Who's Driving Global Yields - The Fed or the ECB? I think what happened this Summer is that we got into a vicious cycle where lower rates actually were calling for lower rates. The issue with that is, you get rational individuals turning into irrational collective behavior. I heard the Kansas City Fed, George welcoming fellow central bankers in Jackson Hall saying, don't feed the bears. So obviously thanks for inviting me back. So I founded GTI research about five years ago now. What we tried to provide is a wider array of clients with strong and accurate global micro outlook to feed into a top-down strategy for whatever investment process they might be trading. So I also have a unique 20-year experience in both portfolio management and strategy which I think enables me to like connect the dots from the micro-strategy to actionable trade ideas. That's what made the success of GTI research for the past five years now and gave us like one of the highest hit ratio in the research industry. Reviewing 2019. Really it started in 2018. Mid-2018, we started to recommend short inflation break events and then from December last year long 5-year bonds. There were two main reason for that which were not linked to China. Firstly, I think that quantitative tightening directly feeds through lower global liquidity and naturally slower global activity. That's exactly what happened this year and I was very easy to actually forecast. The second thing, is that the Fed's really tripped into the trap that Trump put last year by increasing the real equilibrium rate, but only temporarily. What's really interesting is that the Fed actually at the time did totally take on board that real equilibrium rate was higher. They went into coding it like short-term equilibrium rate. What's interesting is that in 2019 the concept of short-term equilibrium rate totally disappeared. So you had basically Fed hiking into rising equilibrium rates of, I would say one percent in 2019 which basically dropped to zero by the mid of this year just on gross converging to its potential which I see around like 1.7 to 1.8 percent. The problem is the Fed forgot that it was like a real short-term equilibrium and they were late to cut again. So that really Fed through my view that the Fed was going to start cutting from mid 2019 and that's exactly what happened. But now we've talked about the past I think no one is sitting in front of their screen to talk about the past. So what I would like to discuss is really what happened this Summer. I think what happened this Summer is that we got into a vicious cycle where lower rates actually were calling for lower rates, even lower rates. The reason is that we look at macroeconomic models, assuming that human behavior will be rational and the rational idea when you have forward guidance and central banks telling you that rates are going to be zero or even negative. The rational behavior at least in Europe is too easy to jump at the last opportunity to get a positive yield. The issue with that is you get rational individuals turning into irrational collective behavior. So that means instead of having a model where low rates mean high investment and lower saving, higher spending, you actually get people like you and me thinking, what am I going to retire on if I can get any returns on my retirement funds? You just save more. I've seen it, I don't know if you've seen it as well, but clearly that's something that you can see on the on charts and something that's actually turned. I actually think that we've reached the reversal rate in Europe about three years ago, and in Japan about five years ago. What that means is you've got real rates becoming lower rates and negative rates actually becoming contractionary. So the more you lower rates and the more you need to lower rates and that basically causes the explosion in negative yielding debts that we've seen over the Summer. That's basically what's happening in Europe where real negative yields actually become contractionary. But what it does in the US as well is that it spreads like fire, it spreads into more inverted curve. That can in itself, as we both know, be self-fulfilling and lead to recession. That's very much what happened this Summer and they sort of like group think, irrational collective thinking. What changed your outlook? The way I started thinking is when I heard Kansas City Fed, George welcoming fellow central bankers in Jackson Hall saying, don't feed the bears. That's exactly the way I'm thinking at the moment. If you basically keep cutting because markets demand cuts and that's what the ECB has been doing and it's in itself very detrimental not only to investment, but also to demand, then you're basically feeding the bears. What's needed in a effective liquidity trap is government spending to basically offset private saving to effectively load the global saving glutes to be upset. The interesting part especially in Europe is that also the debt to the GDP ratio exploded since the last global financial crises by about like 15 to 20 percent. Actually the interest expenditure as a percentage of GDP has absolutely collapsed to all time low. That's really interesting especially in the context of Mrs. Legarde now taking over the ECB. Actually the IMF just put out a paper reviewing what's happened with nip and the fact that they were also advising fiscal austerity at the same time. They've been arguing that clearly it was wrong and that you can't just have like monetary policy, you also need fiscal policy otherwise it's just completely counter-productive. So what I'm thinking is very much what's happening at the moment. There is really realization that debt to GDP ratio are becoming quite irrelevant if you can fund negatively. So you've got the French looking to cut taxes for the lower middle class by like nine billion already. Next year the Germans are looking to do a climate saving program. The Dutch are also looking at the Investment Program and more importantly as well, French and Italian governments are now back in love. I think that can really lead us towards more fiscal policy, especially with Lagarde having the political clout to properly explain why and how this needs to happen. Another thing that is really interesting on that side is that the Germans might not like spending, but what they hate even more is negative yields.I think that is a thinking that is really spreading