Surveillance: Treasury Market Needs Fixing, Dudley Says

the theory is a gentleman from Berkeley. William Dudley joins us, the former president of the New York Fed. Obviously for years at Goldman Sex. Bill Dudley, you separate the men from the boys, the women from the girls with the logic theory of necessary and sufficiency in an undergraduate ass you speak of the necessary and the sufficiency that we saw yesterday from Chairman Powell. What did he do that

you say was not sufficient? Well, I think that he did a good job and basically edging closer to the notion of we're gonna start to do the taper, but not so much so that it puts the markets on edge. The general expectation at this point is uh that probably won't start tapering, probably won't make the announcement on tapering until November December, and probably won't start until early next year. So I think we did a good job on that.

Where I would but where I would say the Fed hasn't gone far enough is the changes that they've made in terms of there that's it, Danny repo facility that they announced yesterday. It's a good start to have a standing repo facility backstop the treasury market, but they capt its size at five billion, and they limited limited access to only primary dealers, and I think the access should be considerably broader than that to support to support the

function of the treasury market. Also, I think they need to make changes to their capers so that when the FED buys treasuries and agency mortgage backed securies and that increases reserves in the banking system, that doesn't interfere but with good market functioning in the treasury market. These are delicate phrases and we appreciate the candidacy. As a former government official, Bill Duddley, we have the overnight repo market now moving back up through one trillion dollars. Let's cut

to the chase here. If the overnight goes near a trillion, above a trillion, how will the FED adapt and adjust to that? There's no magic number that where where If the FED is soaking up a trillion dollars of of repo through their reverse overnight, that's not a problem. But I think it does tell you that there are consequences

of of the FEDS asset purchases banking systems. It's essentially a washing reserves and that's making the leverage ratio more binding, which is constraining banks activities, and it's also causing banks to essentially push away corporate deposits. The thing could fix this by making changes to how the leverage ratio is calculated, and I think they should do this sooner rather than later. Is a treasury market as it is now broken? I don't think it's broken. It just needs a little bit

more belt and suspenders. Uh. The standing repo facility is a good start, but as a Group of thirty report with published yesterday points out, there's a lot of other things that need to be done to the US treasury market. The G three report talks about central clearing of treasuries for customer trades that would make the market. I think a lot more solid talks about increasing the transparency in US treasury market. So having a standing repo facility is a good start, but there's a lot more to put

the US treasing market on a firmer footing. This may sound esoteric, it is not. It is the underpinning of the what we pay for all of the loans that we take out is the fun underpinning, frankly, the functioning of Wall Street. And there is a question about the functioning of the treasury yield as as an indicator right now.

Even fed share Powell came out and said he didn't quite a understand why yields where we're where they were, And a lot of analysts have raised the issue of liquidity, the fact that there are these malfunctioning aspects of the bond market that made it get very difficult to get a clear signal from treasuries. Do you think that that is a factor in yields that are persistently low given the inflationary outlook. Well, I'm surprised by how low long

dated treasure yields are given the level of inflation. The fact that commedies and recovery mode. Uh. And the fact that feeds said that they're going to be very very patient before they actually ray short term interest rates and the environment, you would think treasure yields will be higher. I think what it's what's what's really happening is quantitative

easing is very very powerful. As a federal reserve buys more and more assets those that creates deposits in the banking system that people don't want to hold, and as they don't want to hold those deposits, they bid up other financial assets. So I think we're just finding out the quantitative easing is very very powerful and pushing around bond yields and bond prices. We tossed around the phrase reaction function Bill Dudley and the media like it's a mint.

