Why the Fed Risks Losing Control of the Bond Market | Andy Constan

In Episode 389 https://hiddenforces.io/podcasts/fed-risks-losing-the-bond-market-andy-constan of Hidden Forces, Demetri Kofinas speaks with Andy Constan, the founder and proprietor of Damped Spring Advisors about why he believes the Federal Reserve is at risk of losing the long-end of the bond market, which would lead to a reacceleration of inflation and a hard landing for the economy. Andy and Demetri spend the first hour discussing the subject of a recent letter he published in which he warns that the Federal Reserve, by continuing to lower interest rates and ease monetary policy, could cause a sell-off in long-bonds and a rise in term premia, paradoxically tightening financial conditions while intending to ease them. They further discuss Treasury issuance, management of the Fed's balance sheet, the weighted average maturity of assets in the central bank's portfolio, and how conditions in the U. S. economy measure against the Fed's summary of economic projections. In the second hour, Kofinas and Constan dig into the government's finances, its fiscal picture, and how Trump's election may exacerbate or alleviate trends that have been in place for decades. They also discuss equity markets, the broadening of the equity rally beyond the Magnificent Seven that's been underway this year, earnings expectations for these companies, whether they're elevated or conservative, and how we should go about valuing them. You can subscribe to our premium content and access our premium feed, episode transcripts, and Intelligence Reports at HiddenForces.io/subscribe https://hiddenforces.io/subscribe. If you want to join in on the conversation and become a member of the Hidden Forces Genius community, which includes Q&A calls with guests, access to special research and analysis, in-person events, and dinners, you can also do that on our subscriber page at HiddenForces.io/subscribe https://hiddenforces.io/subscribe. If you enjoyed listening to today's episode of Hidden Forces, you can help support the show by doing the following: Subscribe on Apple Podcasts https://podcasts.apple.com/us/podcast/hidden-forces/id1205359334 | YouTube https://www.youtube.com/channel/UC8URhgYos5fjHqFSO4RSIEg | Spotify https://open.spotify.com/show/0TK6u251zGSlMgJKH6cOaP | Stitcher https://www.stitcher.com/podcast/demetri-kofinas/hidden-forces | SoundCloud https://soundcloud.com/hiddenforces | CastBox https://castbox.fm/channel/2629539 | RSS Feed http://hiddenforces.libsyn.com/rss Write us a review on Apple Podcasts https://podcasts.apple.com/us/podcast/hidden-forces/id1205359334 & Spotify https://open.spotify.com/show/0TK6u251zGSlMgJKH6cOaP Subscribe to our mailing list at https://hiddenforces.io/newsletter/ https://hiddenforces.io/ Producer & Host: Demetri Kofinas http://www.demetrikofinas.com/ Editor & Engineer: Stylianos Nicolaou Subscribe and Support the Podcast at https://hiddenforces.io https://hiddenforces.io/ Join the conversation on Facebook https://www.facebook.com/hiddenforcespod/, Instagram https://www.instagram.com/hiddenforcespod/, and Twitter https://twitter.com/hiddenforcespod at @hiddenforcespod Follow Demetri on Twitter at @Kofinas https://twitter.com/kofinas Episode Recorded on 11/11/2024

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00Demetri Kofinas?

  What's up everybody? My name is Demetri Kofinas and you're listening to Hidden Forces, a podcast that inspires investors, entrepreneurs, and everyday citizens to challenge consensus narratives and learn how to think critically about the systems of power shaping our world. My guest in this episode of Hidden Forces is Andy Constand, the founder and proprietor of Damp Spring Advisors, who previously worked at Bridgewater Associates as an idea generator, more recently at Brevin Howard as chief strategist, and spent 17 years at Solomon Brothers, where he served as head of global equity derivatives. Andy and I spent the first hour of our conversation discussing the subject of a recent

• 0:42Demetri Kofinas?

  letter he published, in which he warned that the Federal Reserve, by continuing to lower interest rates and ease monetary policy, is at risk of losing the long end of the bond market, and paradoxically tightening financial conditions in the process, taking us from what could be a soft landing or no landing scenario, to a re-acceleration of inflation and a very hard landing for the economy. We discussed treasury issuance, management of the Fed's balance sheet, the weighted average maturity of assets in its portfolio, and how conditions in the US economy measure against the Fed's summary of economic projections. In the second hour, we dig into the government's finances, its fiscal picture, and how the election may exacerbate or alleviate trends that have been in place for decades.

• 1:26Demetri Kofinas?

  We also discuss equity markets, the broadening of the equity rally beyond the magnificent seven that's been underway this year, earnings expectations for these companies, whether they're elevated or conservative, and how we should go about valuing them. If you want access to that part of the conversation, and you're not already subscribed to Hidden Forces, you can join our premium feed and listen to the second hour of today's episode by going to hiddenforces.io/subscribe. All of our content tiers give you access to our premium feed, which you can listen to on your mobile device, using your favorite podcast app, just like you're listening to this episode right now.

