KEVIN MUIR: Here we are in the third bubble and staring us right in the face and nobody wants to call it a bubble.
We've constantly tried to stimulate the economy with more and more monetary policy. We're going to get a wave of fiscal spending that will actually create the inflation and it'll be the old adage that be careful what you wish for, it might come and it might come too fast and too hard.
Crises always occur in stuff that people aren't expecting. That's by its very definition of crisis. If it was obvious, everyone would have already hedged for it.
ED HARRISON: Ed Harrison here for Real Vision. I'm in Toronto, Canada, talking to some of our Canadian guests about not just the Canadian economy, but macro environments more generally. We're talking to Kevin Muir first. I'm going to talk to him about his thesis about what the new Black Swan is that no one is thinking about and how to invest against it. We're talking about inflation and he has some very good ideas about this. I want to pick his brain, hope that you enjoy what he has to say, and enjoy this interview. Thanks very much.
Kevin Muir, it is a pleasure to talk to you. I think this is the third time that you've been on Real Vision now. I'm very looking forward to this conversation. We're going to talk a little bit about investing, macro, we're going to talk about Canada in particular. Let's start it off with what are you looking at, like what is in the investing world, the thing that you think that people are missing the most that you want to talk about?
KEVIN MUIR: Well, it's great to be with you today, Ed. The one thing that I find perplexing and the most unusual is the fact that here we are and I've had two bubbles in my lifetime that I've experienced, I've had the dot-com bubble and I've had the credit real estate bubble of 2007. Here we are in the third bubble and staring us right in the face and nobody wants to call it a bubble. To me, that's the very definition of a bubble, because everyone always tells me, "Oh, if I was around in the dot-com bubble, I would have nailed that trade. I would have been short because it was so obvious." I said, "No, back then, it wasn't so obvious. It wasn't clear that these things were going to collapse."
Yes, there were some people that called it, but on the whole, the reason that it got so frothy was that everyone truly believed that the internet was going to change the world. In fact, the internet did change the world but just the prices of those securities were mispriced. Fast forward to the real estate flash credit crisis bubble. Again, we saw a situation where everyone says, "Oh, it's so clear. The Big Short, all these guys nailed this trade." Well, no. A lot of guys tried and then they got their head handed to them and a lot of people gave up and by the end, there was very few people that were actually fighting against the bubble. That's the reason the payoff was so great, was because there was so few people actually taking the other side.
Well, today I'm confused as to why-- well, I'm not confused. I'm actually, I understand why everyone's not willing to call this a bubble, because that's the very definition of a bubble, is the fact that when you're in them, they're very difficult to know you're in them. I look at the sovereign debt bubble and I look at interest rates at minus 60 basis points in Germany and I see people telling me how 100-Year Austrian bonds are the greatest thing since the spread. I see that the summer just that reach for duration that was just epic. I think to myself, here we are, we're in another bubble.
I'm not afraid to be the guy that's going to stand out here and say we're in the midst of a bubble, and for now, everyone's telling me I'm a fool and I don't understand the 3Ds, the debt, deflation, demographics. I argue that those things are all in the price. When I think about the investing landscape going forward for the next decade and how you want to set up your portfolio, I ask what the bigger risk is. Is the bigger risk the thing that everybody's warning me about, which is more disinflation and interest rates going even more negative, or is the bigger risk that we get the thing that no one is expecting? That is inflation.
ED HARRISON: Very interesting. Yeah. How do I unpack that? The macro, let's look at it from the macro context. What are the macro factors that would lead to that bigger risk actually coming into fruition?
KEVIN MUIR: Well, one of the things that I'm a big believer in is the fact that we don't understand why we've had disinflation or disinflation over the last three, four decades. We look at it and we look at this trend in 1981, interest rates for the 10-Year were 15% and they're now 1.50%. We think to ourselves, well, this trend is going down, and it's just going to continue downward. Many people are drawing trend lines and saying, "No, no, this is going to go negative, the US has headed minus or to zero or maybe minus four, whatever the number."
One of the things that I think that we haven't understood is why we've had this. I've view it as-- it's actually a feeling of economics. It's a feeling of understanding what's truly driving the economy. We've focused on the monetary side of the equation so much that we've ignored the fiscal side. It was only once we hit the zero bound that we realized that the monetary policy wasn't is in control as we thought it was. All it was doing was actually affecting the behavior of individuals and encouraging financial speculation and other things of that nature, but wasn't really affecting the economy as much as we thought.
What's happening is that we've constantly tried to stimulate the economy with more and more monetary policy. We've done this to the point where in Germany, they refuse to do anything more, but to shove more and more negative rates into their system to try to fix it. What we finally have hit this point is when we realized that that's actually not effective anymore, and it actually doesn't do what we think it does to the economy. When I think about why this trend might change, it might change because we wake up to the fact that really the fiscal side of the equation is much more important than we ever imagined.
