MAGGIE LAKE: Hi, everyone. Welcome to the Real Vision Daily Briefing. It's Wednesday, June 22nd, 2022. I'm Maggie Lake here with Darius Dale, founder of 42Macro. Hi there, Darius.
DARIUS DALE: Hey, Maggie, it's good to see you. How are you?
MAGGIE LAKE: I'm doing okay, dude. Okay. I think everybody are watching the Fed still, we had Jay Powell testifying in front of Congress again, reiterating, trying to be as hawkish as possible, committed on-- strongly committed to inflation. But it was really interesting to watch.
The stock market seemed like it was ignoring for most of the day, we had what looked like a little bit of a rebound going on, but it dropped out a little bit at the end, they rolled over back into the red, nothing huge in terms of selling but just interesting to see that negative sentiment or just lack of buyers, I guess, in the last half hour trade. 10Y bond yield down to 3.15. We have crude prices lower. Of course, crypto getting shredded again. What did you make of the market action today?
DARIUS DALE: Yeah, the market action today was pretty interesting. So, it's in the context of what we're observing here in the process at 42Macro as a potential market regime transition from what we call inflation, which is where the market's pricing in an accelerating inflation and growth slowing to what we call a deflation, which is where the market is pricing in these simultaneous decelerations in both of those factors.
We saw pretty significant selloff in crude although we rallied off the lows, another big drawdown in energy stocks, a big drawdown in crypto, you're seeing emerging markets take it on the chin. So, separate and apart from this intraday rally in stocks, which it may itself be incrementally fueled by the post opex dynamics. Don't forget, we're two days after a pretty chunky opex, removed a significant chunk of negative gamma. I think this market is starting to sniff out this move towards deflation which we'll unpack.
MAGGIE LAKE: Darius, when you say deflation, because there's this huge conversation, and it came up today during the testimony around inflation, the idea that they're trying to bring it down. But just because the rate is lower or is decelerating or there was smaller increases, however you want to categorize that, that it's still going to get stuck at this really elevated level.
That's when people, especially those in the inflation camp, are really concerned about. When you're talking about deflation, is it possible the way you look at it that it can be lower but still stuck at a high level, or do you see this thing going back down?
DARIUS DALE: Yeah, so just in terms from a risk management perspective, our core process at 42Macro, at least on the fundamental forecasting side, really anchors on the rate of change of primary economic variables, like the rate of change of growth in the economy, the rate of change of inflation, or the second derivative is what I mean by the rate of change. So yeah, the trend it change in those time series will have an important influence on dispersion across asset classes, both within and across asset classes we've backtested the six ways this Sunday.
But when you think about it from the perspective of the Fed, there are actual targets, levels that they're concerned about, not just in reported statistics, but also in market-based measures, in terms of expectations, etc., which Powell outlined last week, and further outlined this week, happy to unpack those as well.
MAGGIE LAKE: Yeah, what jumped out at you? We're hearing this similar message over and over again, I know everybody parses everything they say to look for any changes. Is there anything that jumped out at you today from the testimony?
DARIUS DALE: Yeah. So, from the testimony specifically, no. I thought he reiterated everything that quite frankly, I live tweeted about during last Wednesday's FOMC press conference, which is, this is a Federal Reserve that is content with sending the economy into what it hopes would be a mild recession in order to tackle what I consider and I think Jay Powell himself considers to be an inflation disease, it's willing to amputate its arm or its leg in order to save the whole body, if you will, from the spoils of inflation.
So, I think he did a decent enough job reiterating that amidst a sea of nonsensical-- political nonsense around gas prices and regulation, etc., etc. These semiannual testimonies are always fraught with politics. But when you read through the tea leaves, there wasn't actually much substance in terms of incremental information relative to what we heard from last Wednesday.
MAGGIE LAKE: Yeah. And it's been interesting to watch the data because as you said, this conversation's really turned very quickly and everyone's talking about recession, because we saw, as many had been predicting, those of you who've been worried about the economy, we're starting to see some of those early warning signs, those more forward-looking indicators, whether it's some of the manufacturing indicators, or some of the early housing start to turn really in the last week. I know that's got everyone thinking about inflation.
I want to play a clip right now because as we've been discussing the Fed and how behind the curve they may or may not be, Tian Yang weighed in on this subject in a recent Expert View he did for us here at Real Vision. Let's listen to a clip of that and then we'll talk on the other side.
TIAN YANG: Right now, the market narrative is very much that yes, the Fed is behind the curve. But in terms of how fixed income markets should be behaving in a "normal" hiking cycle, I would say the behavior is not that bad, right? Yield curves generally bear flatten in terms of this hiking cycle, which is typically what you would expect. If you look at some of the longer-term things like 5Y 5Y, if you look at term premium, these things haven't really gone to crazy levels, so for sure, there has been a lot of adjustment, clearly, bond yields need to reset.
