ROGER HIRST: Hello. Roger, here. How are you?
BILL FLECKENSTEIN: Hi. How are you?
ROGER HIRST: Very, very well, thanks. Very well, indeed. So I would just like to crack straight into, I mean, an incredible end to last year. There's this incredible stuff going on in the repo market. I think the liquidity, in some ways, has a lot of people looking at these markets and thinking that with the data last year, things are going to roll over. We had yield curves that were implying recession, although I think the yield curve is different today than before.
But the real thing was that the Fed has come in with liquidity, and as of, I think it was yesterday, it's still over-subscription to both overnight and term repo. Is this thing just going to go on and on and they're going to withdraw it out and we'll just keep on going up?
BILL FLECKENSTEIN: Well, it's hard to say exactly. Obviously, we can't go up forever. We both know that.
ROGER HIRST: Yeah.
BILL FLECKENSTEIN: Having said that, I read a short-only fund for a long time before I closed it down in early '09 because the Fed began QE. And part of what I used to do to as part of my risk control was I was really focused on what the Fed was doing from a liquidity providing standpoint and having rates too low.
My view is that the equity bubble, the real estate bubble were caused by the Fed and their monetary policies. Probably that's not very controversial amongst the crowd of people that might watch this interview. And QE turned out to be very powerful. My belief is all of the bull market, essentially, in stocks, bonds, real estate, art, everything is a function of the central bank policies. And I think perhaps the thing you just touched on may give us some anecdotal evidence of how powerful the Fed is.
Arguably, Q4, there was reasons to wobble, reason to think the economy could wobble. And given some of the macro stuff that happened in geopolitical stuff, you might have thought the stock market could be dented at least for a day. And as we saw, you know, in the first couple of days of the Iranian conflict, if that's what we're going to call it, nothing mattered. And you could argue, well, nothing mattered because it turned out to be a positive outcome, at least for these five minutes. But I think the real reason, is what I'm getting to, the real reason nothing mattered is because the repo facility is essentially the size of a year's worth of QE3, except for they did it in one quarter.
ROGER HIRST: Yeah.
BILL FLECKENSTEIN: And I don't know if you and I would agree as to the root cause of why they did it. I mean, we may or may not, because I'm not sure what you think. But to me, the cause was the size of the deficit financing coupled with the changes in the Graham Dodd in what the banks needed for collateral cash all that stuff combined to create a situation where had the Fed not created this massive repo facility, who knows where repo rates and short rates would be and where the whole curve would be. They could have been quite an accident. Nobody seems to think that that factoid increases the risks because I guess we're just going to party because we know they're going to be there.
So that was a long answer to a long answer to your question, but what the Fed does, if they do it in enough size, trumps everything else, no pun intended with the president.
ROGER HIRST: Absolutely. Yeah, I think that from my angle, one thing the Fed got wrong in a way in September is that there was a lot of capital, a lot of liquidity out there, but it was visible but not available liquidity, which goes to your point about the global systematically important banks. And we've seen this with JP Morgan, because of these rules, the reason why they went from $180 billion of loans into $180 billion of bonds, which grew bond yields to where they were, which created the illusion, perhaps from the bond market, that the economy was slightly worse than it really was-- well beyond the economy.
But then when it came to September, because of the deficit, some financing, the rolling off of the debt ceiling issues, suddenly there was this demand on capital. They saw the capital was there on balance sheets. All these banks, particularly the likes of JP Morgan, were hoarding it and saying, look, we're not giving this out. We're going to hold onto this.
So suddenly, there was, effectively, a liquidity crisis. Now they've come in, but it looks like also at the same time, the financial players have also been at the trough of liquidity, which has then been going into the market holding it up. So now you've got this problem, which is so many players are now involved in this that it has liquid assets. And if they stop, then do we unwind the 13% rally that we've had since the middle of September?
