“Something’s Gonna Crack”: Bond Strategist Warns Stealth Tightening Is Hitting Markets
Summary
George Goncalves, Head of U.S. Macro Strategy at MUFG, joins Maggie Lake to explain why the market may be underestimating …
Transcript
Both oil and rates now are actually tightening the financial conditions in the economy. Like equity markets are doing their own thing. They're on their own planet. We don't know how long what's the breaking point because again the Fed hasn't hiked, but the markets hiked for them and this is this is going to be a drag for corporations. These high rates are going to start to really hurt. Eventually something's going to crack. >> Hello and welcome to Wealthy. I'm Maggie Lake. Joining me today to discuss the outlook for US markets is George Galves, head of macro, US macro strategy at MUFG Securities. Hey George, great to have you with us. >> Uh, good to be with you, Maggie. Good to see you. >> So, and welcome to all of you tuning in as well. Just a reminder, if you'd like help navigating these volatile markets, you can get a free portfolio review from an adviser in our network. Just hit the link in the description or go to wealthyondon.comfree. So, George, uh, really interesting action, um, right in in your area of expertise, we saw a significant synchronized selloff in global bonds. What message is the bond market sending or are bond investors sending? >> Sure. Maybe just like a little bit of background on me for those that, you know, don't are not familiar with my approach. I'm a macro strategist but look at the world through a fixed income lens because our our overall mandate is fixed income here and and and clearly the bond market is front and center very important to us and interconnected and drives other markets as we all know. Um and the bond markets are sending a signal around concerns about inflation and then down the road what will be the response to inflation if the inflation shock ends up with demand destruction, weaker economies and then governments have to step in with some sort of fiscal support. I think there's a lot of that all happening at once. It's hard to disentangle like what's the primary driver. Uh the short-term factor is inflation. The long-term factor is just the general health of of countries and sovereigns. Yeah, I think and I think you just put your finger on why this is so complicated, you know, because I we hear people say all the time or I think the question out there are are are the correlations that we're used to still in place like you know the the sequence of events that we would expect when something like this happens um and that you try to model out does that still apply because we do have this crosscurren of really strong sort of macro forces. So, let's un unravel that a little bit when you're talking about So, let's maybe start near-term with inflation. I mean, um, are we in a are we in a situation where there is a feeling that this is really related to what's happening in the street? Um, and or have we have we tipped over somehow and now and this is why we're seeing this reaction in bond markets that investors are starting to think, wait a minute, maybe this isn't going to subside if we get a resolution in the war. Maybe global supply chains are different now. Maybe this is stickier. Uh and it's and we're higher for longer. That's a phrase we hear all the time. Thoughts on that? Is that does that seem like the scenario we're in or is that what is bothering bond investors right now? >> I think there's a lot of lot of different factors at play here as you kind of spelled out. Maybe we could pull up one chart on slide 22 because I think this is a chart that gets overused a lot both in financial media as well as analysts and strategists across the the the spectrum tend to look at this chart on page 22 that shows you a comparison of the inflation uh reaction during the 1970s into the early 1980s. Some people even call it chart crime to be doing these parallel analysis. There's probably some truths to that. And then the uh the red line is kind of the 1970s approach to inflation. >> And then in the black line is the current inflation run rate since really postcoid the pandemic. And they kind of like look very similar, right? You had a first kind of big massive wave led by supply disruption. Both both instances had that. And and what kind of differentiates between now and then is that we are you know we're at this kind of crossroads where we've seen what happens all the time. Whenever we go into a crisis where something you know bad happens usually governments intervene and if they were to intervene again you get another impulse in inflation. So I think in the back of everyone's mind especially buying investors is that if we you know right now everyone has a kind of optimistic outlook on on growth which to me is a little bit perplexing but if we were to go into an economic slowdown we know that what's going to step in is these fiscal stabilizers. The government will kind of provide liquidity inject capital into into the markets into the economy. Then you get a a second wave of inflation or you get government sort of stimulus and that's kind of what happened in the 1970s. If you look at there's a lot of little small things people maybe can can point it out and zoom in on this chart when they look at it. You can see that there was a lot of government intervention. If government starts to kind of intervene providing stimulus or gas you know uh benefits uh to to their population that money gets spent it goes into the economy creates inflation. So it depends on the nature of where money's coming from >> and and it and like I think in the back of everyone's mind is that there's going to be a eventual government answer to this which will be more printing of money and therefore it creates inflation. So it's not just a near-term oil shock inflation. It's like what follows >> what matters. >> That's super important because that's the that's the sort of 800 pound gorilla in the room. And I think this is why you have people talking about bond vigilantes again, right? So this isn't just a reaction to a temporary situation with inflation. This is sort of bond investors saying we've had you're spending like drunken sailors. This is this is just the knee-jerk every time and we don't think we want to hold your bonds if you do that. Is that is that what you're saying? >> Partially. I mean I think it's the the bond market's commanding a premium for the first time saying look we you know bonds are going to get underwritten regardless. It really comes down to what yield what price right. So um and and to and they're commanding a premium higher rates even though the Fed's not hiking. And we don't expect the Fed to hike even in this environment. >> The bond market's hiking for them by commanding this extra premium 10-year rate above 4.5, the 30-year rate above that psychological 5% level, even though the Fed has cut 175 gis bucks. So like we've we've seen a pretty big reversal. It's the bond market asking for uh some compensation. So, you do not think the Fed's going to rate uh hike rates because the market is now pricing that in based on everything we've seen with these sticky hot, you know, PPI and it's starting to flow through and now this trade's been closed for so long. The bond market has gone from thinking, oh, the new Fed share is going to cut rates to thinking that the first move might be a hike. You disagree with that? >> I I disagree with that. I mean, and we've been here before. So, maybe, uh, calling up on another chart, um, which is slide 37. You know, here I'm I'm kind of comparing the 2008 experience, and you have to go back to 2008 and remember that we also had a pretty big move in oil up to $147 a barrel, roughly almost 150 back in 2008. In in today's dollars, that's well over $200. And so, yeah, I'll change my view. If oil starts to spike towards 200 bucks, everyone's everyone's going to change their view. But at these levels, we're not at the point yet where we think the Fed would want to even entertain hiking rates, they have a dual mandate. They they are equally concerned about the labor market. And if you look at this chart on the left on page 37, even in like before the financial crisis really got going in late 2008, the market priced for a nancond, 18 basis points of hike. So like almost one full hike was priced in in 2008, which of course the Fed never delivers. That's a little black line over the red. >> Eventually, we all know the rest is history. The Fed ended up cutting rates down to zero in reaction to the financial crisis, no less. But still, like we're at, you know, critical potential inflection points with, you know, financial markets highly valued. We have concerns around private credit. So there's enough sort of like u kind of tail tail risk tail risks in on the on the side. they have this inflation shock that's hit bond markets pricing in hikes. That would be a policy error for the fi the Fed to be hiking now. The the most they could do is stay on hold maybe for you know ride this out for another three to six months and see if it does feed through into inflation or permanently into inflation. There's clearly going to be a shock from the energy. We're already seeing it in CPI, PPI, but to hike in this environment would only compound the pain that's being felt by households in the US >> that are really great sensitive down in the lower income middle to lower income brackets. So, I think it it would just be unnecessary. It would cause more damage than it would help. >> Um, and so yeah, so we've seen this movie before. Bond markets price in hikes and then they're never delivered. I think we're seeing a repeat of that. >> So interesting. And I'm going to ask you about you. I think you brought bring up a really important tension that the Fed is dealing with. But when we're talking about the bond markets now and if they have to sit through this and it's not just the US, right? We have global bond markets selling off. I think because of what you pointed to this uh tendency to run in with a fiscal response based on and just the overwhelming amount of debt that we have uh in addition to some country specific things. Uh the speed's pretty quick now that we I mean we've seen a sort of that that repricing has been pretty powerful. Where do you think rates what's the sort of ceiling before the Fed or central banks would have to respond? Do you think that we saw that or is there a potential for us to see rates get substantially higher from here before something were to happen or something were to break? you know, what does that upward momentum or that upward risk for yields look like for you? >> As with everything in our business, it's time and the ultimate level. So, how long you're at a certain level, this this is true for both oil for rates. Both oil and rates now are actually tightening the financial conditions in the economy. >> Like equity markets are doing their own thing. They're on their own planet. But the actual inputs that matter for the cost of funding, cost of energy to run a a country are going up and so that's like a tightening that's massively happening in the background. We