Jonathan Matthews' Perspective on Inflation Control and Trading Tactics

Unlock the secrets of macro trading with trading maestro Jonathan Matthews, as he shares the wisdom gleaned from his illustrious career at Brevin Howard. I'm your host, Michael Gayed, Publisher of The Lead-Lag Report, and in this episode, we delve into Jonathan's transition from handling equity derivatives and FX to revolutionizing the way retail subscribers view the markets with his 'Super Macro' analysis. Our exchange is sprinkled with tales of volatility and the rare, golden moments that define a trader's journey, offering you a front-row seat to the thought processes of an industry veteran.

The Fed's recent mixed messages have traders and analysts alike scratching their heads—what's their endgame? Jonathan and I dissect this bewilderment, contemplating the interplay between economic signals, such as the soaring core PCE inflation rate, and the silent response from the Fed. We examine the peculiar timing of rate cut speculations considering global financial uncertainties and the upcoming U.S. election, giving listeners an edge in understanding these cryptic strategies.

To cap off, we probe the U.S. economy's surprising resilience to the Fed’s rate hikes and what this means for inflation control efforts. The conversation transitions to the broader market, where we discuss vulnerabilities and the capacity for potential deleveraging events, contrasting current market conditions with those in the run-up to the 2008 crisis. Plus, we shine a light on the curious case of precious metals amidst a skeptical market. Join us for a session packed with expertise to help you navigate the tumultuous waters of finance.

The content in this program is for informational purposes only. You should not construe any information or other material as investment, financial, tax, or other advice. The views expressed by the participants are solely their own. A participant may have taken or recommended any investment position discussed, but may close such position or alter its recommendation at any time without notice. Nothing contained in this program constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments in any jurisdiction. Please consult your own investment or financial advisor for advice related to all investment decisions.

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Transcript

Speaker 1: 0:08

my name is michael guy, a publisher of the lead lag report. I joined me for the hour as jonathan matthews. Jonathan I I know we connected kind of previously on that other space that we were both on, but it's up to, uh, the audience and me more formally who are you, what's your background, what have you done throughout your career and what are you doing currently?

Speaker 2: 0:23

yeah, thank you, michael. First of all, thank you very much for having me on the show. I'm honored to be here. Just briefly, I was a partner at Brevin Howard. I was a portfolio manager for 12 years there, trading macro, and prior to that I was a trader at Citigroup for about 11 years where I was trading mainly equity derivatives and FX.

Speaker 2: 0:44

Since I left Brevin Howard, I've been managing my own capital. I write an institutional level research piece called Super Macro and that goes out to pretty much someone in every one of the investment banks here in the city of London and a lot of the large hedge funds, and about six months ago I decided to make it available to retail subscribers. So the subscriptions are building up and it basically Super Macro really explains what's going on with the economic data and I give my opinion of what the likely impact is on markets, and I also talk about my own trades. You know I'm still managing my own capital and I put the details in the weekend note for what I'm doing and why. So that, in a nutshell, is what I've been up to.

Speaker 1: 1:32

So I'm going to ask an odd question, but I think, an important one, which is what does trading macro actually mean? And where I'm going with that is look, we all talk macro, everyone loves to talk about macro on FinEx, and I would go back to this point that macro, you know, tells you the likely outcome, but not necessarily how you get there, and trading is about the path, right? So how do you think about trading macro, what that actually means in practice?

Speaker 2: 2:09

Well, that's a hedge fund. Very difficult, actually, because at a hedge fund, as soon as you do a trade, the market to market is going to be against you. So you've got to be very sure of what you're doing and why you're doing it. You've got to be able to analyze the economic data, the fundamentals of the trade, implied volatility. If you're doing volatility, relative value, all those kind of factors and think about why it is that the market has mispriced, whatever it is that you think should be a different price to where it currently is so I used to I've found that, in all honesty, there's probably only one or two really good trades per year. So for a lot of the time you're analyzing the data, you think you find some opportunities, putting on trades in fairly small size, waiting for that really great opportunity. And I've got to say that, since I left Brevin Howard and I've started doing my own research and my own analysis, I've found that whole process clarifying my thoughts, analyzing the data, doing my own research, taking research from a variety of other sources and thinking about whether they've got the correct idea of what's going on. Putting all that together, putting my own charts together where I compare economic variables, see if there's a correlation. Doing all that stuff myself, I found, has improved my trading a great deal.

