ALFONSO PECCATIELLO: Hey, everybody. Welcome back to the Real Vision Daily Briefing. Tonight, it's a pleasure to host the comeback of Mr. Andreas Steno Larsen, who doesn't need any introduction. But while he's an art investor, a Real Madrid fan, [?], I don't know what else. How are you doing, mate?
ANDREAS STENO LARSEN: All good. It's been a while since I've been on this platform. But it's super good to be back.
ALFONSO PECCATIELLO: Well, I guess everybody's just happy to have you back. By the way, this is Alf speaking. I write The Macro Compass newsletter, but you have heard enough for me. Today is January 18th, 2022, and the bond market is going ballistic more or less. We have the frontend, which is now pricing 4.2 hikes, which translated means that there is 100% certainty in Eurodollar futures that there will be four hikes by the Federal Reserve this year, and there is an additional about 20% chance that there will be a fifth rate hike somewhere down the road. What do you make of this, Andreas?
ANDREAS STENO LARSEN: Well, I think three or four months back, I started forecasting three hikes from the Federal Reserve in 2022. And I remember that everybody just started calling me names when I dared saying that. But all of a sudden, everybody suddenly agrees that they will have to hike every quarter. And I even see the debate of a 50-basis point hike in March picking up now, which I simply lacked the imagination to consider a true risk. But who knows, they will have to tighten, at least to a certain extent, I think they will get some help from the economy basically, by itself. But let's get to that.
ALFONSO PECCATIELLO: Well, the interesting part is that if you look at curve dynamics, 2 Year yields are as high as the 27th of February 2020, so basically, before the pandemic. The 1.04% as we speak. The long end of the curve, though, hasn't really picked up that much. 30 Year bond yields are below 2.2%. The curve has been flattening very aggressively. And before, we had a bilateral conversation where you pointed out at people looking at the wrong yield curve or not paying attention to how flat or steep is the real interest rate curve and how flat or steep is the nominal interest rate curve. What do you mean by that?
ANDREAS STENO LARSEN: Well, if you look at the real yield curve, the one where you adjust for inflation, then you have a very negative front. But if you look at the 30 Year point, you have roughly 0% real yields. That's a much more steep curve compared to what you see in the nominal yield curve. The interesting thing is that it also means that the market over time expects inflation to converge back to the 2% target of the Federal Reserve.
To me, that's the key question for this year, will it happen sooner or later than priced in? To me, the risk reward clearly favors a view that it will happen sooner. We already know that in the second quarter of this year, the inflation rate will have to combat material base effects if it wants to stay as high as it is right now. My money would be placed on inflation disappointing, not the opposite.
ALFONSO PECCATIELLO: Basically, to break down for the listeners, obviously, the difference between nominal interest rate curve and real interest rate curve is inflation expectation or inflation breakevens as they're called in jargon. And Andreas is pointing out to the fact that long term inflation expectations, so 30 Year inflation expectation or 5 Year forward 5 Year, they actually have gone down over the last month, month and a half while nominal interest rates are going up, which is quite the dynamics.
We've pulled a chart that shows-- this is some work I've done at The Macro Compass that shows the credit impulse. And then inflation breakevens, 10 Year inflation breakevens lagged by 12 months against this credit impulse. This credit impulse has peaked a while ago, and it's now plateaued as there are no new stimies coming and bank lending has not picked up yet to actually offset that.
You have inflation expectation normally plateauing first and then starting to revert back when there is no new credit flowing to the economy. Do you have a similar theory, Andreas? Do you expect inflation expectation to revert back, or?
ANDREAS STENO LARSEN: Yeah, I do. And one important thing to notice in that regard is how correlated the inflation expectations are with the oil price. And I'm not talking about the nominal oil price, but the running change in the oil price since a year ago. And what we will see in the second half of this year, basically, throughout the commodity space, in particular in oil markets and also natural gas markets is a very negative base effect due to the fact that we saw such a big increase in the commodity space during the second half of last year.
It would be very tricky to keep inflation rates when you measure them on a running basis against the year prior high into the second half of this year, also in the commodity space. And that should also lead to a negative effect on inflation expectations in the inflation swap market.
ALFONSO PECCATIELLO: Well, as we speak, we're painting a pretty bleak picture. But in the meantime, we have 10 Year Treasury yields trying to test 1.87%. How sustainable do you think this move is?
ANDREAS STENO LARSEN: I'm a bit scared to say that the time is now to go against it. But the timing is soon at least. I know that you tried to go against the move already today. And my point is that we still have a couple of months where it will be at least decently possible to beat the inflation rate from 2021. The monthly increases in the dollar inflation in January and February 2021 were pretty low.
It is actually possible to see even higher inflation rates over the next couple of months, which is why I want to wait a bit with the outright long duration bet, so buying long bonds. But I still think that the safest bet right now at all is just to flatten the yield curve. For example, between the 30 Year point and the 5 Year point. I think it can flatten much quicker than anticipated forward pricing.