• 2:04Demetri Kofinas?

  If you want to join in on the conversation and become a member of the Hidden Forces Genius Community, which includes Q and A calls with guests, access to special research and analysis, in-person events, and dinners, you can also do that on our subscriber page. And if you still have questions, feel free to send an email to [email protected] and I or someone from our team will get right back to you. Lastly, because this conversation deals with investing, nothing we say on this podcast can or should be viewed as financial advice. All opinions expressed by me and my guests are solely our own opinions and should not be relied upon as the basis for financial decisions.

• 2:48Demetri Kofinas?

  And with that, please enjoy this timely and thoughtful conversation with my guest, Andy Constan. Andy Constan, welcome back to Hidden Forces.

• 3:01Speaker 01

  Thanks, Dimitri. Good to be here.

• 3:04Demetri Kofinas?

  It's great having you on. How are you doing?

• 3:06Speaker 01

  I'm doing well. Got my Santa beard started.

• 3:08Demetri Kofinas?

  Do you normally shave in the summertime?

• 3:10Speaker 01

  No, I'm always one of the two gray beards, but now it's getting a little out of control.

• 3:16Demetri Kofinas?

  Right, exactly. That's your other show. So one of them is the Two Gray Beards. That's the name of it, which is videos mainly of you and your business partner.

• 3:24Speaker 01

  Once a week videos and investment portfolio that we use to create a long-only beta, a smart beta portfolio that's really designed for people who are not super active traders, but are long-term investors.

• 3:37Demetri Kofinas?

  Yes, and you also are the proprietor and author of Damn Spring and the Damn Spring Reports. And what prompted this conversation was actually the most recent report that you put out, which was titled "Warning," and I think you published it on November 3rd, a few days before the election and before the FOMC meeting. And in that letter, you wrote that, quote, "The risks are high that the consequences of next week's FOMC will be the Fed losing the long end of the bond market."

• 4:04Speaker 01

  Yeah.

• 4:04Demetri Kofinas?

  What did you mean when you wrote that? Why did you write it? And do you still feel this way?

• 4:09Speaker 01

  So again, when one creates a warning, I was very careful in that report to not say that it's a prediction. There's a difference between a prediction and a war and a risk. And so coming from that standpoint, let's start there. I think there is a risk that the Fed will be too easy relative to conditions such that the economy heats up and the long-term bond market starts to sell off. And once the long-term bond market sells off, it's harder to manage the financial conditions, which, you know, I've been saying for many, many months, well, really the whole

• 4:53Speaker 01

  period of the tightening cycle and now the current easing cycle, that the federal funds rate is not what the economy is driven by anymore. And the Fed seems to be very focused on the federal funds rate. That's their main lever and not at all focused on the impact of financial conditions on the market.

• 5:21Speaker 01

  And so what I'm hoping for from the Fed, I imagine everyone is hoping for from the Fed, is for them to nail the soft landing. And to do that, you need to avoid a meaningful disruption in any of the markets, but particularly the markets that long-term investors hold. Because that since the COVID inflationary period where prior to that, most homeowners, corporations and anyone who is needs to borrow, borrowed at extremely low rates for term.

• 6:06Speaker 01

  And that allowed balance sheets of both corporations and households who own assets to

• 6:18Speaker 01

  Really strengthened over the last few years as asset prices rallied. And so that has allowed corporations to continue to raise wages, to maintain employment, and so on. And also, anyone who is, needs to spend can dis-sav by selling assets or borrowing against assets. So I look at financial conditions as being, you know, they vary, but easy. So to achieve a soft landing in the real economy, which is GDP growth that is consistent with

• 6:55Speaker 01

  trend growth and inflation that's at target, I believe it's also important that to have that soft landing hold is for the financial markets to achieve a soft landing. And while there's some debate on whether the economy has soft landed, or, you know, the summer it looked like it was heading for a harder landing, and now since then it's looking like it may be a no landing, and obviously we have the election and all of those things that influence the economy. Let's assume it's heading or at a soft landing.

