GEORGE GONCALVES: The reserves that were in the system that were inflated because of QE3 have basically returned back to the same level pre-QE3.

The US government decided to have larger cash balances for a whole host of operational readiness issues, you can argue it's like having a Strategic Petroleum Reserve.

They now are challenging the markets, quite frankly, that they've now managed to do the soft landing. What they'll end up having to do, if they're proven wrong, is to floor rates again back to zero.

DANIELLE DIMARTINO BOOTH: I'm Danielle DiMartino Booth with Real Vision. I've got a special treat for you this afternoon. I've got George Goncalves with me. He's a 20-year veteran of the Street. He and I go way back to my time when I was an advisor to Richard Fisher at the Dallas Fed and George was one of my closest confidants and advisors and guided me through all of the mechanics of the bond market throughout the financial crisis. Richard Fisher knows George by name and came to rely on his really in-depth knowledge of how the bond market operates, as well as his great grasp of how that mixes with the macro economic outlook. I'd like to welcome you, George.

GEORGE GONCALVES: Great to be here. Thank you.

DANIELLE DIMARTINO BOOTH: Thank you. Let's paint a picture of where we are, because we're going to talk about the Federal Reserve. We're going to talk about how the bond market works. We're going to talk about things like liquidity crunches occurring at times we weren't expecting. Let's start with the basics.

The Federal Reserve has just had a meeting. Jerome Powell characterized the economy as being in a good place, the labor market as being very strong. Fed officials have actually taken a rate cut in 2019 off of the table. I think this came as a surprise to the markets that had been pricing in at least one more rate cut in 2019.

What I find to be curious, though, is Fed officials pay attention to macro-economic data, especially the kind that comes from the Bureau of Labor Statistics. Now, we just had a big benchmark revision to private payrolls of 514,000, 40 some odd jobs per month. If you add on the five straight months that we've had of negative revisions to non-farm payrolls, you have 17 consecutive months of downward revisions.

I would not call this an economy or a labor market that is gaining momentum and yet, Jay Powell characterizes it as being strong and indicative of the fact that the US household can continue to carry this economy. The Fed raised its GDP projections. At the same time on the same exact day, the CEOs across America took their GDP forecast down. Is Jay Powell right, or are the CEOs right? Where do you stand?

GEORGE GONCALVES: I stand more with the CEOs. I do think that we are heading towards a slowdown and the Fed is really trying to project confidence and it has a deep belief that their mid-cycle adjustments are going to be enough to actually soft land the economy, something that really only has happened a few times in history. That's really where I think they're trying to protect the confidence. We'll see.

DANIELLE DIMARTINO BOOTH: You were in the trenches in '98 when they managed to have three rate cuts and extricate themselves from the easing process. It wasn't an easing cycle. Talk to us about what that time was like and why the Fed succeeded in making a mid-cycle adjustment and stepping back and how does today's environment differ or not?

GEORGE GONCALVES: I guess what really stands in comparison, what's different from them now is we built this recovery based on financial conditions being as blunt as they've ever been. Whereas in '98 to 2000, you still had that last two legs, you can say it went beyond and they actually inflated the bubble or helped to inflate the bubble. We are now at a point where we're very long in many, many metrics that you and your firm have been tracking. It's not an exact comparison between '98 to 2000 where we are now.

DANIELLE DIMARTINO BOOTH: The other parallel that keeps coming up is the 2015-2016 industrials recession. Yet we've seen indicators such as temporary staffing. We have fresh data out that showed that temporary staffing is growing at the slowest pace since 2009. We've seen, obviously, industrial production go into an outright contraction. It looks as if we've seen, obviously, I just mentioned a turn in the labor market.

You start adding up the things that the National Bureau of Economic Research counts, all the boxes that they check off, that indicate that we're heading towards a recession. What would you say to people I guess who say, "Well, this is the same as 2015-2016. We're going to come out of this. We've had two industrial recessions in the current economic cycle. This is just another one, we're going to whistle past this?"

GEORGE GONCALVES: The difference is what's happening in the funding markets, which I know we'll touch upon later and what's happening with overall liquidity and how the curve is shaping. We've had a steep curve. As long as steep curves persist, and that's what we saw in Japan and that's what Europe's been trying to do, muddle along through this process. With the US curve being as flat as it is, and what that means for foreign buyers of our debt and what that means for the banking system at large and globally, I think that's what stands different between the '15-'16 comparison, and I don't think we can dodge that bullet.

DANIELLE DIMARTINO BOOTH: You just mentioned Europe, we know that Mario Draghi has resumed quantitative easing. In Europe, that was his swan song before he leaves on Halloween. Talk to me about how or if should, should Jay Powell be influenced by relativity? Should he care that the lower rates go in Japan, the lower rates go in Europe, the stronger the US dollar is going to be and the more crowding into the positivity in US bonds, the rest of the world is going to be compelled to continue piling into? Can he make monetary policy? Can the Fed set interest rate policy agnostically, regardless of what's happening with the ECB, with the Bank of Japan, with the People's Bank of China?

