ED HARRISON: Welcome to Investment Ideas. I'm your host, Ed Harrison. Today, we are talking to Luke Gromen of FFTT.
The Fed is about to do some very funky things with interest rates going forward. Luke tells us what he believes is going to happen later this year and how you should be positioned in terms of your investments over the next six to 24 months as a result.
Luke Gromen, it's great to have you here back on Real Vision. And I'm looking forward to talking to you about what's going on in the economy- both the real economy and also in the markets, especially because of some of the volatility that we've been seeing. We spoke a little bit earlier before the interview and you were saying that this is a great opportunity for the Fed to complete a pivot. Tell me- before we go into what that pivot is going to be, what your investment idea is, given the outlook and why that is.
LUKE GROMEN: Yeah, the bottom line for my investment outlook is I think you want to be long risk with a weaker dollar coming, weaker than expected. And I think long risk with a pivot towards value versus growth pivot towards emerging markets versus US and we also like gold, Bitcoin as well.
ED HARRISON: We've had some guests- actually, we had one guest very specifically on the show who had a somewhat bullish call on risk assets the way that you did. But I think his reasoning was probably a lot different than your reasoning. Where are you coming from in terms of why you think this is the move to take?
LUKE GROMEN: So, where we're coming from is, is we're seeing a number of things play out in markets that are really the culmination of a number of factors we've been watching and writing about over the past five years. And so, if we take a step back, about five years ago, global central bank stopped buying treasury bonds, or stopped adding to their treasury bond portfolios on net. And what this ultimately did is forced the global private sector to begin financing the US government. And ironically, you would think that would be bad for the dollar. But what it actually started to do was squeeze out global dollar markets at that point.
You saw a sharp move higher in the dollar beginning in the third quarter of 2014. You saw the US react to this number of different ways. You saw the United States government increase or encourage banks, regulate us banks into buying more Treasuries through HQLA. You saw the US SEC regulate money market funds in the United States into buying more treasuries. You saw the US government pass Obamacare, or ACA, which if you read articles at the time, The Wall Street Journal talked about it as a measure to reduce deficits. It was one of the benefits. And so, you're basically pushing government costs off on to US consumers.
And so, it was all a patchwork to try to have the US funded more by the global private sector as opposed to the foreign official sector as it had been for a long time. That worked up until 3Q16 when effectively, the higher interest rates caused by the crowding out, the higher dollar and the reduced consumer dollars in pocket as a result of higher out of pockets with health care costs led to a slowdown in the US economy. You saw US deficits rise as a percentage of GDP for the first time since 2009.
Now, historically, that didn't only happen where you saw deficits as a percentage of GDP peak and fall only seven prior times in 50 years. And then six of those seven prior times, the US was in recession within about 12 to 14 months, sometimes shorter. The one time it didn't go into recession was in the mid-1980s when you had the dollar devalued significantly at the Plaza Accord so our call at the time in the end of 4Q16, which was pretty contrarian at the time was unless that we think the dollar is going to be weakened, because if you don't, you're going to get into a recession scenario in 2017. And if you get that, all bets are off because of where the US in the global fiscal situation is at the sovereign level.
And so, 2017, you saw the dollar fall 12%, that bought some time we came into 2018. And there was a talk of global coordinated growth, and the dollar began to strengthen. And we quickly saw that what many thought was global- coordinated growth was actually just dollar down 12% in 2017, because the dollar short cuts both ways. If everyone's short dollars and the dollar falls 12%, everyone's got more money effectively in their pocket. And that's what happened throughout 2017 as the dollar weakened.
So, as we move through 2018, you got into the third quarter or late third quarter of 2018. And something very important happened, which was that the hedging costs for foreign investors to buy US Treasuries went negative. In other words, for a Japanese or German private sector investor- and again, the US government's now critically reliant on foreign private sector investors to buy treasuries, the yield FX hedged turn negative. And so, people looking at nominal yields still look like it made sense. But the reality was, is if they wanted to hedge the risk of the dollar, they were going to have to take a negative coupon on treasuries, which was a problem, because in 2018, the United States government issued gross $10 trillion with about 70% of that less than a year of maturities. This year, they're gone on pace to issue 11.5 trillion in US Treasuries, again, 70%, less than one-year maturities.
And so, you're now talking what began happening and 4Q18 was that the global private sector began being paid not to buy treasuries, or they would have to take the dollar risk on themselves. Some of them have done that on the margin. But the amounts involved are so big that you simply can't- you don't have the mandate, or you don't want to take a career risk to take all of that on, taking a dollar risk on $11 trillion in new issuance and roll.
