MOHAMED EL-ERIAN: I Went to Salomon. Now if you want to shock, go from a bureaucracy in Washington to Salomon.
I do think we are in the midst of a change in the liquidity issue.
When the dollar appreciates sharply, it breaks something else. And the reason why break something else is what's called the original sin. There are days when I'll listen to you. And the other days, if you come anywhere near me, I'll shoot you.
LARRY MCDONALD: My name's Larry McDonald, creator of The Bear Traps Report. With Real Vision, we're pleased to bring you today Mohamed El-Erian, best selling author, renowned global strategist. We're going to take a look inside the global economy, the Federal Reserve, the European Central Bank, and what's coming down the road ahead at investors, as we look down 2019 out to 2020.
Mohamed El-Erian, a pleasure to have you with us.
MOHAMED EL-ERIAN: Thank you, Larry.
LARRY MCDONALD: Been a fan for the longest time.
MOHAMED EL-ERIAN: And the other way around.
LARRY MCDONALD: And you inspired me when I wrote A Colossal Failure of Common Sense, because I think your book was the first one out of the financial crisis. Definitely, you were more proactive than most authors that tried to write the books after the fact. So a job well done there.
MOHAMED EL-ERIAN: Thank you.
LARRY MCDONALD: But Most inspiring has been your life. How do you make it from the highest levels of academics to the buy side? I mean, that transition is just fascinating. Because as we've seen with the Fed and a lot of these economists around the world, a lot of them get stuck in academia.
MOHAMED EL-ERIAN: So the big secret is none of this was planned. None of it was planned. I was doing my PhD me in England, and I was going to be an academic. And then my father passed away suddenly. My mother had never worked. My sister was seven years old. So the issue became who pays a PhD economist? And at the time, there were only really, two organizations that did-- the IMF and the World Bank.
So I ended up at the in Washington DC for 15 years had the time of my life. It was incredible exposure to policymaking I was turning 40. I had never tried the private sector. I thought, I better try it now before human capital disappears completely. And the IMF had this wonderful program, where you could leave for two years, and come back at the same level. So basically, risk free move.
LARRY MCDONALD: But wasn't there still some comfort zone there? Or is that really--
MOHAMED EL-ERIAN: There was. But there was also a sort of drive-- you better get to know how the private sector works. So I went to Salomon. Now if you want to shock, go from a bureaucracy in Washington to Salomon.
LARRY MCDONALD: What was your big break to get into Salomon.
MOHAMED EL-ERIAN: So I and I literally went to the emerging market research team.
LARRY MCDONALD: OK.
MOHAMED EL-ERIAN: And they offered me a job to head that. Nine months into that, I got a phone call, my head hunter saying there's this very large investment management firm in the West coast that have identified 20 people for a EM team. They're looking for one. Would you like to go? And I though, great. They're going to fly me to California. I've never been to California. And I went, and I met the smartest people that I've ever come across.
And I had a series of interviews. And I remember being told, we're going to hire you for a portfolio management team. And I said, but I've never traded a bond in my life. And they said, we can teach you that. That's not why we're hiring you.
So they helped the transition. So I went from academia, policy, the sell side, to the buy side. But none of it was planned. It was all a series of good fortune all along.
LARRY MCDONALD: So you make the move from academia to the buy side, which is the asset management side. Now you're at the highest level of asset management. And the difference in terms of your daily routine, the inspiration. Did you find it was a little bit tougher bar each day to hang with that crowd in terms of daily inspiration, and I guess, achieving alpha?
MOHAMED EL-ERIAN: Yes, a lot tougher. And for two reasons. One is at PIMCO, the people that were in the room were the smartest people I had ever met-- in fact, I've ever met. I haven't met a group of smarter people and more driven people than PIMCO. So you're in a completely different environment.
And the second is that you're judged every single day by the markets. And if it's not going your way, which as you know, happens, you've got to figure out why. Is it a question of time, did I get something wrong. So you can't just rest. Every single day, you're being questioned. And even if it's is going in your way, you have to think, well, has it gone as far as it will go? So it was quite a shock to the system. But something that I really enjoyed. And I was very lucky to be at PIMCO.
LARRY MCDONALD: When I was at Lehman, one of my most impressive investors that I've ever met and worked with was Mike Gleband, who now runs Exodus Point. And Mike used to come by the desk, and he used to say-- he'd look at your position, and stare you in the face and say, are you long because you like it, or do you like it because you're long?
MOHAMED EL-ERIAN: And it's amazing how many people end up in the second bucket.
LARRY MCDONALD: Yes.
MOHAMED EL-ERIAN: And we always used to say if we didn't have to trade on, who would we put it on now. And we would try to question that. My-- I'll tell you, I've had lots of major events that have changed my life. One was my first day at Salomon. So I come with a research driven, policy driven approach. And my boss is a 24-year-old trader. And I wrote about this in the book.
