Passive Easing Is Fueling The Next Inflation Wave | Danny Dayan

Last year's rate cuts were a policy mistake. Every single day they're not hiking rates, they're easing. Financial conditions since the 2022 rate hike cycle have been extremely loose. We have the biggest inflation impulses that we've seen going back 15 years other than 2021. And that's why I say we're in big trouble on inflation. Unfortunately, inflation is like a disease. If you don't kill it, it'll just stick around and linger and it'll get worse and worse and worse. Risk assets are just going to go parabolic. And you see earnings expectations are exploding. You have everything you want to see this epic melt-up continue until... This episode is brought to you by Fidelity Crypto, a platform built in-house with the same discipline. Fidelity applies to everything, so you can invest in crypto confidently. Nothing said on Ford Guidance is a recommendation to buy or sell any investments or products. This podcast is for informational purposes only, and the views expressed by anyone on the show are solely their opinions, not financial advice, or necessarily the views of Blockworks. Our hosts, guests, and the Blockworks team may hold positions in the company's funds or projects discussed. As always, investments in blockchain technology involve risk, terms, and conditions apply. Do your own research. All right, what's going on, everybody? Welcome back to another episode of Forward Guidance. and joining me today is repeat guest of the show, Danny Dan. Always great to have you on the show, Danny. Always great to have you on the show, especially at a time when people are confused and trying to figure out what the hell's going on with the US economy, with markets. We were just saying before we hit record that there's a lot of anger in the market type and the price action that you can tell. And yeah, I think there's a lot of questions that we need answered. You always bring a lot of data back, ideas and thoughts. So just thought it would be great to get you on and hear about how you think about things. Welcome back. Yeah, thanks for having me. Before we begin, I have to do a quick shout out to the Montreal Canadiens. Off to the second round. Go, Haps, go. But thank you for that intro. Honestly, what a fascinating time, you know, between the macro and what's happening, obviously, with the war. From, you know, to the point where you were saying where a lot of people are angry, I think a lot of people are focusing solely on the war and not on the cyclical conditions that were starting to manifest before the war. And we really need to put both together to understand what's going on. And so hopefully we can do that in this conversation. Amazing. Yeah, I will say I'm bandwagoning the Habs now that the Oilers got out on the first round. They are my second favorite team. So I'm happy at least one of them made it to the second round. So go Habs, go. All right. So, yeah, I think where we want to start is just understanding the state of the U.S. economy and what is driving it. Because it's oftentimes when you hear about macro analysis of the economy, you look at, okay, what's the Fed doing? Are they cutting rates? What are fiscal authorities doing? Are they sending bills through Congress that are going to give a bunch of money to people and they're going to go spend it? And I think a lot of the confusion lies in the fact that neither of those have really been happening for quite a while now. and regardless the economy you know the the economic data points you've been getting over the last couple months have been exceptional despite this huge energy shock that's occurred despite WTI above 100 bucks and despite all of that as well U.S. equity markets are at all-time highs so we'd love to just hear about how you're thinking about the U.S. economy and what's really driving this just strength despite a major energy shock that we're seeing. Sure that's a great question. So coming into this year, my year ahead outlook was cyclical acceleration. I compared it to the 1967 period, where in that period, the Fed misread what was causing a little bit of softness in the labor market. In this period, I think they did the same thing. They've, in my opinion, over-eased or eased too much. I called very loudly, proclaiming to clients as well as on X that last year's rate cuts were a policy mistake. A big part of it is I didn't think they understood the labor supply issue. They're starting to come around to that now. But what I saw coming out of those rate cuts was a lot of the parts of the economy that were dormant or stagnant were starting to wake up. And so we had what I call cyclical acceleration in the economy. A lot of different areas like manufacturing, durable goods, new home sales. We were seeing the transport sector, the freight sector. All of these are interest rate sensitive sectors. So we've gotten used to the drivers of the economy being AI and fiscal and things of that nature, obviously service suspending, but none of that is actually interest rate sensitive. That would happen regardless. But what we have seen is, in my opinion, they cut rates below neutral. They've misjudged what neutral is, where it is. And as such, they have reinvigorated those aspects of the economy. And we see inflation pick up in a material way prior to the war. Core inflation on a three-month annualized basis running about 4.4% prior to the war. And then now we have the war and all of the myriad things that that's going to bring. That's going to impact the economy in a lot of different ways. And so I call them now passive easy. I think that every single day they're not hiking rates. They're easy. And I think they're