So, fast forward to what this effectively did was it began shifting, we'd already shifted once from the foreign official sector to the global private sector, and that squeezed the dollar higher, squeezed rates higher. What this then didn't-
ED HARRISON: So, wait a minute here, because you know because we were talking about this. My paradigm says that, when you look at supply and demand, that's not the driver of interest rates globally. So, for instance, if you look at the Treasury curve and the Treasury curve is inverted from three months to three years as it is now, it's really telling you what people think is going to happen to Fed Funds going forward. So, it's not really per se, I would say that these rates are driven by supply demand, it's really driven by policy rates. How do you square that?
LUKE GROMEN: I would say at the longer end that you're exactly right.
ED HARRISON: But I'm talking even three months to three years because that's the belly of the curve.
LUKE GROMEN: Sure. When you look at Libor for example, right, so you're talking about offshore euro-dollar rates, they bottomed the second foreign central bank stopped buying treasuries. 3Q14, you started sucking that dollar liquidity out of the global system and Libor began rising. The US was also tapering at that point in time as well. No question. Would you look at what happened here in the 4Q18, it's very clear that when on the margin, your foreign private sector investors, their choice all of a sudden is I can buy a JGB at 10 basis points, or I can buy a US Treasury hedged at negative 45 basis points, or I can buy a US Treasury unhedged at 2.25, 2.4%, whatever it was, at the time, 2.5%. But my risk there then is that I get another 2017 in the dollar and I lose four or five years of coupon if the dollar goes down 12%. That's the risk they're taking. And they're probably going to lose their job and assets with it.
And so, what that did was it forced, on the margin, more of the United States deficit on to the US private sector, US banks. So, you can start to see even in the 4Q18 risk off, yes, yields came down, but the tails on auctions were consistently very, very large. Private yield, if you look at charts of primary dealers holdings of Treasury starting in the fourth quarter of '18, they are up into the right at a 45-degree angles. Primary dealers were having to take down more and more of this. And so, what all this was doing was crowding out the US- it's creating a dollar shortage in the US, its own banking system.
This came to a head on March 20th, Fed Funds Rates rose above interest on excess reserves. And there was talk at the time that this was tied to tax season, which made sense. There's a lot of dollars moving in and out of the system around tax day. Tax day came and went and FFR, Fed funds remained above IOER. The Fed clearly was aware of it because about four weeks ago, they cut interest on excess reserves rate, which should have injected more dollar liquidity into the system. It did normalize Fed Funds a little bit, but it remains above IOER.
And so, what this is telling you is that the Fed is losing control of Fed Funds Rate at the short end because US deficits are growing as fast as they are. And because foreign official sector is not buying really at all on net. The foreign private sector is not buying enough, they are buying some unhedged but not nearly enough relative to the size of the deficits we're running.
And so, it's its primary dealers, it's US banks, basically, what it's telling you is the Fed is being forced into a decision where- and this ties into our point of why are we bullish on risk assets, which is the Fed is losing control of the price of money in the United States. Fed Funds moving where it's moving, it shouldn't be. And so, the Fed's entire reason for existence is to control the price of money in the United States.
And so, the Fed is going to need to make a choice very soon, they can either cede control over the price of money in which case we don't need the Fed anymore. Or they're going to have to cede control over the quantity of money in order to control the price of money. And we think that's the choice they're going to make. We think that's basically the message when they've came out and cut interest on excess reserves. That was the first signal they know something's wrong.
Now, what's really interesting in all this is unemployment's at 60-year lows. The US economy is definitely slowing, some areas faster than others. But it's not bad. The economy's still decent. But the reason- we were talking before we came on camera that there's now over 50% chance we get a rate cut in June or July. I don't think it's fully appreciated yet. The reason the Fed is, reason markets are pricing that the Fed is going to cut rates so aggressively in the back half of this year, has nothing to do with the economy. It has everything to do with Fed funds. With them losing the money markets are pricing in, that the Fed is losing control and it's going to have to react.
ED HARRISON: So, you don't buy any of this trade stuff. You think that's a red herring, the whole concept that trade is really what we care about. We think that's got- because the NABE came out, the National Association of Business Economist, saying that by the end of 2020, we're going to have a recession, it's going to be trade issues that's going to cause that. You're not buying that as the proximate reason. You think that it's actually what's happening with the Fed.
LUKE GROMEN: I think trade is an issue. The primary issue is that the US government deficits matter for the first time in 70 years. For 70 years, everybody else funded America's deficits. Foreigners funded our deficits. And so, we could run deficits without tears. Beginning in 3Q14, the period of 70 years of deficits without tears for America began ending. And then they started ending faster in 3Q16. And then they began ending faster and really faster in 4Q18. And as of March 20th, the alarm bells started going off at the Fed.
