The Next Step for Central Banks
Featuring Max Wolff
Published on: July 8th, 2019 • Duration: 13 minutesMax Wolff, co-founder of Multivariate, explores the potential knock-on effects of the Fed’s next policy decision at their upcoming FOMC meeting in late July. In this interview with Jake Merl, he discusses the importance of an independent Fed, notes the impact of Christine Lagarde taking over the ECB, and considers playing the current situation with a currency trade of the euro. Filmed on July 3, 2019.
JAKE MERL: Welcome to Trade Ideas. I'm Jake Merl, sitting down with Max Wolff, co-founder of Multivariate. Max, great to have you back on the show.
MAX WOLFF: Always my pleasure, thank you and happy holidays.
JAKE MERL: So today, we're going to be talking about central banks, specifically the Fed and the ECB. We have some important meetings coming up. So, I wanted to get your thoughts if you think the Fed is actually going to cut rates in their next July meeting.
MAX WOLFF: Yeah. So, I don't think I'm alone here. But yeah, I do. I don't think we're going to see 50 basis points. And the reason I think we'll only see 25- and I'm not sure, we'll see, too, is we have a very politicized rate environment, which is terrible for the Fed long term. It's not about one regime or another, one party or another. But the independence of the Federal Reserve has been a cornerstone element of the success of the American financial markets, really, since the period between World War I and World War II, that's tremendously valuable to the US, not least to the US government, which is the world's premier debtor by total size of indebtedness, and as therefore, the world's premier beneficiary of low interest rates.
So, lots of reasons not to do what we began to do here, which is politicized the Fed over the last many years, but increasing the last little while, not so hot. And I also just think that the Federal Reserve wants to have the credible ability to really cut if things get bad, which they're not yet. And if you preemptively slash rates, especially under political pressure, you don't have dry powder for the possible lead case in the future.
JAKE MERL: So, you're expecting what- a 25 bips cut in July?
MAX WOLFF: Yeah. I think we're going to see a lot of language. And a lot of we are watching closely to cut if need be, we might see the strident nature of that warnings calm, but I think they're going to try to do more jawboning and less cutting. I certainly wouldn't just because especially if you price in as the markets more than half, a likely 25 to 50 basis points cut. How low are you really going to go here? I guess you can go 100 basis points and you get to where the 10-Year Treasury is right now, which tells you that the bond markets are already pricing, a totally different economic scenario then the President needs to get reelected and is asking the Federal Reserve for and then the equity market investors think they see when we're getting close to record breaking territory on the Dow.
JAKE MERL: So, Max, we've also seen a recent nomination for Judy Shelton for the Federal Reserve Board. What do you make of that?
MAX WOLFF: Yes, we've seen a few. Obviously, the Federal Reserve is a weird place to be a gold standard advocate, only because it's the modernization we did to get rid of the gold standard when 100 years of history suggested it wasn't always suitable to the long term macro goals. Obviously, it's a different world now. But that's unusual. And what gives me pause is nothing about the individual in question. We don't want overtly political Federal Reserve Board governors. So, it's a two-way street, the independence of the Federal Reserve, the Federal Reserve should stay out of a direct political opinion about what the Senate and White House we're doing in the house, and vice versa.
So, having someone so affiliated with a particular candidate in the political process is unnerving. Particularly because Trump rose to some prominence and in part making some good points, but saber rattling about too low interest rates and how it's a political hustle to have interest rates go down. It's then very hard to put on a political appointee, who has a political affiliation with you, who wants to cut interest rates. It just isn't great for the independence of the institution.
JAKE MERL: So, obviously, we've seen this huge rally over the past six months as the Fed pivoted and got dovish about six months ago. And we also saw them reemphasize that point last month in their meeting, and the stock market bounced off the May lows. But my question to you is, Max, do you think we're going to get the same response going forward? Because historically, when you look back over the past two cycles, when the Fed initially eases and initially pauses, you do get this rise in the stock market. But that signals the top. And this is a question I've been asking a lot of our contributors recently, I would just like to get your thoughts if you think it would play out the same way this time?
MAX WOLFF: Yes. It's a great question. I think this market's been trying to correct since 2016. And this is going to be the same story though this is however unpopular, when you don't let the little tiny forest fires calm and clear the brush out, when something finally gets lit and it's hard to put out right away, you end up with a big fire. And so, we failed the soft constraint, we've now chose the big fire. So, it makes it harder to know what you're going to do, because that's likely you want more dry powder ironically.
But I think, look, we've gotten to a point of a market expectation where the Fed is being asked to engineer abnormal, unsustainable above me and market returns all the time. And people have lost the understanding that that can't be done, because it has more or less been a bull market for pushing 10 years, one of the longest expansions in American history off a really low base. So, we're more than three x the baseline equity performance in a 10-year period, which is not the historical norm. And the bond markets got it on the action, spiking and pushing rates down, which means that somebody is wrong for sure. And it might not be just one party.
So, look, I think that by the end of 2019, the US economy is already weak. I don't know if it'll be in a recession or not, very well could be. And I think everybody knows that. And the question is whether you're going to use the stock market as a way to pull the economy out. And given that only about 15% of the country owns any meaningful stock, that's not a great idea.
JAKE MERL: And so before, off-camera, we were talking about the Fed Funds Rates versus the prime rate. Can you walk us through what you were looking at there?
MAX WOLFF: Yeah. So, there's lots of conversation in the marketplace from authorities and market participants, and John Q public, or whomsoever, and I think it's interesting to reality check that a 5% prime rate and a 3% discount rate for the Federal Reserve, we're at or around the lowest rates we've ever had in American history outside of the trough of one or two severe recessions. So, yeah, it might have been lower two years ago, a little bit lower. But the truth is, we are at rock bottom rates. This economy has never gone off the stimulus trip.