GEORGE GONCALVES: Well, two things. They cannot set policy independently, because one, we are the reserve currency and we are the medium of exchange globally. The dollar and all the liquidity which we'll get to in the latter part of this interview, I think that plus the fact that we are so linked globally and policies feed off each other, the fact they not really go about it on its own path.

DANIELLE DIMARTINO BOOTH: With that as backdrop, what's the Fed's next move? More importantly, I think, when do you think markets are going to be pushing the Fed to make another move? According to Jay Powell and company, their next move is in 2021. Then it's going to be a hike, and they're going to be in a holding pattern. Until then, of course, there's been an obvious dissent.

There was a dovish dissent by Bullard and George and Rosengren put in another hawkish dissent. There's obviously a lot of disconnect in terms of where members of the Federal Open Market Committee see this economy headed and the policy, the best rate for the best policy path. What does the Fed do next in your mind?

GEORGE GONCALVES: Look, at least we don't have the discord like we're seeing in Europe where Mario Draghi put everyone into it the ECB QE program at against the odds and wishes of the French--

DANIELLE DIMARTINO BOOTH: A unilateral decision, it seems.

GEORGE GONCALVES: That's right. At least we're still seeing some camaraderie at the Fed. I think that will persist. What I'm worried about going back to the economy and what could happen in the very short run, we're going to get a false sense of security. We're going to see the data look a little bit better. We're going to see the benefits of the easing that the Fed is done both from them no longer hiking, as well as actually doing two rate cuts, stopping the balance sheet roll off, and actually reinvesting into securities. All these things should create some stability in least on economic inputs. The question that really bothers me and is what happens as we get into yearend into the start of next year, if we get really a true size of dollar liquidity shortage.

DANIELLE DIMARTINO BOOTH: Dollar liquidity shortage, let's talk liquidity. I don't think we can talk about liquidity unless you understand what got us here. What's different in the current era is quantitative easing, and all 22 trillion of it? We know that the world balance sheet is about to start growing again, but specific to the United States, how do quantitative easing play into what we're seeing occur today in short funding markets?

GEORGE GONCALVES: It's a long story. We have to probably start in the beginning. We have to almost break apart different QEs that the Fed actually put in place.

DANIELLE DIMARTINO BOOTH: Educate us, George.

GEORGE GONCALVES: If we think about QE1 as reliquifiying and actually really curing assets that got dislocated post crisis, QE1, I think everyone, a lot of people view actually worked as planned. QE2 and QE3 are probably really a little bit beyond what was needed, and especially QE3. What QE3 then created, at the same time, as we saw changes in regulatory requirements for banks and liquidity, it provided a massive buffer and cushion of excess liquidity that was used for liquidity ratios and regulatory needs.

DANIELLE DIMARTINO BOOTH: Talk to me about the regulatory changes and how they affected what's on bank balance sheets today, what banks have to hold, just break it down.

GEORGE GONCALVES: There's a lot of moving parts. The bottomline is that those that are market makers have one hand tied behind the back if not two, and when it comes down to how they manage their balance sheets, how they get funded, who's funding them, we've taken pride-- we meaning the collective system, that the regulatory bodies of the world have disintermediated risks and funding to all other actors, where you have real money investors, you have hedge funds, mutual funds providing liquidity, but they're not mandated to actually be market makers.

DANIELLE DIMARTINO BOOTH: They're not regulated by the Federal Reserve.

GEORGE GONCALVES: That's right. What we see in moments like the last couple days, what typically is a standard process, we get corporate tax payments every three months and you have bonds to settle every single week. There's always a constant ebb and flow in liquidity the banking system which should be well forecasted by risk managers at every single dealer, shop and investor on the other side.

DANIELLE DIMARTINO BOOTH: They should not have been a surprise in theory. Before we get to what has happened, walk us through what the quantitative tightening alone that depleted the reserves to what we now obviously know are too low of levels. You've mentioned in the past that excess reserves have been cut in half. How did that happen?

GEORGE GONCALVES: It's been slow and methodical. That's been happening ever since and this goes back again to the overall global needs for dollars. You see currency circulation of north of 6% per annum, close to $200 billion per year, a lot of that are actually not even residing in the US really goes to show that the reserves that were in the system that were inflated because of QE3 have basically returned back to the same level pre-QE3. Even though the Feds concluded the QT program, their quantitative tightening, they only accounted for half of that reduction in reserves. The other half really was currency in circulation. It was other foreign central banks depositing cash at the Fed, which is an important topic.

DANIELLE DIMARTINO BOOTH: Sure, and the controversy there if you want to talk about it.

GEORGE GONCALVES: Absolutely. Also, the US government decided to have larger cash balances for a whole host of operational readiness issues, you can argue it's like having a Strategic Petroleum Reserve. The US government has a massive cash hoard to either deal with debt ceilings, or whatever may come. That's how we got to the point of being half of the reserves. That's where people are trying to say that 1.3 trillion reserves is not enough when pre-crisis, we didn't have, very little.

DANIELLE DIMARTINO BOOTH: Liquidity for dummies, how does it work when foreign central bank sees the attractiveness of the rate that they can earn here? Just walk us through one transaction, for example, on any given day.