• 7:36Speaker 01

  For that to be maintained, financial markets have to return to normal. And they can return to normal rapidly and disruptively, or they can return to normal gradually. And that's what the warning was about. It was, financial markets are not normal at all right now. Doesn't mean they're going to go down, or crash, or do anything like that, but they're not normal. They need some meaningful adjustment in order to return to a normal financial market, regardless of what the real economy is doing. And so I can tell you why I think that, but in order for the soft landing of the real

• 8:20Speaker 01

  economy to occur, I think we need to move toward a normal financial market. I don't want that to be a rapid descent because a rapid descent can have a secondary effect that can cause a hard landing in the real economy. And that's what I'd like to avoid. So the warning was to tell the Fed, you were very, very dovish. You've been very, very dovish all year because you felt that the financial conditions were restrictive. Every presser, financial conditions are restrictive, including the most recent one, when they're not. They're just not restrictive. The economy is going between two and a half and 3% real

• 9:02Speaker 01

  GDP, while very short dated PCE inflation is near target, longer term, one year, and certainly, most recently, a tilting up of the one year shows inflation above target. CPI is, of course, CPI is still well above 3%. And jobs are historically strong, if not slightly less hot than they were in the midst of COVID. And so that's not restrictive financial conditions. That's financial conditions that can manage through at current levels and deliver warm, if not hot, economic activity. And so my point to listeners is that if you

• 9:46Speaker 01

  remain easy, conditions will continue to warm up and you have the potential of having the bond market steepen aggressively. And if the bond market steepens aggressively, it's fairly likely that risky assets will correct in a more rapid way than they need to. And that could create an economic hard landing. So what I'm hoping for is the Fed stays a little hawkish longer instead of being resolutely dovish.

• 10:19Demetri Kofinas?

  All right, so let's dissect this. Let's clarify some points and bring the clarity that you bring to your reports, which are really excellent. I want to say that I don't just say that in general. Actually, I get a lot of value out of your writing. And I love how reflective it is too. By the way, Andy, I love that you reflect on the process that created the results that you put forward in your projections. So let's do that and let's also create structure around your response. First of all, I just want to clarify something. When you talk about a steepening, what you're describing is a steepening of the yield curve. And you're describing a bear steepening, a potential bear steepening, which is the the long rates rise, not the short rates drop.

• 10:55Speaker 01

  Yes.

• 10:55Demetri Kofinas?

  But let's actually start from first principles. So first of all, you talked about financial conditions coming back to normal. First of all, how do we measure financial conditions? And then what are normal financial conditions?

• 11:06Speaker 01

  Right, so many people measure it in many different ways. I think one of the best ways to do it is to see its works, as Powell regularly says. And to see its works, you see whether the economy is contracting in a disinflationary slowing growth way. And clearly, we've been in a transitory, supply chain driven inflation period. And now we're in a disinflation period that has made a lot of progress. And maybe it will continue to go on and reach target, or maybe it won't.

• 11:46Speaker 01

  But it's heading in the right direction, while real growth and employment are just, you know, gangbusters. Not gangbusters. I mean, we've had hotter growth and we've had tighter employment, but there's no sign of it in its works. So that's one thing. And then the other thing is the conditions of those who want to borrow and the conditions of those who are able to lend.

• 12:11Speaker 01

  That's another sort of what I would call fundamental analysis that one would do. It's not market-based and it's not results-based, which was the first category. So again, the framework is results-based, conditions of those who want to borrow and lend, and market-based. So when you look at conditions for those who want to borrow and lend, while there's always a bank that's struggling, and there's likely banks that will fail, the by and large is the banking system has almost never been as able to lend as they are right now. And they're not lending much.

• 12:52Speaker 01

  They're lending a little bit lately, but not much, which tells you something about financial conditions. They're able and willing, but they're not lending. So why is that? That must be a demand issue. People don't want to borrow. And we know that to be true because housing activity is slow, mortgage refinancings are nonexistent, relocations are being impacted by homeowners who have low mortgages unwilling to pass up and to move, and job activity is mostly stable. There still are trends in the economy in terms of where people want to live that's having some impact. But corporations don't need to borrow.

• 13:33Speaker 01

  You know, the biggest corporations in particular are flush with money. They don't know what to do with the money, so they're not borrowing. And small businesses, you know, they're struggling. We do have a K-shaped sort of economy going on, so there's always some that are struggling and have too much debt. But by and large, there's no demand for borrowing and there's plenty of supply. And you can see that with credit spreads. Credit spreads have been going in one direction, and that indicates very little demand to borrow and lots of supply to lend. Now, that's a market-based thing, so now let's jump into market-based things that determine financial conditions. And so, you know, the simple thing is, if you look at all the people who want to borrow or lend...

• 14:19Speaker 01

  What are the rates they're getting? You know, what's pricing? So the government is able to borrow at, I don't know, four thirty on ten year notes, whatever the rate is, it might be four twenty five today, whatever it is. They can borrow municipalities, mortgagers, creditors, corporates. Pretty much everyone who wants to borrow in the debt market is seeing both relatively low long term rates and and very tight spreads. So that tells me that people who want to borrow to either consume or invest in the real economy have cheap cost of funds. Add that extremely high equity prices relative to where they've been.