Speaker 2: 3:41

It's re-crystallized my thoughts, made things very clear, and I've also found that there are certain analysts are just stuck in a particular way of thinking. It's confirmation bias. They have a particular idea that the economy is, for example, going into a recession and they look at every new piece of data. They'll try to find some element of it that supports their view, regardless of the fact that they've been wrong about a recession coming for the last two years. And so I've learned that really you've got to do your own research, you've got to think, work things out for yourself, and I do actually read.

Speaker 2: 4:25

I'm not going to say which research outfit it is, but I have a subscription to a number of different economic consultants. One in particular has been firmly in the economic slowdown camp and has been rotten. But their research is very good and I like to understand their rationale for thinking that it's very good, and I like to understand their rationale for thinking that I disagree with it and I've got my own views about where the US economy is going, but I like to hear the contrary argument as well. Just to sort of as a just to make sure that I'm really thinking along the right lines.

Speaker 1: 4:58

I'm glad you made that point about there's really only one or two good trees in a year, because I do find a lot of people seem to think that the way this game is played is by hitting the singles and the doubles, but in reality you know the game is won from the home runs, right From those junctures where you know you really kill it from a magnitude perspective. The thing is you and I both know the timing of that is always the question mark right. You might have a thesis. I mean gold is a good example of that. Right now. A lot of people have been bulged on gold for a while and now suddenly it's working. You can argue that they were wrong and early, or you can argue that they were just in time, depending on how long your own view of time is. Talk about some of, just from your own trading portfolio, what some of those really big outsized trades have been for you historically. Let's go through some war stories.

Speaker 2: 5:50

Well, okay, I can tell you a great war story going back to when I was at Brevin Howard before the financial crisis and I had really done a lot of volatility, relative value using variance swaps, all kinds of complex structures in equity indices. I had all these relative value trades on and I had some idea of the macro. I didn't focus as strongly on the macro at that time and then in 2007, I don't know if you remember, I think it was around about August there was some kind of funding crisis. The LIBOR spreads blew out, the TED spread blew out and for a long time I'd been reading about the housing market. We knew the housing market was going to collapse and at the time I thought honestly, I felt so sick that I wasn't just outright long volatility, I thought that was going to be the end of the world. When that crisis first started to erupt, it was in 07, but I thought this was the beginning of the end for the markets. And, as it happens, that crisis blew over and the S&P rallied in towards the end of 2007, and it was just the most fantastic opportunity to really get long of volatility in my case, variant swaps, which are a slightly complex way of capturing collapse in the market but that have such a strongly convex payoff If you get it right, you really clean up.

Speaker 2: 7:19

Now, when we went into 2008, those variant swaps really started to pay off. But just to put things in perspective at the start of 2008, the markets were declining, volatility was picking up. Implied volatility on these variant swaps went from 20 to 30. Then it came back down to 20. Then it went back up to 30. The market had a rally I remember this in April of that year and I started giving back a lot, a hell of a lot of money. And then, by the summer of 2008, volatility picked up again. The market was tumbling.

Speaker 2: 7:55

This was before Lehman disappeared. Things were going. You know, I'd made a shitload of money and I really just cashed the whole lot in. I thought this is as good as it gets. It's going to be a great year. I don't have to do anything for the rest of the year and I'm going to pay the load of money. It's great, cashed the whole lot in and, of course, then Lehman blew up and I missed out on probably making three times as much. It's not the end of the world, but just to your point, michael, timing is really difficult Now. I could have been a long variant swaps the prior year and I would have just bled money. I could have held on to those variant swaps for a little bit longer and made three times as much. But I think you've got to have an idea in your mind of what you're trying to achieve with any trade put on. And it's very important not to get greedy. Just don't get greedy. I mean, in my case, that was good enough.