don't know how long what's the breaking point like is it a three-month window, six month window at these elevated both high energy prices and high rates >> because again the Fed hasn't hiked but the market's hiked for them and this is this is going to be a drag for corporations for the marginally attached uh to the economy. These high rates are going to start to really hurt. I don't know what the right level is. I mean, I think we're close. I mean, I think, you know, 5% higher or higher on the 30-year is a big drag. The 10-year above 450, which is roughly where we are in at the time of reporting. And so, like, if we're staying at these 450 or higher for a prolonged period of time, I think it's going to do a lot of damage. The housing markets are race struggling as it is. um you know auto sector all these interest rate sensitive sectors are are under pressure and the consumer is not as strong as optically it looks like that if we sit here until you know deeper into the summer I think the odds of of of recessions go up like this is like a tightening that's very stealth in in nature >> of course um super inconvenient heading into the midterms for us to see the economy move lower which I'm sure is raising concerns for bond investors Um George, we have heard concerns about recession before, right? This is the sort of recession that never comes. Um and there were a lot of other factors including the spike we've seen in oil that everyone thought, okay, this time this is going to push the economy into recession. There is weakness under the hood. It's just a matter of time. And then it has proven to be so resilient. Why might it be different this time? So let's go to page six and look at the long historical account of both recessions and expansions in the US. This is one of one of my favorite charts. It goes back back to the MBR calculations in the late 1800s. And the first thing you're going to notice is that in the past recessions and expansions were almost like symmetrical. Like you would have just as long drawd downs and weak economy versus really strong booms. You had this kind of boom bust cycle up until 1971 when we got off the gold standard and really allowed for sort of fiscal expansion, monetary policy to kind of smooth out the business cycle sometimes maybe like creating excesses along the way as we saw in the late 1990s and as well as into the housing crisis. And so you kind of see the black bars get bigger as you get into the 70s, 80s and 90s and so forth. I do find it interesting that the current expansion of roughly about five plus years is similar to the 2000 pre pre208 experience. And why do I think that's interesting? Well, one there's a lot of financial innovation taking place from 2000 up to 2008. similar there's a lot of financial innovation happening postcoid >> with you know with a lot of sort of derivatization of the equity market faster access to liquidity a lot of leveraged uh vehicles out there margin debt you name it there's a lot of excess liquidity and different ways of expressing uh putting on views with these sort of new uh instruments and you had the the the real taking off the private credit sector which has been the marginal provider of credit to you midsize companies throughout the US like a high rate environment andor for economic weakness if they were to happen in that sequence would really uh expose some of these u fragilities that are been kind of masked by really elevated financial markets which gives the perception that everything's good and everything's great and so I find that ironic that like we're kind of getting close to that window of comparable to the 2007209 window where some shock out of the blue like we the economy has been resilient but let's not like underestimate how much uh support it it has had for the last five years and each time you do it you kind of run out of runway and I think we're getting close to that point uh where the fragilityities around the credit markets and uh equity valuations being very stretched >> uh the economy really hinging on just two real growth factors both you know AI and upper income spending and they're linked so if you get a sort of correction in financial assets and or some bigger shock that's macro which we might be in the midst of it right because we've never had the straight horses closed this long. Uh the potential disruptions, the shortages, maybe rationing that's coming ahead, like we don't know how what that's going to do to the gears of growth in the economy. The gears might start to grind to a halt and then you get a recession and then you expose that the financial valuations were too stretched. That sounds very similar to like a late 99 2000 or 2007209 window and like the business cycle has been long but eventually I think it will come to an end. The question is, is this enough damage uh to actually put it over the top? >> And I think the question also people are really concerned about is um do we see a correction and a recession or do we see a crisis and a really difficult a lot of pain in equities? Because when you talk about 2000 and you talk about like 2008, those are really concerning times to compare it to. um do do we know based on what we're seeing or are the bond markets giving us any indication of where where the risk lies or where the probability lies when we're talking about those two scenarios. >> So both in in both those instances in 200 the Fed was actually raising rates which kind of helped kind of take out the excess liquidity that was running rampant in the and the euphoria in the whole dotcom phase. So there was clearly a lot of liquidity and then financial innovation a uh euphoric move around a new technology and ended up with a very minor recession in the grand scheme of things but valuation still still got cut in half or the markets got cut in half roughly speaking and tech were down like over 80%. Um you look at maybe slide 13 I think this is a good a good way to think about it. um and comparing what we've we've we've seen a lot of others uh kind of compare and contrast how consumer sentiment is not lined up with the sort of uh sentiment that's being expressed in the stock market. And this is uh looking at the S&P the chart on the left >> in red relative to uh consumer sentiment from the University of Michigan. And you can kind of see like up until like uh Trump's second sort of term, the early part of the second term, there was like a little bit of a bump in in enthusiasm around sentiment. Stocks were going up. So there was a minor kind of correlation between stocks and um and consumer sentiment and then it broke down after liberation day and but yet stocks have kept going higher, right? Uh we've we've kind of u identified why that's the case and I'll get to it in a second, but look at the chart on the right. This is looking at the unemployment rate compared to whenever oil prices are up 80% or more. I mean again none of these rules we've and we've learned this. We have to be very careful in the macro space to have these sort of steadfast rules. You know the yield curve did not also predict a recession, right? Uh I mean it was predicting if it never came it did you did have moments of weaker uneven growth but not a real full-blown recession. But you know each time we do this eventually something's going to crack I think. and and this latest round being the oil driven I think matters more and and you compare like the little circles that I have here on this chart on the right is looking at the unemployment rate after we've seen oil almost double >> and when that happens 6 months to 18 months at maximum you do fall into a recession there's only been one or two head fakes which was around the Russia Ukraine invasion of 2022 you had a big spike in oil but yet the economy managed to kind of uh kind of uh lived through it. Even though we had some weakness in in the economy in early 22, it it was not a full-blown recession. And I we we attribute that largely because we were just coming out of the pandemic. There was, you know, trillions of dollars of excess savings. There was pent-up demand because everybody was uh locked locked in. And so that unleashed so much demand for the economy in 23 and 24. We don't have the same sort of backdrop. We have the consumer tapped out. We don't have excess savings in the system. and all markets are at the local highs. Like, how are you going to perpetuate this if oil does not come down? Like, we we think oil has to come down back to $75 to to avoid a more sharper downturn. Maybe it's not a full-blown recession, but the second half it's going to be much weaker unless oil meaningfully comes back down to like 70 bucks because if it doesn't, then this chart might actually be a good predictor that we're going to head into an economic slowdown in late 26, early 20 soth. Yeah, George, are are bond prices tracking oil or are they tracking debt and government large ass or both? >> I think both. Uh but you know, if you you can kind of get a sense of this and I know we're bouncing around a little bit. >> And and that last chart, by the way, if anyone doesn't understand what people talk about for the K economy, that last chart literally K that's why people started calling it a K economy for that very reason. So it's a great point. >> Absolutely. the the biggest divergence possible. How how's that all consistent? I don't think it is or it's not sustainable until you see it more brrawny out and everybody participates in the economy, not just a few. >> Yeah. >> But if you look at page 55 of of the of my PowerPoint, you see that, you know, as the kind of title suggests, until growth is clearly obviously weakening because right now we're in this kind of dubious state, we think the economy can weather it and the data so far has been okay, but it hasn't really factored in all the disruption. We don't think so. And that's why the sooner you know we get some sort of conclusion or at least the straight of poor moose opening up and letting oil flow and that taking down prices and providing some relief at the pump until that happens we're going to have a growth shock at some point >> and um but until then the rates market is clearly just trading with oil. So the chart on the left kind of shows you the two-year Treasury going up and down with the es and flows of the oil market. you know, now that the two-year is above 4% since the time of this chart was kind of published, um, and we have oil still sticky at around 100ish, uh, there's going to be a point where oil could keep going higher, but the the the rates market should decouple. We're not there yet, but I think it's going to be close. Uh, and that's why we favor short-term treasuries more so than long-term treasuries don't have the sort the same sort of duration risk. And if we do get an economic slowdown, the two-year should perform better. At these high rates, you're actually starting to compete with money markets for the first time for the two-year. But nonetheless, yeah, for now, oil oil is driving everything. It's the the key macro factor definitely for rates. Uh and it's it's that inflation linkage. It's that concern around uh you know, how disruptive this is going to