BILL FLECKENSTEIN: If they stop, yeah, we'd unwind it in a heartbeat, I think. I mean, it's hard to know the leads and lags because one of the problems in discussing this topic is, and I remember when I first started thinking about it when I first got in the business almost 40 years ago, is that in the old days, when the Fed would inject a little liquidity to buy bills or whatever they were going to do or coupons, having rates being too low relative to where they theoretically should be or injecting liquidity tended to help the markets. Now that was just a very small rounding error relative to what happens now. And you can't explain to people exactly when the liquidity gets shoved in, how it goes.
But it's going to go somewhere. And where it goes is, I believe, a function of the psychology of the day where the markets want to move to. So it goes into fixed income, and then that rallies. And then so tangentially, equities lift. And then some part of its Pavlovian. Some part of its plumbing. You can't explain it exactly, so some people want to poo-poo it because you can't give them a proof and connect the dots from the beginning to the end, but it's what happens. If you've observed markets with any degree of intellectual honesty for any length of time, you can see that's what it is.
Now we have a whole generation or two of investors who've never operated in anything but what I like to call the interventionist central bank era. That's really the last 20 years plus. So I don't know how they would feel discussing this because in some ways, you have to have been around long enough to see how some of this stuff used to work to know how distorted today is. Now I guess they could come back with, well, it's a new era. But we all know how the movie ends when people start claiming it's a new era.
ROGER HIRST: Yeah. On that front, I'm going to ask you a couple of questions from the audience. We've got Rick Mayer and then Mitch have got some questions. And you actually touched on this already, but I guess just sort of will then move us on. But the first one is, if the Fed does stop the repo of liquidity injections now after the term of year end, which you've just had, will that be a catalyst for a market correction, which you've already slightly addressed. But then I guess the other question which Mitch had asked is what will make the Fed stop injecting dollars into the market? Because that's going to be the key question here. Is it seems that they're on a hair trigger. What's going to kick them around?
BILL FLECKENSTEIN: Basically nothing. Nothing will stop them until the market stops them, and I'll explain what I mean. The difference between this all-encompassing bubble mania, whatever pejorative term you want to use, more egregious, less egregious, is all a function of what the central banks have done. And contrary to the stock bubble and the real estate bubble, this has been sponsored by the central banks. I mean, they're quite happy to drive asset markets.
They don't think anything bad can come from asset inflation. They don't think that asset inflation could ever lead to CPI inflation, even though they think they want more CPI inflation. And they don't understand the consequences of their actions that lead to the debacles that we've had, the stock bust was sizable. The real estate bust almost wiped out the financial system. Now we've got this thing going on with kind of the everything bubble.
But they don't see it that way, and so they're not going to stop because of anything the asset prices do, I don't believe. I mean, I guess we can get stupid enough that where the curve bends back to the left, the prices go up fast enough, which of course, is impossible. But I don't think they would do anything. And so I think they don't even really understand how their policies work. And so I think if they tried to remove this liquidity facility, they tried to run it down, especially if they did it quickly, I think asset markets would break, to some degree.
Now I think the real danger is that people don't fully appreciate is that in the structure of the market, it's extremely brittle. There's so much hot money and VIX selling. There's all this kind of stuff that would turn into forced selling on the way down. So I think any bit of weakness that broke out, for whatever reason, could quickly feed on itself. But then the Fed would ride back to the rescue, I believe, because they think the portfolio balance channel is the key to happiness.
So what will stop them, in my opinion, is only one thing, and that is when the psychology amongst market participants, or enough market participants at the margin, concludes that these policies are not 100% pure ecstasy but that they have problems that come associated with them. And if we start to get a change in this inflation psychology, I mean, after all, at least in America, I don't know what it's like over there, if you really look at the cost of living, it's different for your demographic and how much money you have and where you live. It's over their number. It's been over their number. And guess what? They never had a mandate for 2% inflation. They just made that up along the way.