There's a matthew nous to it. Can we generate constructive reaction functions given the wall of liquidity? Or do we just need to become a nerd to the idea we will have jump conditions, We will have suddenness over the next many two three, five years. Well, we'll have some suddenness in the sense that the FED at some point is gonna go from maximum Monterey policy stimulus to something else and at some point the FED has actually being

a lift off and raise short term rates. Uh. You know, the FED, I think it's going to try to minimize that jump function by communicating clearly. And I think they've done a pretty good job in terms of, you know, signaling when the taper might take place and that it's going to take place in a gradual, in in an

organized type of way. Before we came on, we were alluding to Alan greenspan and build uh and to Arthur Burns And do you just assume and I say this Dr Dudley very carefully, that we have is we become less accommodative a measured green spanning in a pro coach? Are we going to go back to a FED that's more at hock like we saw was some of the

sudden lifts and larger lifts in the Burns era. Well, I hope we don't go back to the Burns theory because at that point the time that that was very very late in terms of raising interest rates and pushing

down inflation. That would be a very bad model. I think that what the FED is doing, though, is basically saying we don't really know exactly where full employment is, and so we want the economy to run a little hot so we can find out where full employment is and make sure we employ the maximum number of people

we can without having a long term inflation problem. Bill always got to get your vs. Especially twenty four hounds after the fetist Matt that blood bug opinion columnist and fum A Federal Bank of New York President Michael Schumacher long agoing far away, there was a CCUM five stripe. That's a stick the rich kids had, And you say, this is a yield that's gonna look like a CCUM five stripe hockey stick discussed that the nirvana out to

a higher yield. Yeah time, especially when you consider the idea of really yields in the US being minus one some crazy number in ten years. It makes very little sense. Really yields that this negative level are remarkably unusual. It's happened only a couple of times. Last time was just before the Taper tantrum. And you've got to ask yourself, what is the economic backdrop today versus twelve months ago? Substantially better. We can talk about COVID case counts going

up recently, et cetera. But still it's pretty hard to dispute that things look a lot better now they did then get yields are much more negative in real space, and we think this is a bit crazy. Frankly, So when you've got high inflation, it should push up nominal yields. Really, yields probably follow suit. We think the stage is set for yields to climb. However, I've said that before in this show, and in the last couple of times it's

been wrong. So I think little humilities in order. We think it's going to take a while, probably three to four months for this move to get in trained. I think it's probably a November December type of scenario. It's on the stand why they're going to go high, Mike, I need to understand why they went lower in the first place. Why did they Mike? Yeah, A bunch of things came together, John, and in fact yesterday is a good example. So why did yields drop in the last

hour two a trading yesterday? Well, one of these arcane things we think there was tips investors adding duration before month in which is tomorrow. So not the sort of thing necessarily tied to a FED meeting. But it did crop up. But I suspect the bigger thing going back to the June FED meeting is the FED really gave the green light for people and they said, look, we're

not going to do anything for a while. We'll sit here, maybe we'll put a mention of taper in the statement, that sort of thing, but we won't actually really change policy for quite some time. So a lot of investors out there look at the yield back drop and say, well, it's super low. I have to do something. I've got to pick up a few pennies in front of the Steamberen or what can I do. I can move out, I can buy longer maturity, longer duration bonds, maybe I

can sell some options, that sort of thing. But the FED really put that back in play in June, and we think that was perhaps the big drive her. On top of that, you've got overseas flows which have been pretty strong. Mike. One thing that always confuses me, and I'm a little bit uncomfortable with, is when people take the price of the bond market and say this is what the market is looking for inflation x percent over

whatever time period. Might I'm uncomfortable with that because some people buy inflation protection, not with conviction but as a hedge. And I just wanted to Mike whether we misread what markets are actually tanning us behind the motives of the people making these decisions. Like another way to consider that, John, is does the inflation market that we trade so tips, swaps, etcetera. Is that really predictive of future inflation? I would say

not very well. I think you make a good point that quite a few investors and other players out there by inflation protection because they need to, not because they want to. It's probably the case again, but still in terms of short term market dynamics are have a fairly big effect. I think another way to to consider this question is do forward rates in aitals really predict future actual yields? And the answer consistently from academic after academic

has been known. And if we take that analysis today, the forward ten year treasury rate at year ends about one forty Does anyone really think that's a great predictor of where it will be? I would say not. So what do we have to see? What's the trigger to get real yields less negative off their lowest levels ever seen? At least I think a few things have to come together,

probably even more strength out of the labor market. Thinking about some of the comments that chair Pole made yesterday, very few specifics, a lot of generalities, but one thing that came through is more and more strength out of the labor market. There's been a lot of concerns, speculation, hope perhaps that come September, maybe October, the labor market would be much stronger in the US, and it has been. If that happens, that probably pushes yields up quite a bit.