Speaker 2: 8:55

And then, obviously, as we rolled into 2009, by, I think, march of 2009, if you had come to the right conclusion that the world wasn't going to end, honestly, you could have just picked any sort of assets, whether it was credit, whether it was complex things like forwards on the Nikkei, which were when you looked at them. They were pricing negative dividend yields on the Nikkei. Everything was so out of line. You could just take your pick with whatever you wanted to buy. You're going to make a lot of money in 2009.

Speaker 2: 9:31

So that's not really a war story. That's just how things worked while I was at Brevin Howard. Those were great couple of years For me. In more recent times at the start of 2022, I was on vacation in the States into Las Vegas and Palm Springs and Los Angeles and obviously reading the macro and the pandemic was sort of coming to an end. The US was partially opening things up and the 10-year treasury yield, I think at the time was 1.2% and it seemed very clear to me at that time that as soon as the US really opened up properly, there was going to be a mighty boom. These rates were just completely the wrong price and that was the great trade for 2022, just being short treasuries really.

Speaker 1: 10:22

Convexity is always the thing you want to go after. Obviously, Convexity tends to happen with extraordinary volatility. Just given the way that tail event seemingly came out of nowhere and the payout associated with that, I am curious. In terms of the environment that we're in now, where is there convexity potential? Where is there this fat pitch, this asymmetric payoff from what you're looking at?

Speaker 2: 10:47

The funny thing is often you don't know where these really far right hand tails or far left hand tails, or whatever you want to think about them are hidden until after the event In 2008 when the world blew up and I thought I had unwound all my variance swaps. Anybody that really has a deep understanding of variance swaps and the nature of convexity within them. When you actually unwind a trade, if it's at a different implied volatility to where you put the trade on, there is a tiny residual amount. The two trades have different convexities. Now, ordinarily this doesn't make any difference. When you're dealing with Vols 20 or Vols 30, it doesn't make a difference. But when Vol goes to 80, as it did, that tiny little residual bit of convexity all of a sudden becomes worth a whole lot more a whole lot more. The same thing with some of the variant swaps were capped. If you buy a variant, typically the cap was at two and a half times strike. So if you paid 20 for a variant swap, it would have been capped at 50. And then if you unwound it at 30, it's going to be capped at 75. So you think you're flat, but you've still got little residual kind of cool spread on volatility between 50 and 75. Now, this kind of stuff we never thought would come alive ever. But of course, at the end of 2008, it did come alive and it did bite a lot of people in the arts. So you know, this is very difficult to see in advance where this convexity might be hiding.

Speaker 2: 12:30

For me, as things stand right now and I've written about this in my daily note I look at the major indexes. The implied volatility on, for example, the S&P, it's barely in double digits at the money implied vol Same with the Eurostox. It's rarely in double digits at the money implied vol Same with the Eurostox. It's rarely this low. And especially, you know the short-dated options coming into this week, where you've got the jolt states, you've got payrolls, you've got European CPI reports, you've got a whole number of significant macro events that could just shake things up a bit, certainly change the profile of interest rates and what's priced into the rates market. And I think with implied volatility this low, it's worth just having a strangle or a straddle or something and either hedging it to capture the volatility or just buying some out-of-the-money options and hoping for the best I've been highlighting in the last several weeks what I think could be the start of a currency crisis between, really primarily from Japan.

Speaker 1: 13:36

I think they started the process right with their hiking rates minimally and the yen still depreciating. And now they're telegraphing right, they're going to intervene. And also now China, right, telling state-sponsored banks to intervene with the yuan and the dollar has been strong and looks like it wants to break out here. What are your thoughts on currency volatility, maybe spilling over?

