Speaker 1: Welcome to COVID Time, a podcast series on Markets and
Speaker 1: Economies from Devious Group research. I'm Tambe, chief economist. Welcome
Speaker 1: you to our 102nd episode today. It's time to take
Speaker 1: a deep dive in the world of global fixed income
Speaker 1: macro from debt ceiling to the forthcoming tsunami of treasury issuances,
Speaker 1: funding conditions to fed rates and quantitative tightening. There's a
Speaker 1: lot to chew on.
Speaker 1: Our guest is an absolute expert on these issues. Musta
Speaker 1: Chori has held senior positions at several leading firms including
Speaker 1: voya Investments, Deutsche Bank, Bear Sterns and Freddie Mac. He
Speaker 1: has a wealth of knowledge and expertise on trading research
Speaker 1: and
Speaker 1: proportio management of G 10 macro rates, mortgage backed securities
Speaker 1: and derivatives. Most recently, Mustafa was the head of rates,
Speaker 1: effects and derivatives at Y investments where he was part
Speaker 1: of a team that managed more than $40 billion in
Speaker 1: institutional fixed income portfolios. Must chori a warm welcome to
Speaker 1: Cope Time.
Speaker 2: Thanks for having me on your show and congratulations on
Speaker 2: uh more than 100 100th episode at this point.
Speaker 1: Thanks very much. And you know, we've been talking about
Speaker 1: having you on for a long, long time. So I'm
Speaker 1: finally glad that between your busy schedule and travel, you
Speaker 1: manage to squeeze in some time for us, but I
Speaker 1: will take full advantage of that one. So I have
Speaker 1: lots of questions for you. So, uh let's uh, start
Speaker 1: with the recently quote unquote concluded debt ceiling matter. Looks
Speaker 1: like we're done for a couple of years. What should
Speaker 1: we take away from this drama? And what about the
Speaker 1: eventual resolution that we have right now?
Speaker 2: Uh I think the drama ended a lot better than
Speaker 2: I had anticipated. Uh I had, I was uh deeply
Speaker 2: uh uh
Speaker 2: uh uh uh uh part of our observing 2011 and
Speaker 2: 2013 drama and that those both of those ended with
Speaker 2: a lot of volatility and anxiety, et cetera this time around.
Speaker 2: Uh It clearly shows some maturity among the key players
Speaker 2: and so it ended without too much shock. Uh in
Speaker 2: the market 2011 was really ugly
Speaker 2: uh with even rating agencies not knowing what to do
Speaker 2: um downgraded right in the middle of the whole drama.
Speaker 2: This time, rating agencies away from everything. So I, I
Speaker 2: very encouraged by uh the maturity shown by the players.
Speaker 2: Uh what will happen politically. I don't know, there will
Speaker 2: be some turmoil probably in, within individual parties, probably in
Speaker 2: the Republican Party, but that's a different story.
Speaker 1: So you wouldn't say there was any winner or loser.
Speaker 1: This seems like possibly the best of all worlds, a
Speaker 1: bit of a win, win for everybody.
Speaker 2: Well, winner clearly is Biden administration uh in the deal, it,
Speaker 2: they got a much better deal than uh initially anticipated
Speaker 2: and the Republicans, the G O P got a worse
Speaker 2: deal than what they were significantly worse deal than relative
Speaker 2: to what they were asking for. Um And Biden also
Speaker 2: got two years,
Speaker 2: uh time got the and so it don't come up
Speaker 2: until after the next uh coming election.
Speaker 2: So uh winner clearly uh is Biden administration. But as individuals,
Speaker 2: both uh speaker mccarty and President Biden won for their
Speaker 2: personal carriers.
Speaker 1: The uh most of all we are having this discussion
Speaker 1: on the sixth of June. I remember a couple of
Speaker 1: weeks ago, Janet Yellen saying by the first week of June,
Speaker 1: the treasury would be basically out of cash. Um So
Speaker 1: even though the deal has worked out, they need to
Speaker 1: replenish their cash balances. And we're hearing all these astronomical
Speaker 1: numbers about how they have to issue like a trillion
Speaker 1: dollars worth of treasury. And it could have some seismically
Speaker 1: destabilizing impact on the market. What are your views on this?
Speaker 2: Um I don't think it's uh it will be destabilizing
Speaker 2: but it will be important and probably will provide opportunities
Speaker 2: for investors. I think that um they will probably target
Speaker 2: replenishing the PGA that uh uh the uh the treasury's
Speaker 2: account in the Federal Reserve to about 500 billion from
Speaker 2: near zero at this point.