If instead we get a reaction where the COVID case counts half worsened, delta seems to becoming almost endemic, that scares a lot of people. That keeps yields pretty low. So I think the tipping point my colleagues on the Walls Fargo Economics team would share this view as well, is going out two to three months you really get a break. Does that supply chain really start to move

to the labor market? Clear up, that's the key question, Mike for everyone Right now, my shoemaka west Fonca, Global head of Macris Strategy, we're getting into a Christianity starting to tear it apart for our top Live team, and Johnny makes very clear consumptions there. We're gonna get a breakout on that data as it comes along. But again that goes to where David Rosenberg is, which is not the numbers we're looking at right now, which is the

last three months. But where are we right now? And John? That is a raging debate. Let's go right to this right now with Matthew. Lizette thrilled he's with us with a more optimistic Deutsche Bank right now, Matthew, this data totally unfair question. But it's unfair Thursday. Does this data allowed Deutsche Bank to adjust to a more cautious economic growth? Sure than Thanks so much for having having me. Um. You know, I don't think it in and of itself

really really changes too much. We'll have to see the details they are out there. It looks like consumer spending was actually a good amount stronger than expected, uh in Q two. I think the key question for the growth trajectory over these quarters is it is actually a lot about inventory. So inventories was expected to be a big dragon Q two. We expect to get a big boost boost in Q three. But I think you're you're absolutely right. You know, this data is backward looking it is Q two.

I think what is most important for markets and the FED right now is the labor market data and the stalling on a jobless clims that we've seen is an important development. Uh. You know, jobless claims have not been as reliable as they wear pre COVID, but it is evidence of you know, some stalling out or some softening

and the improvement that we've seen there. If that continues, it's it's certainly an important development from the Fed's perspective, because pal noted yesterday, certainly that is the key consideration for when they are going to take Matt. For many people September and Q four, it's just huge. It's going to be massive to shape some of these debates. Golben out earlier this week suggesting that that full service sector recovery is going to take a little bit more time.

They downgraded their estimates. Where are you given the team at Deutsche Bank on that algument right now, Matt, sure, I think there's you know, this is the area of debate. We have expecting good spending to be coming off, durable good spending, housing to be coming off, and we were anticipating that services would help lift the economy to to a stronger growth profile and in the second half of

the year. Obviously the return of COVID and the delta variant is a downside risk to that, but I view it as a downside risk, not something that impacts our baseline outlook at significantly at this point. I think Cherpowe made a good point yesterday. If we look back at these past waves, they were not as impactful as we were anticipating. I anticipate that will probably be the case again.

And when we look at those states that are probably most susceptable, that have lower vaccination rates, I think they are also us likely to bring back restrictions. You are so less likely to see there's people pulled back from economic activity. So it is no data downside risk to growth over these coming quarters. But that's how we're viewing it, not not impacting our baseline outook at this point, Matt. When you dig under the headline of the GDP number,

are we getting whiffs of stagflation? And I know that this is the pendulum of doom. However, residential investment spending fell about a ten percent annualize. Paces has to do with supply chain issues, a lack of lumber, and of course the high prices are the high prices headwind to growth at this point. I think in certain areas that they certainly are. Housing is one uh and yes there are supply chain issues, but we're seeing demand come off.

Mortgage purchase applications have weakened, perspective, bio traffic has has softened, so demand is being impacted. But I don't want to just focus on the prices either. We've seen, you know, durable good spending was six above where was pre COVID trend. Housing jumped above the pre COVID trend. So this is a very unusual recovery. It was a very unusual recession, and we've been anticipating that these cyclical sectors will come off even if you didn't get these these price pressures.

So that that does make the services sector really critical to the trajectory of the economy from here on out, and we do think that it will help to carry stronger growth over the second half of the year. Do you think that this is indicative the weakness or at least the disappointments that we're seeing in economic data points. And I don't want to stop call a six and a half percent growth weakness, but we have gotten disappointment

after disappointment. Does that indicate a trend that will carry into the end of the year or could things change in September when kids supposedly go back to school. Yeah. From a labor market perspective, I think we are all anticipating in share powel that is certainly anticipating that that

will help to open up labor supply. Um. You know, we have focused on COVID as being a big driver of the constraints on labor supply, not necessarily the unemployment insurance benefits, and so whether or not schools that are schools are able to reopen significantly on September fully in person, I think is a critical question for the labor market outlook.