Speaker 2: 14:47

Because I think that's where it gets to be interesting and potentially quite messy. When I thought they'd lost the plot. Really, they were signaling three rate cuts, but they'd revised up their inflation forecast and the growth forecast for this year and yet they hadn't changed the median expectation of where rates were going. And the data has since been picking up. Just for example, let's take the PCE inflation rate core PCE inflation. Before Christmas, powell was highlighting how core PCE, the six-months rate on an annualized basis was 1.9%. Great, you know. There they are on the way to the 2% target. They made a big deal out of that. Now, in this latest PCE inflation report, we see that the annualized rate of six months PCE inflation is now 2.9%. It's gone from 1.9% to 2.9%. The Fed isn't talking about that anymore. So I think there is a danger. There is a danger that the Fed they like to stick with their forward guidance. They've spoken about rate cuts for a long time now, since November. That was the peak in rates and everybody started pricing in rate cuts. As a result, financial conditions eased, the market took off, household wealth went through the roofs. Everything was great. They, I think, now believe they have to follow through with the rate cuts and I'm surprised.

Speaker 2: 16:24

To me it seems there's a risk of currency debasement here and I said a couple of weeks ago I'm surprised gold hasn't done better Now. I didn't have the trade on at the time. I just couldn't understand why, with all this dovishness in the face of reasonably strong economic data, I was surprised that gold wasn't attracting more money as an inflation hedge. Obviously it's had a good run in the last week, but when it comes to currency volatility, usually it's driven by widening rate differentials and I think the market is pricing a similar sort of pace of easing from the major central banks, apart from Japan. Just getting back to Japan, japan's going in the opposite direction and I think Japan it's difficult. I mean, my god, anyone that trades FX would have had a go at in in the past going long dollar yen one way or another, with auctions, longer dated auctions, expecting the yen to just have a nasty run at some point, and it hasn't happened. But now I think maybe things will start to pick up.

Speaker 2: 17:36

Implied volatility is still very low in all currencies. I mean realized volatility has been incredibly low. So I think any opportunity that you see in FX, you should use the options market to express it with one-month options or however you want to do it. It's a cheap way of putting on a trade, cheap and low-risk way of doing it. So I'm hopeful, especially for the FX traders out there that have had a really rough time the last couple of years with nothing going on. I'm hopeful that now we will see some sort of differentiation in central bank policies. If you I mean especially if you look at the European data European inflation prints have come below expectations in Germany, france, italy and Spain, the big four European countries. We've got the Eurozone aggregate inflation print tomorrow and there is just a possibility that the ECB actually cuts ahead of the Fed, which would be quite something. So maybe we will start to see a pickup in ethics volatility.

Speaker 1: 18:46

The argument is that the Fed wants to cut rates because of the election. I'm not a believer in that. I know that the line that you hear constantly. It seems to me more likely than maybe the Fed still telegraphing cuts because they're expecting some kind of a risk. And I keep going back to where I still think it's, you know, no different than the way the Pentagon has plans to invade every single country, right, Including, you know, England, right, and I mean literally. There are plans for that, because that's just what the Pentagon does. The Fed must have similar type of scenario analysis and plans on the back end. Well, if Japan were to raise rate by X amount and it has this kind of impact on currencies, then it might impact equities. So we want to cut rates if that happens. Right, I'm sure there's scenario analysis like that. So how much of the rate cut narratives could simply be? Because the simplest answer is the right one, which is that the Fed sees something or knows that there is a scenario that would require them to do so anyway.

Speaker 2: 19:43

I'm not a great believer in these sort of semi-conspiracy theories. I do think that the Fed, prior to Christmas they were talking about an excessive tightening of financial conditions and it's true. At the time Treasury yields had risen a long way, equities had had a rough year, credit was a lot wider than it currently is. And then Waller first gave that speech, where I think it was the end of November. And then we had the Fed meeting at the beginning of December where they highlighted the fact that financial conditions had tightened, they were doing the Fed's work for it and so the Fed should cut just to sort of offset that tightening of financial conditions. And then Waller made the point that as inflation starts declining, if they don't cut the fed funds rate, then the real fed funds rate is going to be increasing. And I think they gave all that forward guidance and now to some extent they feel like they need to follow through. I'm not sure the election, the timing of the election, should be a major factor, but there is this issue that if they don't cut in June, the next summary of economic projections is going to be in September, just a month before the election. It's going to look a little bit fishy if the Fed suddenly cuts just before the election, it's going to look like that's really not going to look ideal. So to some extent, maybe because of the election calendar, they feel like, okay, well, we better get the first cut done in June and then we can do another one in September. It'll be part of a sequence and, to be honest with you, a 25 basis point cut, or two of them in sequence, really isn't going to make much difference to the economic outcomes.

