The Fed’s Arrogance
Featuring Michael Gayed
Published on: August 2nd, 2019 • Duration: 11 minutesMichael Gayed, portfolio manager at Pension Partners and author of the Lead-Lag Report, explains why he sees the Fed’s decision to cut interest rates as a mistake. In this interview with Jake Merl, Gayed highlights the knock-on effects of central bank policy, reiterates his thesis on reflation, and discusses how traders and investors should position themselves in the current market environment. Filmed on August 1, 2019.
JAKE MERL: Welcome to Trade Ideas. I'm Jake Merl, sitting down with Michael Gayed, portfolio manager at Pension Partners, and author of the Lead-Lag Report. Michael, great to have you back on the show.
MICHAEL GAYED: Always a pleasure. Thank you.
JAKE MERL: So we just saw the first rate cut in over a decade. Yesterday, we just had the FOMC meeting. I know you watched the Fed extremely closely. What did you make of the meeting?
MICHAEL GAYED: Yeah, some people call it a rate cut. I think actually it was more of a rate pike.
JAKE MERL: Why is that?
MICHAEL GAYED: When you look at-- look, all of this has the caveat that it's just an initial reaction. But if you look at the way the markets behaved when the Fed cut by 25 basis points, treasuries on the long end, price rallied, yields dropped, significant flattening. The dollar spiked. Stocks broke down. You had some minimal, maybe just starting, credit spread widening. All those are symptomatic of a hike, of a reduction of liquidity, not an increase in liquidity.
And if the dollar, which I maintain is kind of the key thing for any central bank as their currency, if the dollar does continue to keep appreciating, that undoes any kind of rate cuts that they're trying to do. To me, it's very bothersome, I think, the arrogance the central banks have, whether it's the Fed, the ECB, or any other central bank, in terms of trying to use tools that clearly are not creating the inflation they've been hoping would be transient for as long as they've been saying it has been.
And I think the issue with the Fed here is that they are going to be constantly be having to play catch down, as opposed to catch up-- catch down to the long end, with this yield curve flattening, such that they cut rates, but then the long end actually goes down at a faster pace, suggesting disinflation is going to be even more severe. So I think in some ways, the cut was a mistake.
JAKE MERL: So what should they have done instead?
MICHAEL GAYED: So look, this is a game about psychology. One of the reasons you really haven't had inflation is not because of the money supply is because of the velocity of money, the speed with which people are transacting. You don't get that unless you get urgency. I think in many ways, you only get urgency if you get people thinking that rates are going to keep rising. So it seems counterintuitive, but you could actually get inflation if you scare the public into thinking that low cost of capital is not going to be here forever. And that would increase the velocity of money, could increase inflation, and perversely, cause a lot of these concerns to disappear with actually hiking rates.
In many ways, when it comes to markets what's the most important thing is not policy, it's behavioral changes. The market likes to have the illusion of certainty about an unknowable future. You don't give the illusion of certainty by saying, well, we're going to cut 25 basis points. It's going to be one and done and we're not sure we're going to be doing.
Better to say we're either not going to do anything, we're going to keep rates as they are because we're confident, instill that confidence in market participants. Or say, you know what, we are confident we're going to do everything we can to cause the yield curve to actually steepen. And we're going to go ultra aggressive cutting short rates to stop this trend. But to go in the middle and to be wishy-washy the way it seems, as I like to call him Papa Powell, from the Fed, has done, I think it's a very, very bad judgment call on the Fed's part.
JAKE MERL: So you're not worried at all about slowing growth with an upcoming recession?
MICHAEL GAYED: Recessions are healthy. I've made this point on Twitter, on the Lead-Lag Report, given all this Democratic debates and politics season coming in here. The best candidates, whether it's for a Fed chair or for a presidential spot, is the one that recognizes and says to the American people, we have to suffer now to have a better future later. The US government has $22 trillion of debt. Stop all conversation. $22 trillion of debt.
The Fed continues to enable ongoing borrowing by lowering rates, so there's never any discipline on a spending side from the fiscal end of things. And you're going to have a recession no matter what, or at least very poor future growth, because at some point that debt has to be paid by the taxpayer or inflation. The Fed's not getting inflation. Good luck trying to get voted in on taxes. So I don't fear a recession now. I fear a depression later.
JAKE MERL: So in terms of playing the current market environment, how do you suggest traders play the setup?
MICHAEL GAYED: I think it's very tough, in the sense that obviously you're not just combating rates here, you're combating rates overseas. And we may see what the ECB ultimately is going to be doing on that end and how that impacts European credit markets as well. I think this is an extraordinary different juncture for all asset allocators. I really do. I've maintained that you're probably more likely to have the reflation theme. I still think that's more likely than not.
JAKE MERL: Even though we're seeing the dollar spike?