You know, at this point we just don't know. We'll have to see how the variant evolves over the next couple couple of months, how policy evolves over the next couple of months, But that will be a really important consideration for getting back to maximum employment or these types of labor market numbers that then wants to see. There's a lot we don't know. There's a couple of things we can take a good guess on. One of them is inventories, and you mentioned that earlier on Matt. This

is what Luke Kawa had to say of UBS. The one point one percentage point drank from injurantries in Q two is just not sustainable in the slightest Yesterday straw downs equal tomorrow's demand, Matt, would you go with that as well? That seems to be what has led us towards this downside surprise this morning. Absolutely so, we were below consensus on on this GDP print, the key driver

of that being a big drag from inventories. We know we have in the retail and especially in the auto sector, very low inventories, which we expect to begin to build in the second half of the year. And so I think what you tend to see in these numbers, if private final demand is actually pretty strong, which it looks like it might be given a strong consumer spending, you should get a reversal of inventory and that should help

to lift your Q three growth number versus Q two. Mozz, you want to use the word for Jean Clautriche that he loves to use and he says it with a French accent, which has got a lot more punache than you and I are going to do. And that is diffusion. There's a belief here in a mystery about the diffusion from a good centric consumer over to a service sector consumer. Do we see that in this data or does that wait for another quarters report? We have been seeing it

in the monthly data, no doubt. We've seen good spending. Retail sales in nominal terms has has flatlined out over the past couple of months, and adjusting for prices, given how strong price games have been, we've seen weakness in real spending on goods. I want to emphasize that was to be anticipated. We were well above trend on on good spending, and price pressures are obviously having an impact. So we expect this handoff to the services sector to

continue over the next couple of months. The next couple of quarters. We're still below uh you know where we anticipated we would be in leisure and hospitality UH and and all these other services items. So I think that should continue to be the key driver for growth going forward. Matlazette of Deutsche Bank cannot align, so it's going to catch up, thank you very much. The movable feast here, folks, is the market reaction and maybe some of the childish

interpretation into very sophisticated political economics. Jeffrey You has made a career of this at B and Y Melon as their senior strategists. John, why don't you bring in Jeffrey You with his perspective synthesizing all this together for vision. Jeff You joining us now from BN Y Melon a senior strategist. Jeff, as always, you're gonna be super helpful working away through this issue for us, all walk me through what we need to pay attention to and what

is worth ignoring. Right, So, firstly, pay attention to differentiation what you're seeing with individual companies in China and in terms of vidual sectors. The regulatory crackdown. There are different motivations behind it. Some have to do with international capital involvement, especially in the education sector. For example, they've stressed this so much money pouring into an arms race amongst Chinese families to get their kids ahead. Um, it's you know,

it's seen as damaging. So they want to treat this on an individual basis. Now, the second part of it is this framework of international investors investing in China. How should it be done? Should it be in the U S. Should it be closer to China. That is something they're going to be looking at as well. And here's where you know, geopolitics can come into the phrase. Thirdly, and most important, I think what people are missing right now. We're talking too much about the equity market. Right now,

we're talking too much about individual companies. What about the growth Embarber And no one's talked about the triple our Cup that has happened and more that may come now. No one's talking about the delta variants starting to spread and multiple provinces and the intalities in China. Growth expectations are coming off. And this is what we need to be a team to heading into the second half of

the year. Let's build on that, Jeff. The degree to which the issues in the property market now are linked to perhaps a downgrade to the outlook on the Chinese economy. So two things here. Firstly, let's stick with property now, so any day now and you're normally it comes out around the end of July. In the early August, we get the two thousand twenty one Financial Stability Report from the pbo C. This is a brilliant report and they look at and they do stress test the entire banking

