Surveillance: Fast as Lehman with McDonald (Podcast)

he made them some money. He went on to do all sorts of other things, including books and of course the Bear Traps Report. But what he's really known for is every once in a while writing an essay we're in a given year, you stop. He did that this morning for the Esteem zero Hedge. Larry. First thing I read this morning as well. I've been talking up Tunisia is something interesting in the Middle East and in the Levant, and you are focused on the fixed income deterioration of

emerging markets. We've seen this before, haven't we. Oh, Tom, it's amazing. This period that we're right now is so amazing because once or twice a decade, maybe three times in twenty years, you get a two three four week period where asset prices are moving at an accelerated pace so fast, and normally economists that that are on all the shows they're looking at economic data. But when when risk assets are moving this fast, the risk at risk

assets take over economics a difference delivery. The difference here, and this is really important, folks, is a mens esteem. For Lawrence McDonald. While everybody else in the bow tie world was studying economics, McDonald was down at the Brothers for in the casino by the sea on Cape Cod having a good time where he learned how to trade. And as you know, Larry McDonald, what this is about is the bid walks away. You've got a Bloomberg terminal behind you there in your Matt's explain to me right

now the character of the bid walking away right now? Well, it's the rate of change of asset price. It's where it be leverage loans, emerging market bonds, UH credit, the fault swaps on banks. So we're seeing just just the the highest acceleration in the rate of change speed. It's literally as fast as COVID, as fast as Lehman, and economists around the world are looking at Okay, all these rate hikes. At the end of the day, credit risk is about to veto the FEDS policy path. In other words,

the dollar is so strong it's the global wrecking ball. Uh. The i m F, for example, is owed one hundred billion dollars tom from emerging market countries and the FED is lighting that balance sheet on fire right now. Well, but Larry, I'm trying to write my head around some of the rhetoric, which is incredibly poetic, that describes the moment credit risk is about to veto the Fed's tightening path,

that risk assets are taking over for economics. Basically, we're reaching a breaking point akin to a Lehman moment or even what we saw during COVID. Are you basically saying the FED will have to backtrack or are you saying that there is a more more material fissure that's coming that's really irredeemable given where the FED is with inflation. Well, think of you've done a great at least of this morning.

Your job when the stress has have been phenomenal, because if you look back on June, late June, the results came out and the media was really celebrating these results, and now here we are not even three weeks later and there's a restatement of those results. That tells me that the regulators uh saw a shock. Um something is really scared the regulators for that type of change in

position over thirty days. And if you look at the rate of change in bonds, copper, and um in oil inside a thirty day period, we've never had a move like that without jobs being down like a hundred thousands to two hundred thousand within three months. So it's so, what's the breaking point here? I mean, you talked about emerging markets, you said multiply that by ten, and are we seeing that already beginning or are we not yet

even seeing it? And we're just sort of on the precipice of we're seeing the beginnings of the breakage in the dollar in what you're seeing with a Japanese yen, in which you're seeing in certain markets for risk assets. The fan is trying to stop inflation in the United States by promising, you know, a thousand rate hikes essentially, right, I'm just exaggerating, but about fifteen rate heiks, including one

trillion of quantitative tightening. The rest of the world is not doing anything in that regard in the developed markets sets up from maybe Canada. So what happens is when the dollar strengthens and you're in Indonesia, an emerging market country, You're trying to buy wheats, you try to buy corn, you're trying to buy oil gas, You're the FETE is essentially exporting information from the United States through the developing world,

and they're crushing civilizations around the planet. Larry, I get this one question and before we go, and that is the famous shot of Lehman brothers and they're standing there watching the deterioration of the company, and the Gartment report is up on the guy's screen as well. That was a time of leverage. The optimists are pushing back against you, saying the leverage here is not like it was a

ninety eight or in the Great Financial Crisis. Do you buy it or is the leverage just different in different place this time? Well, we behind me. We run a Bloomberg chat tom with institutional investors on the by side

in twenty plus countries, so we monitor the conversation. In the last two weeks three weeks, the conversation from by side investors that run billions of dollars is focused on sovereign risk, and that's where your nose has been focused on this week, and so exactly which transferred the Lehman risk from the balance sheets of the banks to the sovereigns. And now the Feds accelerating rates up and they're blowing up the global bond market and that's what's going to