be. But eventually, we do think there's going to be a decoupling between the oil markets and rates. We're not just there yet, >> right? And if they decouple, it's already priced into the short end, but you could see more pain further out the long term. >> If we see that growth shock and oil moves lower, can we count on yields to move lower too? Because presumably if we have a growth shock, we may have a fiscal impulse to fix it. So, do you get the do you get the move lower or are we at risk of now having bond investors start to worry about that as well? and that kind of create an inability to pull those rates down. >> Yeah, that that that was perfect for Amy and that's kind of what we discussed at the start of our conversation that each time we we go through a mini crisis or an even larger crisis, we go back to the same well, which is more fiscal spending, more government intervention, and that the bond market is saying like we can help you underwrite this, but it's going to be to come at a cost. You know, that said though, I do think that rates would rally if we go into an economic slowdown. Even though there's be government support in general, rates would come down. It's just that long-term rates would come down less. >> And we, you know, and maybe don't even revisit the levels that we used to see in prior economic slowdowns. I mean the 10 year not as low in outside of outside of the pandemic, you know, 150 2% 250 would be like a level you can see the the 10-year rallying to in a in an old school kind of economic recession. But given how fast the reaction would probably be from government authorities, if we get back down to 3.5 on the 10ear, I'd be happy. So like so I I think there'll be a limit how low long-term rates can go and and what we're doing each time we're doing this we're reestablishing a higher base and the ranges are shifting higher. >> Yeah. >> And we we we've clearly broken the 40-year bond bull cycle. The question is is it starting a you know 20 30 year bond bearish cycle we can't afford it. So I think there's a limit on how high we can go as as there is a limit on how low we can go. So uh in that in that situation let's talk about uh corporate bonds. H are are they also reacting negatively to this? Are the same dynamics driving them or are they insulated for other reasons? >> Yeah. So uh corporate corporate market has been operating uh to its own devices largely on the back of a much healthier kind of balance sheets relative to government bonds, right? Uh you know and and and better earnings prospects and the like. And so you're not seeing the same sort of dynamic in the past where if there was like a risk around the financial markets, you would see you know spreads widening >> blow out on corporates especially you know uh lower grade higher yield in corporates. >> Yeah, we're not seeing that and look we get episodes of of widening around more like um positioning realignment or if there's a big shock financially but they usually don't last long. But I do worry that that's now conditioning uh credit investors to kind of think that's the new norm in general like this kind of characteristic is very similar to what you see in emerging markets where uh it gets the lines become more blurry between the government and the credit markets >> until you actually have an economic slowdown and then people still prefer the risk-free rate because the government will still pay you back. And so um it means that you're gonna up until the time of the worst case of whatever might lie ahead. The corporate markets will be kind of more um stable and then you'll have a more of a shock that oh we are going into a recession. It's going to be much faster. So it's going to be like very narrow tight ranges on spreads and then once we get closer to an actual event you'll see spreads widen because the preference will shift back to higher quality shorter duration uh treasuries. Yeah, George, if we see a fiscal response, if this plays out where we see these high energy prices, high rates trigger uh a recession or some sort of downturn and the government steps in. What does that look like? I mean, some people have postured that maybe the stock market's too big to fail now. Uh so, what what do we you know, what does that sort of support looks like look like? And do do investors prefer something over another? Do we see yield curve control? Are we see outright purchases of of stocks? Are we, you know, we talking about uh STEMI checks to people? You know, like what what would that look like that would be of concern to investors? >> I mean, luckily, most of these playbooks have been used already. So, we're going to see probably all of that and and probably some new things uh thrown into the mix. Um, you know, maybe if we like if you look at page 62 and and look at just uh valuations and how and and this is true for many different valuations and this is looking at a percentile from 0 to 100. How stretched are valuations for various metrics for the for the stock market and we've been sitting at very stretched valuations for a long time. So is this the new normal and everyone's kind of believing that you know equities are the only alternative? They give you access to earnings which are indexed to nominal inflation which the government ultimately controls by through the printing press uh and if they were to come into rescue that would indirectly help out you know strong corporations. There's definitely truth to that. And so maybe like our our measuring sticks have to be have to be changed in the sense that um a a 40 capum uh ratio is high historically speaking. But maybe we can't let it go down under 30 because if we went under 30 that wealth effect would be the actual wealth loss would be so massive >> that it would be even more expensive than governments would be able to bail out. So like it's like you have a high there's also that I don't want to use the Irving Fisher higher plateau because that's usually a jinx that could make things uh go the other way but usually like um you would think there would be some sort of mean reversion but these uh metrics have not been mean reverting. We've been getting more debt, >> higher valuations and yet no real pullbacks in equity markets. If we ever did if we ever had a real pullback in equity markets, it would upset the equation massively because um everything's linked as you know. But I think it's just interesting. You saw like you know post pandemic big increase Fed hiked. We saw some valuation retreatment stocks did go down after the Fed hike. So there was some fundamental connection there for sure. And then since then with the advent of AI and all the uh other or all new industries adjacent to it there's been a big capital u capex wave a lot of spending but valuations are reflecting that it's not it's not as if the market's cheap like the stock market >> um we just can't afford a revaluation of it because then the response would be even equally larger which is why some people call it the the crack up boom that you know that the response will be something even larger than before. So you you have to stay vested all the time. But um maybe if you look at one more chart on the next page, page 63, this is really the way that I look at it from the credit perspective. Uh if you take uh all corporate debt excluding bank debt which is fungeible and close to the the banking system um you just look at pure corporate debt as a ratio of the value of the stock market that gives you the black line >> which basically predicts or is you know is consistent with where spreads are. So if you have a highly valued company, they have their balance sheets look stronger and so they can handle more debt. >> If if the their if their equity values were to decline, their debt to equity ratios go the other way and then spreads would have to reflect that. So that everything's linked. So we cannot we can never let stocks ever go down because if they did, we would have to repric everything. >> That's a that's a huge statement, right? That's a huge statement. So So what does that mean in terms of investment strategy? What does that mean for bonds in a portfolio given that there's a limit to to the extent that officials or anyone are going to be able to let stocks go lower? So, you've got to be exposed somehow to stocks. How do bonds fit in? >> Yeah. So, I look, as I've been kind of alluding to, you you have to pick your spots. I mean, rates are getting higher and more attractive now. So, o over time and there is value in dollar cost averaging in every asset class, including the bond market. Just the idea of the trying to time the markets are obviously difficult. Um so the higher rates go the more attractive they're getting this bottom line. Um and so I do think that there's some value in introducing a kind of ballast now after equities being so highly valued. And by the way even if equities end up you know always having um support coming in from the government in one shape or another there can still be draw downs that are easily 30 40% before they bounce back again um if we go into a proper economic slowdown. So, it's not like as if you're completely immune and you might end up still being better off in a three-year window, but you can still see some sort of losses in the near term. So, having some bonds here, especially given where everything is, makes sense. But shorter duration bonds just get the exposure if the Fed does go back to cutting to help the economy later in the future. >> Um, and emerging market debt. I mean, other, you know, yeah, there's high quality, uh, structured debt that's interesting. Um and you know in you know in general like if you think about like equities relative to US equities relative to the world there is benefits in diversification everyone you know doesn't well the left folks don't want to think about the international uh sector as as a as a viable alternative but this is now a time where it makes sense to kind of shop around the world and look for uh other equity markets that are that are much more attractive at least from a yield perspective. There's no yield left in the S&P. Um, so I do think that there's, you know, there's a a case to be made to diversify outside the US. >> Yeah, we we keep banging the table on diversification. There are some people who feel like bonds though are not um that if you're going to diversify, you've got to think about commodities. You got to barbell that way. That bonds are uh uh given all the dynamics around debt in the world are just not a way to diversify. You're just eroding because of the purchasing power. It's just it's it's money going down this thing. Overstated is that maybe on the long end where those concerns are versus shorter end as a person who um is is so cognizant of what's happening around bonds. How do you react to that kind of statement? >> I mean I think it depends on each investor type. I mean yeah retail versus institutional investors have a different sort of perspective. Um and and the bond market is still largely an institutionally uh marketplace. Um, and so, yeah, I do think that, uh, you know, bond investors that have specific mandates, um, like insurance companies and