system last year's numbers. Right, if you have a fifteen percentage point rise and property mpls amongst other scenarios, you can see catalantic. We see real ratios within Chinese banks scope from down to below ten the low the regulatory limit. Right. So this is how important this is for the sector, individual companies. They're looking at exposures as well. Is it manageable yes? Is its systemic? Probably not? At this point that the damage to wealth, the damage to consumer expectations

and helples, that will drive growth lower as well. You know, I look at Jeff, you where we are in this This is not a crisis. But this moment for China, this moment for the Pacific RIM and the elephant in the room is we don't have Hong Kong anymore. It's a different Hong Kong. How do you perceive, Jeff, the Western banks and I don't want you to speak for the management of b and y melon, but how do the Western banks adapt and adjust now that Hong Kong

is different? Well, they would adapt to looking at China as a whole and the new avenues of opportunities by look at what are the the five year Plan detailed. It was very explicit welcoming foreign investment into China's industries, welcoming foreign talent to drive China's best for self reliance. Right, So China notes that cannot grow by itself. It's going

to need external expertise as well. But at the end end of the day, it has to be done in a way which is manageable and that does not introduce systemic risk or other risks. So, going back to the education issue for example, this is not a financial systemic risk or anything like that. It's something that's more statial and in the prison of falling birth rates and demographics,

that is a serious challenge. So if foreign investment facilitated by the financial institutions, if it's seen as broadly damaging, then like any regulator globally, it's not a China specific issue, they probably want to do something about it. It's growing

pains for wall streets and for everyone. And I think as China develops and integrates itself with the rest of the world financially, we have more index inclusion, c gbs, increasing ownership, all of this is going to happen, you know, just calibrated pick the right pace, because sometimes you know things, even with good intentions, you can actually end up with outcomes, Jeff.

This is one reason why a number of investors said that in particular education sector in China, but including other shares as well, were uninvestable following a number of regulatory crackdowns over the weekend and Monday. The idea that it wasn't just education, it was also the data and the control over such things in the country. Given the pushback, the fact that authorities did have meetings with banking executives to try to push back some of this concern and

shore up support for the markets. Do we have a sense of how far or not they are willing to go with crackdowns, with restriction in in specific industries, they could further royal markets. So I think China is learning as well like any regulator, that this is a new environment for China. They've realized how invested in the international community is in certain sectors, right so again education and

being one of them. So they wanted to gauge the market fallout and if it has become excessive, and you saw the a three pronged launch and from the main financial papers in China yesterday expressing that over the medium to longer term, China is a strong market welcoming global investors to there, so of course they don't want to damage sentiment either. Then they know how inter linked it

is and the country needs to stay inter links. So they will learn as well from this, and as future sectors go by, maybe they'll do it differently as well. But just pay attention to the strategic initiatives they want to communicate them better up ahead. By the way, something similar happened a few years ago to the childcare sector, exactly the same language. Not allowed to make profit and not allowed to use captain market to raise money. They

wanted to dispatch the nationalized framework. As seems we all forgot about that that this has happens again and again they're learning by doing as we all are. Right now, Jeff, let's put some money to work. We spent a long time talking about the risks of framework for thinking about the situation. Where do you want to put capital to work? Considering everything you've just said in the last seven minutes, right,

so three things here. Firstly, on rem and be I still finkering and be trades to arrange and ignoring all of their current news right now. They are worried about CPI and the PPI divergence, right, so exports are still very important mmm, so they wanted to limit them be appreciation anyway. So the recent news over the last few days, and probably it's not unwelcome in Europe. I think what

the ECB has done very good for European equities. I think those trades and where people invest in European equities on their heade basis, I think that will work as well. By anchoring expectations and finding the US and the dollar. We are not ready to call time on on on the dollar strength and not by any means. It's still going to lead the way in major policy renewal and a normalization. So these carry trades you want to own dollar carry against the low yielders, especially in Asia, and

in the high yielders. I think they're gonna folder against his daughter as well. Jeff. Interesting stuff, Jeff, you f bn y Melon a strategist I have known from London to for a long long time and one of the sharpest in the city, that's for sure right now, and this is really really important for your infrastructure. We go to the gentleman from Flint and on up to Saginaw