ALFONSO PECCATIELLO: Interesting thing is that if you clean the noise away from the credit spread between Treasurys and swaps, and you just look at the pure swap curve, so 5 Year swaps and 30 Year swaps, and you look at that slope of the curve, you actually have the spread being only 26 basis points between 5 Year dollar swaps and 30 Year dollar swap. It's quickly getting to zero. Can you give the audience your rationale why that curve is going quickly to zero? And why do you expect it to continue?
ANDREAS STENO LARSEN: We've been talking a lot about so-called quantitative tightening so far this year, which means that the Federal Reserve plans on bringing the nominal amount of assets on its balance sheet down over the next couple of years. To me, that's really the key when we are talking about a flattening yield curve.
Interestingly, when the Federal Reserve talks about quantitative tightening, they actually expect that process to steepen the yield curve, since what they do in this process is that they allow the private market to swallow bonds with a longer duration again. But the interesting thing is that empirically, you've actually seen the exact opposite effect throughout such a process, for example, in 2018, 2019.
The point here is that when you withdraw dollar reserves from the financial system, I think there is a tendency for this to spill over to higher cost of capital, for example, higher credit spreads, but maybe also via weaker multiples for companies seeking new equity. And a higher cost of capital will eventually lead to a weaker activity level.
And I think that is essentially what you should expect from the second half of this year as the Fed is already paving the way for this process to unfold itself. To me, QT means weaker activity than anticipated. And therefore, you could actually get a scenario where long bond yields will drop.
ALFONSO PECCATIELLO: Let's break down for a second this quantitative tightening story. I've recently published a piece of the Macro Compass that also covers that. And basically, if you are a private sector entity that during QE, got a lot of bonds taken away from your balance sheet and exchanged with something that is a zero duration, zero yield, zero risk reserve or bank deposit, if you're not a bank, then you're a pension fund, instead of a bank reserve, you got a bank deposit but it's useless.
It's in there, it's sitting there and doing nothing, then obviously, what you will try to do over time is to rebalance maybe your portfolio back to a certain risk appetite that you have, maybe you have some risk on the liability side of the balance sheet you need to hedge so you tend to recycle some of this risk back into first, Treasurys, then credit spreads, etc., etc. And this virtuous cycle of low volatility tighter credit spreads is backed by this process.
Quantitative tightening is the opposite. You just revert back everything. You drain these reserves from the market, and you make the private sector absorb, as you said before, net net, new bonds. Obviously, when that happens, you need to make room, or you're not crowded out anymore, you're crowded in the bond market. You need to make room for those.
And as you make room for those, then your appetite marginally to move and buy high yield bonds becomes just less, because you need to make first of all, room to buy your Treasurys back that you didn't have any natural appetite to buy before as you were crowded out by QE. QT is just the opposite.
ANDREAS STENO LARSEN: Yeah. And now, I'm going to say something that will not make you happy, Alf. But the interesting thing is that during the process of QT, you will actually see the market getting collateral back in return for cash. The issue that we've had over the past couple of years is that we have too much cash and too little collateral.
And the QT process will lead things in the opposite direction, meaning that cash will be less abundant, and collateral will be less scarce. To me, that means that it will be easier to take bets against sovereign curves, for example, the Italian one, because it will simply be cheaper to bet against the Italian sovereign curve, meaning that you will lend the bond then short it. And therefore, I think you should expect such events to show up during 2022, where you will have targeted attempts to bet against curves like the Italian one again.
ALFONSO PECCATIELLO: Yeah, and also from a European perspective, come on, we are Italian and Danish, we should talk about Europe bit as well. If a process like quantitative tightening happens in Europe as well, and I do expect the ECB balance sheet to reduce this year on a net basis, when that happens, as you described, the imbalance between let's call it cash, well, reserves, anyway, cash for simplicity, and collateral, which during QE, gets much more skewed towards abundant cash and slowly reducing the amount of collateral in the system, and it gets taken away from QE. In QT, it just gets the opposite effect.
You get these reserves drained from the system and the collateral being pumped back again into the system. When you reverse this imbalance, and your favor collateral, there is an abundance of collateral relative to the abundance of reserves into the system. The first victim very often overlooked is the repo market. Generally, when repo transactions happen, the price or the yield of these repo is set, given the demand and supply of collateral relative to cash.
And if we invert these dynamics, and repo levels are going to, of course suffer, which makes, as you said, shorting several markets more affordable in the first place. The most vulnerable parts of the market, which may be in the US can be high yields, or in Europe, can be BTPs, so Italian bonds are generally the ones that might tend to suffer at the beginning a bit more.
ANDREAS STENO LARSEN: Yep. And I think into this scenario, I would still consider credit spreads in high yield to be generally too low. That could be one clear victim into this QT process unfolding.
ALFONSO PECCATIELLO: Yeah. And if we move back to the good old stock market, we're talking basically about a trickledown-- well, that's a scary term to use in economics. It never works. But let's try it, a trickledown effect from the repo market to risk free rates and then to credit spreads and then to equity markets. Am I making this right, or?