getting behind the curve. Hopefully they wake up soon, but otherwise I'm concerned that we're going to head for an overheat and them needing to slam the brakes with aggressive rate hikes. Whereas I think if they were to act now, it could be gentle and we'd be fine. I think one important component that you've mentioned many times before on the show, which is in the modern monetary policy era, You know, there's everybody, of course, pays attention to what the Fed does in that meeting. Do they cut rates? Do they not cut rates? But I think something that you brought up and nicely identified is it also really matters what's getting priced into the forward curve of rates as well. um and you know despite even though we've we haven't really had any meaningful rate cuts for for quite a few months now the curve has been implying cuts regardless up until basically the the iran war and that's been shifting we can get into that but i'm just curious about one what is it about that notion of in this era of you know for guidance name of the show etc etc like just this hyper focus on the forward curve why does that actually provide this like passive reason you talk about and then now that we're seeing the forward curve actually start to shift and start to price in hikes even though you know we started to see that you know the this is what the fed does right is that like last meeting they had a couple people dissent just about the language on the same but not even about the actual decision itself and then probably next meeting there'll be some sort of talk about planning towards some sort of hike and then you know we go to down the sequence of events etc etc but just yeah walk me through like how does that modern weird convoluted monetary policy execution that we live in now? How does that incorporate itself into the economy and markets? I do agree that forward guidance is what drives a lot of this. And when we look at the Fed funds rate is the rate that they change, but that rate propagates to other parts of the interest rate curve, but nobody really borrows at the Fed funds rate. I mean, some small businesses borrow floating rate loans and things of that nature, but the majority of economic activity happens in the five to 10-year sector. And so those rates are driven by expectations of what Fed policy will be. So the clearest transmission of monetary policy, I'm going to talk about two transmission mechanisms of monetary policy this cycle that have been really interesting. The first is the savings rate, the household savings rate. And I've studied this very closely. I have a model and I shared a chart, a couple of charts on it with you. The model basically shows what fundamentals suggest the savings rate should be and then what actual savings rates should be. But historically, the way it works is when you have rate hikes, households get a little bit more cautious with a lag of 12 months and the savings rate will start to go up. It will get a little bit more cautious because rate hikes are associated with economic slowdowns. contractions perhaps. Plus, it is actually more advantageous to save when rates are higher than when they're lower. Both of these factors happen. And so you tend to get a lag of 12 months from rate hikes to savings rate rises. We had exactly that cycle. They hiked in March of 22. By March of 23, the savings rate started to go up. And so it operated perfectly. where we see a very unusual circumstances, it tends to be six months of a little bit faster than the rate hikes for rate cuts to see a savings rates decline. So you see rate cuts and then six months later, you would see the savings rate decline. This cycle, savings rates declined six months prior to the first rate cut. Now, why is that? It started to decline in early of 2024. for. It started to do that because every single week we get 10 speeches by the Fed and all they talk about is when are we cutting rates? How much are we cutting rates? What do we need to see to cut rates? This propagates into behavior throughout the economy, not only in financial markets, but it propagates into consumer behavior. And so you see that savings rates actually declined well ahead of their rate cuts, which led to consumption obviously being a little bit stronger. The second way it propagates is an area that you know I focus greatly on, financial conditions. Financial conditions is basically how movements in the markets translate back into the economy. So equities increase household wealth when they go up, and that makes consumers a little bit more able to spend. Interest rates affects all the interest rate sensitive sectors that we talked about. And then obviously the dollar affects things like import prices and whatnot. But what we see is that financial conditions since the 2022 rate hike cycle have been extremely loose. And the Fed, which in the hiking cycle was talking about financial conditions, They just basically ignored this persistently and consistently in financial conditions being loose. I've developed proprietary models that basically show the impulses to growth and inflation. We have the biggest inflation impulses that we've seen going back 15 years other than 2021. We have the biggest we've ever seen. And so the fact that they guided rates lower and we've consistently priced rates lower is partly the reason we've had the equity bull market that we've had. I think they would have gone up, but not by as much. The dollar is obviously weaker than it would have been if rates were higher. And, you know, housing activity and other interest rate sensitive sectors would be weaker if they stayed at, you know, five and a half percent. So I think the two methods there is what they've