Speaker 2: 21:38

I think to some extent, the Fed has an exaggerated opinion of the impact of monetary policy these days. We had a decade after the financial crisis when rates were zero and the yield curve was super flat. Households turned out their funding, so did businesses, and now the rate hikes that we've had. The monetary policy tightening has had far less impact than might have been expected and we can see that in the economic performance. I mean the Fed hiked rates. They did the first 425 basis points of hikes in this cycle in 2022. Of hikes in this cycle in 2022. And they talk about the long and variable lags between. You know their actions and the impact on the economy, but you know they did most of the hiking in 2022. They did another 100 basis points in 23. And growth in the second half in the last two quarters of 2023, was at an average annualized rate north of 4%. So, quite clearly, those rate hikes didn't have the kind of impact that might have been expected.

Speaker 2: 23:00

And if you look at the household sector, household wealth has gone up something like 40 trillion since the pandemic. I mean it's just a ridiculous number and sometimes you think, okay, so what does that mean? Well, what it means is that households sure, the savings rate has gone down, but households don't need to save. Why do they need to save at the same rate they used to be? They're much richer than they ever used to be. And that increase in wealth, the percentage increase in wealth, is quite evenly spread across the income distribution. Those at the lower end of the income distribution have had the same sort of 30% increase in their net worth, same as those in the top 1%. So the bottom line is that the Fed policy tightening hasn't had, in fact it's done nothing to household wealth. That's gone through the roof.

Speaker 2: 23:54

And then you look at the corporate sector and you have the corporate sector deleveraged itself after the financial crisis by the corporate sector. I'm talking about the non-financial corporate sector Okay, so we're excluding the banks Deleveraged itself after the financial crisis, and now you've got companies like Meta, apple, I think, apple, alphabet, I think, who are net, who earn income on their cash piles, and so if you look at the net interest paid by the corporate sector as a percentage of profits, it's the lowest it's been in decades. So the bottom line is, these rate hikes haven't impacted the economy anywhere near as much as might have been expected. So we're at a point now where I think the only reason the Fed really is going to cut is because they believe they have to follow through with their full guns, and the electoral calendar would make it easy. If they don't go in June and then September, they will get attacked by both sides of the political spectrum.

Speaker 1: 25:37

Yes, reset the rumor. Please make sure you follow Jonathan Matthews here on X. If any of you want to come up and ask questions, click that bottom left micro request button and, as always, this will be a podcast under Leadlag Live on all the three platforms Apple, youtube and Spotify. I agree with you, by the way, on that point. I floated the idea that if you were to have a currency crisis, and if it does get sparked by Japan, that gives them the scapegoat, because it's a lot easier to say that they lower rates closer to the election. If there's an entity outside the US that's causing them to Right, it becomes sort of an excuse for them. But you know unclear how that plays out. Do you think that we're at a point in the cycle now where, even if the Fed were to actually hike rates, the Fed can't do it alone. It needs something exogenous as a shock to really get inflation to that 2% level.