pensions, they're going to have a different reaction to this sort of statement versus someone that's managing their own money, which again, I'm not giving any advice. like this. It depends on where you're coming from, but I do think that, you know, over time, yeah, having a broader diversification like the 6040 portfolio probably doesn't make sense in the world that we're living in. If it's going to be slightly higher inflationary concerns and higher rates, you have to kind of shift that around and look for alternatives like commodities like overseas assets that give you uh you know, some sort of uh diversification. I mean, I think, you know, like looking at page 44 though, I think would also help and I think people sometimes forget that even though the bond market's gotten bigger and the US bond market is large and it has a lot of support coming from overseas investors, the US equity market's even larger like in the in in the terms of allocations and how much it is relative to the global landscape. >> Uh this is looking at um you're looking at two charts. The chart on the left is comparing the country weight of the US market relative to other countries. >> And even though the US bond market has been growing, it's it's it's marginally larger than what it was in 2010. So even though we have a lot more debt, everyone else is also taking on more debt. So on a relative basis, foreign investors still have to have exposure to the dollar. >> And then you look at the stock market though and you look at it's like 70% of the global equity market. >> Wow. like how much larger can the US equity market get relative to all other equity markets I think it's at the limits personally speaking in 1987 the Japan's uh stock market was 40% before it went into its downturn um look the US economy is bigger the US equity market is much more diverse and it offers a lot more upside potential but there might be just like sector rotations that happen within the US and stays large or you're going to see people move capital or repatriate capital back home to their home countries. And I think what's more at risk of the dollar diversification is more equities more so than uh than the bond market. >> That's a really really interesting chart. Uh do do is there enough we've got a lot of auctions coming up. We've got a lot of supply coming on the market for treasuries. Are there enough investors to absorb that? Are you concerned about what they're what the demand is going to be? Yeah. So, we we've seen the auctions get, you know, a little bit weaker or at least not perform as strongly as they have in the past. Um, I think um there's always demand like we said at the right price, right yield, there's always demand. Uh so, the markets are are trying to find out that equilibrium right now. Um and you know, over the over the coming months and quarters, there's uh a few changes that are taking place on the banking side with with bank reg uh relief. So I we we do kind of expect banks to be US banks especially to become larger buyers of US fixed income especially at these higher rates. Uh so there's there's I think that just that the investor uh mix is going to shift more towards domestic focused. Uh even US investors like you know again uh you know are going to look at look up and say hey 4% on the two-year might be you know an attractive alternative given where everything else is right now. So uh we do think that um that there's a a domestication happening of the US bond market away from foreign investors uh and that will be where most of the demand's going to come from going forward. >> Interesting. Let's finish up with private credit. So, one thing we haven't talked about is that is that a risk you're concerned about is do are some of the sort of, you know, repricing and some of the issues that seem like, you know, the there's not only one cockroach, uh, have is it working its way through in the private credit markets? Do they present a risk to the greater economy? How are you thinking about that space? >> I think we need to like, uh, compartmentalize it into a few different places. one, it's the macro side of it, which is my area that I focus on. And then is there like a systemic connection back to the financial markets, and that's the part that I'm a little bit still dubious on. I still I think we all have to still put our thinking caps on and analyze this sector more closely. But if you let's look at page 65 and look at non-depository financial institutions, so they call them NTFI, so the non-banks. Um, and I'm going to show you two charts. So, I actually think they're they're really interesting when you look at them together. The chart on the left is looking at money velocity relative to loans and leases as a as a ratio of bank deposits. And so, how fast is money turning over drives money velocity and you can really see after QE1 from basically the last 15 17 years, we've had a collapse in money velocity. So even though we we printed so much additional money, it's not really uh circulating as fast through the economy as it did. Every once in a while we get these spikes, but then they they collapse. It has turned the corner. It clearly has turned the corner post pandemic. And so it's kind of going going back up again. In order for it to to really accelerate, you need a number of factors. One, more demand for credit. And two, population growth. We're not getting really population growth. and and and and many uh you know the more indebted uh borrowers are not going to be able to take on more debt. So we're so we're not gonna get like a massive increase there. But that's the chart on the left which is the long historical account showing you that money velocity and the kind of turnover in the banking system is what kind of creates this kind of uh credit lending uh growth which also then feeds into inflation feeds into all other things. Right? You can kind of say that the economy has kind of been zombified from basically 2010 onwards. >> Right? Which is what people worry about, right? It's not getting into the real economy. >> Correct. by slowly turning the corner. If you look at the chart on the right, this is where it's really interesting. So, this is a zoomed in version of the chart of the left starting from basically, you know, the early 2010s >> and then going through going through the pandemic and then coming out of the pandemic. I broke down the um bank lending between pure lending to the real economy coming from banks and the and the part that's being driven by private credit which is like this non-bank lending. You can see that that if you exclude if you take out the non-depository financial institutions, there's been very little bank lending. Most of the marginal credit being provided to the US economy has been coming from private credit >> and the banks are the originators of that because banks are ultimately what creates and destroys money uh and expands the money supply. It comes from the banking system and the Fed. So if you don't have that, it won't you won't have growth. So the banks are providing kind of like warehouse and bridge loans to private credit and all these financial sponsors which then expand it and grow into the economy with different sort of uh regulation around them or less regulation. And so that that's where it becomes potentially problematic that the marginal credit for the macro has come from a very narrow set and if there is you know either you know malinvestment or just you know bad lending standards whatever the case may be then you'll have a credit event potentially there or from a pure macro side the these loans were originated when rates were much lower and with as loans come due and they have to reset at higher rates and a weaker economy it could expose you credit defaults and weakness in in the underlying, you know, companies that borrowed. And so that that's the the part that we're not there yet. And that's why each time we go through these cycles, we get closer to that tipping point that could expose the credit fragilityities, could expose them, you know, a recession along with it. Um, and then you get, you know, then you potentially get real real credit losses. and and even if it doesn't necessarily emanate from there, if you need to um raise liquidity, you sell what you can, which could be bonds that are in the public market outside of the credit. And that's where the rubber hits the road. If you have to source liquidity, you sell what you can. >> So that's that's interesting. And I think that's a that's a kind of different I think everyone had been waiting just because of the experience of the great financial crisis that oh we have this massive private credit somebody's going to blow up there's going to be counterparty risk and they're going to kind of take the system down. You're describing just pulling support from the economy and then the knock-on effects of something like that happening of that um the sort of providing loans and money to the the economy itself through that and then just having a negative feedback loop from that. That's so interesting. And that's >> and it's also slower and it's also slower and you can you can observe it better and that's why it hasn't yet registered in our radar as systemic in nature. >> Of course, we don't know if there might be some hidden risks out there that are just unbeknownst to all of us and then they do become like a kind of like a big shock that comes from a very narrow set. >> Uh I just don't think we're there yet and we're needing to see more evidence of it. But the there is signals there that are very similar to 2008 as well. Maybe kind of concluded on the last last slide here on page 71. History doesn't rhyme as Mark Twain says, but it can repeat in different ways, right? Um if you look at the sort of path that we show here on page 71, there is a, you know, there's depending on uh your borrowing base, you know, mark to model versus not marketing at all to um potentially some concerns around ratings, uh looking for redemptions and you can't get your money and access to your money. uh 2008 was more of a banking sort of system risk and this one might be more acute to the bar the lenders which are coming from non-banks like insurance and pensions that have been providing the capital for a lot of this private credit. So like again doesn't nothing ever repeats exactly the same >> but there it could go down this path where economy weakens exposes the fragilityities and then you actually get the credit event later. >> Yeah. >> Instead of the instead of the credit event triggering it. >> Yeah. No, that's it's such an important distinction and this is all really important. Listen, the bond market is the plumbing is the financial plumbing and we say that all the time. So really understanding what's happening in that market is really critical even though a lot of people sort of open the newspaper and see the Dow and the S&P and NASDAQ and look at that. Um if the bond market's not working properly, then nothing is. So uh appreciate you running through it all for us, George, and sharing your expertise. Really, really interesting stuff. >> Thanks. Thanks for having me on. >> Yeah, come back again soon.