ignored. and yet I think this is a big part of the reason they haven't gotten that side of the mandate right. Fidelity Brokerage Services, LLC. Member NYSC SIPC. Yeah, I've been on the side of your camp of this cyclical re for quite a few months now but I be honest I started to second guess it once we got oil doubling in a month Like when I think about something that can really just you know cut the momentum in consumer consumption, it would be a doubling of oil. But despite that, your proprietary financial condition models have continued to loosen. And then with that, equities have gone higher. And, you know, it's hard to say most of the data that's come out since the Iran war started is mostly lagged. We have a couple, you know, things that would start to incorporate it in. And thus far, it seems mostly fine. And I'm personally surprised and had me rethinking, okay, is it just this doesn't matter as much anymore? Or is it just, you know, maybe everybody's worried about inflation. So they're just pulling forward demand. We've seen like very strong ISM prints. Maybe that's what's going on. I'm curious your perspective on why the doubling of oil in a month didn't just like cut this acceleration in its tracks. Well, we did have the potential of that to happen. We did have financial conditions tightened. We had about an 8% equity correction after they had gone nowhere for a solid six months. We had the dollar strengthened. You know, the euro fell to a 113 handle as an example. We had, you know, obviously yields moved up in response to oil going up. So we did have some financial conditions tightening. And the nice thing about my models is I'm watching this in real time and I'm saying, hey, time to be a little bit more cautious here because we could get negative growth outcomes if this persists. The issue is that it didn't persist. And financial conditions basically quickly deduced the markets are the most efficient transmission of how tight policy is or not. they quickly deduce that this is not going to be a catastrophic event or like a flea bite. And if you look at energy as a percentage of consumption, it's at all time lows. And so it'll rise from that very modestly, but it'll go back to where it was just a few years ago. We're not talking about anything like in the 1970s or 80s or other oil shocks like in the early 90s, where it was a huge part of consumption budgets. And so I looked at oil as, you know, the oil situation is very complicated. I tend to defer to the experts on this. I'm not an oil expert, but they were all saying, you know, we were going to get catastrophic, you know, pricing in oil. And to me, that's like $150 to $200 oil. In that context, we could get demand destruction in a material way. But oil at the 90s to low 100s is really just inflation. It's just going to be a source of inflation. But on the consumption budget perspective, you're not seeing it. In fact, when we look at trackers of retail sales, which we got last month, and Redbook sales, which is like a weekly mini version of retail sales, they're showing acceleration, meaning consumers are spending the same on everything else. They're just spending a little bit more on oil too. And it's not crimping their spending. What they're doing is drawing down their savings rate, again, because they feel confident on the economic prospects. That's what the savings rate tells you. And so we did get financial conditions loosened. Now, here's why I think that's a problem for the Fed. Commodity traders know this very, very well. And if you listen to the oil traders or analysts, they'll tell you exactly this. When you have a supply disruption on the scale of what we have, what you need is the oil market to get into balance. And the only way it gets into balance is either we have a miracle where supply comes back up. That's not realistic with this shock. Or demand has to come down and match supply and we get a new equilibrium balance. The only way that happens is prices go materially higher. So you have the same thing in the economy, right? We have a massive supply shock, not just oil. It's going to propagate around supply chains throughout the economy. And what you need is demand to match that by thumbing down a little bit. You need financial conditions to tighten to match the reduced supply in the economy. When you instead have financial conditions loosening like it's 2021, well, then you get a demand impulse into a contracting supply. And that's why I say we're in big trouble on inflation coming up, because now we're going to get the cyclical side of inflation that we already were seeing. It was already a major problem. We're going to see now an oil shock plus a 2022 style supply shock across all the supply chains. And then finally, demand is boosted by financial conditions. You're going to get it from every single aspect at different points in time. They'll not happen all at once. So that's why I think, you know, the Fed is behind the curve. It's such an interesting contrast that I've been thinking a lot about this idea of, you know, authorities basically intervening in market forces and almost making things worse because, you know, it's no secret that the Trump administration has been trying very hard to keep a lid on oil prices. and to the point where you're almost within this realm, this window of where it's just purely inflationary between, I don't know, like 80 bucks and 100 bucks oil, say. And within that realm, it's actually much worse because you only get the negative effects of higher inflation, but not quite bad enough. You're not getting to the $150 price of oil where you would get the demand destruction. And that just, it seems like a perfect