Speaker 2: And so 500 billion plus the ongoing funding needs uh
Speaker 2: could get to a trillion dollars. Uh I think that
Speaker 2: the the treasury will uh focus more on the short
Speaker 2: end of the curve because there is uh the biggest challenge.
Speaker 2: Uh challenge will not be selling the E bills. I
Speaker 2: think there will be enough demand for, for T bills
Speaker 2: just because uh of the higher rates and transition from
Speaker 2: bank deposits to money market funds.
Speaker 2: I think the, the challenge uh would be uh
Speaker 2: not to disturb the reserve bank reserve positions as much
Speaker 2: and try to take away from the revers of uh
Speaker 2: the book of business, the rev reversible funding uh that
Speaker 2: the fed has so the, the slight cheapening or some
Speaker 2: cheapening in T bills will be healthy because that will
Speaker 2: allow
Speaker 2: uh money market funds to switch from reverse people positions
Speaker 2: within the feds that uh with the fed to buying
Speaker 2: G bills uh without fed, having to shrink the bank
Speaker 2: reserves too much. Uh My biggest worry is that uh
Speaker 2: the system is not uh ready to handle large sudden
Speaker 2: changes in bank bank reserves and we can come to that.
Speaker 2: Uh This is a whole lot, whole topic by itself.
Speaker 2: Uh But, but uh it was a bit cheaper and
Speaker 2: it uh and an opportunity probably to buy T bills.
Speaker 1: Would you uh consider the possibility that that half a trillion,
Speaker 1: which is above the sort of the target balance that
Speaker 1: they absorb uh because they need to spend, but they
Speaker 1: go ahead and spend it immediately and the cash then
Speaker 1: just goes back to the economy within a month or
Speaker 2: two.
Speaker 2: Um
Speaker 2: The uh go goes back. Uh
Speaker 2: uh I am uh I'm, I'm not totally sure they,
Speaker 2: uh the uh that's, I, I don't know there is any,
Speaker 2: anything that the, that was uh pending or postponed in
Speaker 2: terms of spending. Uh There, there were some coupon payments
Speaker 2: to some trust funds, et cetera. That was the only
Speaker 2: extraordinary matter that the treasury did in the last
Speaker 2: 5.5 months or so.
Speaker 2: So I'm not sure that, that, that itself will be
Speaker 2: very stimulated because the cap will go to the uh
Speaker 2: on the a the asset side of the pet balance
Speaker 2: which will not increase as well. It will just be
Speaker 2: a rebalancing. They're not seeing a huge um stimulus to
Speaker 2: the economy just from that cash. It's more of a
Speaker 2: valuation between bills. Um And uh also the reverse repo
Speaker 2: rates as well as the um
Speaker 2: uh the banks having enough reserve. That's the biggest question,
Speaker 1: correct. Um So Mustafa, you said earlier that there is this,
Speaker 1: you know,
Speaker 1: need for replenishing the target balances. And then uh we're
Speaker 1: gonna have this large insurance which may or may not
Speaker 1: have a establishing impact with the question mark around reserves.
Speaker 1: But who is going to buy this? Um Are we
Speaker 1: talking about non-bank financial institutions with a substantial need for
Speaker 1: short term securities or who else is out there are
Speaker 1: a large demand internationally. What's your sense of the investor
Speaker 1: base that will pick up this issue?
Speaker 2: I think that will, that will be an increasing challenge
Speaker 2: to sell treasuries. Uh Right now, the uh the cushion
Speaker 2: between the H two L A, the H T L
Speaker 2: A cushion for banks is fairly tight. So we might
Speaker 2: see banks try to buy more bills and uh take
Speaker 2: uh get out of uh reduce some of the other
Speaker 2: longer duration assets, et cetera. Uh Just because they trust
Speaker 2: a lot of
Speaker 2: changes are coming in terms of banks uh managing their
Speaker 2: balance sheets as well. Uh I also think that investors
Speaker 2: in general, uh this is an uh for them to
Speaker 2: remain a
Speaker 2: remain more, having a higher rate in cash and using
Speaker 2: bills uh would be uh would be another source of
Speaker 2: um buyers in the in the bills market. But over,
Speaker 2: over a, over a longer horizon, there is a big
Speaker 2: challenge for buyers for treasuries. Uh whether it's foreign central
Speaker 2: banks um or banking system, the traditional buyers are uh
Speaker 2: are slowly going to drift away from us treasuries. Uh
Speaker 2: given the size that's coming, not just this replenishment, but
Speaker 2: just the fiscal expansion that's expe expected over the next
Speaker 2: two years that uh selling would be a big problem.
Speaker 2: So in that context, I do, I also think that
Speaker 2: the Q T, uh, they'll have to stop Q T
Speaker 2: fairly soon.