But you're not seeing the typical panic that you will see at the federal level. If they truly weren't, you will probably see term premium rise a lot more, you actually probably see a curve steepening in response to Fed policy action, because generally, you see a flattening trend, it shows that at least the market is going to give the Fed some credibility that the Fed is serious about fighting inflation, to the extent that they may be willing to engineer a recession, hence, you get the curve flattening.
As of right now, again, these are things that we want to watch for in terms of whether that's truly a change, but the Fed still is credible, in my view, because they might be behind the curve, but they're still doing things to address it and the market is giving them some credit for it.
MAGGIE LAKE: And that full Expert View is available to Essential Plus and Pro members on our website. So, people taking the Fed at face value, I suppose that they're more serious about it. I think it's an open question still there, is how much they can actually influence what's going on. They're targeting the demand side, we know there is some supply side issues involved here. Where do you come down on this? And I guess the question is, where are we with the bond market? The bond markets giving them some credit, but is the Fed leading the bond market? Or is the bond market leading the Fed?
DARIUS DALE: So, right now, that's a phenomenal question. And by the way, I generally agree with Tian's view, he's another data driven investor, I tend to side with a lot of data driven macro risk managers. But just going back to your question, I think what Powell's most concerned about, and he articulated this several times particularly in the last week or so, which is very concerned about long term inflation expectations, and the volatility associated with them becoming "unmoored", if you will, to borrow a phrase from our friend Jim Bullard yesterday.
Brian, I sent you a chart from one of our decks that says Powell is fighting to maintain control over the bond market. And what this chart shows in the top panel is just the 10Y 3M yield spread. That's a proxy for the growth expectation of the economy, if you will. Powell has really got growth expectations at least still reasonably anchored, because we have not seen a significant flattening of that curve generally via bull flattening, if you will, which you typically see into a recession.
But on the bottom, I think that's the more important part-- or sorry, the middle panel is actually the more important chart, which shows the term premium, which is a very wonky academic measure that really is just trying to assess how much premium investors demand for holding longer term maturities. Once you X out things like the expected growth rate, the expected inflation rate, the inflation risk premium, etc., etc., what you're left with is the term premium.
And right now, at minus six basis points, we're only in the eighth percentile of that on all daily observations going back to the early 1960s on this metric. And so, what that's telling you is that the bond market believes the Fed still has credibility with the bond market in terms of its inflation forecast, its growth forecasts, and ultimately, its desire to maintain that control by effectively quashing out inflation really quickly and really effectively.
Now, if at any point in time, as you can see from the chart going back to the mid to late 1970s all the way through the early 1980s, the Fed, starting with Arthur Burns, really lost control, Arthur Burns was the Fed chair back in the 1970s who really let the inflation genie out of the bottle, which obviously Powell is trying to avoid. He really let that genie out of the bottle, and you saw the term premium widened to just under 500 basis points over.
So, if you think about just without any change in growth or inflation expectations, you could have the 10Y Treasury yield gallop three, four or 500 basis-- not three, four or five, but more like 200 to 300 basis points higher just on a revision to the term premium, which again, is the bond market pricing in the uncertainty around Fed policy. This is what Powell is hyper concerned about because again, if you let the inflation genie in the bottle, it's really hard to get that back in.
MAGGIE LAKE: Yeah. And that is why that is one of the pillars of their mandate, price stability. It was last of the four because of the disinflationary slash deflationary period we were in but question on bonds, Gary from the RV site, the 10Y Treasury rate peaked right at the top of the stock market in early 2000 and mid-2007, per the title of this interview, why do you think rates will keep going higher this time? I would say, do you think we've seen the peak? And if not, what's going to keep them elevated? Or what's different this time around?
DARIUS DALE: Yeah, I think that's a difficult question to answer in this particular juncture, the first part of the question, which is, have we seen the peak in rates? We're going to see new highs in rates if inflation continues to misbehave. We've been talking about this for the past month or so about the potentiality for inflation misbehaving. It did misbehave in the May inflation reading, we did see a step function increase in terminal Fed Funds Rate expectations and policy rate expectations across the curve. And ultimately, that big shock higher in the UMich five-year forward inflation expectation, which really spooked the Fed is obviously filtering its way into the bond market.
So, we could continue on in this process. I don't need to go into the details on the inflation statistics, that will tell you that that risk is still very much on the table. We saw a broadening out of inflation data or inflation pressure in the most recent meeting, the May reading just to get those statistics at three-month annualized median CPI, which is everything in the CPI basket on the median basis, accelerated to 6.4% on a three-month annualized basis, fastest rate ever.
So, the broad basis of inflation is a real issue and has not been tamed yet, at least not according to the data. As it relates to the bond market, have we seen the highs in yields? I think that's a 50/50 toss up right now, it's difficult to ascertain that at the present juncture. And generally speaking, just to take a step back from a risk management perspective, it's always difficult to catch falling knives in any market, obviously, catching the falling knife in bond crisis here so just be careful with these types of questions.