“Something’s Gonna Crack”: Bond Strategist Warns Stealth Tightening Is Hitting Markets
Summary
George Goncalves, Head of U.S. Macro Strategy at MUFG, joins Maggie Lake to explain why the market may be underestimating …Transcript
Both oil and rates now are actually tightening the financial conditions in the economy. Like equity markets are doing their own thing. They're on their own planet. We don't know how long what's the breaking point because again the Fed hasn't hiked, but the markets hiked for them and this is this is going to be a drag for corporations. These high rates are going to start to really hurt. Eventually something's going to crack. >> Hello and welcome to Wealthy. I'm Maggie Lake. Joining me today to discuss the outlook for US markets is George Galves, head of macro, US macro strategy at MUFG Securities. Hey George, great to have you with us. >> Uh, good to be with you, Maggie. Good to see you. >> So, and welcome to all of you tuning in as well. Just a reminder, if you'd like help navigating these volatile markets, you can get a free portfolio review from an adviser in our network. Just hit the link in the description or go to wealthyondon.comfree. So, George, uh, really interesting action, um, right in in your area of expertise, we saw a significant synchronized selloff in global bonds. What message is the bond market sending or are bond investors sending? >> Sure. Maybe just like a little bit of background on me for those that, you know, don't are not familiar with my approach. I'm a macro strategist but look at the world through a fixed income lens because our our overall mandate is fixed income here and and and clearly the bond market is front and center very important to us and interconnected and drives other markets as we all know. Um and the bond markets are sending a signal around concerns about inflation and then down the road what will be the response to inflation if the inflation shock ends up with demand destruction, weaker economies and then governments have to step in with some sort of fiscal support. I think there's a lot of that all happening at once. It's hard to disentangle like what's the primary driver. Uh the short-term factor is inflation. The long-term factor is just the general health of of countries and sovereigns. Yeah, I think and I think you just put your finger on why this is so complicated, you know, because I we hear people say all the time or I think the question out there are are are the correlations that we're used to still in place like you know the the sequence of events that we would expect when something like this happens um and that you try to model out does that still apply because we do have this crosscurren of really strong sort of macro forces. So, let's un unravel that a little bit when you're talking about So, let's maybe start near-term with inflation. I mean, um, are we in a are we in a situation where there is a feeling that this is really related to what's happening in the street? Um, and or have we have we tipped over somehow and now and this is why we're seeing this reaction in bond markets that investors are starting to think, wait a minute, maybe this isn't going to subside if we get a resolution in the war. Maybe global supply chains are different now. Maybe this is stickier. Uh and it's and we're higher for longer. That's a phrase we hear all the time. Thoughts on that? Is that does that seem like the scenario we're in or is that what is bothering bond investors right now? >> I think there's a lot of lot of different factors at play here as you kind of spelled out. Maybe we could pull up one chart on slide 22 because I think this is a chart that gets overused a lot both in financial media as well as analysts and strategists across the the the spectrum tend to look at this chart on page 22 that shows you a comparison of the inflation uh reaction during the 1970s into the early 1980s. Some people even call it chart crime to be doing these parallel analysis. There's probably some truths to that. And then the uh the red line is kind of the 1970s approach to inflation. >> And then in the black line is the current inflation run rate since really postcoid the pandemic. And they kind of like look very similar, right? You had a first kind of big massive wave led by supply disruption. Both both instances had that. And and what kind of differentiates between now and then is that we are you know we're at this kind of crossroads where we've seen what happens all the time. Whenever we go into a crisis where something you know bad happens usually governments intervene and if they were to intervene again you get another impulse in inflation. So I think in the back of everyone's mind especially buying investors is that if we you know right now everyone has a kind of optimistic outlook on on growth which to me is a little bit perplexing but if we were to go into an economic slowdown we know that what's going to step in is these fiscal stabilizers. The government will kind of provide liquidity inject capital into into the markets into the economy. Then you get a a second wave of inflation or you get government sort of stimulus and that's kind of what happened in the 1970s. If you look at there's a lot of little small things people maybe can can point it out and zoom in on this chart when they look at it. You can see that there was a lot of government intervention. If government starts to kind of intervene providing stimulus or gas you know uh benefits uh to to their population that money gets spent it goes into the economy creates inflation. So it depends on the nature of where money's coming from >> and and it and like I think in the back of everyone's mind is that there's going to be a eventual government answer to this which will be more printing of money and therefore it creates inflation. So it's not just a near-term oil shock inflation. It's like what follows >> what matters. >> That's super important because that's the that's the sort of 800 pound gorilla in the room. And I think this is why you have people talking about bond vigilantes again, right? So this isn't just a reaction to a temporary situation with inflation. This is sort of bond investors saying we've had you're spending like drunken sailors. This is this is just the knee-jerk every time and we don't think we want to hold your bonds if you do that. Is that is that what you're saying? >> Partially. I mean I think it's the the bond market's commanding a premium for the first time saying look we you know bonds are going to get underwritten regardless. It really comes down to what yield what price right. So um and and to and they're commanding a premium higher rates even though the Fed's not hiking. And we don't expect the Fed to hike even in this environment. >> The bond market's hiking for them by commanding this extra premium 10-year rate above 4.5, the 30-year rate above that psychological 5% level, even though the Fed has cut 175 gis bucks. So like we've we've seen a pretty big reversal. It's the bond market asking for uh some compensation. So, you do not think the Fed's going to rate uh hike rates because the market is now pricing that in based on everything we've seen with these sticky hot, you know, PPI and it's starting to flow through and now this trade's been closed for so long. The bond market has gone from thinking, oh, the new Fed share is going to cut rates to thinking that the first move might be a hike. You disagree with that? >> I I disagree with that. I mean, and we've been here before. So, maybe, uh, calling up on another chart, um, which is slide 37. You know, here I'm I'm kind of comparing the 2008 experience, and you have to go back to 2008 and remember that we also had a pretty big move in oil up to $147 a barrel, roughly almost 150 back in 2008. In in today's dollars, that's well over $200. And so, yeah, I'll change my view. If oil starts to spike towards 200 bucks, everyone's everyone's going to change their view. But at these levels, we're not at the point yet where we think the Fed would want to even entertain hiking rates, they have a dual mandate. They they are equally concerned about the labor market. And if you look at this chart on the left on page 37, even in like before the financial crisis really got going in late 2008, the market priced for a nancond, 18 basis points of hike. So like almost one full hike was priced in in 2008, which of course the Fed never delivers. That's a little black line over the red. >> Eventually, we all know the rest is history. The Fed ended up cutting rates down to zero in reaction to the financial crisis, no less. But still, like we're at, you know, critical potential inflection points with, you know, financial markets highly valued. We have concerns around private credit. So there's enough sort of like u kind of tail tail risk tail risks in on the on the side. they have this inflation shock that's hit bond markets pricing in hikes. That would be a policy error for the fi the Fed to be hiking now. The the most they could do is stay on hold maybe for you know ride this out for another three to six months and see if it does feed through into inflation or permanently into inflation. There's clearly going to be a shock from the energy. We're already seeing it in CPI, PPI, but to hike in this environment would only compound the pain that's being felt by households in the US >> that are really great sensitive down in the lower income middle to lower income brackets. So, I think it it would just be unnecessary. It would cause more damage than it would help. >> Um, and so yeah, so we've seen this movie before. Bond markets price in hikes and then they're never delivered. I think we're seeing a repeat of that. >> So interesting. And I'm going to ask you about you. I think you brought bring up a really important tension that the Fed is dealing with. But when we're talking about the bond markets now and if they have to sit through this and it's not just the US, right? We have global bond markets selling off. I think because of what you pointed to this uh tendency to run in with a fiscal response based on and just the overwhelming amount of debt that we have uh in addition to some country specific things. Uh the speed's pretty quick now that we I mean we've seen a sort of that that repricing has been pretty powerful. Where do you think rates what's the sort of ceiling before the Fed or central banks would have to respond? Do you think that we saw that or is there a potential for us to see rates get substantially higher from here before something were to happen or something were to break? you know, what does that upward momentum or that upward risk for yields look like for you? >> As with everything in our business, it's time and the ultimate level. So, how long you're at a certain level, this this is true for both oil for rates. Both oil and rates now are actually tightening the financial conditions in the economy. >> Like equity markets are doing their own thing. They're on their own planet. But the actual inputs that matter for the cost of funding, cost of energy to run a a country are going up and so that's like a tightening that's massively happening in the background. We