Speaker 1: Ok. I was gonna ask you a question at the
Speaker 1: very end of the podcast and I will ask you
Speaker 1: that question, but just as an early favor. So it
Speaker 1: sounds like you are not particularly bullish to fix and
Speaker 1: come out luck.
Speaker 2: Uh, I am more. Um,
Speaker 2: I'm not particularly bullish at all, uh, in general in
Speaker 2: terms of duration, in terms of, uh rates. But within
Speaker 2: the fixed income, there are areas where there is value and,
Speaker 2: but generally, I think that the fed will have to
Speaker 2: come back after the skip in this week's meeting, but
Speaker 2: uh they will have to come back and hide quite
Speaker 2: a bit.
Speaker 1: All right. Hold on to that thought, we will get
Speaker 1: a deeper into that later. But before we go in
Speaker 1: that direction, I just wanted to ask you your overall sense,
Speaker 1: you know, given this debt ceiling saga and the fact
Speaker 1: that us fiscal debt GDP ratio is, you know, in
Speaker 1: triple digit territory,
Speaker 1: w what would allow for a political consensus to fiscal
Speaker 1: consolidation or is it just hopeless regardless of Republicans or Democrats,
Speaker 1: we will not see meaningful fiscal consolidation in years if
Speaker 1: not decades.
Speaker 2: Uh Yes. And uh I think that we will not
Speaker 2: see any um any sort of fiscal consolidation in years
Speaker 2: to come.
Speaker 2: And uh there's a lot of it in the there
Speaker 2: will be increase in borrowing coming from new sources. Of
Speaker 2: the some of the trust funds are running out by
Speaker 2: the end of this decade. So those will have to
Speaker 2: be run as ongoing entities going forward. So there is
Speaker 2: a lot more insurance needed and this, sorry,
Speaker 1: I just want to interrupt you for one second. So
Speaker 1: by trust funds, you mean social security related
Speaker 2: trust fund by Medicare,
Speaker 2: if Medicare especially is running out uh sometime uh within
Speaker 2: the next 89 years. And so the amount of the
Speaker 2: borrowing that needs to be done just to replenish the
Speaker 2: trust funds or making it an ongoing uh making it
Speaker 2: ongoing rather than using trust fund. Uh will the borrowing
Speaker 2: will go up a lot but interest payments is going
Speaker 2: up also astronomical level, we keep touching a trillion a
Speaker 2: year and these high rates.
Speaker 2: So you uh yes, I I I don't see any
Speaker 2: sort of fiscal consolidation coming up or any kind of ignorance,
Speaker 1: right? So it goes back to your earlier point of
Speaker 1: not being particularly constructive of this income outlook. Um So
Speaker 1: a few months ago, I was visiting you in Washington
Speaker 1: DC and we were talking about the information content in
Speaker 1: the yield curve. Uh It's deeply inverted, it expects lots
Speaker 1: of cuts within a 12 to 18 month horizon.
Speaker 1: Uh Is it necessarily pricing and recession and rate cuts
Speaker 1: or there's something else going on with respect to the
Speaker 1: market structure that we tend to have such steeply inverted
Speaker 1: yield curve?
Speaker 2: I I, I don't think it's, uh, maybe a little
Speaker 2: bit of recession, but I don't think it's, uh, reflecting
Speaker 2: recession or impending recession. Because if you look back a
Speaker 2: year ago, the curve was equally sort of like a
Speaker 2: hockey stick shape is steep decline for the next
Speaker 2: eight quarters and fairly flat after that. And it remained
Speaker 2: the same shape for last one year. So, if the
Speaker 2: yo was any predictor of recession, recession would have uh
Speaker 2: come any uh already by this time. But there's no
Speaker 2: sign of recession. And I don't think when it comes,
Speaker 2: it will be uh
Speaker 2: nowhere close to where the yield curve is telling us.
Speaker 2: I think yellow curve reflects uh mostly markets
Speaker 2: extremely positioned for uh the carry that's available. It's unusually
Speaker 2: large carry from uh betting against the easing that's pricing
Speaker 2: the curve and it's so large that it doesn't allow
Speaker 2: the curve to move much. So every time fed height,
Speaker 2: then the market rep prices one more height and then
Speaker 2: in the curve and not the terminal rate
Speaker 2: and then an offsetting ease after that. And that reflects
Speaker 2: more positioning rather than uh a any kind of uh
Speaker 2: recession uh ahead of us. And I don't think us
Speaker 2: is anywhere near a recession.