Speaker 2: 26:33

Well, that's, yeah, I do think so. Now I think, from the Fed's point of view, where we are now, where growth has been really solid for the last few years, got inflation, they've done the I would say the easy part of getting inflation back down again. To get it all the way down to 2%, they're going to have to really do something quite nasty to the economy. And I say this because when you break down the components of inflation, you look at the dynamics of what's going on there. We had what I would call the transit. They were kind of right about transitory if your timescale is two years for transitory the supply chain snags and the energy crisis and all that has now played out. So if we look at durable goods prices, I mean you had prices for used cars that were up more than 40% year over year and then they went into freefall and so the declines in used car prices are coming to an end now. So durable goods prices were a drag on inflation. Energy was a drag on inflation. Those two components are now reversing. So it's quite clear that you know base effects in energy mean that energy is going to be making a positive contribution to inflation. Goods prices, I think, will go from making a negative contribution to making zero or maybe a small positive. Food disinflation is still ongoing. But then you come to services inflation and that really hasn't declined much at all. While you've got wage growth. If we use something like the Lancet Fed wage growth tracker, it's still growing at about 5%. Very hard to get services inflation much below 4% where it is now, I think. So I think we're going to be left with a core inflation that is dominated by services. Well, we already are, and I think that's going to be an ongoing problem.

Speaker 2: 28:41

So for the Fed, they've got a choice. If they really want to get inflation down to 2%, they could hike rates. They could crush the economy. They could send unemployment up another two percentage points. Should we say, tip the economy into a recession and sure enough, we get inflation back down to target? Or they could say we'll keep rates where they are. Maybe do a couple of little tweaks and we can see the disinflation process is still ongoing. It may be beginning to peter out. Maybe inflation settles down at something like 3% While we've got full employment and while economic growth is north of 2% still. Maybe that's not such a bad outcome as far as they're concerned, maybe it's not such a bad outcome. I don't think they would ever admit that they've changed the inflation target. They will still say, okay, well, we're still expecting inflation to decline towards 2%. They'll give all kinds of reasons. I think they may well be happy with an inflation rate that's 3% and economic growth staying intact and unemployment staying extremely low. That's not such a bad outcome. It's also a good outcome for the treasury.

Speaker 2: 30:01

If you look at countries with high debt-to-GDP ratios, like, for example, the UK after the Second World War, where our debt-to-GDP was something like 200 and something percent and the way you get it down is a combination of financial repression. So you find a way of convincing people to buy your long dated paper and you have a period of high nominal GDP growth, a combination of reasonably strong growth and high inflation, and that is the best way to get your debt to GDP back down again, and perhaps that is what the US is going to do. Debt to GDP in the US, I think it peaked at over 130% just after the pandemic and it's come down to 120% or so as a result of very strong nominal GDP growth over these last few years. As a result of very strong nominal GDP growth over these last few years. The trick is getting investors, convincing investors to still buy your long-dated paper while it's still got a relatively low yield. So that, I think, is you know, the US is managing that process quite well so far, absolutely, I mean.

Speaker 2: 31:12

The point you made is a very valid one, but I think, from looking at the experience with the Fed's true reaction function, when there is a market crisis, they will find an excuse to cut rates. They will I mean, let's put it this way If household wealth takes a really big hit as a result of an exogenous event somewhere, that will bring down consumer spending. I think if, for example, if the equity market really gets crushed, the CEOs will start hiring people to improve the bottom line. That's just the way the world works, and so I think, from the Fed's point of view, they'll be very reactive to an event like that, regardless of the outlook for inflation. They'll be able to say well, we're looking at these forward indicators of employment and economic growth and it's quite clear to us that things are looking ugly. And don't forget, don't forget this you know the Fed a while ago said they're going to be data-dependent, not forecast-dependent. And yet, you know, the data recently have picked up Inflation. You know they had two consecutive upside surprises to inflation. Employment growth was much stronger than they were expecting and yet they're still forecasting. I think Powell said you know label market indicators point to some softening and all that kind of nonsense, so they're relying on the forecast to justify the start of a rate-cutting cycle.

Speaker 2: 32:46

The Fed will always be able to find some excuse to cut rates. If there was a collapse in asset prices, without doubt in my mind they would pull the trigger on rate cuts. And it's interesting one of the other points you made about the labor market and supply of labor kind of drying up, partly due to demographics. I would have thought another factor in that is that people's 401ks have just gone through the roof. So a lot of people that may be approaching retirement can now think well, what the hell cash the whole lot in and I'll tell the boss what to do with his job. I mean so, in a sense, this rapid increase in household wealth, is it in a way exacerbating the labor shortage and lowering the participation rate? But that's another, that's a slightly different issue. Just to your point, I do think yeah, without a doubt the Fed will cut if there is some kind of blow up.