And ironically, three years ago, candidate Trump was screaming bloody murder that Janet Yellen had too low interest rates and was politicizing her job, even now, with lower rates where he wants to rates cut. So, look, I think we need to get into reality check mode here where we do not have high interest rates, full stop. We do not have interest rates that would snuff out any robust economic expansion, full stop. The average economic expansion since World War II is six years and we're 10 years in. So, there is no magic that any Federal Reserve Board should be asked to do or can do that repeals the business cycle. And all efforts to do so have ended much more with tears than with cheers historically.
JAKE MERL: And so, I know we've been talking mostly about the Fed. But we also have an important meeting with the ECB coming up as well. And just recently, Christine Lagarde got picked to be the new replacement for Mario Draghi for the ECB. So, what do you see going on there?
MAX WOLFF: Yeah. So look, it's always a bit tentative when you come in new. That being said, I don't think you could have made a more calming choice. Obviously, very well thought of, a good run as finance minister in France, which some in the US don't know as much about because it's less international. But she was also finance minister during their dark days around the '08-'09 crisis and prove pretty adept in that role. So, I think that gives her some gravitas with Europeans and market participants. Also, IMF run that was pretty good, which might reassure people.
I guess the issue for some might be that she's less a banker, historically, and more political creature on some level, but I think it'd be pretty hard to say that interest rates are in a political hot potato these days, not just in Europe, but really globally. So, I think she's quite adept. And I think she's also already committed to keeping Draghi's team. So, I think a lot of continuity there, I do think it's always a little bit more difficult. And my guess is the big test for her is she'll probably come in with one to two quarters of goodwill honeymoon, and then she might be slightly more prone to attack some credibility, if things are tumultuous, only because she won't have the long history in the markets that Draghi had. And she won't have the benefit- nothing to do with her, but she won't have the benefit of having been in there a long time.
Powell, a little bit. He's new herb, but he's much more settled in. So, I think less of an issue there. I also think Europe is much ahead of the US in a weakening macro situation, having never had as strong of a macro situation. So, I think more cutting is reasonable there. And I also think that you'll probably see them push more quantitative easing, and Europe are going to have to, and at some point, not right away. So, they have three or $400 billion. And then they're going to actually bump up against their own self-installed constraint. And it'll be very destabilizing and interesting to see if they have to give themselves a higher limit for QE.
And if they do that, it will be a very negative signal. And it will create some instability between the euro and the dollar as well. And we'll be looking closely to see if that happens. Again, don't anticipate it, at least not for at least half a year or more. But we'll keep our eyes on if we are approaching that.
JAKE MERL: And so, bringing it back to markets, what's your outlook for the S&P 500 given the dovish Fed and the dovish ECB?
MAX WOLFF: Yeah. So, my guess is that even though I think things are pretty overvalued right now, my guess is they become more overvalued. And I think we'll probably end up the year at or around where we are now having gone higher, and then come back down. The $64,000 question on toward the end of this year becomes, how quickly does the US soften? And how well does the rest of the world stand up? And the reason that's so hard to figure out is where we go in terms of the trade disputes with China. How much, if any, forward progress can be made, and whether we can patch things with Europe or that disintegrates too into a more hostile situation.
And then the deep out of the money stuff we're looking at, which is interesting to us, low probability but big impact is there is a possible ability for a rapid weakening of macro in the US. And we will keep a very close pitch on that. And there's also the possibility that the unsustainably low rates, particularly on some of the weaker European sovereigns could unwind badly and thinking- but not exclusively of Italy here, sub 2% seems very aggressive given some of the structural headwinds and political uncertainties that surround Italy in the near term.
JAKE MERL: So, is there a specific trade you'd be looking to put on here? Or how do you suggest traders play the current environment?
MAX WOLFF: Yeah. So, we actually think the dollar will weaken ahead of the US weakening economy in the back half of the year and markets have not priced that. So, we're going to look at dollar-euro, much more interestingly as a barometer of relative economic weakness, and we feel like the markets will be underwhelmed by the rate cuts. And we're also going to look at that for some weakness in risk assets. A lot of folks think that the equity markets will prove right and the fixed income markets will prove wrong, we think the reverse is true. But we think the equity markets will prove right short term. And then even after one quarter or more, it'll be the fixed income markets that win this and very few people are making that bet, so we'll watch that closely. But if it's true, then risk assets are relatively more overpriced.
And last piece I think we need to keep in mind here is that there is a non-trivial possibility of one of these simmering confrontations becoming more aggressive. And if that happens, it will not be constructive for risk assets. And I have still not met a single risk asset bull who has any position on that one way or another, which makes me nervous.
JAKE MERL: And so, how much downside do you see for the dollar over the coming months?
MAX WOLFF: I don't think we're going to see a crazy downside, but I think we'll see a lurch downward when we get a disappointing total rate cut in this month, in July. And then I think we might see a little bit of a readjustment of the total rate cuts of this year. I think the best we're going to get is 50 basis points this year. And the only way we're going to get more than that, because the Fed wants some dry powder, is if things really turned down i.e. the macro circumstance turns down. Doesn't mean recession but it can mean real weakening, slowing. If that's the case, then the extra 25 basis points won't be enough to push risk assets back up.
JAKE MERL: Well, Max, that was great. We'll see how it plays out. Thanks so much for joining us.
MAX WOLFF: Always my pleasure.
JAKE MERL: So, Max is bearish on the US dollar. Specifically, he thinks the euro will rise 68% against the dollar over the next four to six weeks. That was Max Wolff of Multivariate and for Real Vision, I'm Jake Merl.