And he tells me, look, I want you to understand there are days when I'll listen to you. And there are other days if you come anywhere near me, I'll shoot you. And the difference is that sometimes, the market trades on fundamentals. Sometimes, it trades on technicals. And I don't want to see your face when the market trades on technicals. And that for me was this sort of early indication that I better figure out what those technicals are. Otherwise, I'm going to be relevant for just part of the time.
So it was a really important way of understanding a broader point, which is, while we like to specialize in one of four circles, over the academic side of it, or a policy side of it, or the market side of it, or the political side of it-- that's not what the world solves. The world solves at the intersection of all four. And you've got to realize that most people specialize in one of the four or two of the four. But if you are going to serve your clients, you better understand how they intersect.
LARRY MCDONALD: So now we're looking at the world today in different markets. And I'm thinking about your book, and I'm thinking about Canada, because you have a highly leveraged consumer income relative to debt levels. You have housing sales, which are falling at a very-- as they say, real estate sales lead prices. So if you have very steep declines in sales, typically, a year from now, you'll have problems on the pricing side. And then you have a central banker, Mr. Poloz, that has been last year and a half, aggressively hiking into a leveraged consumer.
How do you look at Canada relative to the US now? And do you think there's a 2007 brewing in Canada?
MOHAMED EL-ERIAN: So I don't think a 2007 boom in Canada, because 2007 was a crisis of payments and settlement system. And I don't think that's going to happen. I think central bankers have understood that they can't take risks with the payments and settlement system. And that means the banking system. So it's not a 2007 situation.
But they in Canada, and I can cite your other countries, face conflicting signals. And insufficient policy tools. And they're trying to strike the balance not only between competing domestic issues, but also, competing domestic issues and competing global issues.
It's easier for the Fed. The Fed is the most important central bank, the most powerful central bank. It is operating in the biggest economy in the world, which is relatively close. So the Fed can say, I will just focus on the domestic economy. Then it has to figure out what to do.
For the rest of the world, and especially for the open economies-- Canada, Australia, the UK-- you have to strike that balance. And it's a very tricky balance to strike.
LARRY MCDONALD: You know, I read your tweets almost every day. And I like the way you balance your personal tweets that the business. And I'm thinking about when you watch someone's tweets over the course of, say, two, three years, I can see some moments in your tweets when there's higher conviction. And I remember toward October, you know, the Fed in October, November-- you know, the Fed was talking up it very aggressive rate hike cycle. And I think through October, November, December, I saw he was being a little more skeptical of the policy path.
And I'm just thinking the way the Fed has turned relative to say to the world in October, November, that we're going to stay in our leads. That the global economy is in such a meaningful factor. And then to make such a drastic turn. Number one, you know what's really happening behind the scenes they see something on that so famous December 24, 25 weekend that maybe in the repo market, that was heading not at 2008, but in a situation where they had to make a drastic move? Or it just seems like the move was such an embarrassment to the Fed that something behind the scenes was more powerful than meets the eye?
MOHAMED EL-ERIAN: Yeah, I think to understand that episode-- and it is a really important episode, because it was a dramatic U-turn that happened in three months without a major shock to the economy if you look how much they swung. You have to go back a little bit earlier. You have to go back to the beginning of the year.
The Fed like a lot of other analysts and central banks, bought into the notion of a synchronized pickup in global growth. Why? Because every major economic jurisdiction was accelerating in terms of growth. What they didn't realize, and I had argued at the time, is that this was just a coincidence. There were different things happening in different places, but there was nothing synchronized about them. And the feedback mechanisms wouldn't work. And in particular, what was driving Europe, what was driving China was short in duration.
So the Fed was thinking, this is great. We have the tailwind of the global economy. We have the US economy doing great with the business sector responding to deregulation, with the household sector responding to tax cuts, with the labor market strong. We can normalize. And not only can we normalize, but we can maintain the notion of automatic pilot on the balance sheet.
Towards the middle of the year, it became clear, that Fed had started to guide towards full hikes, which I thought was excessive. I kept on saying three and wait. Towards the middle of the year, it was clear to markets that this synchronized pickup in global growth was having problems. Markets started getting a little nervous. But the Fed continued on the same path. And this Fed in particular has, I think, issues understanding market technicals.
So we enter the fourth quarter where the markets start getting really negative numbers from the rest of the world. Not the US, the rest of the world. Markets get nervous, Fed continues. And continues delivering, guiding and delivering on four hikes in December. And repeating with autopilot.
Now it doesn't take long for the markets to realize that the Fed is over tightening on rates, and is forgoing major policy flexibility on the balance sheet. So what happens, we start getting market disruptions.
I think somewhere in November, December, they realized that there was a chance of bad market technicals contaminating the economy. And then the question is, how do you do a U-turn. And I think the biggest mistake that was done is that they-- not that they delivered the fourth rate hike. But they continued to stress autopilot. And the market punished them.
And I think there's two consequences of this. One is a recognition that the Fed needs to understand market technicals better. But two, which is problematic for the Fed, this market hasn't has been emboldened. This market now believes that there's a Powell put, just like there was a Yellen put, just like those of Bernanke put. That feeling wasn't there a year ago. And I think that that's going to prove problematic for the Fed going forward.