stop them. Larry McDonald, thank you so much. Sobrata Rajapa now was suck and joining us here. What is the correlation that matters to you right now? Sobrata, what is the relationship not only in rates but outside rates for you? Well, I mean everything is a correy ad market, right, I mean, the bond heels are all very correlated. What's happening in Europe is definitely impacting what's happening in the In the US,

inflation is correlated. It's it's a global phenomena. But what we're really seeing right now is sort of a record

slow motion, if you will. We're in the US. You're seeing the steady rise in inflation, prints the Fed acting aggressively as predicted, and then the very sharp inversion of of the yield curve because of that, and the market is starting to price in a much higher probability of a recession that leading to potentially, uh, you know, FED funds rate peeking around three and a quarter three and a half to three point seven five percent, and then

cuts being priced in for next year. So this is all very much what you would expect would happen in a scenario like this where the FED is very aggressive. UM, as far as Europe is concerned and Easy Beast concerned, they're in a much toughest spot. Like you pointed out, you're looking at you know, very high inflation, headline inflation because of higher energy costs, higher oil prices, potential rationing.

But then on the other hand they have to be concerned about growth as well, because if there is a shutdown of of nursing one, that's going to lead to a significantly sharp decline and growth. So policy there becomes a lot tricky than it is in the US. We need to be building up gas storage in Germany apparently right now we're working it down. This is really problematic, Savantara. More broadly, for the bond market, I'm trying to work out what the anchor of global rates will be. Over

the last twenty years. It was Japan, then it was Japan of the e c B and Europe and the button market, and now there are doubts about the policy at the b J complete unknown. When it comes to European debt market, I've got no idea how you forecast European debt yields at the moment, Savanria, how do you come up the treasury call as you think about the

global fixed income universe. So to me, at this point, the anchor is the treasury market because things in the US are much more predictable, like you pointed out, than in other jurisdictions. Uh. You know, the Bank of Japan, you have they have eukur controls are in some respects along and it's going to remain somewhat PEG, but there's a lot of pressure on the currency side of the equation. So at some point they're going to have to, you know,

move away from the hag in Japan. So for me, what I'm really anchoring our rate forecast is on on on on the tenure and you know trajectory, the trajectory for growth over the next couple of years. Uh, And that's really where I think that it's going to be very difficult for tenny yields. Rives meaningfully from huron given the fact that growth is poised to store on quite meaningfully over the next year with the Fed expeditiously hiking rates over the over the next you know, three to

six months, so bad. Let's take that a step further and building what Bank of America did where they down gooded their forecast for the yield of differential and this rever the baseline yields for ten year and thirty year treasuries at the year end and even next year. How low and have you been revising even lower your expectations for those yields based on the deteriorating macro economic backdrop.

So our view for for the for treasuries is that tenny yields will peak sometime in the second or third quarter, we might have already peaked, and then after that we have a very steady trajectory of yields going lower from from here on after the third quarter of perhaps ending around you know, two and a quarter to two and a half percent by the middle of next year. So

that's kind of the trajectory we're looking at. It is quite a dramatic move lower in yields from where we are right now, but it's all about, you know, the trajectory for for growth after the FED has addressed it's uh, it's you know, raised rates and address the inflation problem if you will. How much is also a hinged on the idea that the FED will not be able to shrink its balance sheet materially beyond perhaps just the middle of next year, because they will have to backtrack in

the face of altility, in the face of recession. Yeah, that's a very good question because the whole policy framework, it's very very tricky this time around, given the fact that you know, after September, the Fed's balance it's going to decline at around ninety five billion a month, So that's a very rapid pace of balance sheet on wine

starting as as early as as September. So, you know, I think I view is that the FED might be able to raise rates, maybe to get to three and a quarter three and a half percent by the end of the year. But then you're going to see this this the balance sheet run off act as a as a second second order effect tightening financial conditions as well.