encapsulation of what we've seen with just monetary policy over the last few years too which is that we did a little bit of hiking um but not quite enough to break anything so now just basically since 2022 we've been in this weird doldrums where it's like we can't hit the two percent target um we're not skyrocketing either and then you just have like consumers get really frustrated and and pissed off because everything's costing more but not enough more to cut consumption and we're just like stuck in this weird limbo. And now you're adding on this other one. It just, yeah, it seems like fuel to fuel fire. And it just, I don't know what breaks it. I don't know if you have any ideas on what breaks these intervention loops that keep us in the doldrums. There's no tolerance for pain. There's no tolerance for pain. We saw that with the Silicon Valley Bank where the Fed, in my opinion, I think that spooked them from finishing the job on inflation. I think they were scared from that and the consequences of a banking crisis, which they managed well with their facility. But I think their facility enabled them to continue hiking and they stopped before long. We see it, like you said, with the headline games that we get out of the administration to manage oil. You know, we see that everywhere. There is no tolerance for pain. Unfortunately, inflation is like a disease. If you don't kill it, it'll just stick around and linger and it'll get worse and worse and worse. And we are seeing that in consumer sentiment surveys that are basically in the Great Depression. But you see nominal consumer spending is very strong. And so it's, you know, we as an economy, we have to watch what they do. But policymakers should be paying attention to what they're saying because it's their job to manage this. And they're just ignoring it. And I think it's in some ways it's negligence. You know, I think it's really bad because it really hurts the little guy. It hurts the lower income groups the most. You know, food prices, energy prices are a much bigger share of their consumption basket than they are for the wealthy. And, you know, they're getting hit on all corners in inflation. You see some of these surveys where they say, you know, financial situation is worse due to higher prices. And it's that we have 75 years of history and it's at like record highs of saying that financial situation is worse. And then the Fed will be like, no, we're well positioned to just sit here and wait. No, you're not. You're really not. You're killing people. You were literally killing people. And what breaks it, again, is going to be, are they going to be late to respond to this and have to slam the brakes on the economy and basically say, we have to crush it. We have to break things. That is exactly what happened in the dot-com situation. They cut three times when they shouldn't have. Financial conditions went into overdrive. The inflation was 1.5%, went to 3.8%. Nominal GDP, which was persistently six, went to 7.7. And Greenspan turned around, slammed with, I think, 250 pips or something like that of rate hikes. The economy buckled. The productivity miracle that you had from the tech sector went away. It disappeared. We have a nice productivity boost from AI, from demographics, whatever it is that we're seeing. and it can go away if they have to slam the brakes again, which increasingly looks like it's a risk that they may have. Yeah, I agree. Obviously, the X factor here is that the next time we hear from the Fed, we're going to have a new Fed chair, Kevin Warsh. He's a monetarist, and you actually brought a couple of charts in that I think are relevant for how I want to think through this situation, which is, one, if you're a monetarist and you see M2 money supply growth going up, because you have a chart here, but accelerating higher. Okay, we have new money in the system at a time where inflation is above target. Intuitively, you would assume that that would be a really hawkish reaction function from a classical monetarist like Warsh. But at the same time as well, you also have one around loan growth increasing as well, commercial loans are finally increasing for the first time in a long time. So with that as the baseline, I want to hear your perspective on what you think will happen because obviously, you know, it's not every day we get a new Fed chair, especially a Fed chair that is so different from the last chair. We've had a lot of hyper Keynesians for quite a while now. And now suddenly we have a monetarist. And so I'm curious how you think about that. I think there's what he wants to do and what he will end up having to do. And I think ultimately he'll do what is in the best interest of the economy. And I think it's going to be overwhelmingly obvious that he's going to have to tighten policy. but what he wants to do, I mean, his confirmation hearing, the Fed has like 12 inflation metrics and he miraculously picked the lowest one that has like trimmed mean and takes out all the big numbers and congratulations, you get a low number when you do that. But I think you're spot on when you worry about, is it just a supply shop, right? Like if we go back to last year, we had the Iran-Israel skirmish, 12 days. Oil went up. oil went right back down within a month. That's transitory. You are supposed to look through that. You are not supposed to adjust policy in either direction for something like that. But when you have now in February, we had 11% annualized increase in money supply. You had regional banks, which a year ago, loan growth was basically zero. Now it's 12%. You have the big banks and looking at the chart, you're at 12%, the fastest in 15 years. that's going to be