Then once we understand that, and you see it with Draghi recently calling for more fiscal, even Ben Bernanke in the time of the Great Financial Crisis was calling for more fiscal, as central bankers push back and say, "No, we've done everything we can, we now have to do more fiscal." Once the government's realize that they can basically go spend with almost no cost, let's face it, Germany can go spend and actually make money by spending. As long as they don't lose the money, they invest in infrastructure that is productive for their economy, they're actually better off as a society because the interest rate is negative.
Once people realize this, and once governments realize this, we're going to get a wave of fiscal spending that will actually create the inflation and it will be the old adage that be careful what you wish for, it might come and it might come too fast or too hard.
ED HARRISON: Well, a number of different places I can go with that. What I'm thinking in particular is-- the first thing I'm thinking actually is I'm thinking about like Bill Gross. I'm thinking about Jeremy Grantham, Jeffrey Gundlach. That's the third one. They were all saying that the end-- the bond bear market is upon us that just as you were saying that bonds are in a bubble at this point in time and it's only going to go higher. I think we were probably at like 2.50%, maybe something like that at that time, but the bond rates went lower. How do you time this if-- there's only so far down that interest rates can go most people will say, how do you time this? How do you know when this could potentially occur?
KEVIN MUIR: Well, I think that the thing they missed at that time was it was actually caused by the Fed being tight. That bond bear market like when they-- I think was Gundlach's famous two closes above two and a quarter, three and a quarter and that ended up being his technical signal for when it was about to break out, where yields were going to break out ended up being the absolute basically the top in yields, and from then, it went down. I think that that was caused by the Fed being too tight and it caused a bear market in US bonds and people misconstrued that. I actually think that the next bear market in bonds will not be from the Fed being too tight, it will actually be from the Fed being too loose.
If you think about a long bond investor, what is their number one concern? It's inflation. If you have a Fed that is on top of maintaining the purchasing value of your dollar, then as they raise rates, you should actually be more willing to go out the curve and buy long bonds. This is the same deal with the-- you see Stanley Druckenmiller talk about the fact that QE is actually bond negative. Everyone, that doesn't make sense for a lot of people. They say, "But wait, the Fed's buying bonds, why would that cause the long bond to sell off?"
The reality is that if you actually believe that QE is inflationary, and we could debate if it actually is or not, but if you believe that, at the very least, it should cause investors reallocate their portfolio and actually sell long dated bonds because they expect higher future inflation. I think that those that were expecting higher bond, sorry, higher yields because of higher rates in the US, I think they're mistaken, that will not be the trigger. In fact, the trigger will be a Fed that is too easy and doesn't actually chase the market higher.
That is what the true bond bear market will be created was when we finally get the inflation and the Fed should be raising rates and they deem that they can't afford to because there's too much debt out there. That will create a self-fulfilling inflationary loop in my opinion.
ED HARRISON: Well, rather than go further in terms of the macro side of that, let's talk about the how do you play this or how do you-- give me a scenario, a mechanism for being able to take advantage of this. Because I know that at The Macro Tourist, you wrote up something on this particular subject and you went step wise, right through how you would construct an investment to take advantage of this situation.
KEVIN MUIR: Well, one of the easiest ones most people will say is you should just buy gold. I'm not disputing that that's an easy way to do it. There's doubt that that might solve your problem but you don't want to be only invested in one asset class only, like as your protection against inflation returning. We spoke a little bit about this earlier, if you think about a portfolio that's long, let's say 60/40 traditional portfolio, that's long 60% equities, 40% bonds or whatever it is that you view is appropriate. I think about the return of inflation, I could see a situation where that inflation causes both bonds and stocks to go down.
You need something to offset that and so sure, gold will help, but another way to do it is actually to own inflation breakevens. Inflation breakevens are-- they are the difference in the yield between a TIP of a certain maturity and that corresponding treasury of the same maturity.
ED HARRISON: When you say TIP, just for people who don't know what TIPs are, what are those?
KEVIN MUIR: Those are Treasury Inflation Protected securities. Those pay you a yield plus inflation. If you go look at the, let's say, the 20/44s, the TIPs, they'll be yielding 75 basis points. Let's say that the equivalent Treasury is yielding, I don't know, let's say 2.5. Let's do the quick math, that's 25 plus 1.5, that's 175. That would mean the inflation breakeven, which is the difference between those two, is 175. 175 basis points.
If you think about it, if you were someone that was going to hold this to maturity for the next, whatever that works out, to 25 years, if inflation ends up being higher than 175, then you would have been better off owning the TIP. If inflation ends up being lower than 175, then you would have actually done better by holding the nominal just regular Treasury security. That inflation breakeven is in essence, the forward expected inflation that the market is pricing in, the difference between the two.