So it's gonna be it's yet to be seen if they're going to be able to continue to run off their balance sheet after the middle of next year, given the fact that they're going to potentially have to cut rates if the economy slows down meaningfully. Savantra also going to get your views. What a morning for it? What a twenty four savant Jamper of schen What a year it's been? What a few years? I'm sure somebody are screaming at the TV and radio as I say those

words right now. Conrado Quadros who the senior economic advisor that bring capital? And this is the conversation of the day. If you're worried about where that's so called terminal rate is, there's three, there's three and a half. John Farrell just mentioned four percent and a given bank, Okay, you out do them all. What happens to us if we go to a bring capital four and a half percent home, maybe we make some progress on bringing inflation down. I mean,

obviously the problem of the day right now is is inflation. Um. We've had, over the course of the last two and a half years a number of poor narratives on inflation. Right We started with the COVID's going to be disinflationary. That went for six months with economists and the FED. Then its inflation is going to be transitory. It's only in a handful of goods. We saw on yesterday's CPI report that Um, it's neither transitory obviously, um. And we

have very broad based increases. I mean, it looks to us like underlying inflation is somewhere in the neighborhood of five percent. Now if we look at those trimmed means and medians and steaky price measures. So so the problem of the day is dealing with inflation. Um. And you raise a very important point on that TTERMO FED funds, right, and the the idea here from the Fed is to get policy to neutral and maybe a little bit beyond neutral.

But the problem is, I think they're misjudging neutral. The two and a half percent neutral rate is a neutral rate that existed when inflation was still at two percent. We're not at two percent anymore, and it's a nominal rate, so that neutral rate is probably higher, and I think the Fed has got some work to do to get policy tight and bring inflation down the terminal rate four and a half percent. The path to get there is

important to understand. Is this a front loading? Is this a rapid rate rise of a hundred basis points at several consecutive meetings or is this a gradual and steady, painful drip drip drip of let's get it up there, because it's not coming down when we look at inflation, well, at least, I think that the Fed will take what the market gives it. And right now the market is giving the Fed basically a green light to go by

a hundred basis point at the July meetings. So unless that changes before July, I think the Fed will take that. They have told us that they want to get um as you said, they want to frontload these moves. They want to get the funds rate to what they think is neutral and maybe a little bit beyond. And as I said, I think that that judgment might be off. I think that the neutral rate is probably higher. I mean, if you if you think about it, if you look at the the FED funds right and put it in

real terms, it's still significantly negative. And I don't know how we bring inflation down with negative real rates. Conrad, when we take a look at some of the data that we've gotten this week, We've gotten the cp I, we've got JP Morgan earnings, and Morgan Stanley, and now we have p p I and perhaps more importantly, initial jobless claims coming out higher than expected, rising more than expected. Can you put into perspective how telling that is versus

perhaps noise and data that has been pretty noisy. Yes, And I think that's the jobless claims are important. It's it's a very high frequency indicator of the labor market, as might point it out. And I think it's a very important point that July is a difficult time to read jobless claims because of those auto shutdowns. And we had an announcement a couple of weeks ago from one of the large auto manufacturers that they're shutting down production

until September, and that's related to shortages of parts. UM. But if we take a broader view of the labor market and we look at things like job openings, whether it's the BLS data on job openings or small business job openings for June, which showed fifty of small businesses survey reported a job that they could not fill UM the record high, and we have data on that going back to three The record high was fifty one last month,

so we have very high levels of job openings. UM. We might see some pick up in in in layoff rates. But but right now, if you look at the broader data or the small business data, it looks like there are a lot of jobs out there to fill. So as people lose jobs, I think there'll be opportunities to

get jobs with other firms. Conrad. Long ago, there were research reports that would come out and there was a young Turk named John Riding or you have a nudding acquaintance with that would write about tumal like I remember this very clearly, waiting for Elliott Platt's book and all of it and all the research from Bear Stearns and d l J and such. Are we back there now? When you look at the correlations out there, the deterioration and e M two stents spread in a heart beat

down to twenty seven basis points an hour ago. Are we getting that kind of tension in the global system? Well? I I think one of the things that we're trying to adjust here is to a market that is UM is more on its own, it's less being influenced by

by the FED in terms of UM its balance sheet. Right, so we have the FED that's begun the process of normalizing the balance sheet I think that that's had very important implications for the functioning of markets UM and and it raises other issues right in my opinion, the we can look now at the FED shift and it's it's monetary policy framework to flexible inflation average targeting and say

that that's been a disaster for price stability. But I also think the other issue we have to deal with is we've had over the last fifteen years or so a shift in the FEDS reserve policy, and this relates to markets UM and the first FED has shifted to an ample reserves policy, but with tight regulations on bank liquidity, and I think that we're going to have some stresses to deal with as it begins to reduce its balance sheet as forward funding rates are now a lot less

certain If you think back to late May and you told all that so for for example, would be two and a half percent at the end of July or approximately that, that would have been a shock, right, So there's a lot more uncertainty and funding rates UM. The FED is pulling back on on the size of his balance sheet, and aggregate liquidity is still very high UM.

