ANDREAS STENO LARSEN: Good afternoon, everyone. And welcome to the Real Vision Daily Briefing. I'm Andreas Steno, live on air from Copenhagen, Denmark, the 29th of June. We've had a lot of central bank talk today, but a fairly quiet day on markets in response to all of the talking. So, to assess the upcoming trends with us, I'm joined by not only a friend of the show, but also a friend of mine, Darius Dale, the founder of 42Macro. Welcome to the show. How are you, Darius, my friend?
DARIUS DALE: I'm well, my friend. How are you doing, brother? It's good to see you, man.
ANDREAS STENO LARSEN: Yeah, likewise. I actually wanted to start with a quote that you also tweeted earlier today. And I'm reading out loud here. It's from Jay Powell, we have the tools and resolve to return inflation to the 2% inflation target, the process is highly likely to involve some pain, but an even worse pain would be falling if failing to achieve our objective. What do you make of that quote, it's pretty direct?
DARIUS DALE: Yeah, it's unusually direct. Central bankers are very rarely just straightforward with their intentions, particularly as it relates to withdrawing liquidity for markets. They're usually very straightforward when they're talking about adding liquidity. What I take from this, and I want to paint a picture for everyone. Imagine where, I don't know, let's call it a 10-year-old's birthday party, let's give him 12, 12 a little bit more strength.
We're at a 12-year-old's birthday party in your backyard and you're talking to your buddies out and all the kids are sitting around a tree. And as a 12-year-old with aluminum baseball bat swinging at a pinata, except this 12-year-old doesn't have a blindfold on. This 12-year-old is going to whack and whack and whack that baseball bat until the candy spills out and that candy spilling out is inflation returning back to target. So, be prepared for that, for a bumpy road ahead.
ANDREAS STENO LARSEN: Thanks for that picture, Darius. This is probably as crystal clear as it gets from a central bank that they want to see demand destruction. So, let's get to the probably the hottest topic at the moment, the risk of a recession. Because obviously, when a central bank goes aggressively ahead and tightens policy, there is a risk of a recession. If we look at current risk measures of a recession, how big of a probability do you think there is for a recession over the next, say, one, two quarters?
DARIUS DALE: Yeah. So, I've actually sent a series of charts on this, and I think it's very important to unpack at least the first few, which is the model implied probability. So, I'm not a big believer in recreating the wheel. Let me add another psalm on the roll of sayings this year. Smart people don't recreate the wheel, they create electric vehicles.
And so, what I mean by that is, if something out there exists, and it's really good, and it's back tests, and it back tests well, then use it, don't waste a bunch of time trying to figure it out and recreate it yourself. So, that's what I mean by these recession probability models. One, the blue line in that chart, or sorry, recession watch model implied probability, Brian, is the chart.
The blue line in the top panel is the New York Fed's model that goes all the way back to the early 1960s. And then the red line on the chart shows the yield curve implied recession probability models, I blended those two together based on the 10s 2s spread and the 10s 3s spread, 10Y 3M spread. And right now, the former, the New York Fed model is at 4% and it typically is somewhere around 27% on average heading into recession.
Again, average, you've heard me also say average is most dangerous in the world of finance. So, be careful that but understanding that we need some guideline, guideposts, the yield curve model is a lot closer to singling recession over the next 12 months. That's a 25%. And on average, in terms of the cycles that it's seen, it's only been around since 1992, that average reading prior to just the onset of recession is around 35%. So, we're pretty close there.
ANDREAS STENO LARSEN: Yeah. At least, it signals that there is a clear risk over the next 12 months. And I guess one of the areas of the economy that we need to watch closely when it comes to the recession risk is the consumer. We know that the consumer is important for the US economy. What do you make of the most recent trends that we've seen in consumer confidence and the embedded risk of a recession?
DARIUS DALE: Oh, yeah. So, I heard you, you're talking now yesterday on this very brilliantly might I add. I just have a few couple things to follow up with because I thought you've hit the nail on the head as it relates to what the decline in consumer confidence is signaling. So, I have two charts on that. So, Brian, the next chart is consumer confidence, recession watch consumer confidence, we just show you one of the things you want to look at to gauge whether you're in recession because typically, what happens, the NBER comes out after the fact and tells you a recession.
You don't know you're in recession generally speaking until it's too late. Generally speaking, the markets are for looking and they're obviously moving in that direction into it. And so, very clearly, I think we're in one of these pre-recessionary periods. When you look at the breakdown in consumer confidence, particularly, below its trailing three-year trend, historically, that's been a very clean-cut indicator that you're either in or as closely headed to recession.
And as we can see from this most recent confidence print, which is actually a better indicator than the University of Michigan print for a variety of reasons, not the least of which it's tethered to the labor market, not inflation. That number, it's 99, is just collapsing below its trailing three-year trend of 110. So, that's a green light, if you will, from a recession signaling indicator. And then another green light or bright red, if you want to think about it from a risk perspective, would be the next chart where we show consumer expectations.