don't know how long what's the breaking point like is it a three-month window, six month window at these elevated both high energy prices and high rates >> because again the Fed hasn't hiked but the market's hiked for them and this is this is going to be a drag for corporations for the marginally attached uh to the economy. These high rates are going to start to really hurt. I don't know what the right level is. I mean, I think we're close. I mean, I think, you know, 5% higher or higher on the 30-year is a big drag. The 10-year above 450, which is roughly where we are in at the time of reporting. And so, like, if we're staying at these 450 or higher for a prolonged period of time, I think it's going to do a lot of damage. The housing markets are race struggling as it is. um you know auto sector all these interest rate sensitive sectors are are under pressure and the consumer is not as strong as optically it looks like that if we sit here until you know deeper into the summer I think the odds of of of recessions go up like this is like a tightening that's very stealth in in nature >> of course um super inconvenient heading into the midterms for us to see the economy move lower which I'm sure is raising concerns for bond investors Um George, we have heard concerns about recession before, right? This is the sort of recession that never comes. Um and there were a lot of other factors including the spike we've seen in oil that everyone thought, okay, this time this is going to push the economy into recession. There is weakness under the hood. It's just a matter of time. And then it has proven to be so resilient. Why might it be different this time? So let's go to page six and look at the long historical account of both recessions and expansions in the US. This is one of one of my favorite charts. It goes back back to the MBR calculations in the late 1800s. And the first thing you're going to notice is that in the past recessions and expansions were almost like symmetrical. Like you would have just as long drawd downs and weak economy versus really strong booms. You had this kind of boom bust cycle up until 1971 when we got off the gold standard and really allowed for sort of fiscal expansion, monetary policy to kind of smooth out the business cycle sometimes maybe like creating excesses along the way as we saw in the late 1990s and as well as into the housing crisis. And so you kind of see the black bars get bigger as you get into the 70s, 80s and 90s and so forth. I do find it interesting that the current expansion of roughly about five plus years is similar to the 2000 pre pre208 experience. And why do I think that's interesting? Well, one there's a lot of financial innovation taking place from 2000 up to 2008. similar there's a lot of financial innovation happening postcoid >> with you know with a lot of sort of derivatization of the equity market faster access to liquidity a lot of leveraged uh vehicles out there margin debt you name it there's a lot of excess liquidity and different ways of expressing uh putting on views with these sort of new uh instruments and you had the the the real taking off the private credit sector which has been the marginal provider of credit to you midsize companies throughout the US like a high rate environment andor for economic weakness if they were to happen in that sequence would really uh expose some of these u fragilities that are been kind of masked by really elevated financial markets which gives the perception that everything's good and everything's great and so I find that ironic that like we're kind of getting close to that window of comparable to the 2007209 window where some shock out of the blue like we the economy has been resilient but let's not like underestimate how much uh support it it has had for the last five years and each time you do it you kind of run out of runway and I think we're getting close to that point uh where the fragilityities around the credit markets and uh equity valuations being very stretched >> uh the economy really hinging on just two real growth factors both you know AI and upper income spending and they're linked so if you get a sort of correction in financial assets and or some bigger shock that's macro which we might be in the midst of it right because we've never had the straight horses closed this long. Uh the potential disruptions, the shortages, maybe rationing that's coming ahead, like we don't know how what that's going to do to the gears of growth in the economy. The gears might start to grind to a halt and then you get a recession and then you expose that the financial valuations were too stretched. That sounds very similar to like a late 99 2000 or 2007209 window and like the business cycle has been long but eventually I think it will come to an end. The question is, is this enough damage uh to actually put it over the top? >> And I think the question also people are really concerned about is um do we see a correction and a recession or do we see a crisis and a really difficult a lot of pain in equities? Because when you talk about 2000 and you talk about like 2008, those are really concerning times to compare it to. um do do we know based on what we're seeing or are the bond markets giving us any indication of where where the risk lies or where the probability lies when we're talking about those two scenarios. >> So both in in both those instances in 200 the Fed was actually raising rates which kind of helped kind of take out the excess liquidity that was running rampant in the and the euphoria in the whole dotcom phase. So there was clearly a lot of liquidity and then financial innovation a uh euphoric move around a new technology and ended up with a very minor recession in the grand scheme of things but valuation still still got cut in half or the markets got cut in half roughly speaking and tech were down like over 80%. Um you look at maybe slide 13 I think this is a good a good way to think about it. um and comparing what we've we've we've seen a lot of others uh kind of compare and contrast how consumer sentiment is not lined up with the sort of uh sentiment that's being expressed in the stock market. And this is uh looking at the S&P the chart on the left >> in red relative to uh consumer sentiment from the University of Michigan. And you can kind of see like up until like uh Trump's second sort of term, the early part of the second term, there was like a little bit of a bump in in enthusiasm around sentiment. Stocks were going up. So there was a minor kind of correlation between stocks and um and consumer sentiment and then it broke down after liberation day and but yet stocks have kept going higher, right? Uh we've we've kind of u identified why that's the case and I'll get to it in a second, but look at the chart on the right. This is looking at the unemployment rate compared to whenever oil prices are up 80% or more. I mean again none of these rules we've and we've learned this. We have to be very careful in the macro space to have these sort of steadfast rules. You know the yield curve did not also predict a recession, right? Uh I mean it was predicting if it never came it did you did have moments of weaker uneven growth but not a real full-blown recession. But you know each time we do this eventually something's going to crack I think. and and this latest round being the oil driven I think matters more and and you compare like the little circles that I have here on this chart on the right is looking at the unemployment rate after we've seen oil almost double >> and when that happens 6 months to 18 months at maximum you do fall into a recession there's only been one or two head fakes which was around the Russia Ukraine invasion of 2022 you had a big spike in oil but yet the economy managed to kind of uh kind of uh lived through it. Even though we had some weakness in in the economy in early 22, it it was not a full-blown recession. And I we we attribute that largely because we were just coming out of the pandemic. There was, you know, trillions of dollars of excess savings. There was pent-up demand because everybody was uh locked locked in. And so that unleashed so much demand for the economy in 23 and 24. We don't have the same sort of backdrop. We have the consumer tapped out. We don't have excess savings in the system. and all markets are at the local highs. Like, how are you going to perpetuate this if oil does not come down? Like, we we think oil has to come down back to $75 to to avoid a more sharper downturn. Maybe it's not a full-blown recession, but the second half it's going to be much weaker unless oil meaningfully comes back down to like 70 bucks because if it doesn't, then this chart might actually be a good predictor that we're going to head into an economic slowdown in late 26, early 20 soth. Yeah, George, are are bond prices tracking oil or are they tracking debt and government large ass or both? >> I think both. Uh but you know, if you you can kind of get a sense of this and I know we're bouncing around a little bit. >> And and that last chart, by the way, if anyone doesn't understand what people talk about for the K economy, that last chart literally K that's why people started calling it a K economy for that very reason. So it's a great point. >> Absolutely. the the biggest divergence possible. How how's that all consistent? I don't think it is or it's not sustainable until you see it more brrawny out and everybody participates in the economy, not just a few. >> Yeah. >> But if you look at page 55 of of the of my PowerPoint, you see that, you know, as the kind of title suggests, until growth is clearly obviously weakening because right now we're in this kind of dubious state, we think the economy can weather it and the data so far has been okay, but it hasn't really factored in all the disruption. We don't think so. And that's why the sooner you know we get some sort of conclusion or at least the straight of poor moose opening up and letting oil flow and that taking down prices and providing some relief at the pump until that happens we're going to have a growth shock at some point >> and um but until then the rates market is clearly just trading with oil. So the chart on the left kind of shows you the two-year Treasury going up and down with the es and flows of the oil market. you know, now that the two-year is above 4% since the time of this chart was kind of published, um, and we have oil still sticky at around 100ish, uh, there's going to be a point where oil could keep going higher, but the the the rates market should decouple. We're not there yet, but I think it's going to be close. Uh, and that's why we favor short-term treasuries more so than long-term treasuries don't have the sort the same sort of duration risk. And if we do get an economic slowdown, the two-year should perform better. At these high rates, you're actually starting to compete with money markets for the first time for the two-year. But nonetheless, yeah, for now, oil oil is driving everything. It's the the key macro factor definitely for rates. Uh and it's it's that inflation linkage. It's that concern around uh you know, how disruptive this is going to