But we've learned over the last few years that liquidity doesn't necessarily get to markets that needed, and so we've had these these policies we had to blow up in the treasury market in March. I mean, these are some of the issues that we that we still have to deal with, and I think we think are still out there given the FEDS reserve policys. Thank you so much.

Let's take what we see in the correlations of the market and go to the single correlation for Washington, which is no one's getting paid anything given this high inflation. It's the real wage reality that all of Washington faces. Andrew Blacker has spent years looking at this. Ec ten told him at Harvard years ago, guess what jobs matter? The wage matters. He is with Investco, his global head of public policy, Andy. What is the urgency this time

around of a horrific negative real wage. Well, politically it's it can be deaf um for politicians. So right now, we talk about the economy always being the most important thing. Well, inflation is a major part of the economy that talks about how people actually live every day. And so with this latest spike to nine point one percent and us not seeing the top um soon enough for the November elections, I think it can have a real impact on what's

happening in the midterm elections. I guess the suits and ties will tell us that a higher unemployment rate is good for us right now, explain that to the American people. How does Mr Powell, frankly, how does President Biden sell a higher unemployment rate is good for you as we

bring inflation down. So, of course you give me the tough task here, But theoretically, thought would be a higher unemployment rate would actually soften wage inflation, and which can be the core of inflation, so that they're really focused on getting down inflation for and if you're just looking at it from an inflation perspective, it could be good. But but the other side of it is it's an economic downturn potentially, So um, they are really trying to

walk that fine line. And as you've seen, you guys have been talking about, you know, we've had the seventy five basis point increase, we're looking at the full point um this full hundred basis points. This is this is a tough place to be right now, and I'm just glad I'm not working at the FED to try to

navigate this. Meanwhile, in the here and now we're trying to parse out the rhetoric of President Biden and some of his associates with what they're actually are planning to do with respect to going after companies that they are accusing of price gouging. I'm thinking of oil companies, for example. But I'm wondering who's next. Considering the fact that places like airlines are not increasing capacity in the face of increasing demand, how much is this going to be a reality?

Is their meat behind some of these threats versus just simply lip service. Well, there's only meat behind the threats if there's actual um mouthfeasance. So I mean that remains we've seen. Look, the administration right now is in the

toughest of all world. They have high inflation, they have a potential recession on on the on the horizon, they have people really feeling the pain, and so they make they need to make sure that they are out there looking at every level they can, pulling every level to help make things better. And so whether it's going to Saudi Arabia, which we you know, we've heard that may not be about oil, but we know it's a big part of it is oil, or whether it's going after

UM companies in the US. They're trying to pull every level to make it look like they are doing everything they can for the American people. And when they have no more levers andy, they say, look to the FED. They're going to do everything. It's their job. How politicized right now is the FED? Well, the reality is the

Fed's been politicized for some time. And I don't want to go too far here here, but I mean we've gone from a dobbish FED, who many people think relate to the inflation UM acknowledgement maybe saying it was short term UM, to now where they are really kind of putting on the gas to raise rates. And and to say that politics didn't play a role in both being dubbish at the beginning and now being hawkish, I think would be missing the point. And they so well set

that any flock of that, even Meskan. This is the Bloomberg Surveillance Podcast. Thanks for listening. Join us live weekdays from seven to ten am Eastern on Bloomberg Radio and on Bloomberg Television each day from six to nine am for insight from the best in economics, finance, investment, and international relations. And subscribe to the Surveillance podcast, on Apple Podcast, SoundCloud, Bloomberg dot com, and of course on the Terminal. I'm Tom Keene, and this is Bloomberg.