GEORGE GONCALVES: You have opportunity sets in all asset classes, and that applies for every single investor. You can pick and choose where you want to allocate your money. You could buy T-bills and fund the US government, you could buy commercial paper and fund a corporation or a bank. You can deposit money at the Fed if you are a foreign official, central bank entity. That specific category that's a liability for the Fed's balance sheet has been growing ever since the Fed started to raise rates.

Look, that we don't know if it was a function of the Fed needing to have a helping hand in the early days of raising rates and being scared that there's too much central bank liquidity, buying T-bills and those rates wouldn't go up. Then you have the flip side at this point, which we did not know in order the Fed pre the Trump administration and knowing that there was going to be massive deficits and a deluge of Treasury supply.

Now, you've increased your opportunity sets. Now, you can decide do you want to have short term treasuries, or deposit money at the Fed? What we've seen is nearly almost $200 billion increase in the foreign cash hoards that are sitting at the Fed instead of being allocated into the marketplace.

DANIELLE DIMARTINO BOOTH: Drainage has come in many forms is the bottomline.

GEORGE GONCALVES: Most of them, out of the control of the Fed.

DANIELLE DIMARTINO BOOTH: Speaking of which, I'm curious about your reaction. At the press conference, Jay Powell said that this liquidity issue, and I'm wondering if you can thread the needle and marry it back to macroeconomics for a minute-- but Jay Powell said that this liquidity crunch that we've seen in the overnight markets has absolutely no bearing on monetary policy, true or false?

GEORGE GONCALVES: It's false. It's true only if they get their arms around it. That really requires them to see stability for multiple days and weeks. Just conducting operations and expecting it to go away is not the approach the Fed should be taking. I think, in general, the idea of a repo facility, which we've discussed before, is one way of bridging the gap between getting liquidity into the system when needed. We joked around saying it's a bridge loan to QE eventually. Nonetheless, it would at least provide something for markets and I think, to come out blank, at least say that, I think it was another one of those confidence games, he had to say that.

DANIELLE DIMARTINO BOOTH: Let's leave that facility on hold for just a second, because I don't think we can talk about how the facility would work in times of need until we walked through what happened on September the 17th and what happened on September the 18th. Was this something that happened overnight or was there a slow build and for heaven's sake, why do we have quarter ending funding needs in the middle of September? Something's not right here. This is not just a calendar effect. What happened over that 48-hour period?

GEORGE GONCALVES: Well, you need to go really all the way back to last September, when QT got fully supersized and you got to a point where the Treasury issuance was also increasing at the same time. That really started to labor and put a massive footprint on the dealer network, and their holdings of treasuries start to pick up a very big way, and you saw that--

DANIELLE DIMARTINO BOOTH: As their holdings of Treasury picks up, then the reserves are depleted?

GEORGE GONCALVES: Well, more importantly, even beyond that, it's just the idea that they have to fund it. They need to actually compete for funding with everyone else. They don't have a natural depository base to actually get that funding. You had first wave which took place throughout Q4 of last year and also that happened, it does create a crowding out effect, you start picking your battles, what do you fund and which positions do you own and which ones are you mandated to own as a primary dealer and as a sponsor of auctions?

You have that, you have what's taking place now all throughout the summer and the end of QT, where the Fed is no longer buying mortgages only above the 20 billion threshold per month. It's hard to get to that cap. What we're seeing now also in the publicly available data is primary dealer holdings of mortgages are starting to go up as well and so it eventually starts to leave this massive footprint on the dealer side, they need to find funding. You have that coupled with other levered players that don't have access to facilities, which we can talk about in a moment.

DANIELLE DIMARTINO BOOTH: Non-primary dealers?

GEORGE GONCALVES: Yes, and you get to a point where-- or REITs or whoever you want to call it that are leveraged investors or hedge funds that hedge funds that need liquidity, and you can full circle come back to what's happening the last two days is just this reflection of there's only so much capacity to-- marginal capacity to give out to those investors.

DANIELLE DIMARTINO BOOTH: Debunk something for me, did the disruption have anything to do with the attacks on the Saudi Arabian refineries?

GEORGE GONCALVES: Look, we don't know for sure. That creates great headlines. What I know is that if there's any connection at all-- and again, this is all speculation, it would need to be somehow how it works through the euro dollar and overnight offshore dollar markets. If there was any pullback in liquidity there, that would naturally feed back into what's available as flow here in the New York trading sessions.

Nonetheless, I think that, we can't prove, but what we do know is that we saw the largest bond market, if you think about it, is really the bloodline of the whole system, you have--

DANIELLE DIMARTINO BOOTH: The global system.

GEORGE GONCALVES: --you have roughly six or seven issues that are the benchmark liquidity points on the Treasury curve and underneath those-- those are called on the runs. Underneath those, you have repo which is viewed to be a level playing field for most of the time until you get to a point where repo is trading according to Bloomberg and Financial Times, 8%, 10%. That's not normal. Those are high yield emerging market type levels of rates. It should be the bedrock of the financial system, which is you should be consistent and reliable pricing on how you fund yourself.

Because if you