• 15:01Speaker 01

  Not and I don't mean particularly high in like, oh, my God, equities are incredibly rich. I mean, they were a lot cheaper six months ago or a year ago than they are now. So the ability, if somebody wanted to raise money, and Michael Saylor is a great example of that, he's getting paid three times the price of the thing he's going to invest the proceeds in. So there are, there are places where you can raise money. Now, the funny thing is, no one needs it. No one needs the money. So that tells me that people don't need to borrow, people don't need to finance to do capital investment. And that tells me that conditions are easy from a market pricing, from a supply and

• 15:45Speaker 01

  demand of lending and borrowing, and from a work, how it works, what's happening in the real economy. While the Fed appears to think that the Taylor rule is a judgment of financial conditions, and the Taylor rule suggests that financial conditions are tight because real Fed funds rates are higher and getting higher as disinflation occurs.

• 16:12Demetri Kofinas?

  So the Taylor rule, the data upon which the Taylor rule depends is what? GDP, unemployment rate? What are the key metrics?

• 16:20Speaker 01

  There are two metrics. There's output gap, and there's also a secondary way that people look at that, which is the labor gap, but also inflation, the desired inflation target, the actual inflation that's being experienced. And the employment rate fits into that version where you have the labor gap. So.

• 16:45Speaker 01

  It's all in there. And in the most recent SCP in September, the Fed projected a 4.4% unemployment rate. It's currently 4.1, but was 4.3 after that bad NFP in August, which seems to have panicked the Fed a bit. And PC inflation, based on, you know, we'll get a lot of information this weekend, this week with the CPI. PC inflation is going to really, really struggle to come in anywhere close to 2.6% on an annualized basis. And probably

• 17:23Speaker 01

  will be 2.8 to 3%, where they had a 2.6% target. And GDP growth, they had a 2% target, and it's going to be hotter than that for sure. So pretty much every factor, what I call the three legs of the tailor roll, are suggesting the Fed shouldn't cut, but they probably will.

• 17:46Demetri Kofinas?

  Well, haven't they, sorry, didn't they, you mean to cut again? They just recently cut.

• 17:50Speaker 01

  Yeah, yeah, they cut.

• 17:51Demetri Kofinas?

  If they continue on their cutting cycle. So let's, again, let's, I want to, what I want to do here is also create structure for the listeners.

• 17:57Speaker 01

  I thought they would have cut, I thought they were going to cut in November. They did. I think they're going to cut in December. They shouldn't, but you know, that's, I'm not the Fed.

• 18:06Demetri Kofinas?

  So, great. So, we're going to do a number of things here. First of all, I just want to clarify some acronyms you threw out in case people are, SCP is the summary of economic projections, and NFP is the non-farm payroll number. I think, I want to clarify something for listeners who might be confused here, because what you're basically saying is, financial conditions are loose. We need to slightly tighten them so that they don't become much tighter themselves on account of the bond market significantly increasing term premiums, which is to say, demanding a higher return for duration risk on long bonds.

• 18:40Speaker 01

  Right.

• 18:40Demetri Kofinas?

  And counterintuitively, your, your way of achieving looser financial conditions is by raising the short-term interest rate, or your suggestion for the Fed is to, is to raise, not raise, sorry, or is to not, to not lower short-term interest rates, which, again, counterintuitive for someone listening is saying, wait, so Andy wants to loosen financial conditions slightly by keeping a higher short-term interest rate. How does that work? Explain for listeners what they might be missing in that concept.

• 19:10Speaker 01

  Right. So firstly, the way I want to describe it is I don't want the Fed to be as loose as they are planning, to ease as much as they are planning. I'm not suggesting they tighten. I'm saying ease less.

• 19:27Demetri Kofinas?

  Ease less using the Fed funds rate as the proxy and forward guidance.

• 19:32Speaker 01

  And forward guidance, which is what the summary of economic projections provides and their rhetoric. So I'd want them to ease less, if at all. Now, if they ease less, let's just say that means tighten, right? Okay, you're right. It means tighten. Hazing less means be more tight. So one would think that if you're saying keep short-term interest rates higher, that should tighten the economy and risk a harder landing. Well, that's true, that I am suggesting that because the alternative of staying loose for longer is that the long-term interest rate, which,

• 20:15Speaker 01

  as I said, the Fed is very focused on the Fed funds rate, and I am very focused on what is actually happening and impacts the economy, which is the longer-term interest rate and financial conditions as I've defined.

• 20:29Demetri Kofinas?

  Because the credit complex takes its cue more from the long end than it does in the short end. Mortgages, car financing, stuff like that.

• 20:36Speaker 01

  It's interesting. You have to look through history about when, like, the short-term rate was the only thing they ever used in the past. Until 2007, that's all they used. The money supply and the short-term rate. There was no QE.

• 20:48Demetri Kofinas?

  What was the weighted average maturity of the Fed's portfolio pre-2008?

• 20:52Speaker 01

  They didn't have one.

• 20:53Demetri Kofinas?