So the only thing that will ever stop them, and I've been saying this for 10 years, is when psychology changes about their policies. And it's been now 10 years since QE started. And so far, everyone's given them a standing O. But that could change this year because we could see inflation psychology start to change. I see the ingredients of how that could happen. Will it? I don't know, but that's one thing I'm looking at.
But other than that, I don't see what will cause them to change. They're not going to wake up and get smart, and they're not going to wake up and become responsible because responsible would equal lower stock prices and then they'd panic about deflation or all that other stuff. So we're on a one-way street towards them losing their credibility. And when that happens, life will get very complicated.
ROGER HIRST: A couple of questions that I'd like to ask, one is, again, from the audience. Vernon's said, on the back of this, who are the biggest beneficiaries of this Fed repo? Is it hedge funds? Then brings up, who brings us back to one question. And a slightly different question of my own here, which is that I'd love to focus on that inflation because I think a lot of people say that inflation is the thing that can break it. What I find quite interesting there is that if we going from a world where we're still worried about disinflation, to get through inflation, you have to go through good inflation, which actually means equity prices should be a lot higher as you go from one, one, two to three and then we get to four, five. So I was just wondering first, we'd like to know, who have been the beneficiaries of all this repo first, and secondly, that inflation question.
BILL FLECKENSTEIN: Well, I think the beneficiaries of the repo are the same beneficiaries of everything we've been doing-- assets, anyone who owns assets. I'm not saying there's not a specific bank entity that did better. But that's small potatoes relative to the fact that assets have benefited and people who have owned assets have benefited.
And as far as the inflation question, I would argue we've been in the good inflation part for quite some time. We're at the part where people are rooting for more because the central bankers are saying we need more, whereas I don't think the average person, in the street, go out and interview people, if you said, hey, do you think your cost of living is going up too slow, I don't think any of them are going to say, well, no, it should go up faster.
This whole idea that because we've got technological advances, that we're in this period where we have dangerous deflation is kind of silly because technology, even if it's just going from a horse to a car, as opposed to going to having supercomputers in our hands, that's always what technology is. That's what advancements are about. We should be having deflation, given the tremendous increase in productivity that's been caused by digitization of everything, for lack of a better word. And we don't.
We don't because when they print money, that money go someplace, and they don't know where it's going to go. Things go up in value. And in this cycle, it's been more assets. We could get to a point where that changes to more cost of living. But the official statistics that are constructed by the central banks or the governments are complete nonsense. You've got substitutions, hedonics and the way they calculate owner's equivalent rent. There's a whole bunch of games they play.
So the CPI is never going to tell them to stop. They're going to have to lose psychology. And of course, that'll be a nebulous thing. It'll be very difficult to find out. And it may be six months away. It may be three years away. I don't have any idea. All I can do is try to be alert to something that's happening and that's different.
ROGER HIRST: And in terms of this inflation risk, do you see inflation risk being that we've got this vast quantity of, effectively, capital in the system from central banks that's at a very, very low velocity and if we get a little bit of a pick up in growth, in the economy itself, then this low-velocity capital suddenly picks up into high-velocity capital and that $14 trillion of central bank liquidity over the last 10 years can suddenly go from doing nothing to suddenly having a significant upside impact over and beyond the inflation that has always existed that's underlying?
BILL FLECKENSTEIN: I think it's not a matter of mathematics. It's more a function of psychology because there is a tremendous amount of fuel in the system, so to speak. x But even if there isn't, if people start to change their psychology about the efficacy of this and the danger, maybe fixed-income buyers say, hey, we want a little more yield to compensate us. I mean, it is interesting that the way the repo market broke loose and was that a signal, the first signal in a couple of decades that rates are at the wrong price? I don't know. It's interesting that the BOJ is backing off from their idea of negative rates.
But I think it's more a function of psychology. If people stop believing, then they would act differently. They wouldn't buy bonds at the rate that they are. Maybe