demand-based inflation. Now, it'll take time for that to propagate into the statistics, but that's demand-based inflation. That's the type that only tighter policy stops, right? Supply shocks are tricky on how to react to that, but that's the issue. And then you look at things like, there's a lot of other things that I'm looking at that are very concerning. So number one, I have the supply chain. I created a supply chain index and it looks like it's going to be a very big, broad supply chain disaster ahead. I broke down the CPI basket into all the different categories. We have 55 categories. It looks like 51 of the 55, to me, will be impacted to some degree by this. And as you know, they don't all hit at once, right? It's not like they all hit in March and then that's it, it's over. These things take time to propagate through the system. We have inflation expectations When you look at the consumer side of inflation expectations forget the breakeven market inflation swap market These are wealthy guys sitting on trading floors you know trading just trying to make money on a trade with a very short term time horizon When you look at consumer inflation expectations, I look at the University of Michigan, the mean or average inflation expectation for one year at 7.7 percent. for five years, five to 10 years is 6.9%. These are scary numbers, right? I mean, when you're looking at what the average consumer is telling you, they're screaming, this is killing me. And CPI is maybe just not accurate or PC is maybe just not accurate to our experience. Volatility of inflation is starting to pick up. The reason I look at this is every big wave of inflation, you see volatility of inflation start to spike. And so that's when it gets unstable, right? If volatility goes up, it's a little bit more unstable. And I tracked this by looking at the average component volatility, and that leads the overall index volatility, which is weighted by some big items and whatnot. But the average component volatility is spiking. So I think that's another concern that this might get out of control. And then last but not least is financial conditions. So I think all of these different dynamics are going to be hitting over the course of time. And I think it's going to get very concerning. And so I think he will have to respond that way. Now, let's go back to last week in the Fed meeting. he's inheriting a meeting where three different governors well one was Steve Moran we know that he's a political appointee he basically dissented for rape cuts as he's done every meeting he's been in the seat no matter what the data says he dissents for rape cuts then you have three who have been centrists dissent and say why do we still have an easing bias in the language we don't like that that's a step towards saying, you know, we don't want to have a bias in either direction. We want to see what the data tells us. They're not hawkish yet, but they're telling you that we should not even be talking about rate cuts. And I think that's a step in the right direction. You had Governor Waller, who to me is Mr. Permadove. You know, he was dovish in November of 2023 when nominal GDP was 8%. And we're overheating. And he comes out and gives a speech and says, we want to do four to six rate cuts next year. And he's persistently been dovish this whole time. He comes out and gives a speech. And I thought this was very noteworthy. Understanding finally that the labor supply issue means we can have zero job growth or even negative job growth. And that doesn't mean that the labor market is weakening. Our reaction function to this must change. He actually said, and this was very, very interesting, even if inflation got to 2%, I would no longer support rate cuts as if the unemployment rate doesn't go up. That is a major change. If you lose the permadoves, I don't see how he can get rate cuts in. And so it'll just take, maybe the unemployment rate ticks down a little bit further, 4.14%, we're not far, and inflation continues to be a problem. And then they can flip. As much as I, you know, criticize the Fed this cycle, I don't enjoy it, but I do. I have been critical of them this cycle more than I ever have been in my career. As much as I do that, they do eventually come around. They're just slow. They're just slow, but eventually it slaps them in the face. It's too obvious. And they do respond. And I think maybe they'll get there before long. I hope they do, because the way I see it, it's what I call passive easing. Every day that they're not tightening, policy is easing. We see this in the markets. And then it just increases the odds of a more violent action needed from them down the line. But we'll see. We'll see how open Warsh is to these debates in the committee. He seems like he's open to it. He does have a history of being hawkish more than dovish. when he was in the Fed governor seat. So it's a wild card, but he's not going to want to come in and have everyone push for rate cuts while everyone else says no and have the committee look like he has no control over the committee. He's not going to want to do that. So I'm a little more confident that he'll be neutral initially. Turning hawkish, we'll have to. 