  It was all short-term?

• 20:54Speaker 01

  Yeah, they didn't purchase financial assets. The only way they created money or had money supply is by doing repo or reverse repo, depending on whether they wanted to increase. That is an asset purchase program. They had no asset purchase program prior to 2007. You know, some people like to go back to the 40s. They had an asset purchase program in the 40s. They had yield curve control in the 40s, but were, I think, getting distracted. The point being that cutting interest rates does not necessarily cause long-term bond yields to fall. Cutting the Fed funds rate, which is the overnight interest rate,

• 21:34Speaker 01

  does not necessarily cause long-term rates to fall. And you can see that pretty clearly. It doesn't necessarily even mean two-year rates fall when you cut the short-term interest rate. They cut 50 basis points in September on the overnight interest rate, and two-year interest rates rose by 80 basis points, and 60 basis points, and 10-year interest rates rose by 80 basis points. There's your counterintuitive point. I just urge people to differentiate raising and lowering

• 22:16Speaker 01

  the overnight interest rate, meaning the rate people get on money markets, versus changing the long-term rate, which the Fed doesn't control, the market does, unless they're pursuing QE and then they have an influence. So the point being, we already saw the reaction in long-term interest rates, which rose 80 to 100 basis points since the Fed cut 50 basis points. And I'm suggesting that if they keep doing that, cutting more than the market needs, long-term interest rates will go up even more, which will be an aggressive tightening in financial conditions

• 22:59Speaker 01

  and threaten the real economy, which is actually borrowing at the long-term rate.

• 23:07Demetri Kofinas?

  Yeah, so this, I think, is a really important concept, and I hope that people got it. And it's another way of saying that you think that the bond vigilantes are not dead, and that the market still has a say in terms of what the price of credit should or could be, and that financial conditions can be tightened outside of the Fed's control.

• 23:26Speaker 01

  Yeah, I mean, there's this term, "bond vigilantes." I don't know who those guys were or what they were doing, but, you know, if you look at bonds, do you want to own them here or don't own them here? There's not a lot of people that are active managers of money that think the 10-year bond is a great value relative... I mean, it could rally in the next two, three weeks, who knows? But is it a great value relative to cash right now? There's very little... Now, that said, who's buying it all? There are buyers, and I think they tend to be some of the long-only money managers who are allocating to risk parity, 60-40, anything that has a bond component. Pension funds, insurance companies, all are sort of consistent buyers of treasuries,

• 24:11Speaker 01

  and they are the buyer. And there isn't been sort of what I would call a buyer's strike. And so it means that there's probably not much value in bonds right here, but, you know, is somebody going to step up and challenge that? That I think the data and the Fed will determine whether somebody steps up and starts selling those bonds.

• 24:34Demetri Kofinas?

  Let me clarify something. So first of all, is your presumption that the Fed believes that inflation is beat and it's returning to target?

• 24:41Speaker 01

  Absolutely.

• 24:42Demetri Kofinas?

  Okay.

• 24:43Speaker 01

  Well, I don't know about that. Powell certainly does. I don't know if the whole committee is of that mind, but Powell, Powell in his press conference this week, or last week, was so certain in describing the components of inflation and how they were going to target.

• 25:00Demetri Kofinas?

  So if he's right, and inflation is returning to target, would that be sufficient for you to change your mind? Or would concerns about financial stability resulting from easy financial conditions still be a concern? Because we had low inflation in the early 2000s, and you could make the argument that the Fed's myopic focus on CPI and PCI blinded it to the inflation of asset prices and the party that was happening in the real estate market and in structured products and derivatives.

• 25:30Speaker 01

  I think if we continue to see data that supports an economy that is having real growth at trend, not above, that has employment that is not getting tighter.

• 25:46Speaker 01

  And has inflation that continues to return to target that the financial markets will normalize.

• 25:54Demetri Kofinas?

  So let's dig into a little bit more into the macroeconomic picture that would determine some of this. I mean, you touched on a number of these points in your initial answer to my first question of the interview, but let's again create some more structure around them and let's especially dig into the government's finances, which is an important part of this. What is the story that you would tell, the macro picture you would draw about the economy inflation and especially the government's finances, including quantity and duration of issuance and the effect that these variables have on the financial conditions and on Fed policy?

• 26:26Speaker 01

  Right. So again, I think the economy is doing very well. Real growth is above trend boosted on because population growth might have been modestly improved by immigration policies of the last four years and productivity appears to be a productivity miracle in place that's generating trend growth that might be to and a quarter percent, but we're still higher than that. Inflation is, in my view, sticky and still above target, but you know, is going in the right direction. And labor is in great shape, historically great shape, but not as hot as it was in mid COVID and post.

• 27:10Demetri Kofinas?

  And assuming also that this latest NFP print is also very noisy and doesn't, let's say, suggest a deeper trend because it wasn't a good print.