Speaker 1: OK. So the flip side of the uh lack of,
Speaker 1: you know, information content in the um inversion of the
Speaker 1: yield curve is also the question that what are the
Speaker 1: uh inflation expectations market telling us? So when we look
Speaker 1: at tips for the five plus five implied inflation rate,
Speaker 1: very well anchored 2.4% 2.5% that doesn't shift. Although in
Speaker 1: the near term, everybody seems to be rather worried about inflation.
Speaker 1: How do you reconcile these two uh perspectives coming from
Speaker 1: the market?
Speaker 2: I think the tips curve is under pricing. Um
Speaker 2: The the tips uh break evens like in the intermediate
Speaker 2: part of the curve uh real rate at so 17
Speaker 2: sort of range, um 10 years sort of uh 1
Speaker 2: 61 51 60 range. The uh the break even on
Speaker 2: between 2 25 I to 2 40 I uh break
Speaker 2: that break even is really low. The the you can
Speaker 2: look at
Speaker 2: many sources to compare why I think it's the first
Speaker 2: Michigan uh consumer expectation one year forward one year, it's
Speaker 2: still 4%. And so 4% minus 2.25, you have 175
Speaker 2: basis points gap between what consumers are expecting versus what
Speaker 2: the tip curve tip curve is staying at.
Speaker 2: Uh So I think that the real rate either the
Speaker 2: real rate is too low uh at five year at
Speaker 2: 1 70.
Speaker 2: Uh And remember also that the Michigan consumers uh one
Speaker 2: year ahead forecast is actually very reliable. If you look
Speaker 2: at 2000 and uh 21 when even uh Chairman Powell
Speaker 2: was saying transitory, et cetera, et cetera, the Michigan consumer
Speaker 2: expectation was actually fairly high.
Speaker 2: And uh so, and that's, that's more of what the
Speaker 2: consumers are feeling on a day to day basis. So
Speaker 2: my feeling is that the market is uh somewhat underpricing
Speaker 2: either uh future uh inflation or uh uh or uh
Speaker 2: also underpricing the fact that uh some
Speaker 2: uh sources of inflation are robust and chances of coming
Speaker 2: back up is very high. And one of them that
Speaker 2: I'm watching quite closely is rental inflation.
Speaker 2: So they initially the views among economists where that there
Speaker 2: is a 12 month lag uh between the real time
Speaker 2: rental measures and the shelter component of CPR and it
Speaker 2: will gradually get incorporated. And so the expectation was that
Speaker 2: uh we'll see the shelter component gradually uh decline and
Speaker 2: which has been the case.
Speaker 2: But if you look at the recent data on rental,
Speaker 2: whether it's uh zero dot com or if you see
Speaker 2: the rental uh read uh the margins and the profits
Speaker 2: of rental rates, the pricing power is very high in
Speaker 2: the rental uh in the apartment industry. And also the
Speaker 2: rent versus buy decision is that is obvious that uh
Speaker 2: rent overwhelms buying
Speaker 2: because of the mortgage rate and the monthly payment. So
Speaker 2: rental is coming back real time rental is coming back up.
Speaker 2: So it will be another shock few months down the
Speaker 2: line that we'll start to see shelter components to P
Speaker 2: I instead of declining as expected starts to go back up.
Speaker 2: So uh all of these are not priced in the
Speaker 2: tips market. So that's one of the recommendation I'm making
Speaker 2: our clients is uh a long term uh value of
Speaker 2: the curve value of the tips curve is probably good
Speaker 2: value plus. Uh this whole question of uh is this
Speaker 2: R star et cetera, which I I'm nervous about
Speaker 2: uh of piling on uh that whether our star has
Speaker 2: gone up a lot and what it is et cetera
Speaker 2: uh is given, given all the other things that have
Speaker 2: been changing structurally. Um buying tips is probably a good idea.
Speaker 1: That's very interesting. So I have to say that one hand,
Speaker 1: you know, there is this question, whether the R star
Speaker 1: is going up or not. And then there is this
Speaker 1: question of this R star star, the financial stability related
Speaker 1: interest rate, whether that the system cannot really absorb the
Speaker 1: actual R star, it'll collapse long before that. Um So
Speaker 1: it seems to me that the market is also sort
Speaker 1: of betting on that, that, you know, 2% inflation will
Speaker 1: never happen,
Speaker 1: any attempt to get there would create a major financial crisis.
Speaker 1: So let's just not assume that inflation will stay high
Speaker 1: uh or rates will stay high even if inflation stays high.
Speaker 1: I'm gonna come back to that because I want to
Speaker 1: ask you two questions on us, fiscal and monetary policy.