LARRY MCDONALD: If you look at the Fed last year and in through the fall, not just the balance sheet, but the dollar. So when I was younger, the US was like, 30%, 40% of global GDP. Now there's $18 trillion of GDP inside the United States and $62 outside. $18 trillion inside, $62 outside. Now granted, I'm not an academic. I'm more of a trading background. But I look at it like, these academics and the Fed are very poor risk managers. And you can trade against them, because when they try to talk up an aggressive policy path, you get a strengthening dollar.
And there's so much debt that's tied to the dollar globally-- there's about $13, $14 trillion of new dollar denominated debt globally. So the question is, we've had two moments here since 2015 where the Fed has really lost control of the policy path, partially because of the dollar, and partially because of the bet their balance sheet plans. Isn't there an invisible cap on the dollar at that 97, 98 level?
Say we strengthen the middle this year, and they start talking rates up again, the dollar rips, they're still doing quantitative tightening to some extent. Then all of a sudden, once again, we have a liquidity problem in emerging markets. That's $62 trillion of GDP outside the United States that starts to weaken dramatically. And once again, that vetoes the Fed policy path.
MOHAMED EL-ERIAN: So we've got to test, we're I think that cap. I really do. I think we're going to test it. And in terms of what's problematic, I think it's about three things, starting from the least problematic. The least problematic is that a strong dollar is bad for growth in the US. The US is simply not that open. So that's not an issue.
More problematic is that it's bad for the S&P, because the US companies, as you know, earned revenues from the rest of the world that is much bigger than what the US trades-- what trade is as part of the domestic economy.
But the third element, you're absolutely right. When the dollar appreciates sharply, it breaks something else. And the reason why break something else is what's called the original sin. Which is that countries have tended to borrow in dollars because that's where the most liquid markets are. But don't produce enough dollars on their own, so they have a fundamental currency mismatch. And when the dollar weakens, it's in your favor. When the dollar, strengthens it's against you.
Now a lot of countries have understood that. But the original sin migrated to companies. So the big risk is you end up breaking something else. And then it feeds back onto the US economy. I think we've got to test that. I think that we've had now, so far, four quarters of dollar strength ending in March of 2019. We haven't had that for a decade. It wouldn't surprise me if we-- if the XY is around 97 now. They continue upwards. And so I suspect we're going to test that hypothesis again.
LARRY MCDONALD: OK. So that sets up a potential risk for the third or fourth quarter.
MOHAMED EL-ERIAN: Yeah. And I think that people have to realize that the first quarter should not be extrapolated for the rest of the year. The first quarter had two things going for it-- an awful fourth quarter, where the market technicals had really shifted completely. And secondly, what we talked about earlier, which is a dramatic turnaround, U turn in the Fed.
LARRY MCDONALD: So you and I have done our CNBC hits, or Bloomberg hits. And the problem with that kind of media is-- and I love I love both networks-- but you can't really get into answering important questions in a long format. I want to give you a chance right now to answer a question that so many academics have really failed at. And that's describing what happened in that third quarter.
And as we look forward too, a lot of people, including traders that I talk to, our clients, our Bear Traps clients around the world are looking at the liquidity situation with the Fed balance sheet. And they're literally trading desks around the world now are looking at the schedule of liquidity. So tax revenues coming in, debt issuance from Treasury is an extra $150, $200 billion this year. So you've got tax revenues. You've got more debt issuance. And then you have the Fed still in QT, quantitative tightening, until at least September.
Help the Real Vision you were really understand. Because in October, the Fed was in $50 billion a month of QT. Draghi and the ECB had gone from 30, 40 billion a month of quantitative easing down to like, 10, 15. So for the first time, we're in a net liquidity draw. Now this has been written about in all kinds of research. But are you a buyer into this global liquidity dynamic that helped trigger that problem the third, fourth quarter? And could we be looking at that again this year?
MOHAMED EL-ERIAN: So I do think we are in the midst of a change in the liquidity issue.
LARRY MCDONALD: OK.
MOHAMED EL-ERIAN: 2008 to 2010 was about the Fed normalizing the financial system. 2010 onwards-- and you can go back to the August speech by Ben Bernanke at Jackson Hole-- it was about using the asset channel to pursue macroeconomic objectives. No longer about normalizing-- the financial system had been normalized. It was about buying time for the economy until the Fed could hand off to a much more comprehensive set of policies.
No one, I think, imagined that the Fed-- that they would be in debt regime all the way into 2016, 2017. But they were.
Now what happens in that regime? One is that the central bank becomes a major provider of liquidity in markets. Why? To encourage us to take more risk, to push asset prices up. Why would I want to push asset prices up? Because you trigger the wealth effect or your hope to. You look at your statements, you feel richer. You want to spend more. And you hope to trigger animal spirits among corporations so they invest more.
It didn't work that well. But the whole system got used to this liquidity. So people migrated to less liquid asset classes. And when people migrated