• 27:18Speaker 01

  Yeah, no doubt. I'm not a big believer in over analyzing individual prints and I look at the panoply of data that represents the job market and I don't see a reason to be extremely concerned.

• 27:37Demetri Kofinas?

  So, okay, so let's dig in on the government's finances. What is the state of the government's finances? How has the yield on long-term debt been suppressed in your view? Because I think that's an argument you've made with respect to how the Treasury has managed its issuance, as well as how the Fed has managed runoff and reinvestment of its portfolio. And how should we think about that long-term?

• 27:59Speaker 01

  Let's take a snapshot. So, taking a snapshot today, approximately 25% of the outstanding U.S. debt is composed of bills and floating rate notes. And so those are, they have very short-term maturities, or they have essentially three month duration in the case of the floating rate note. So they are for all intents bills. And so they're very subject to the changes in interest rates, because once you finance a 10-year bond, you have 10 years before you're exposed to a change in yields. And so that's the current distribution of existing U.S. debt.

• 28:42Speaker 01

  And that's on the high side of the amount of bills outstanding. Typically, what the government does is it keeps its issuance of coupon bonds, which are two years and longer, out to 30 years, relatively stable and predictable over time. They typically grow because the deficit and the national debt grows, but stable and consistent. And in times when there's high demand for government spending, or the economy falls apart, and there's low tax revenue, and to maintain spending, they need to borrow more aggressively, they borrow with bills. And so the bills percentage goes up.

• 29:28Speaker 01

  Typically, that happens, and it has consistently happened during recessions, where the tax revenues go down because of lower economic activity and the spending goes up because of people out of work and the need for a safety net and you get more financing, which is done with bills.

• 29:47Demetri Kofinas?

  And also, in the recent recessions, short-term interest rates have fallen dramatically. Is that also a reason why?

• 29:52Speaker 01

  It doesn't typically have to do with market timing of interest rates. What it typically has to do with is, because if that were the case, locking in 10-year notes, which a number of people, I think Druckenmuller mentioned, criticized.

• 30:08Demetri Kofinas?

  For not doing it during the pandemic.

• 30:10Speaker 01

  Not doing it during the pandemic, when they could have financed 10 years at 1% and now they're financing bills at 4.5%. The problem is that during a period of time in which interest rates are at 1%, selling a bunch of risky bonds to the market at 1% and financing in the 10-year space is a major tightening of financial conditions. It forces people to shift from assets that they already own into these 10-year bonds, which are risky.

• 30:45Demetri Kofinas?

  Which locks them in.

• 30:46Speaker 01

  Which locks them in, but also are just risky. They're volatile. Forget that they're low interest rate. They're just, this could have happened at 5% interest.

• 30:53Demetri Kofinas?

  And we saw this with regional banks that owned US Treasuries at lower interest rates after the Fed began to raise interest rates and they had to set up the Bank Term Funding Program. Is that an example?

• 31:01Speaker 01

  Right. So, yes, the point being that if you want to borrow money fast, you borrow it at the part of the yield curve that is, has the most demand. And the part that has the most demand is the part that's most cash-like, because people will pretty much all day long give up their bank account or their cash to buy a one-month bill. But asking them to give up their cash for a 30-year Treasury? Is much less likely to get large amounts of supply. You know, we're talking about massive issuance that happens during recessions. Now, let's just move forward. We haven't had a recession here.

• 31:45Speaker 01

  We're issue over the last, you know, two years since quantitative tightening started. And by the way, since that happened, you know, things have been pretty damn good. In the last two years, 50% of the debt that was issued that is now outstanding was bills. Instead of 25%, which is where they were.

• 32:07Demetri Kofinas?

  By the treasury, debt issued by the treasury.

• 32:08Speaker 01

  Outstanding by the treasury. So they significantly issued bills relative to coupon bonds during a period when things were pretty good. And so what does that mean? So what it means to the financing of the country is that over time, getting back to a more normal, again, this is about normalization, a more normal level of treasury bills relative to total issuance, total outstanding of treasuries, below 20% is a target. And to get there, you need to issue a trillion dollars of coupon bonds and retire a trillion dollars of bills.

• 32:52Speaker 01

  And so that's the snapshot. That's what the current status of the portfolio of the US treasury and the direction it needs to go.

• 33:01Demetri Kofinas?

  Now, in order to normalize, what is the role that needs to be played by treasury? And what is the role that needs to be played by Fed? And in the absence of cooperation by treasury, in other words, if the treasury wants to continue issuing short-term paper, what can and should the central bank do in this case?

