really giving you a preview of what this looks like. Then again, I've been talking about this for almost two months now in terms of allocating our portfolio construction towards deflation at the margin. This is exactly what we would expect to right around this time of year. Again, I don't know that we're quite ready for that pivot yet.