MICHAEL GAYED: Because I think the dollar is enormously overbought. Now having said that, overbought can stay overbought for a long time. That's why I'm saying this is very tricky. I think the dollar's strength has surprised a lot of people. And that's what markets tend to do. This is all about probabilities. And I think if the dollar does continue to go higher, the Fed probably will have to do a panic move, or there's going to be some degree of quote, unquote, intervention, even if it's just words. And I'm sure you're going to see tweets from Trump on that end.
So I still think you have the reflation theme in there. I think if anything, we're going to be entering a juncture, a cycle, where what's going to matter the most is those investments tied to discipline, as opposed to a gut reaction or feeling on data that does not predict the future. So what I mean by that is, I think you're entering a juncture where you're going to have a degree of debate around whether the Fiat system as it is now, the central banks removal of their tying to the gold standard was ultimately the right move from a very long-term perspective.
I'm not a gold bug by any means. But I think gold is very much a sign of discipline, or it's a tool for discipline when it comes to policy makers. And clearly, there's no discipline, from the Fed or from the government, in terms of spending. So for anybody that's saying, well, what should I invest in for the next 10, 15 years, I would suspect that gold probably is an interesting play. Because you may have potentially a shift towards a more sane policy. Now if you don't, this $22 trillion of debt-- I keep going back to this debt is the problem-- I don't know how in the world we're going to of this.
JAKE MERL: So you mentioned 10 or 15 years for the time horizon for gold, but what about over the next three months? How should we position right now?
MICHAEL GAYED: So it's always important to recognize where you are on the presidential cycle. And so the third year of a presidential cycle tends to be a pretty strong one. Obviously, markets have been incredibly strong, at least in the US. Small caps have not been as strong. And I always rant on that point. When people say the market is it all new-time highs, stop, don't say the market, because the market is not the S&P 500. When you look at a lot of equal weight indices, when you have more breath, you're not really doing as well as you think, especially when you're looking international.
So I think you still are OK towards the end of the year for risk assets. The caveat to the pre-election year cycle being the strongest in the four-year presidential cycle is that 1987 was a pre-election year as well. And the Dow was up 30% before the crash. I don't think that's necessarily going to be the case here. But I think it's still OK to take on risk. I think reflation still makes more sense. If anything, just as an over sold balance on reflation trades.
But again, I want to caution anybody that's looking at US markets. You have to keep in the back of your mind this issue of equity is going up because we're taking on so much debt. And you can say that debt doesn't matter. But there's a point where debt creates significant divergences in wealth, which is what we've seen over the last several years, significant divergences in how one should behave in a sort of more logical environment. And markets are very good to surprising people. It took 2008 to take away 10 years of gains, really just two weeks in 2008. Nothing is for certain when it comes to returns.
JAKE MERL: And so by reflation trade, I know you've mentioned it a few times in some previous interviews, you're talking about a weaker dollar, long emerging markets. Can you explain that a little more, please?
MICHAEL GAYED: Yeah, so, when the dollar when appreciates, that's a deflationary force. And when the dollar depreciates, that's an inflationary force. Right? OK. So generally, emerging markets, financials, anything that benefits from a yield curve steepening or from commodity cost push inflation will correlate to a weaker dollar. Now given that the dollar isn't so strong, the question is, do you want to keep on betting on that trend, the disinflationary trend? Or are you going to bet that that's going to reverse and have some kind of a meaningful correction? Which in turn, should probably lift all the reflationary trades, anything that would benefit off of the inflation premia rising.
So again, just from a contrarian standpoint, I look of dollar, and I say to myself, it's probably way too strong than it should be. And I suspect that the powers that be will probably try and bring it down. And if that's the case, if you want to bet on the stuff that would be most correlated to that weaker dollar, again emerging markets, financials, commodities, all those areas which have failed to participate exactly because the dollar has been so strong.
JAKE MERL: And so last time you were here, I know you recommended going long emerging markets against the S&P. You were looking for a 20% outperformance. Would you still be recommending that trade?
MICHAEL GAYED: Yeah, I don't thing anything's changed on that. I mean, just short term, again, we don't know what the reaction's going to be later on. I mean, people tend to have this knee jerk response to central bank actions the day of and they think that's the way it's going to be for the next few months. We don't know how markets yet are going to play out. But I think, still, if you like buy low, sell high, I don't know why in hell you'd want to buy the S&P.
JAKE MERL: Well, Michael, we'll see how it plays out in the months to come. Thanks so much for joining us.
MICHAEL GAYED: Appreciate it.
JAKE MERL: So Michael still likes the reflation trade. He thinks the MSCI Emerging Markets ETF could outperform the S&P 500 by 20% over the next few months. That was Michael Gayed of Pension Partners and for Real Vision, I'm Jake Merl.