• 33:19Speaker 01

  Okay, so the impact of not extending issuance, meaning not issuing on the longer end of the yield curve, coupon bonds, twos, threes, fives, sevens, tens and thirties, is that that eases financial conditions. Because people who would otherwise have bought those bonds can buy something else like corporate bonds, which would give corporates the ability to buy shares. Or they might actually buy shares, or they might buy crypto, or they might buy something with the money that they would otherwise buy those bonds with. And so it's an easing of financial conditions.

• 34:00Speaker 01

  It means that savers have a narrower amount of things to save. And that means that there is, you know, cheaper borrowing. So that's the impact that would happen. Now, the Fed could say, fine, we think financial conditions need to ease. That's what they're saying now. They think they're restrictive. So they may play along. And in fact, I think they have played along with that all the last few years. As the Treasury definitely did what it did. And the Fed definitely has been saying for over a year now that their policy is restrictive.

• 34:40Speaker 01

  So will they continue to play around? I don't know, maybe.

• 34:43Demetri Kofinas?

  So just to clarify something here, because again, this is the other side of the conversation. Not this, this is a compendium to the conversation about the Fed's policy on short term interest rates, which is balance sheet management. Your criticism has been that they should have reinvested runoff from the portfolio into shorter duration securities rather than to longer duration. And also that they should have conducted outright sales. What exactly has been your criticism of the Fed's balance sheet management? And again, this is part of the larger argument that you've made that we need to get back to some kind of normal conditions. Because if we don't, the market will impose them on us and it'll be much worse.

• 35:22Speaker 01

  Right. So when quantitative tightening was announced in December of 2021, I said that this was kryptonite for markets and that we are going to experience a significant sell off in financial assets. And actually, I was a little slow to adjust, but ultimately that is in fact what happened in the la- in the next nine months. But at the same moment that I said all those things, I also said that what had happened is that the Fed was going to use what is called runoff to do quantitative tightening versus what the UK does in which instead of letting, well, let me explain both what are those things are since

• 36:07Speaker 01

  I sometimes assume that everybody knows all this stuff at this stage. So let's start with what is runoff? That means that the Fed has a bunch of bonds. And when they mature, they let them mature and that's all that happens. And so their balance sheet is reduced by having their bonds mature and turn back into cash. So that's what runoff is. Outright sales are saying, I've got a bond, I'm going to sell it to the market. And it may have two years to maturity, it may have 30 years to maturity, but I'm going to sell it to the market. And so those are the two ways that quantitative tightening can be done. The Fed chose the runoff way.

• 36:45Speaker 01

  Now, that doesn't mean that one is outright selling of bonds and the other is this sort of silly thing that just, because the money that the Fed gets when a bond matures has to come from somewhere. And it has to be funded in some way. And the way it's funded is by the Treasury issuing bonds. So what quantitative tightening done via runoff does is it takes the choice of what bonds to sell for optimal monetary policy reasons from the Fed, who could have sold the bonds outright, but chose to runoff, to the Treasury.

• 37:30Speaker 01

  And they get to choose what bonds are sold to the market, what bonds the market has to absorb, and thus what bonds impact monetary conditions. And so that's been my whole view from the get go, which is the, what I call the original sin of the Fed is choosing to use runoff instead of outright sales. But here we are, they've done that. So how has it played out? Well, as I said, since quantitative tightening started, the Treasury has made the choice

• 38:10Speaker 01

  to issue 50% bills to fund their obligations, including paying the Fed back, which is a historically high amount of bills. And so to me, that has muted all of the QT impact. And what it has done is it has created the impact of QT as something that may or may not happen in the future.

• 38:40Demetri Kofinas?

  And it's flattened the yield curve as a result as well, right?

• 38:42Speaker 01

  It's suppressed long-term interest rates. And more the important thing about that is it's kept financial conditions easy. The Janet Yellen, whether intentional or not,

• 38:54Speaker 01

  By selling 50% bills over the period of time when QT was in play has eased financial conditions by keeping long-term interest rates lower than they would otherwise have been if she had just issued that extra trillion dollars in long-term coupons instead of bills. And now she's ended herself in a corner where she's financed so many bills that the next Treasury Secretary is going to have, "Oh, my God, I've got all these bills to roll every year. I need to term out my debt."

• 39:36Demetri Kofinas?

  And it also leaves the Treasury vulnerable to a sudden shift upwards in interest rates and financing costs.

• 39:42Speaker 01

  Right. You know, they have some confidence that the Fed's on their side, though. The Fed's not hiking rates.

• 39:48Demetri Kofinas?

  So you wrote in another DSR report that you published, I think, two weeks ago that, quote, "The market has not fully priced anticipated increases in Treasury supply." The expected benign report next week, and this report, I think, was, I don't remember what reporter.

• 40:02Speaker 01

  Quarterly refunding announcement.

• 40:04Demetri Kofinas?