in the rest of Europe as well. That's really the main problem. Is the ECB more important to global yields than the Fed? That's a really great question because for the first time as far as I can remember, I actually think the Fed is much less important in terms of like driving global yields. What we've really had and what I thought would happen, so we knew two things. Firstly, that nip is not working, and secondly that sentiment is spreading on the fact that it is not working. It's quite a big u-turn in Summer because just before Sintra in June, there was an ECB paper looking at the fact that negative interest rates were still walking. The reason is that the central bank was looking before at the supply side of credits. What I mean by the supply side is like our bank is still lending. Because banks were still lending, they were just assuming that everything is fine, but obviously they failed to really look at the demand side of credit which is you and me saving much more which means that their models are broken. The second thing to look at as well, it's like all these insurance, pensions, and etc, as far as yields continue to go down and you can keep like getting a capital appreciation, everything is fine. But when you're not getting capital appreciation anymore when we stall, you're basically left with negative yielding assets and that's an even bigger problem. So I knew on one side that there would be a u-turn in terms of thinking that monetary policy on its own can be potent. So I strongly believe that monetary policy needs to walk in cooperation with fiscal policy, and that's something that on my own I'm thinking about at the moment. The second thing I knew was that we were pricing 42 base point of cuts at the end of August on the EO and Yaakov. So like we were basically pricing that lower rates forever were going to be the answer to the next downturn which I thought was completely wrong. So what I recommended at the end of August was to get out off long fixed income and look to stop selling bubbles, so Gemini five-year minus 93 base point. What I knew was well was that a lot of the US curve as well was the 1.43 prints in their 10-year yield in the US wasn't due to like escalation of the China versus US conflict, it was in my mind mainly driven by expectation of the bazooka that Draghi was going to come for in September. So for me, that was like mind-blowing risk reward trade where you know on one side that the ECB is not going to respond like markets expect them to respond, and that it will basically drive rates everywhere else in the world. I think that's really what happened. What we've seen is like decompression of term premier just on the basis of like okay, we're done with the vicious cycle of calling for lower rates, and now we're going to look for something different. Suddenly, we don't really know what that different thing is going to be, but what we do know is that the dispassion of risk is not like one way as we saw it was in August. I think that was really the game changer in terms of monetary policy. Why is recession more likely than reflation? A trade though is just like a great risk reward because you can see like the different dispassion of risk than what market is pricing, which is really how the traits started at the end of August in short bubbles. Sometime, these trade which is initially it's completely tactical can become a bit more more strategic. I'm not calling for like a global boom, clearly that's not my point. But what I do think is that we had a few game changers in September that were not all linked to monetary policy. So the first thing maybe would be Brexit. So I think there was a game changer in September with Brexit, with Boris Johnson losing his majority in Parliament by more than 40 MPs, suddenly like the DUP wasn't the king maker anymore. That's a big deal because it means that a potential deal with Europe can involve a northern island on the backstop, whether it is by having like agriculture deal or something like that. But that would also allow Boris to basically go with the Canada style agreement that he's been looking for. The second thing is that the leave them's have been going. Basically, we want to remain. If there is a general election and we win, we want to remain and we're going to call off Article 50. That's a big deal for for labor because that means that if there's a general election before UK is out of the EU, leave them becomes irrelevant. But if it's after, it's labor that is becoming irrelevant. So I think that's a game changer in terms of getting labor MPs to basically vote for the deal eventually because they won the election after being out of the EU. Well, that's two things. The third thing is probably that Marco and Michael definitely want to get done with Brexit. I think Marco doesn't want the second part of his mandate to be all about Brexit, he wants to be the post maker who is basically leading Europe to different micro policy, whether it's fiscal and obviously like in very close contact with Mrs. Legarde as well. So that's for Brexit, I see basically much higher chance than we had in August of soft Brexit on 31st October. That's obviously really important for Europe. The second really important game changer which very few are talking about is that the same reason I was calling for US yields to go down from December last year because of global tightening, and the fact that US monetary policy was too tight for the rest of the world, well suddenly we've seen like US ISM collapse and effectively converge to global BMIs. I think a lot of traders, portfolio managers saw like the below 50 prints in a ISM manufacturing as like recession is coming. Actually, I thought brilliant because US is converging to the rest of the world, that mean's we're going to have global policy, which is going to be much more appropriate for the world. If you look at a chart that we love to look at and that you're going to be showing on screen, you can actually see that the mini cycles than we've seen for the past five-six years have been driven by the differential of activity between the US and the rest of the world. Meaning when the US does well, it plunges the rest of the world into a slowdown because the Fed has too high rates and there'll be like eight bells of global transactions are still in dollars. So that's the game changer that basically US is converging to the rest of the world, which