Speaker 1: The first one is fiscal, then we'll come back to
Speaker 1: monetary in a second. So Larry Summers famously, almost two
Speaker 1: years ago, wrote that the Biden administration
Speaker 1: um repeated fiscal measures were going to be stimulatory excessively. So,
Speaker 1: and would be inflationary. Now, he had made other nuanced arguments,
Speaker 1: but that's the argument that is stuck and he's become
Speaker 1: so extra famous for making that. So, are you in
Speaker 1: his camp that the last couple of intimate measures on
Speaker 1: the Biden administration coming into office in 2021 was the,
Speaker 1: so the Camels back if you will, that was broken
Speaker 1: and inflation picked up because of that.
Speaker 2: Yes, I totally agree with that. I think that uh
Speaker 2: that took us to about six trillion of uh fiscal spending.
Speaker 2: And remember the student loan forgiveness is still sitting in
Speaker 2: the court system and that will push uh add another
Speaker 2: trillion into the system. So uh uh I totally agree
Speaker 2: with uh Larry Summers on this point that we actually
Speaker 2: went pretty far
Speaker 2: uh even before the Biden a station, the in terms
Speaker 2: of the responses to the uh to COVID. But that's
Speaker 2: sort of hard to judge because if no one knew
Speaker 2: at that time, uh what the, what the total impact
Speaker 2: of COVID would be. But in the last couple of years,
Speaker 2: it's known and we COVID is under control and we
Speaker 2: are still spending uh almost out of control. So I
Speaker 2: think I, I totally agree that uh the fiscal
Speaker 2: uh impulse has been a key driver of the uh
Speaker 2: demand side of the inflation. Equation at least.
Speaker 2: And the supply side was already there.
Speaker 1: Right. Right. And, and now we're seeing supply side easing,
Speaker 1: but the demand side is still not going away
Speaker 2: and, uh, unlikely to go anytime soon.
Speaker 1: Right. Ok. But what about the fat? I mean, do
Speaker 1: you have any sympathy for the ft that it's easy
Speaker 1: for us to look back and say they should have
Speaker 1: started hiking much earlier. But given the information they had
Speaker 1: at that time, uh they probably did the best they could.
Speaker 1: I'm sort of using the Paul Krugman argument. Do you
Speaker 1: have any
Speaker 2: sympathy with that?
Speaker 2: Uh
Speaker 2: Not as much because I think that uh F F I, I,
Speaker 2: I think that the fed has uh fed had uh
Speaker 2: or rather, I'd rather say that this fed
Speaker 2: even before all the dash New Davis members join is
Speaker 2: inherently Davi.
Speaker 2: And so they want always an excuse not to hike
Speaker 2: even now, uh You see, uh the, this whole skip
Speaker 2: versus pause, there is the wording. So there is an
Speaker 2: inherent ness in the Fed and this whole uh transitory
Speaker 2: versus permanent and leaning towards transitory and then suddenly change.
Speaker 2: All the impatient data was
Speaker 2: fairly strong throughout 2021. Not until November that the chairman
Speaker 2: uh first time mentioned something about non transitory. So I,
Speaker 2: I do believe that there, there, there, there was a
Speaker 2: somewhat of a policy error in 2021 we are paying
Speaker 2: some price for that.
Speaker 1: Um Earlier, you said that you don't necessarily see a
Speaker 1: major recession on the horizon. You see rental prices, you know, again,
Speaker 1: ratcheting up demand being strong.
Speaker 1: Um but we've had substantial policy tightening in the last year. Mustafa,
Speaker 1: and we saw perhaps a bit of that percolating through
Speaker 1: the banking system in March and April. Are you worried
Speaker 1: that there are other areas, there are other fault lines
Speaker 1: to borrow a phrase from Ra Ra Rajan that there
Speaker 1: are other fault lines that are lurking here and there
Speaker 1: that would uh cause us some distress by forward.
Speaker 2: Um
Speaker 2: within the banking system there is I I'm not sure
Speaker 2: prices personally. Uh
Speaker 2: in terms of the way the market is positioned, I
Speaker 2: wanted to uh mention that before I answer this question.
Speaker 2: If you look at the market,
Speaker 2: the Silicon Valley Bank news when it came out on
Speaker 2: the first week of March, the interest rate, the two
Speaker 2: year rate rallied something like 125 basis points almost overnight.
Speaker 2: And then whenever we get a news about heights, it
Speaker 2: doesn't sell off. So there is an asymmetry in the market.
Speaker 2: So the the rallies are big if a bad news arrives,
Speaker 2: but the selloffs are not are sort of gradual. It
Speaker 2: just shows where the vulnerability lies in the market. The market,
Speaker 2: the bond market is vulnerable to bad news, bad banking news.