  Quarterly refunding announcement, the QRA. That this benign report next week will likely be met by markets with a sign of relief. However, one day, the market will awaken to the reality that a tsunami of supply is gathering offshore. With yield curves flat and term premiums quite low, markets will eventually feel the obvious headwinds and hunker down for a multi-year storm. So this is what we're talking about right now.

• 40:26Speaker 01

  Right.

• 40:26Demetri Kofinas?

  What is a multi-year storm? And what are you concerned about happening? Because you just said a second ago that the Fed can be cooperative. Is it that the Fed will be caught between having to fund the deficit and rising levels of inflation? What is your concern? What would that storm look like?

• 40:41Speaker 01

  It's so funny. Compared to the conditions today, what I'm talking about looks like a storm. I'm talking about a 50 to 100 basis point increase in long-term interest rates. I'm talking about a yield curve where two-year rates are about where they are today and 10-year rates are 5, 5 and 1/4, 30-year rates maybe 5 and 1/2. I'm talking about a world in which the PE multiple is 18 versus 22.

• 41:18Demetri Kofinas?

  Yeah, we're also in a world, though, where debt and deficits are. Very high and interest payments are extremely high. So those relatively small moves on a historical basis can have huge impact and ripple effects.

• 41:30Speaker 01

  Well, you know, we can discuss the cost of the funding the government and what such a thing, a storm like I've just described would actually cost. And to be honest, it wouldn't cost anything because a higher long-term interest rate is only modestly going to increase the Treasury's cost of debt. If you get that normalization and bills rates fall from 5% to 4% on what is now $6 trillion of issuance, you're going to save 100 basis points on $6 trillion, which is a lot, $60 billion. So I don't want to go off into the how expensive are the proportion of our budget that is interest.

• 42:14Speaker 01

  It's a red herring in my view. People talk about debt sustainability. That is a potential issue in the future, but it's not relevant in the short term. The government can operate at a 4% interest rate, a 5% interest rate, a 6% interest rate. They might struggle at a 10, 11, 12% interest rate. That might be a big issue, but that's not what I'm talking about. That's not the storm. I'm just talking about we've been operating in an environment in which the yield curve has been extremely supportive of assets and not normal. What is normal is a positively sloped yield curve.

• 42:57Speaker 01

  You look at the average slope of the yield curve through all periods in which we're not in the midst of a recession or emerging from a recession, or you just look at every piece of data, the average slope of the 2s, 10s curve is between 75 and 125 basis points. And that's all I'm talking about. And the reason why, you know, my concern is there's a trillion dollars of duration that needs to be sold to the private sector that is currently being warehoused on the balance sheets of the government. There's a lot of demand in a positively sloped yield curve for Treasury bonds. People like to borrow short and lend long.

• 43:40Speaker 01

  People like to borrow at 4% and buy a 5.5% Treasury bond. What they don't like to do is borrow at 5% and buy a 4% Treasury bond. So it's just a very normal and healthy yield curve to be positively sloped. And so I'm not talking about some sort of doomer scenario. I'm talking about the market over time, not in a violent bear steepening, bond vigilante, inflationary, positive growth, all that sort of stuff, crushing the bond market suddenly and taking the legs out of equities in a violent way. I'm just talking about, let's head toward normal.

• 44:24Speaker 01

  Let's get a positively sloped yield curve. Let's get the multiples of equities down, even if it takes three, four years of just caution in terms of financial conditions, instead of aggressive easing that the Fed seems to be on a path to.

• 44:40Demetri Kofinas?

  So I want to dig a little bit more into the fiscal picture and how Trump's agenda on immigration tariffs, tax cuts, and potentially fiscal spending impacts things. I also want to discuss equity markets, the broadening of the equity rally beyond the magnificent seven that's been underway this year, earnings expectations for these companies, whether they're elevated or conservative, how we should go about valuing them, et cetera. But we're going to do that in the second hour, Andy. For anyone who is new to the program, Hidden Forces is listener supported. We don't accept advertisers or commercial sponsors. The entire show is funded from top to bottom by listeners like you. If you want access to the second hour of today's conversation with Andy,

• 45:25Demetri Kofinas?

  head over to hiddenforces.io/subscribe and sign up to one of our three content tiers. All subscribers gain access to our premium feed, which you can use to listen to the rest of this conversation on your mobile device, using your favorite podcast app, just like you're listening to this episode right now. Andy, stick around, we're going to move the rest of our conversation onto the premium feed. If you want to listen in on the rest of today's conversation, head over to hiddenforces.io/subscribe and join our premium feed. If you want to join in on the conversation and become a member of the Hidden Forces Genius Community, you can also do that through our subscriber page. Today's episode was produced by me and edited by Stylianos Nicolaou.

• 46:10Demetri Kofinas?

  For more episodes, you can check out our website at hiddenforces.io. You can follow me on Twitter @Kofinas and you can email me at [email protected]. As always, thanks for listening. We'll see you next time.