So, I'll take a second to explain this chart a little bit more complicated. The top panel just shows consumer confidence expectations relative to the present situation. As you can see, there's a pretty substantial divide, the expectations index is all the way down at 66 whereas the present situation index is already up at 147, which feels like an economy growing 10% nominally.
Well, the expectation is clearly that the economy is very much not going to be growing 10% nominally, and when you look at that bottom panel, which just shows the point spread between those two indicators, we're at minus, I want to say 81 or so on that indicator. That's a first percentile reading. And as you can see, just going back, scanning your eyes across to the left of the chart with respect in the X axis.
Historically, when you get to a deeply negative reading in this chart as a first percentile reading, it would imply you are headed into recession, my friend. So, the consumer thinks we're heading into recession. I'm not so sure that the average investor realizes that yet.
ANDREAS STENO LARSEN: I agree. I'm on the latter, at least. I guess the textbook definition of a recession is two subsequent quarters of negative quarter on quarter growth. We actually had revised numbers out of the first quarter earlier today showing minus 1.6 in the annualized decline in the first quarter GDP growth. So, we just need a negative quarter this quarter to call it a recession, don't we?
DARIUS DALE: Not so fast, my friend. See, there are two types of recessions. There's the technical recession, as you just highlighted, which is two negative quarters of GDP. But there's also the actual recession that markets are trying to sniff out and price in, which is a statistically significant deviation to the downside in output. And you can measure output, obviously, to GDP, total employment, income, industrial production etc., etc., consumer spending, etc. And we have not seen anything of the sort.
Obviously, the markets are starting to sniff that out. Certainly, our models at 42Macro in terms of our leading indicators for growth are pointing to a statistically significant deviation to the downside in the growth rate. But whether we actually get a contraction in output, I think the jury's still out on that. But I certainly think we're moving in that direction in terms of pricing in that risk and assessing that risk.
ANDREAS STENO LARSEN: If we look at forward looking gauges of the recession risk, the yield curve is obviously one of such gauges. And I've noted how we've seen a material implied probability of rate cuts being priced into the outlook for 2023. What I would like to debate with you is whether it is feasible at all to think of a pivot from the Federal Reserve in the direction of rate cuts less than a year from the first-rate hike. We've never seen that before, have we?
DARIUS DALE: Yes, we have. So, on average, and slap me in the face of this is wrong, but someone I respect, I'm citing a statistic from someone I respect, Francis Donald who does great work over at Manulife-- on average, the first-rate cut is usually eight months after the last rate hike. And this is data going back to the 1970s. So, the Fed usually is tightening, tightening, tightening until it's too late, because again, the Fed's focus on inflation and employment lends it to looking at lagging indicators.
Inflation and employment are both lagging indicators with respect to the GDP cycle, with respect to the overall business cycle. And so, if the Fed is focused on trying to achieve its objectives through the lens of lagging indicators, the probability that it overtightens in every tightening cycle is actually quite elevated.
ANDREAS STENO LARSEN: Yeah. But I referred to less than a year from the first rate hike not the last rate hike. That would at least be something new I guess if they manage to turn around that quickly. I also wanted to pick your brain on a few developments from the central bank conference in Portugal taking place over the course of this week, because we had a panel debate between Christine Lagarde from the ECB, Jay Powell from the Federal Reserve and Andrew Bailey from the Bank of England, what a panel by the way. by the way, but they all kind of agreed that they can still take a look at the supply side issues when they try to explain away the current inflation pressures. What do you make of that kind of rhetoric? Still? Is it fair to claim that the supply side is the main caveat here?
DARIUS DALE: For other economies, yes. We talked about Agustin Carstens from Mexico and Bailey of England. Obviously, Christine, Madame Lagarde in the ECB, those economies did not stimulate demand in the way that the US economy did. We dumped multiple trillion, I want to say, $6 trillion, $7 trillion in fiscal stimulus into our economy, into our $18 trillion economy in a matter of 18 months.
That was obviously unprecedented in size, both in a nominal real basis, but also in terms of relative to this narrative that it's all supply. No, supply is set and I know a thing or two about economics, having studied them on the hallowed grounds of Prospect Street in New Haven, those of you know that where that is. Price is set at the intersection of supply and demand. You don't just get supply generating price. There needs to be a level of demand that exceeds supply. And what we've had is the inverse shift in the supply curve that the Fed is now trying to perpetuate a similar shift in the demand curve, otherwise, you're going to continue to have elevated prices.
So, to me, that was one of the two things I really took away from the event, which is yes, supply matters. But ultimately, you cannot have a sustained inflation bout-- sustained bout of inflation without supply, having issues across whether it be physical commodities, etc. And then two, the second thing I took away was Powell just seem exasperated, he almost felt like he was at low energy. Maybe he was sick or something. But I think he's just tired of explaining and repeating himself.
Guys, I'm going to tighten until inflation returns back to our target. And I think he's just as a human being, he's just sick of trying to come up with a bunch of different clever ways to say it. There's too many ways, we're all looking for tea leaves, and quite frankly, we need to stop drinking the tea.