ANDREAS STENO LARSEN: Potentially, yes. I think that's more of a dark horse. At least I would envisage a rotational play in such a scenario in equity space. I'm not sure that we will see a massive drawdown on the index level, I wouldn't bet on that at least. And therefore, I would be on the watch for the sectors that are clearly overweighted right now. Everything's cyclical. That means banks, energy, sectors like that. They are, as you can see from the fund manager survey, clearly favored by market participants right now.
And if we get a rotational play into a slowing economy with the QT process unfolding, then I would expect the fund managers to leave such sectors in favor of less risky equities, you might say, within other sectors. And that could be pharma for example.
ALFONSO PECCATIELLO: Yeah. As we're talking, we're making a climax on higher and higher risk and volatility assets. We started from rep, then Treasurys, then credit spreads, then equities. I want our listeners to listen to a conversation that happened on Real Vision between Mike Green and Ben Savage, where they talked about volatility and how investors are digesting this asset class and how are they looking at volatility today?
BEN SAVAGE: Well, I think it translates to more risk. I don't think folks change what they want in terms of lifestyle. If anything goes the other way, people want more out of life than they've been getting pre this vol shock that crystallized a higher risk tolerance. And they're going, okay, I want the same level or better of returns that I was getting before. But I'm willing to take more risk to get there in aggregate.
That functionally lowers the anticipated Sharpe ratio across all asset classes. In order to then get to the return levels that I want, I essentially have to move more and more into higher risk asset classes, I have to lever up. I have to actually take more risk on from a market standpoint, which in some sense, is reflective of their pain, actually more risk in the world. As I said, reality vol is independent of humanity has just gone up, and the parts that are dependent on humanity have gone up.
But from a market standpoint, yeah, nobody wants to own this safe, boring, low vol, high Sharpe asset. You'd rather own the high vol, low Sharpe asset and have more of a chance of winning the lottery. I do think what that will ultimately imply is even if yields come back up, nobody's going to want to own bonds. Because they're just not going to return enough to be interesting in this world.
And you see it, like in my world which is venture capital, you see it very much in the capital inflows into this asset class, which is, theoretically in a way among the highest volatility asset classes available without using leverage to investors. And there's this ongoing flood of capital into venture, which isn't so much chasing yield, it's chasing volatility.
ALFONSO PECCATIELLO: And this interesting conversation between Ben Savage and Mike Green is available for all tiers, subscribers at Real Vision. And Andreas, Ben there was saying that ultimately, winning the lottery is what mattered the most for people in 2021. And you were just talking about pharma, this boring, low beta stuff that it's all but winning the lottery when you look at the stock market. You have a different take on sector and sector rotations, correct?
ANDREAS STENO LARSEN: Yeah. The environment that we are approaching is an environment with, for me, less risk appetite than what we saw in 2021. And that's essentially also the only direction risk appetite could move in. I'm not saying that this will be a medium, but it will move in a slightly more conservative direction due to the fact that central banks will not keep pushing the party. Therefore, I already now would start planning on rotating my equities into more defensive sectors.
ALFONSO PECCATIELLO: Yeah, talking about commodities, we touched that before and we're looking at oil that keeps on rallying. The same time, interesting, we're looking at certain pockets of the emerging market worlds that are shaking up, Russia the latest example, Turkey before that. What's your view on industrial commodities or commodities in general and emerging markets?
ANDREAS STENO LARSEN: I would be super short industrial commodities. And I know this is a contrarian bet already now, as well. The reason is that if you look at the correlation between credit creation and industrial commodities, that is maybe the strongest link you have between credit and asset classes in general, since credit creation in the real economy usually filters directly into activity such as buildings and other very thorough uses of commodities.
So, as soon as you withdraw credit, which is exactly what is about to happen, then you will see a small demand for industrial commodities very soon. A key topic for me this year, industrial commodities is a big short.
ALFONSO PECCATIELLO: And I guess then all emerging markets that are high levered to this asset class actually are not amongst your preferred.
ANDREAS STENO LARSEN: No. The regions are, to a certain extent, obvious. Brazil could be one example, Russia other example of countries very clearly linked to this cycle.
ALFONSO PECCATIELLO: Yeah. And as you came back after a while live on the show, we have quite some questions from the audience too. You used to be pretty big, I have to say, in calls when it came to FX, so there is a question on Eurodollar. Where do you see that going?
ANDREAS STENO LARSEN: 105 to be very precise. That's been my target for a while. And I've been short in my thinking on Eurodollar sense, basically, last summer. The reason is that I expect the balance sheet drawdown of the Federal Reserve to be more aggressive than that of the ECB, simply due to the fact that there is a bigger chance that the Federal Reserve can actually get going with this process than the European Central Bank, for example, due to the scenario that we talked about with the Italian bonds.
My expectation is that the rundown of the Fed balance sheet will be swifter than that of the European Central Bank. And that should lead the way for a stronger dollar versus the euro, for example, via a move in the cross-currency basis swap.
ALFONSO PECCATIELLO: Yeah. And then we have another one about China, which is an interesting debate at the moment, because the PBOC has started some easing, at least. We have seen the first action being taken. If you look at the credit impulse from China, there are