means like given the Fed is going to be just doing what markets are pricing. That means when global monetary policy is going to become appropriate. The third game changer which I am either identified after the Biarritz G7 is that clearly initially I thought it was just Trump who just would be taking a much softer stance with China, but it appears that China is willing to play game as well. I think something happened after that Friday where there was huge escalation and in my head it was really capitulation than the G7 happened, and we got two best stands down in stocks and suddenly like Trump came out and like I got a call from China. I think what's really clear is that the US main weakness is its financialization, meaning the economy is going to be extremely linked with the stock market, and that means if you get like five best sends downside in stock markets, the economy is not going to be as resilient as it was last year, especially given Trump can't come out with another fiscal plan before the next election. So that really just told me that as a deal-maker, it would make a lot more sense to get a much softer tone. I think that's really what happened and I'm not saying there's going to be a great deal, I think it's just going to cosmetic deal. But really what's important is we don't get escalation. So that's three game changers following a major game changer which was the fact that the ECB wasn't looking to keep digging a hole for itself if you believe it. What does Central Bank policy convergence mean for marketers? Personally on the ECB, I was actually amazed to see like my view completely validated so quickly. I actually thought it was going to be like a Draghi not saying too much and then Lagarde coming out with "Look, monetary policy is not really working anymore, at the minimum, we need cooperation." But actually Draghi just came out and suddenly it was not about monetary anymore, every single question was about just spent more money. So that was really the interesting part and also to the question about whether we had hit the reversal rate, he was much less optimistic than he was in June and saying like clearly it was going to be something that would be discussed in a future. Also obviously the Q Infinity is an enabler for more fiscal policy, is giving a wildcard to government to spend. So I think the message from the ECB was extremely clear, and I didn't expect they would be so clear. What indicators should investors pay attention to now? If you look at what's happened in the US for example, the cyclical versus defensive move has been completely in line with the replacing of the Fed. So I think we've priced out like 30, 40 base point, that's exactly in line with a ribbon in encyclicals versus defensive, and that's a tough lot to look at in terms of figuring out whether it's going to be a shock, a yield shock and like a mini tantrum or whether it's like a positive thing. So that's really telling me that it's a positive thing. Obviously, European stocks have been trading really well since DCB, and that's being led by banks which is the interesting thing as well. I think talking about the dollar and Euro dollar, the interesting thing is that it puts less pressure on the Fed to like deliver like immediate cuts. Because if the ECB is not cutting anymore, not digging its oil anymore, then suddenly you get some support for euro versus dollar, which means like, okay, the Fed is still relatively quiet okayish and the dollar is supported, but it's not making new highs. I think that's really what we've seen in September. How should investors trade fixed income and equities? What I've been recommending since end of August, was short Germany five year. I got out of long US as well. I'm feeling very bullish European stocks. I think they are cheap. They are very leveraged to the global cycle, which I think was too bent towards imminent recession. I think there's a possibility that we have an awesome mini cycle. I don't see huge vulnerabilities within the US or in Europe, or at least not as much as what the market charter is about. I like European stocks. I like short bonds in Europe. I think one of the theme that's going to be really interesting is monetary policy in the US, where it's easier to sustain the price cuts than obviously in Europe. So we're going to have Europe doing fiscal versus US doing monetary. I think that's going to keep the dollar from strengthening much. I think that will keep Europe supported and eventually means higher euro. But I don't think that's an imminent story. I think in term of US fixing commerce and we probably done 75 percent of the move in terms of decompressing premier. I would be looking to re-enter 10-year yields closer to two percent, and to basically run the trade short bubbles versus long US. I think that could be something that really starts trending into next year. What is the potential for global yield convergence? Well, we've literally seen almost nothing now so far in terms of convergence, because it was really the first part of the move was like **** premier decompression. In fact, I think the US has moved more than Europe since the beginning of September. I'm not exactly sure about that, but I think it has. But I think that's the first step, and I think the second step is basically US is still, there's no imminent recession but we're still going to be slowing down. I don't have any question about that. I think probably we currently around zero in terms of real yields. I think probably equilibrium would be a bit negative. So I'm still looking for another cut at least this year. So that really I think should fit through the kind of new theme, which is Europe fiscal versus US monetary. What happens to the yield curve? I would be looking for steepening there. I think, we're still pricing too much negativeness around Europe. If you really look at what's happened in Europe, the interesting thing is that a lot of the weakness has been completely driven by Germany and Germany manufacturing. The thing there is that Germany has by far the largest fiscal space. I think in Germany, you could basically run deficits of two percent per year, and still keep your debt ratio stable. That's almost like a no-brainer. If you start seeing employment going down in Germany or unemployment going up, I think straightaway you can result to fiscal policy. If you look at the services sector in Europe everywhere, it's