Speaker 2: It's just that banking, bad banking news
Speaker 2: is not happening.
Speaker 2: Uh The the interest of uh in terms of the strength,
Speaker 2: why this session is less likely announced when the fault
Speaker 2: lines are coming, the strength of the market,
Speaker 2: uh the, the fed, the and also the economist commu
Speaker 2: the analyst community et cetera, all sort of misread and
Speaker 2: constantly under uh predicting the payrolls that 15 months in
Speaker 2: a row that the payroll forecasts have been lower than realized.
Speaker 2: So the everyone's forecasting a recession, but it's not happening.
Speaker 2: I think that one of the things that
Speaker 2: the most ignored has been how strong the households are,
Speaker 2: the and most of that is because of the lock
Speaker 2: in effect,
Speaker 2: uh that they're locked in a 2.5 to 3% mortgage,
Speaker 2: but they stay, they close to 7% that created a
Speaker 2: lot of implied wealth in the housing household balance, even
Speaker 2: if it doesn't show up in the bank account and
Speaker 2: the impolitic to take risk uh for the households as well.
Speaker 2: And so what it really means is that
Speaker 2: any, any kind of credit tightening does not seem to
Speaker 2: affect the households, uh They seem to be rock solid fan.
Speaker 2: Uh And I think it, that's that that whole lock
Speaker 2: in effect is way bigger and has not been in
Speaker 2: anybody's model because there is no data uh from the
Speaker 2: past for the lock in effect.
Speaker 2: So when it left leaves us, so we can't tighten
Speaker 2: credit for households because they're coming to this hiking cycle.
Speaker 2: So strong and getting stronger. Um
Speaker 2: But at the same time, firms are gradually starting to
Speaker 2: um with show weakness. And the first we start the
Speaker 2: pricing power and the the ability to maintain margin that's
Speaker 2: starting to deplete somewhat. And the weak link really is,
Speaker 2: uh in my opinion, coming from, eventually come, already started
Speaker 2: coming from and get bigger is the small banks
Speaker 2: to small firms
Speaker 2: to jobs and then demand as opposed to path when
Speaker 2: we had demand directly from tightening credit to consumers.
Speaker 2: So there is a few steps that will happen. And
Speaker 2: that's where the main uh a measure weekly because I'm,
Speaker 2: I'm playing with some data on uh small banks, uh
Speaker 2: financial statements for the first quarter. And I see that
Speaker 2: almost all of them have significant decline in non-interest deposits.
Speaker 2: And then they have replaced that with higher interest rate
Speaker 2: bearing deposits uh or a home loan advances which are
Speaker 2: full interest rates, et cetera. So the margin is compressing
Speaker 2: much faster than the aggregate data show that. And if
Speaker 2: you look at the behavior of the small banks in
Speaker 2: the United States,
Speaker 2: they tend to uh lend, they, they, they usually don't
Speaker 2: have securities and they lend to small businesses that are
Speaker 2: mostly relationship based
Speaker 2: and as uh the margins compressing for small banks, the
Speaker 2: small big businesses will have the first hit in terms
Speaker 2: of credit availability from small banks. And we are already
Speaker 2: seeing that, that some of the survey results for small businesses,
Speaker 2: uh N F I B et cetera. Uh The creditability
Speaker 2: for small businesses are
Speaker 2: uh compressing and so, and the jobs, a large portion
Speaker 2: of the job in the US are actually small firms.
Speaker 2: And so that's where we'll see uh the, the weak
Speaker 2: link coming. Uh but that it's slower process than in
Speaker 2: the past. And, but that's that I think is uh
Speaker 2: a major weakness uh going forward.
Speaker 1: First of all, what about the link between banks and
Speaker 1: commercial real estate?
Speaker 2: Uh If there is a uh
Speaker 2: commercial deals, say that you know, that um really uh
Speaker 2: vulnerable
Speaker 2: uh with the vacancy rate uh and office properties is
Speaker 2: extremely large. Uh so, but proportionate. So there will be
Speaker 2: vulnerability uh especially the same banks that are uh also
Speaker 2: uh the small banks will also be hit with the
Speaker 2: commercial real estate uh but also commercial C N I
Speaker 2: loans for local small banks. But middle price banks um
Speaker 2: uh will also be hit somewhat with the commercial real
Speaker 2: estate as they reprice uh going forward.
Speaker 2: Uh But they are not
Speaker 2: the size of the commercial real estate market is still
Speaker 2: not big enough to cause a serious systemic risk of
Speaker 2: the kind that we have seen in 2008 and nine
Speaker 2: from uh residential real estate.