Speaker 1: 33:46

Yeah, I guess it's a question of the when right, it's like you know. Do they respond immediately? Or is it, with the delay to Bondock's point, just to create some disinflationary pressure, you know, to take hold? We'll see. I mean, these are all different scenarios. Let's go to our question Go ahead.

Speaker 2: 34:02

I actually I do think there is a case for bullishness for a little while longer and there are major differences with 2008. Primarily, it's the leverage. I mean the household in 2008 were using their houses as ATMs. I mean they were just getting HELOCs and taking the money and buying a new jet ski or a motorcycle, whatever they did with it. So there were so many households that had remortgaged and remortgaged and they had a mortgage that was worth roughly the same value as the house and as soon as the housing market took a minor tumble, obviously the whole house of cards collapsed and that transmitted throughout what was at the time a 10 trillion mortgage market, which was itself highly leveraged. With this tranching and the subprime and all the rest of it, it was highly leveraged. It only took a small decline in the value of housing to really cause catastrophic losses for the banking industry that were multiplied up by the withdrawal of credit in that space. I think there was something like. I can't remember the figures. It was something absolutely horrific if you looked at the global losses to the banking industry.

Speaker 2: 35:22

Well, now you compare it to where we are now, house prices in the US have roughly doubled over the last 10 years and throughout that period people have been looking in lower and lower mortgage rates. So where we are now? The average outstanding rate, the average rate on all the outstanding mortgages, is something like 3.7%. So for households, the new mortgage rate is 7%. They're not going to sell, they're not going to give up their existing mortgage, they're not going to take home equity lines of credit. They're not doing anything like that. For many of these households, they've now got a mortgage which is roughly half the value of the house a huge amount of housing equity stored up. So the household is far less vulnerable than it was in 2008.

Speaker 2: 36:18

And for corporates as well. When you look at the leverage, whichever way you look at it, it's tricky getting the aggregate data out of either Bloomberg or the Fed. The Fed thing is much easier and you can tease some non-financial aggregate data out of that. The corporate sector is far less leveraged than it was and primarily it turned out to funding rates. Sure, you've got some smaller companies and some highly leveraged companies that maybe just should go.

Speaker 2: 36:51

For the last 10 years I've heard about how zombie companies were being kept alive by low rates and we're seeing a misallocation of capital keeping these companies alive and it was bad for productivity and all the rest of it. Well, now we're going to have a bit of a clear out of those zombie companies that can't survive with a more normal level of rates. But I really don't see that the financial markets are on the brink of a catastrophic event like 2008. And you might think well, how can you tell when something like that is about to happen? You really could in. In 2005 and 2006 it was clear, the market was unsustainable, really clear. But obviously, if you did something about it back then in 2006, you were too early and you were getting screwed on your marks. Eventually it did all come crashing down. It took longer than any of us expected, but it did in the end. But where we are now, I don't see those similarities, I don't see the vulnerabilities.

Speaker 1: 37:56

I will say notice. Previously I think you said the leverage component is intriguing to me because I think you can make an argument that and this is more about market structure there is more leverage just from the proliferation of options trading than we've ever seen in market before and you don't have to have a crisis like 2008 that forces a household deleveraging, but you can certainly have a financial deleveraging event. I think right just from that perspective, that's more of a market structure issue than anything else.

Speaker 2: 38:28

Yeah, I wonder about this option. I suspect that you know this increased options trading, especially the same-day options that become very popular. This is generally, I imagine, just retail punters taking a view and the market makers that hedge these reasonably competent. It's interesting because we haven't had a true test. We haven't had a significant move in the S&P for months. It will be interesting to see how the market copes with something that causes a big daily move, like 3% in a day. What happens? Can they hedge themselves? Success? But I don't think. You know, I don't think handle, you know, I don't think.