With Fed Funds went over interest on excess reserves, that was a sign that the United States government's deficits were getting so big and foreigners' interest in treasury bonds, because FX had yields, were so negative, though the interest from foreign private sector investors was so low, that we are crowding out our own banking system. And so, if the Fed does not inject a significant amount of dollar liquidity soon- be that via repo, be that via rate cuts, and I think you're going to be seeing QE probably in six to nine months at the latest.
Then in terms of regrowing the balance sheet, then yeah, absolutely. I think you'll have a recession, probably sooner than mid- 2020. It would be a very bad scenario. You'd see strong dollar- we don't think it's going to happen because we just don't think- to believe in that scenario, you have to I believe the Fed is going to stand by and do nothing and basically say, we're not going to control the price of money in the United States. I think there's very little chance of that happening. And because of that, we're very bullish on risk. Because if you look at positioning, the dollar, the bullishness on the dollar is extraordinarily high right now.
It's not just positioning, but confidence, right? It's not just batting averages, slugging percentage. There are lots of bulls, and they are extraordinarily confident. The positioning on bonds has gotten very extreme. The negative positioning on equities has gotten very extreme. And as I go around and talk to customers, as I talked to- I read stories, I'm on Twitter, the appreciation that the Fed is going to have to cut rates for nothing to do with the economy. And basically, in plain English, what I'm saying is the Fed is going to have to cut rates to finance the US government.
And I think once they start doing that, people are going to see through that pretty quickly, global markets are going to see through that pretty quickly. And what that means is I think the dollar is going to head notably lower, I think risk assets are going to head notably higher, led by value versus growth, led by EM versus US in particular. I think gold will do quite well. Some of the commodities could do quite well, etc. That's what I think is really the primary driver. And I just don't get the sense that's fully appreciated this point.
ED HARRISON: Talk to me about some of those asset classes that you're talking about. So, say we're looking at a July rate cut, that that has a positive impact in terms of people's thinking about recession, in terms of the Fed's ability to maintain interest rates, what happens with things like gold? What happens with things like junk bonds, in particular?
LUKE GROMEN: I think gold probably does quite well. I think whatever the Fed does in July, it's going to be a down payment on what they have to do. Because the reality is with FX hedge markets, where they are, with the FX hedging markets, where they are, you're going to need either a significant increase in rates or a significant decrease in the dollar in order to make FX hedging markets, to make Treasuries attractive again on an FX hedge basis where people don't have to take on the currency risk themselves.
And so, ultimately, what that suggests is that any rate cut you have because, again, the reason why all this is happening is US deficits are big and growing and structural. And they're crowding out the US private sector. And so, basically, the primary dealer of last resort, I think I saw someone say, or call it, the Fed is going to have to start bidding for these bonds again. So, I think it depends a lot on messaging on July- we were talking before, if they don't do what's expected, it's not going to be good for risk. But ultimately, they're going to have to unless they don't want to exist anymore.
ED HARRISON: And so, junk bonds, we already know that up until this point, we had a very low default rate in the high yield space. So, you think that that would continue? The Fed basically, will be giving a Powell put and then we'll continue to have a rally in the United States, the economy will actually- it's not that it will do well, but it won't fall into recession?
LUKE GROMEN: I don't think it'll fall in- I don't think Powell is going to like it. I don't think the Fed's going to like it. But I don't think they have a choice. They've made their bed. And now they're going to have to lie in it. And so, when I see things like Lael Brainard at the Boston Fed three or four weeks ago, bringing up yield curve control that they might have to do that in the next recession. And Clarita had talked about that back in February.
They brought it up that it was during World War II, the US did this. Well, if you look back at the data, yeah, the Fed pinned 10-Year Yield's at 2.5% from 1942 to 1951. And they basically said, we'll buy every 10-Year you issue at 2.5%, no questions asked. So, they control the price of money. And they've ceded control over the quantity of money. And as they did that in those nine years, the S&P 500 rose 5X in nine years, CPI rose 4X in nine years, and 10-Year Treasury holders got paid every dime they were owed, but they lost between 75% and 85% of their money relative to stocks and relative to CPI.
And I think that's what we're going and so to directly answer your question regarding junk bonds, I think you'll see spreads continue to narrow and it'll probably be hard to watch when you look at the sustainability of it. But again, because this is being driven by the combination of US federal government, deficits are going to grow structurally unless something happens in the next month to 75 million baby boomers, these deficits are going to go structurally for years and years and years. And unless something happens sharply to the dollar on the downside, or sharply higher on rates to make it attractive for foreign private sector investors to buy Treasuries again on a hedged basis, which is what they need to do for the amounts involved, they're not going to buy trillions of dollars unhedged. They