be. But eventually, we do think there's going to be a decoupling between the oil markets and rates. We're not just there yet, >> right? And if they decouple, it's already priced into the short end, but you could see more pain further out the long term. >> If we see that growth shock and oil moves lower, can we count on yields to move lower too? Because presumably if we have a growth shock, we may have a fiscal impulse to fix it. So, do you get the do you get the move lower or are we at risk of now having bond investors start to worry about that as well? and that kind of create an inability to pull those rates down. >> Yeah, that that that was perfect for Amy and that's kind of what we discussed at the start of our conversation that each time we we go through a mini crisis or an even larger crisis, we go back to the same well, which is more fiscal spending, more government intervention, and that the bond market is saying like we can help you underwrite this, but it's going to be to come at a cost. You know, that said though, I do think that rates would rally if we go into an economic slowdown. Even though there's be government support in general, rates would come down. It's just that long-term rates would come down less. >> And we, you know, and maybe don't even revisit the levels that we used to see in prior economic slowdowns. I mean the 10 year not as low in outside of outside of the pandemic, you know, 150 2% 250 would be like a level you can see the the 10-year rallying to in a in an old school kind of economic recession. But given how fast the reaction would probably be from government authorities, if we get back down to 3.5 on the 10ear, I'd be happy. So like so I I think there'll be a limit how low long-term rates can go and and what we're doing each time we're doing this we're reestablishing a higher base and the ranges are shifting higher. >> Yeah. >> And we we we've clearly broken the 40-year bond bull cycle. The question is is it starting a you know 20 30 year bond bearish cycle we can't afford it. So I think there's a limit on how high we can go as as there is a limit on how low we can go. So uh in that in that situation let's talk about uh corporate bonds. H are are they also reacting negatively to this? Are the same dynamics driving them or are they insulated for other reasons? >> Yeah. So uh corporate corporate market has been operating uh to its own devices largely on the back of a much healthier kind of balance sheets relative to government bonds, right? Uh you know and and and better earnings prospects and the like. And so you're not seeing the same sort of dynamic in the past where if there was like a risk around the financial markets, you would see you know spreads widening >> blow out on corporates especially you know uh lower grade higher yield in corporates. >> Yeah, we're not seeing that and look we get episodes of of widening around more like um positioning realignment or if there's a big shock financially but they usually don't last long. But I do worry that that's now conditioning uh credit investors to kind of think that's the new norm in general like this kind of characteristic is very similar to what you see in emerging markets where uh it gets the lines become more blurry between the government and the credit markets >> until you actually have an economic slowdown and then people still prefer the risk-free rate because the government will still pay you back. And so um it means that you're gonna up until the time of the worst case of whatever might lie ahead. The corporate markets will be kind of more um stable and then you'll have a more of a shock that oh we are going into a recession. It's going to be much faster. So it's going to be like very narrow tight ranges on spreads and then once we get closer to an actual event you'll see spreads widen because the preference will shift back to higher quality shorter duration uh treasuries. Yeah, George, if we see a fiscal response, if this plays out where we see these high energy prices, high rates trigger uh a recession or some sort of downturn and the government steps in. What does that look like? I mean, some people have postured that maybe the stock market's too big to fail now. Uh so, what what do we you know, what does that sort of support looks like look like? And do do investors prefer something over another? Do we see yield curve control? Are we see outright purchases of of stocks? Are we, you know, we talking about uh STEMI checks to people? You know, like what what would that look like that would be of concern to investors? >> I mean, luckily, most of these playbooks have been used already. So, we're going to see probably all of that and and probably some new things uh thrown into the mix. Um, you know, maybe if we like if you look at page 62 and and look at just uh valuations and how and and this is true for many different valuations and this is looking at a percentile from 0 to 100. How stretched are valuations for various metrics for the for the stock market and we've been sitting at very stretched valuations for a long time. So is this the new normal and everyone's kind of believing that you know equities are the only alternative? They give you access to earnings which are indexed to nominal inflation which the government ultimately controls by through the printing press uh and if they were to come into rescue that would indirectly help out you know strong corporations. There's definitely truth to that. And so maybe like our our measuring sticks have to be have to be changed in the sense that um a a 40 capum uh ratio is high historically speaking. But maybe we can't let it go down under 30 because if we went under 30 that wealth effect would be the actual wealth loss would be so massive >> that it would be even more expensive than governments would be able to bail out. So like it's like you have a high there's also that I don't want to use the Irving Fisher higher plateau because that's usually a jinx that could make things uh go the other way but usually like um you would think there would be some sort of mean reversion but these uh metrics have not been mean reverting. We've been getting more debt, >> higher valuations and yet no real pullbacks in equity markets. If we ever did if we ever had a real pullback in equity markets, it would upset the equation massively because um everything's linked as you know. But I think it's just interesting. You saw like you know post pandemic big increase Fed hiked. We saw some valuation retreatment stocks did go down after the Fed hike. So there was some fundamental connection there for sure. And then since then with the advent of AI and all the uh other or all new industries adjacent to it there's been a big capital u capex wave a lot of spending but valuations are reflecting that it's not it's not as if the market's cheap like the stock market >> um we just can't afford a revaluation of it because then the response would be even equally larger which is why some people call it the the crack up boom that you know that the response will be something even larger than before. So you you have to stay vested all the time. But um maybe if you look at one more chart on the next page, page 63, this is really the way that I look at it from the credit perspective. Uh if you take uh all corporate debt excluding bank debt which is fungeible and close to the the banking system um you just look at pure corporate debt as a ratio of the value of the stock market that gives you the black line >> which basically predicts or is you know is consistent with where spreads are. So if you have a highly valued company, they have their balance sheets look stronger and so they can handle more debt. >> If if the their if their equity values were to decline, their debt to equity ratios go the other way and then spreads would have to reflect that. So that everything's linked. So we cannot we can never let stocks ever go down because if they did, we would have to repric everything. >> That's a that's a huge statement, right? That's a huge statement. So So what does that mean in terms of investment strategy? What does that mean for bonds in a portfolio given that there's a limit to to the extent that officials or anyone are going to be able to let stocks go lower? So, you've got to be exposed somehow to stocks. How do bonds fit in? >> Yeah. So, I look, as I've been kind of alluding to, you you have to pick your spots. I mean, rates are getting higher and more attractive now. So, o over time and there is value in dollar cost averaging in every asset class, including the bond market. Just the idea of the trying to time the markets are obviously difficult. Um so the higher rates go the more attractive they're getting this bottom line. Um and so I do think that there's some value in introducing a kind of ballast now after equities being so highly valued. And by the way even if equities end up you know always having um support coming in from the government in one shape or another there can still be draw downs that are easily 30 40% before they bounce back again um if we go into a proper economic slowdown. So, it's not like as if you're completely immune and you might end up still being better off in a three-year window, but you can still see some sort of losses in the near term. So, having some bonds here, especially given where everything is, makes sense. But shorter duration bonds just get the exposure if the Fed does go back to cutting to help the economy later in the future. >> Um, and emerging market debt. I mean, other, you know, yeah, there's high quality, uh, structured debt that's interesting. Um and you know in you know in general like if you think about like equities relative to US equities relative to the world there is benefits in diversification everyone you know doesn't well the left folks don't want to think about the international uh sector as as a as a viable alternative but this is now a time where it makes sense to kind of shop around the world and look for uh other equity markets that are that are much more attractive at least from a yield perspective. There's no yield left in the S&P. Um, so I do think that there's, you know, there's a a case to be made to diversify outside the US. >> Yeah, we we keep banging the table on diversification. There are some people who feel like bonds though are not um that if you're going to diversify, you've got to think about commodities. You got to barbell that way. That bonds are uh uh given all the dynamics around debt in the world are just not a way to diversify. You're just eroding because of the purchasing power. It's just it's it's money going down this thing. Overstated is that maybe on the long end where those concerns are versus shorter end as a person who um is is so cognizant of what's happening around bonds. How do you react to that kind of statement? >> I mean I think it depends on each investor type. I mean yeah retail versus institutional investors have a different sort of perspective. Um and and the bond market is still largely an institutionally uh marketplace. Um, and so, yeah, I do think that, uh, you know, bond investors that have specific mandates, um, like insurance companies and