Speaker 2: 39:08

I don't think households have kind of leveraged themselves up to the with exposure to the stock market. You know with I mean the regulations have changed for how much margin exposure you can have now as a household and all this kind of stuff. So I'm not sure there is that inherent risk in the market that to me it doesn't seem that vulnerable. I think the bigger risk from my perspective is the rates market and something that might cause the long end of the rates market to become unanchored and I mean unanchored in a bad way, where I don't know what will do it. But right now investors are very happy to stick their money into a 10-year note because they're pretty confident that the Fed is going to cut rates and so their expectations are anchored by the 10 years following the GFC and they say, well, okay, if the Fed's going to cut rates probably going to go all the way back down to 2% or lower We've got to lock in a yield north of 4% while we still can. That is what's keeping the long end of the fixed income market stable at the moment. If something changes and investors' expectations do become unanchored whether it's via a pickup in inflation or delay to the cutting cycle, whatever it is, or resurgent economic growth, I don't know that's when I think the whole market will become vulnerable. That's the big risk in my mind. Yeah, I think that is a very strong risk from my perspective and I think that's why precious metals have had a good run lately.

Speaker 2: 40:53

I think to me. You know, I think at the start of this year, when the market was pricing six cuts from the Fed this year, I thought that was just absolutely insane. Now the market is pricing slightly less than three, as of today, I believe. But I do think there is a strong risk that the Fed, like I said, goes ahead, does the cut in June and then again in September, because they feel compelled to follow through with the forward guidance. And we do get a melt-up. You know, economic growth stays robust, corporate earnings are forecast to rise quite strongly this year and next year and perhaps they will and the market carries on and then we get to some kind of bubble and maybe it's the long end of the curve that sells off. Rates go a lot higher. Maybe that's what bursts the bubble or maybe it's something else I haven't even thought of, but that is a risk in my mind that this rise in asset values just continues. I mean, who would have thought? Let's face it, the most interest rates, probably the most interest rates sector of the economy, the housing market. You know the Fed's jacked up rates 525 basis bonds and yet housing house prices are going to new records now. So I think there is a risk of a bubble. Equity is at record highs, gold at record high, so obviously it's off its highs currently, but all this stuff kind of smells to me like a bubble being blown and there are some vulnerabilities.

Speaker 2: 42:29

Now the interesting thing is when it comes to the election and I do remember 2016 election because I was working all night at the time at a hedge fund, we were trading through the night and that was crazy. Trump was an outlier at the time. He was really a long shot and he succeeded. I believe the two candidates are roughly 50-50 now in the bookies, so whichever outcome it is, it's not going to be a huge surprise. It can't be. I mean, half the people already expect it to be either one or the other, and it doesn't seem to me like there's much fiscal consolidation going to take place. So I'm not really sure that the election of Trump this time around, or Biden again, would be a massive shock to the market. But that said, I think the Fed would want to avoid being accused of political meddling and will go ahead and follow through with this rate guidance.

Speaker 1: 43:30

Jonathan, for those who want to track more advice, more your work. What would you want to do, oh?

Speaker 2: 43:34

well. Thank you, yes, you can either look at super-macrocom wwwsuper-macrocom. Or find me on Twitter at super-macro so I think the best place is super-macrocom or find me on Twitter at super-macro. So I think the best place is super-macrocom. Just go on the website. You can sign up for a 30-day free trial and if you like the note you can stick with it. Otherwise, just cancel it. It won't cost you anything.

Speaker 1: 44:01

All right, please make sure you give Jonathan a follow. Great conversation. Hopefully all of you enjoyed it, appreciate you, jonathan.

Speaker 2: 44:08

Thank a follow-up, great conversation. Hopefully all of you enjoyed it. Appreciate you, jonathan. Thank you Well. Thank you, michael. Thank you for having me on the show and thank you for all the intelligent questions. Really appreciate it. Thanks a lot. Cheers everybody.