actually been trending up for the past six months. So we've had a little bit of coming down at the beginning of the year, which was totally making sense but we've actually been trending up in services. I know there's a lot of the narrative that manufacturing always leads services. But this time it's not. I think we've got the biggest divergence. I don't have the chart in front of me, but I think we've got the very large divergence, which is unprecedented in terms of how long we take to reconverge. I think it could be well-explained by the fact that everything is based around China and the trade wall and manufacturing. But right now, it's clearly not spreading. How important is China to the reflation story? You know what, I think China is trying to join the reflation party, but not to benefit the rest of the world. So I still don't think that we're going to see the same big upturn that we've seen in 2016-17 or even like 2009. We're not there at all. But what's happened in China is firstly, the leading indicators have peaked up six months ago and they tend to be six months leading. So we actually end also in September, which was another false game changer maybe is they've really joined fiscal to monetary as well by accelerating the [inaudible] and really moving forward the investment quarter. I think China is not going to be having a big rebound and especially not for the rest of the world, because I think they really want to be focused on domestic consumption. But what I think as well is we could be stabilizing as well there. So meaning, we're not going to get a big rebound. But we're not going to see anything much worse. What happens to bond yields and inflation? I would not rule inflation out especially out in the US, and I've been always a deflationary. I've been recommending short inflation for the past, I think, a number of years. But what's really interesting in the US is that Powell yesterday, was still absolutely talking about muted inflation. Really worried about that. Now, I've call CPI running on an annualized basis as 3.4. So that's nothing to be and also Fed would have been starting to be a little bit worried about that, especially given the consumer is really driving inflation. So of course that could just be temporary. But I wouldn't totally rule out a bit more of inflation bills in the US. I think it's a good thing that the Fed is going slowly, because the risk would be that suddenly the curve steepens. That would be the real risk to assets like financial assets and eventually a recession risk. So I can see reason why you wouldn't go and cut 50 and steepen the curve, weaken the dollar. You might lose a little bit control of inflation and eventually steepen the curve and basically crush assets. What will reflation policies look like and when might they take hold? It could take a long time, but it could get priced quickly. So we're in the middle of budgets at the moment. In Europe, no one is going crazy for sure. But I think there is a move to simplify the fiscal rules in EU. So that's one important thing. Looking towards some more in the future, I think what we could have is, Legarde has been talking about Central Bank issued digital currency. When it was first floated the idea two years ago, the idea was that you and me would have money at the central banks. So I'm not talking about Bitcoin or anything. I'm just talking about you and me having money at the central banks, at the public entity instead of a private entity. What they were thinking at the time is that they could basically cut rates as far as they wanted because they don't have the same constraints as a bank. I think that idea is completely gone now because of what we explained before, they would be totally contractionary. But the way you could use it is basically by doing people QE and that's one thing. That was actually mentioned in Draghi's press conference. He did say that it would be something that would be part of a strategic review when Legarde comes in place. So that's an interesting thing. Then you're just talking about different countries, different policies. In Japan you could easily have monetization. Basically, monetization is debt finance by QE, which is very much already possible, but the Japanese is not using. It might sound really controversial, but actually it was very widely used before the '80s. It's been used in France, Italy, UK, and Sweden. So it's not really that controversial. It's just that then we've got the inflation going out of control and we went into the '80s. Really wanted central banks to be independent and with a strong inflation mandate. But that's the different forms that we could be thinking about like people QE monetization. You could have governments having an account at the central banks as well, which makes the whole fiscal program much more nimble and much more in terms of moving markets expectation, much more transparent. Because the problem at the moment is everybody is asking, "But what are they going to do and when are we going to know it?" But the Germans, they still want to spend. What's that program? What is it going to do like climate change program? What exactly does it mean? I think if you had a basically government account that can be basically filled by the Central Bank also means that the Central Bank's not losing its independence. Then suddenly, we'll be like, "Okay, we can see it's maybe recession is not tomorrow. Can you summarize your view? Well, I think we are at really interesting crossroad, whether it's Brexit, whether it's China, the US election, the ECB, and the sea change in monetary policy. I would urge you to call me and navigate those rough waters together in the future. Let's play a game. I'm going to read out three sentences. You have to guess what they have in common. All right? Here we go. Sentence number one. This has literally changed my life. I'm currently up enough on this trade to pay off my house. Here is sentence number two. This car has been absolutely spot on. It has made a big difference to my year and portfolio returns unlikely up 30 percent by the end of the year. Sentence number three. It's effectively a macro mentoring program from two of the best. Give up. Each sentence comes from one of our many subscribers to Macro Insiders. That's the attritable macro mentoring service from Raoul Pal and Julian Brigden. 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