If you do the math and go through it all and hedge it, you can actually be long that security, that inflation breakeven. You figure out the proper hedging ratios, you go long the TIP and you go short that, and then what you could have is a situation where even if bonds go down in that environment where I was talking about where you see inflation rise and both stocks and bonds go down, you could have a situation where the TIPs yield is actually or the TIPs return over that period is negative but that the bond short that you have on is positive.
It ends up being that inflation breakeven could be a security or an asset that might be non-correlated to both stocks and bonds. We've talked about this in the past. One of my big concerns is, if we get a situation where the 20-year negative correlation between stocks and bonds breaks down, which is something that I'm deeply concerned about, because I think that many modern portfolios are built on the basis that you own some stocks and you own some bonds. When things go bad in the stocks, the bonds are going to save you.
ED HARRISON: It's a hedge.
KEVIN MUIR: It's a hedge, so it ends up being they're negatively correlated and saves you. Well, that might work but I really worry about if you're a German investor and you're buying something at a negative nominal yield, how much that's going to save you in a time of stress? Who knows, maybe they go to minus four, but maybe it actually goes the other way and they actually end up being a negative return. If you also include inflation breakevens into a portfolio, in a time with inflations rising, you could actually have an asset that is negatively correlated to those financial assets, which I think are elevated.
ED HARRISON: The first thing that comes to mind when you say that is convexity, in terms of being able to hold that trade over a longer period of time, that is that as the price moves up or down, then that ratio that you're talking about has to be reallocated. How do you deal with that?
KEVIN MUIR: Well, you do need to manage the portfolio because it's not something you can just go and put buy and put on. One of the ways for those retail people that want to play this, it's not the most capital efficient way to do it, you can go and you buy TIPs, which is the TF and then you can hedge it with a short position in the corresponding ETFs of government securities. Now, one of the things I want to stress here is many people will go and short TLT. The trouble but the TLT is the duration is actually eight years on that ETF whereas, the TIP is only or sorry, the TLT is 18 years, whereas the TIP is only eight years.
What you have to be careful is if you went and did that trade, you would actually have a yield curve trade on. You can't just go put that on, you need to duration match them. Lucky for us that the IEF, which is the mid-range Treasury protected, or the Treasury ETF, that it has the same duration as the TIP or very close to it. It's not the most capital efficient way to do it but one way to gain exposure to inflation breakevens is actually to buy TIPs ETF and short the IEF against it.
ED HARRISON: Very interesting. Now, I think that the one of the more interesting things about this is the concept that bonds and stocks won't be negatively correlated, that's what you were talking about. That's because in the scenario that we're talking about now, we have a secular bull market in bonds which is predicated largely on the fact that inflation has been falling. As a result of that, that puts a floor on underneath stocks. If you're in an inflationary environment, then bonds would sell off, but then potentially stocks would sell off as well.
KEVIN MUIR: That's right, stocks will obviously go-- like the earnings will go up because of the inflation. The question is, will they go up enough to compensate for the fact that PEs will go down? It's not entirely sure. It depends on how fast the inflation comes. I won't say for sure that they're both going to go down. I just worry that that is something that most investors are not the least prepared for. Not only that, most portfolios are set up to assume that that's not the case.
The one thing that I've learned is that crises always occur in the stuff that people aren't expecting, and that's by its very definition of crisis. If it was obvious, everyone would have already hedged for it. That's one of the reasons that I think that inflation is something you should be worried about as opposed to deflation because deflation feels to me like we've been down this road before. We know what we've seen in 2008.
Sure, it will be bad but I think that we'll figure out a way if we do get those crisis situations again, the Fed will go and they will put stimulus and we'll do more fiscal stimulus, they'll be able to stop it. The real endgame occurs when we get inflation, and the Fed won't be able to stop that and they won't be able to afford to stop that. That is actually much scarier of the situation for a portfolio than deflation.
ED HARRISON: Well, the economic environment behind that is the interesting-- the macro behind that environment, because let's go through some scenarios. Actually, let's use Europe as an example because they're the ones that are most hamstrung on the fiscal side and they're the ones you were talking about who were using monetary policy exclusively. Bad things happen globally, and in particular, in Europe, you have a recession of some sort. We're already at negative 60 basis points on the German 10-Year.
What happens then in terms of the policy response? What can they do? What can the Germans do? What can Europe as a whole do in order to create any momentum in their economy?
KEVIN MUIR: Well, this is the pushback I hear all the time is they say, there's no room for fiscal, nobody will do it. They can't, they're hamstrung by legal reasons. There's a variety of different pushback that it just won't happen. I see a couple of things to that.<