pensions, they're going to have a different reaction to this sort of statement versus someone that's managing their own money, which again, I'm not giving any advice. like this. It depends on where you're coming from, but I do think that, you know, over time, yeah, having a broader diversification like the 6040 portfolio probably doesn't make sense in the world that we're living in. If it's going to be slightly higher inflationary concerns and higher rates, you have to kind of shift that around and look for alternatives like commodities like overseas assets that give you uh you know, some sort of uh diversification. I mean, I think, you know, like looking at page 44 though, I think would also help and I think people sometimes forget that even though the bond market's gotten bigger and the US bond market is large and it has a lot of support coming from overseas investors, the US equity market's even larger like in the in in the terms of allocations and how much it is relative to the global landscape. >> Uh this is looking at um you're looking at two charts. The chart on the left is comparing the country weight of the US market relative to other countries. >> And even though the US bond market has been growing, it's it's it's marginally larger than what it was in 2010. So even though we have a lot more debt, everyone else is also taking on more debt. So on a relative basis, foreign investors still have to have exposure to the dollar. >> And then you look at the stock market though and you look at it's like 70% of the global equity market. >> Wow. like how much larger can the US equity market get relative to all other equity markets I think it's at the limits personally speaking in 1987 the Japan's uh stock market was 40% before it went into its downturn um look the US economy is bigger the US equity market is much more diverse and it offers a lot more upside potential but there might be just like sector rotations that happen within the US and stays large or you're going to see people move capital or repatriate capital back home to their home countries. And I think what's more at risk of the dollar diversification is more equities more so than uh than the bond market. >> That's a really really interesting chart. Uh do do is there enough we've got a lot of auctions coming up. We've got a lot of supply coming on the market for treasuries. Are there enough investors to absorb that? Are you concerned about what they're what the demand is going to be? Yeah. So, we we've seen the auctions get, you know, a little bit weaker or at least not perform as strongly as they have in the past. Um, I think um there's always demand like we said at the right price, right yield, there's always demand. Uh so, the markets are are trying to find out that equilibrium right now. Um and you know, over the over the coming months and quarters, there's uh a few changes that are taking place on the banking side with with bank reg uh relief. So I we we do kind of expect banks to be US banks especially to become larger buyers of US fixed income especially at these higher rates. Uh so there's there's I think that just that the investor uh mix is going to shift more towards domestic focused. Uh even US investors like you know again uh you know are going to look at look up and say hey 4% on the two-year might be you know an attractive alternative given where everything else is right now. So uh we do think that um that there's a a domestication happening of the US bond market away from foreign investors uh and that will be where most of the demand's going to come from going forward. >> Interesting. Let's finish up with private credit. So, one thing we haven't talked about is that is that a risk you're concerned about is do are some of the sort of, you know, repricing and some of the issues that seem like, you know, the there's not only one cockroach, uh, have is it working its way through in the private credit markets? Do they present a risk to the greater economy? How are you thinking about that space? >> I think we need to like, uh, compartmentalize it into a few different places. one, it's the macro side of it, which is my area that I focus on. And then is there like a systemic connection back to the financial markets, and that's the part that I'm a little bit still dubious on. I still I think we all have to still put our thinking caps on and analyze this sector more closely. But if you let's look at page 65 and look at non-depository financial institutions, so they call them NTFI, so the non-banks. Um, and I'm going to show you two charts. So, I actually think they're they're really interesting when you look at them together. The chart on the left is looking at money velocity relative to loans and leases as a as a ratio of bank deposits. And so, how fast is money turning over drives money velocity and you can really see after QE1 from basically the last 15 17 years, we've had a collapse in money velocity. So even though we we printed so much additional money, it's not really uh circulating as fast through the economy as it did. Every once in a while we get these spikes, but then they they collapse. It has turned the corner. It clearly has turned the corner post pandemic. And so it's kind of going going back up again. In order for it to to really accelerate, you need a number of factors. One, more demand for credit. And two, population growth. We're not getting really population growth. and and and and many uh you know the more indebted uh borrowers are not going to be able to take on more debt. So we're so we're not gonna get like a massive increase there. But that's the chart on the left which is the long historical account showing you that money velocity and the kind of turnover in the banking system is what kind of creates this kind of uh credit lending uh growth which also then feeds into inflation feeds into all other things. Right? You can kind of say that the economy has kind of been zombified from basically 2010 onwards. >> Right? Which is what people worry about, right? It's not getting into the real economy. >> Correct. by slowly turning the corner. If you look at the chart on the right, this is where it's really interesting. So, this is a zoomed in version of the chart of the left starting from basically, you know, the early 2010s >> and then going through going through the pandemic and then coming out of the pandemic. I broke down the um bank lending between pure lending to the real economy coming from banks and the and the part that's being driven by private credit which is like this non-bank lending. You can see that that if you exclude if you take out the non-depository financial institutions, there's been very little bank lending. Most of the marginal credit being provided to the US economy has been coming from private credit >> and the banks are the originators of that because banks are ultimately what creates and destroys money uh and expands the money supply. It comes from the banking system and the Fed. So if you don't have that, it won't you won't have growth. So the banks are providing kind of like warehouse and bridge loans to private credit and all these financial sponsors which then expand it and grow into the economy with different sort of uh regulation around them or less regulation. And so that that's where it becomes potentially problematic that the marginal credit for the macro has come from a very narrow set and if there is you know either you know malinvestment or just you know bad lending standards whatever the case may be then you'll have a credit event potentially there or from a pure macro side the these loans were originated when rates were much lower and with as loans come due and they have to reset at higher rates and a weaker economy it could expose you credit defaults and weakness in in the underlying, you know, companies that borrowed. And so that that's the the part that we're not there yet. And that's why each time we go through these cycles, we get closer to that tipping point that could expose the credit fragilityities, could expose them, you know, a recession along with it. Um, and then you get, you know, then you potentially get real real credit losses. and and even if it doesn't necessarily emanate from there, if you need to um raise liquidity, you sell what you can, which could be bonds that are in the public market outside of the credit. And that's where the rubber hits the road. If you have to source liquidity, you sell what you can. >> So that's that's interesting. And I think that's a that's a kind of different I think everyone had been waiting just because of the experience of the great financial crisis that oh we have this massive private credit somebody's going to blow up there's going to be counterparty risk and they're going to kind of take the system down. You're describing just pulling support from the economy and then the knock-on effects of something like that happening of that um the sort of providing loans and money to the the economy itself through that and then just having a negative feedback loop from that. That's so interesting. And that's >> and it's also slower and it's also slower and you can you can observe it better and that's why it hasn't yet registered in our radar as systemic in nature. >> Of course, we don't know if there might be some hidden risks out there that are just unbeknownst to all of us and then they do become like a kind of like a big shock that comes from a very narrow set. >> Uh I just don't think we're there yet and we're needing to see more evidence of it. But the there is signals there that are very similar to 2008 as well. Maybe kind of concluded on the last last slide here on page 71. History doesn't rhyme as Mark Twain says, but it can repeat in different ways, right? Um if you look at the sort of path that we show here on page 71, there is a, you know, there's depending on uh your borrowing base, you know, mark to model versus not marketing at all to um potentially some concerns around ratings, uh looking for redemptions and you can't get your money and access to your money. uh 2008 was more of a banking sort of system risk and this one might be more acute to the bar the lenders which are coming from non-banks like insurance and pensions that have been providing the capital for a lot of this private credit. So like again doesn't nothing ever repeats exactly the same >> but there it could go down this path where economy weakens exposes the fragilityities and then you actually get the credit event later. >> Yeah. >> Instead of the instead of the credit event triggering it. >> Yeah. No, that's it's such an important distinction and this is all really important. Listen, the bond market is the plumbing is the financial plumbing and we say that all the time. So really understanding what's happening in that market is really critical even though a lot of people sort of open the newspaper and see the Dow and the S&P and NASDAQ and look at that. Um if the bond market's not working properly, then nothing is. So uh appreciate you running through it all for us, George, and sharing your expertise. Really, really interesting stuff. >> Thanks. Thanks for having me on. >> Yeah, come back again soon.