Speaker 1: Um What about non-bank financial institutions? I mean, over the
Speaker 1: last decade and I have private equity venture capital, these
Speaker 1: entities have played such a big role in fundraising, financing,
Speaker 1: the expansion of the tech cycle and perhaps even going
Speaker 1: forward the industrial policy that is being pursued by the
Speaker 1: US government. Um Where do you see those sort of
Speaker 1: financial models which are highly leveraged, which tend to be,
Speaker 1: you know, long gestation period? Can they survive this spike
Speaker 1: in interest rates?
Speaker 2: Um I the, the, the uh those are uh
Speaker 2: I don't know the survival question, but those are, there
Speaker 2: is
Speaker 2: need to study more of those in general. But in
Speaker 2: the analyst circle, uh there is always uh the question
Speaker 2: of what, what does the price thing mean in private equity?
Speaker 2: Uh the all of the, the whole industry is dependent
Speaker 2: on the fact that uh this sector is not market
Speaker 2: to market and therefore will survive. Uh So the point
Speaker 2: uh the thing to look for is what are the
Speaker 2: events that will lead to market to market uh for
Speaker 2: venture capital, for example. And so they all of that
Speaker 2: will depend on the funding uh as they go for
Speaker 2: refunding and every time they go for refunding, they get
Speaker 2: there is a uh mark to market event for private equity.
Speaker 2: So a lot of this, it is
Speaker 2: uh I I think that will happen, the leverage, the
Speaker 2: refunding will be based on the amount of leverage uh
Speaker 2: in that particular industry. And uh so it may be
Speaker 2: a little slower but there is some vulnerability there
Speaker 1: if we are indeed going to have a higher for
Speaker 1: longer interest rate environment. Comment on the international ramifications of
Speaker 1: that every time we have seen an interest rate cycle
Speaker 1: of the US, it's caused emerging market distress going back
Speaker 1: to the eighties. Uh who's gonna get hurt and how
Speaker 1: bad will be that pain?
Speaker 2: Uh I think it's always the emerging market seems to
Speaker 2: pay a price uh as the interest rates um increase.
Speaker 2: Uh take for example what I think. Uh, so we
Speaker 2: will have no hikes this week, but in July, we
Speaker 2: will have another hike and, um, and maybe one or
Speaker 2: two more hikes the rest of this year. So that, uh, the, the,
Speaker 2: we had a little bit of a do in dollar,
Speaker 2: but we will start to see,
Speaker 2: uh, and this next 100 basis point of hike would
Speaker 2: be a surprise for the market because everyone's thinking, oh,
Speaker 2: it's already too high. It's the end of the hiking cycle.
Speaker 2: But suddenly we are heading for 6, 6.5 in rate.
Speaker 2: And so the dollar, uh, will come back into play and, um,
Speaker 2: hit the emerging market. Uh, I think fairly hard that
Speaker 2: if the dollar, uh starts, uh, we already, uh,
Speaker 2: being three towards, uh, with the euro. Uh, so, uh,
Speaker 2: I think probably about one oh 51 oh six now.
Speaker 2: And so that's, um, I worry about that a lot
Speaker 2: in terms of the US consumers being so strong leading to,
Speaker 2: uh, in, in, in, uh, inflation, persistent more height than
Speaker 2: already happened, which should be a complete surprise to both
Speaker 2: analyst circle and the market. And uh at the end,
Speaker 2: emerging markets and FED has not absolutely always ignored that
Speaker 2: part of their policy decision.
Speaker 1: So I share your concern that yes, of course, you know,
Speaker 1: interest rate channel is one that will create refinancing risks
Speaker 1: all around the world. But this dollar channel in my
Speaker 1: view is even more underpriced because everybody that I talked
Speaker 1: to in the street is basically be the dollar. They
Speaker 1: think the fed is about to pause time to go along.
Speaker 1: Euro long y et cetera. If that scenario that you're
Speaker 1: contemplating that there are several more hikes left in this cycle.
Speaker 1: Um I think it's gonna be pretty bad uh through
Speaker 1: the channel as much as it is through the
Speaker 2: interest rate channel.
Speaker 2: And most interestingly is that it will be, it will
Speaker 2: be bad for everyone else, whether it's emerging markets or
Speaker 2: even credit products like high yield. And uh but us
Speaker 2: consumers will still be fairly redeemed. Yes. Which is the
Speaker 2: interesting part of this whole uh this uh this whole
Speaker 2: uh high episode.
Speaker 1: Yeah, or you could say the unfair part of this
Speaker 1: whole episode, the
Speaker 2: unfair part of it.
Speaker 2: And, and I, one thing I will, I will add
Speaker 2: is uh is that I think the the that the
Speaker 2: part dependency, it's not about what the interest rate level is.