What's more important is understanding the change, the potential change in the regime that could be potentially favorable for the bond market. And that's something we do on a daily basis at 42Macro. Brian, if you bring up that chart, deflation is now the second most probable regime, so going consistent with our GRID framework, which we use the rates of change of growth and inflation to identify what regime the economy is in, we're actually using market signals, core market signals across 42 different markets, all different asset classes, to nowcast what regime the market is in, what is the market pricing in, and it's been consistently pricing in inflation has been the highest, most probable regime.
And oh, by the way, there's 504 unique datapoints that go into that process every day to determine what that market regime is. And now, what we're starting to observe is that deflation is now the second most probable regime, which is actually consistent with our forecasts, which are calling for a phase transition in the economy to deflation, again, growth slowing, inflation slowing by mid to late Q3.
And so, to answer the question just very succinctly, if we've seen the highs in bond yields, it's coming right on time. I'm not certainly seeing the highs in bond yields because I see a scenario where inflation continues to surprise to the upside over the next month or two. And if that happens, we're going to see another step function increase in terminal Fed Funds Rate pricing. But if we don't see inflation surprise to the upside, then it's very likely we have seen the highs in bond yields.
MAGGIE LAKE: Yeah, and that's what's so hard, because this is you're trying to gauge the supply chain issues in some way, not the demand, which was a little bit clear. It's hard to forecast if China is going to close down because of COVID. These are the things that keep roiling us, I think, when it comes to trying to get a handle on that and why so many have gotten the timing on bonds wrong. There are people who think bonds are a good buy here, but it's just so hard to plug in the timing part and not matter. I think just echoing Darius' sentiment, be careful in this environment, it's just a really, really difficult one.
So, the same question we get all the time as you know, Darius, when it comes to stocks, it's that same feeling. Are we through the worst of it? Is it time to start buying? And the way Galan put it in a question here from the RV site, I hope I'm saying your name right, Galan. The average recession has roughly 25% decline in S&P earnings, S&P earnings are $204 as far as I can see, these are the numbers he's using or she's using.
The average multiple on the S&P 500 is 15 times over time, I think. So, assuming the multiple doesn't overshoot, that's a 2300 on the S&P. Do you think this is worthwhile thinking? Thank you for walking through your thinking, by the way, so we can understand where you're coming from with that question. And I think the way I want to put it to Darius is people are looking at this decline from the top and obviously Galan also plugging in some earnings to that.
But I've had people on the program say I don't care what the decline is from the trough to the bottom now because that's not all the information I need to see whether-- maybe it's not going to go back to that level. You got to plug a lot of other data in, so what are you thinking about, Darius, as you try to figure out their trajectory here and the timing for the S&P or for stocks?
DARIUS DALE: Absolutely. So, if I get fired from my day job of helping professional and retail investors manage macro risk, I'll be a professor somewhere maybe back New Haven where I got my degree. But I think this is a perfect question and a phenomenal question, Galan, if we're saying your name right, I apologize if we aren't, to unpack a few things. I'll start by just really quickly, S&P earnings on a next 12-month forward basis which you should be using to help value the market on a forward-looking basis, are currently at $220 per share.
That's a new high, we've trended higher, we've not seen any significant earnings revisions, and we continue to trend higher on an earnings per share basis. So, that's an issue if you think about the significant growth slowdown that we're likely to-- that we've already accumulated in terms of the financial tightening we're seeing, but we're likely to experience in realized terms over the next few months.
A couple of more things that I'd highlight that-- again, this is a fantastic question, great teaching opportunity here. They mentioned the word average several times in that, average drawdown, average earnings, average multiple, average, average, average. Average is the most dangerous word in finance, write this down, average is the most dangerous word in finance. And the reason it's so dangerous is because most time series spend very little time at their average, the average itself is just a statistical concept.
We don't live in a world of apparently observed averages, we live in a world of deviations to the upside, deviations to the downside, and when you put it in an Excel spreadsheet or in a Python script, it becomes an average. And so, we have to understand that there's nothing average about this particular setup, or about any particular setup on an ex-ante basis when you're managing risk in financial markets. So, just get yourself away from that, try to be more Bayesian in your approach. You need to use things like averages, things like mean standard deviation, percentiles, etc., Z scores to understand to how to contextualize risk in ex-ante basis, but at the end of the day, June 2022 is the only June 2022 in the sample, and it will only be the only June 2022 sample. So, be aware of that.
MAGGIE LAKE: Awesome, awesome, thank you so much for that, Darius. And I think that's why-- and thank you for the question. These are the kinds of things we want you to ask because this is the kind of growth mindset that's going to help prepare you and help you make better-informed decisions. And that's what we're all about. So, thank you for that.
DARIUS DALE: Appreciate you. And sorry, Galan, I actually didn't even answer your question. I went on a rant, my apologies. But to answer your question, no, I do not think this is the bottom. Again, we've studied bear markets