in Base City. Dan Kildee is someone with a real view of America, different from maybe inside the Beltway in Washington, and we're honored that he could join us from inside the Beltway in Washington this morning. Dan, you and your family and your constituents have lived the worst water crisis in America. You know better than anybody about lead pipes, about water structure. Is this bill good for Flint, Michigan. Well, it's it's hard to say. It's just up in the

right direction. The question is whether or not there's enough of an emphasis on water infrastructure to prevent the next Flint Michigan from happening. In some ways, you know, and ironically, Flint has some advantage in the fact that the failure of flints infrastructure occurred in public view. I was able to get help for Flint even when I was in the minority, to replace the lead pipes there. But the real question is will the warning that Flint provided the

rest of the country be heated. Will we have enough to be in this legislation to replace every lead pipe in America? And I'm not sure yet we do, But maybe it's a step in the right direction and the Third World Crisis of Flint, Michigan and water. There was no discussion to pay for us. It was like, let's go, let's fix it. How do you respond to this juvenile

debate over how we're gonna pay for this versus let's go. Well, the way I responed a really good question is to point out that when it comes to water infrastructure or other infrastructure failures, we're all going to pay for it. The question is you can pay now or you can

pay later. Flint's a good example. If Flint, say seven years ago, had thirty or forty million dollars available to switch out its lead pipes, we would have saved what is now approaching a billion dollars in costs of compensation to victims of fixing the infrastructure after it's broken. So, yes, we do need to come up with a way to pay for it, but we can't start with the premise that we're not going to pay for it. If we

don't do it. If we don't fix our infrastructure, there's a big do bill coming our way, much bigger than the cost of fixing it in the first place. Congressman, billion dollars in light of the fiscal stimulus past of the past year is not that big, especially when spent

over eight years. How much in the conversation and that you have in the negotiations that burn the midnight oil as you eat tacos and chicken parm each night, as you try to hash out the details here, how much of the debate is connected to the three and a half trillion dollar plan the Senator Sanders is working on right now. It is connected because if in fact we have a bipartisan deal and the President many of us have been very committed to do as much as we

can in a bipartisan fashion. That doesn't mean our works done, but it pushes more of what we may need to do into a reconciliation package. And the concern that I have is that some of our senators who seem willing to work together on the bipartisan piece, get a little cold feet when we think about what we want to put into the reconciliation package. And I'm talking about Democratic senators in this case. We've got a lot of business ahead of us. If we don't fix this stuff, it

doesn't mean it goes away. It doesn't mean that China is not spending ten times what we are as a percentage of their GDP on infrastructure. What I'm trying to convey to my colleagues is, we really don't have a choice. We have to do this. We can't have an infrastructure bill that says one out of four Americans get to have twenty first century infrastructure. The rest of us have

to compete with nineteenth and twentieth century infrastructure. Sooner or later, we got to fix it, and so more of it may have to be pushed into that reconciliation bill if we don't get enough in the infrastructure package itself. Which raises a question, Congressman about unity among Democrats. There's been a lot talked about the splintering of the party, the whole progressive versus the more moderate wing. Given the conversations that you're having, how difficult is it going to be?

Can you characterize whether people are coming together and coming to a more unified vision here? It's hard. I mean, one of the things about having a party with a lot of diversity of thought is that we have a lot of diversity of thought, and it's often hard to land on the same spot. The tough thing is if we're all being asked to compromise. We all have to compromise. We can't have a situation where somebody on the left says the right has to compromise or the middle has

to compromise. If we're going to come together, that means everybody's got to acknowledge that the final product is something that if they were doing it by themselves, they wouldn't do it. And right now, I'm not sure we've completely landed that message. I think too many folks are taking an absolutist approach that without my specific priority, I'm not going to help. And that's just that is not the way this place is designed to work. And the American

people don't care what the excuses are. They just want us to get this work done. They want us to get the work done that affects their lives. You know, the Beltway arguments are of no interest to the people I represent. Dan, I got like fourteen more questions, but we don't have enough time. Dan Kilde of Flint, Michigan, thank you so much for joining us today, the congressman from the fifth District not in Michigan. 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