Speaker 2: It's the part which the interest rate took to get
Speaker 2: to this point is critical and everyone's ignored that. And
Speaker 2: the fact that we remained at this zero rate environment
Speaker 2: for almost a decade makes a big difference to
Speaker 2: uh of uh of this uh 500 plus basis point
Speaker 2: than if it was just a V shape cut and high.
Speaker 2: But zero for many years and then coming back up
Speaker 2: has changed the structure of different participants in the economy.
Speaker 2: So we have uh the market hasn't been able to
Speaker 2: capture that and so constantly underpricing the terminal uh rate scenario.
Speaker 1: Very, very well put Mustafa I think that academics themselves
Speaker 1: have not spent a lot of time thinking about this
Speaker 1: a couple of episodes ago, we had Robert M Raj
Speaker 1: and he is one of those few academics who have
Speaker 1: been writing fairly consistently about this asymmetry associated with Q
Speaker 1: E versus Q T and the various applications get through
Speaker 1: the banking system. Uh You echoed it also very, very well.
Speaker 1: So yes, I I I that
Speaker 1: um OK. Uh Here's a final question for you. How
Speaker 1: would you construct a fixed income portfolio for next year?
Speaker 1: You've talked about the belly of the tips curve already,
Speaker 1: but give us a little more.
Speaker 2: Yeah, so I the the portfolio that I have been
Speaker 2: uh recommending uh uh my clients is that the tips,
Speaker 2: of course, the value of the tips curve uh potential for.
Speaker 2: Uh and that's mainly because the fed might change its target,
Speaker 2: even if it's, they don't talk about, they won't announce
Speaker 2: it publicly, but uh just change the target to a
Speaker 2: higher level. So a good long term investment investment, I
Speaker 2: also think that the US consumer would be very solid.
Speaker 2: And so uh mortgage US M BS is a good
Speaker 2: buy even at this current level. And mainly because because
Speaker 2: of the lock in effect, American households are not moving
Speaker 2: around as much as they usually do. And so housing
Speaker 2: turnover is at its historic low record low and
Speaker 2: just because everyone's so happy with their mortgage, they don't
Speaker 2: want to move. But eventually there is a certain minimum
Speaker 2: amount of relocation that the society has to do so
Speaker 2: or there's only upside to uh housing turnover. And at
Speaker 2: this interest rate, housing turnover is going to be very
Speaker 2: positive for uh valuation of uh us uh mortgages. I
Speaker 2: also think that uh there's some turmoil coming up uh
Speaker 2: in terms of valuation in the next few months
Speaker 2: with the uh with especially this how this replenishment of
Speaker 2: the um the the PGA account and whether the Reserves
Speaker 2: bank reserves will have to fluctuate because of that. And
Speaker 2: that might create some happening in credit uh corporate credit products.
Speaker 2: So I will pay with some cash uh Now at
Speaker 2: this very high yield and potential for higher rates going forward.
Speaker 2: And then I jump in later in the year, maybe
Speaker 2: a few months down the line in probably there will
Speaker 2: be opportunities in high yield and also opportunities in investment grade.
Speaker 2: It seems like unusually tight for this environment. If the,
Speaker 2: the curve was reflecting recession, the brand don't show it.
Speaker 2: So on that,
Speaker 1: I was just gonna ask you any view on a
Speaker 1: European fixed income.
Speaker 2: Uh the, the uh I think that they, they will
Speaker 2: probably uh well, we, we have about two hikes price
Speaker 2: in uh uh in the. So I, I still think
Speaker 2: the US will be a better buy uh in the,
Speaker 2: in the tip,
Speaker 2: uh especially uh with the higher dollar uh staying with
Speaker 2: the US will probably.
Speaker 1: All right, you're, you're, you're giving us views that is
Speaker 1: not widely shared in the markets. And uh so we
Speaker 1: will remember these
Speaker 2: ones
Speaker 2: time. We'll catch up again a few months down the
Speaker 2: line and see if that comes back and hikes. Oh,
Speaker 2: it doesn't have to
Speaker 1: be a couple of months. I'll, I'll give you long
Speaker 1: longer than that. We'll, we'll release the six months from
Speaker 1: now and we see during the IMF animal meetings, we'll
Speaker 1: probably take stock. Uh Most of us, thank you so
Speaker 1: much for your time and insights.
Speaker 1: All episodes of copy time are available on youtube as
Speaker 1: well as an all major platform uh for podcasts including
Speaker 1: Apple Google and Spotify. As far as our research publications
Speaker 1: and webinars are concerned, you can find them all by
Speaker 1: Googling D BS research library. Have a great day.