ANDREAS STENO LARSEN: Yeah, I perfectly agree with you. He's been very direct lately, so we know what he's after. It's a bit trickier to assess the Bank of England and the European Central Bank from that perspective. Bailey, for example, from Bank of England said today that we should basically be prepared for inflation staying around for much longer in Europe than in the US. I find that a very interesting signal to send as a central bank, at least they're preparing us for inflation numbers running hot into the autumn as well.
DARIUS DALE: Absolutely. So, on the inflation numbers running hot, obviously, we get core PCE tomorrow. The probability that we see an upside surprise is actually higher than the probability we see a downside surprise, although, generally speaking, these datapoints come in in line. So, the highest probability is an inline statistic. But if you're a betting, man, just given the breadth of inflation that we saw in the May CPI report.
You look at things that are very close closely correlated to core PCE like median CPI accelerating to an all-time high on both the year-over-year and three-month annualized basis, sticky CPI accelerating to 30-year highs on both three-month annualized and year over year basis. Those two things have historically been very highly correlated with core PCE. So, this expectation that core PCE is going to continue to decelerate year over year and have a very modest uptick month over month, that's scary. I think it's scary.
ANDREAS STENO LARSEN: It is. One of the things that's extremely important for inflation is the housing market. We know that for the CPI index, housing makes up between 30% and 40% roughly of the overall index. It's a bit less in the PCE index, but if you want inflation back at target, you also need to contain the price pressures within the housing sector. What do you make of that particular sector given what we've heard from Jay Powell, etc.?
DARIUS DALE: That's the one thing that keeps me up at night as it relates to, am I short the market enough? Because we're going to short the market and so, what is the market, sorry about that. The net short equity commodity, crypto risk, net long bonds. The issue I'm most concerned with as it relates to the inflation statistics are not the broadening out of inflation pressures, the median CPI, or the increasing stickiness of inflation as I just highlighted, or even ongoing food and energy inflation.
What concerns me most is the massive acceleration we're observing right now in core services inflation. Core services inflation at 7.8% on a three-month annualized basis, fastest rate we've seen since 1990. What's driving that acceleration, what's partially driving that acceleration is an ongoing acceleration in shelter inflation which is being driven by owners' equivalent rent, which tends to have this multiyear tail to it whenever we see these big spikes in housing-- or sorry, big spikes in home price appreciation.
We're currently tracking around 19%, 20% pick your index on home price appreciation, and OER is somewhere around five. So, we could be accelerating for another year or two just to catch up to those prices as it relates to how the BLS calculates OER. So, that is really scary in the context of where we are in this tightening cycle.
ANDREAS STENO LARSEN: Exactly. And when you look a bit ahead, I tend to look at mortgage rates as a leading indicator for the nominal house price development in many countries. And it is essentially also a very good leading indicator of the development in nominal house prices in the US. When you look at mortgage rates, and you allow those to lead the development in house prices by roughly four quarters, you get a conclusion right now that house prices need to drop at least 10% in my view.
DARIUS DALE: Yeah, I wouldn't disagree with that. Quite frankly, I think they're probably going to drop 10% over the coming year or 12 to 18 months. The issue with that is, as it's dropping 10%, you could very easily still have OER climbing higher, just as a function again of [?] dynamic with which the BLS measures that. It takes a while for the house price dynamics to get priced into OER, which obviously creates a tail to shelter inflation, which is 33% of overall headline CPI.
ANDREAS STENO LARSEN: Yeah. I also wanted to play a clip for you that relates a bit to one of the headlines that we also received today of new cuts within Tesla. It's a debate between Francis Gannon and Maggie Lake on the current assessment of the tech sector, and the repercussions for the labor market, etc. So, let's play the clip and have a debate afterwards.
FRANCIS GANNON: The tech companies that are getting hit today, higher rates are causing people to refocus and pivot away from those long duration assets, which have done so well for a period of time. And that's key to what I think is happening in the market and the shifts we're seeing in the market, with those big tech names underperforming and have been underperforming now for a period of time. And I think those areas of the market are going to be, as we've been saying internally here, the ATM, if you will, the cash machine for the rest of the market.
We have been investing in the same companies in a zero-interest rate policy world, or very low interest rate policy world for a long period of time. And so, for us to talk about investing in small cap companies that have cash flow and earnings, it's an odd thing when you could just buy Apple or Google or whatever you wanted to buy for the past 10 years. Now, I think the market is shifting. So, I think as rates move up, the focus of the market is changing.
ANDREAS STENO LARSEN: You can watch the entire interview with Francis Gannon, if you are an Essential, Plus or Pro subscriber to the Real Vision platform. But back to the topic on the tech companies, they've taken a massive hit as a consequence of the repricing of interest rates and the firmer Fed policy. What do you make of that sector given what we heard from Jay Powell earlier today?
DARIUS DALE: Yeah, so one, they've gotten hit from the style factor side of the trade on this rise in real interest rates. One of the biggest, sharpest rises increase in real interest rates we've ever seen if you look at the real 10Y yield, this data going back to the late 1970s, early 1980s. This is the big Vega, we've seen a three-sigma delta, a z score of