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Security is offered by Fidelity Brokered Services, LLC. member NYSE SIPC yeah and I'm curious about the reasoning for them to be so slow all the time obviously parts of it are related to this forward guidance mantra that they hold themselves so closely to like the obvious example is back in 2021 when you know inflation was was getting to whatever it was seven eight percent and they're still doing QE every month because at their last meeting they they didn't signal that they were thinking about thinking about changing that and they need like three meanings to actually make change to something and obviously that's a that's a core part of what warsh wants to end is this whole song and dance that they do which i imagine could make them more flexible and nimble so maybe that will help them be quicker to the turns here um so here's your take on on just the outlook on on that communication style and then also around the models that they use and whether you think that that's also one of the big reasons are slow to the turns is you've done a lot of work. You provided some charts around neutral rates and which one is accurate to even look at. I'm curious, are those the two big reasons why you think that they're slow to these turns? Yeah, this is an amazing question. I'm so glad I get to tackle this as a macro nerd. You know, I get to go into the weeds here. I think one thing they really struggle with as a committee is demographics, okay? And so demographics are basically usually very slow moving dynamics that really don't play a huge part in the macro community. But they are like very small behind the scenes changes that dictate things like labor supply, neutral rates, productivity and inflation. It's just that this cycle, last cycle, we had major demographic changes that were deflationary. And so they were late. They had consistently said neutral rates are 4%. We're going to hike to 4%. The curve was extremely steep as they expected and they guided towards something like that. Now, they didn't move very quickly, but they were guiding towards higher rates than they ultimately delivered. And I was ahead of this, you know, at a hedge fund I worked at at the time in saying that they would not be able to hike above two and a half percent because of demographics that were deflationary. It took them until about 2016 to catch on with the demographic story of last cycle. So well after they started hiking and talking about hiking, et cetera. This time around, they have not figured out the demographics are inflationary, and they still have not figured this out. And this ties in to the neutral rate. Because of the demographic changes that we've had this cycle, and I'll go into some of them in a second, some of the ones we've had, the potential growth is higher, neutral rate is higher, trend inflation is higher, labor supply is lower, productivity is higher. All of these factors, demographic analysis was pointing to as far back as 2018 that we would have this cycle. They have not caught on to this and it's led to a misunderstanding of the economy or a poor read on the economy, in my opinion. But typically, demographics are, again, a slow-moving, behind-the-scenes dynamic that you don't see changes within the cycle due to demographics. And yet we've had three core changes within the cycle due to demographics. Number one, when we had the reopening of the economy in 21 and 22, we had excess retirements. So demographic models would suggest baby boomers would be retiring, drip, drip, drip every single month, a little bit of retirements. We had a flurry of retirements in a short period of time that led to extreme labor shortages. No model would have predicted this, but this was an intracycled demographic factor that complicated monetary policy. In 23 and 24, we had the flood of immigration coming in from the southern border, which raised labor supply by about 1% a year for those two years. And it's what raised the unemployment rate. The unemployment rate didn't go up due to layoffs. Layoffs stayed low. Jobless claims stayed low. Permanent job losers, a series we track in the labor market, did not change at all. But the Fed panicked and said the labor market is weakening. We need to cut rates in response to this. And then in 25, we had the complete opposite. We had Trump shut down immigration to a minimum. And we basically now have labor supply at zero, maybe even negative for the course of this year. 2025 was almost a zero year for labor supply. And 2026 is looking like it might even be negative. And what that means is the break-even level of employment has plunged. And so, you know, this is again, you would not expect these sort of drastic shifts to occur within the cycle. And the Fed has been very late to each and every single one of these to understanding them. But when you have now the current setup, which is a break even rate, now it's well understood, it's between zero and maybe 50, maybe 30. I have 30k as an estimate, you can't be super precise about this. But if it's anywhere near that, in a country of 350 million people, 170 million people in the labor force, growing dynamic economy, you don't need to cut rates by 175 basis points to lift a 25K job run rate to a 45K job run rate. You don't want to lift it to 100K because then you overheat, right? So I think, again, they just have not understood that when you have the labor supply issue as we have it, the employment mandate is taken care of for you. Don't worry about it. As long as the economy is growing, if it's a recession, it's a different story. But as long as the economy continues to grow, this side of your mandate takes care of itself. You don't need to worry about this mandate. it the unemployment rate cannot go up much uh if it does go up it'll go right back down every single time i've been calling that so that's demographics um the other is you nailed neutral rates um i think this is you know the source of all their errors um they have uh an estimate of the neutral rate in the dot plot, the SEP, of 3%. I think now it's 3.1%. 3.1%, which it was 2.5% last cycle. They've moved up very minimally to 3.1%. And the reason they have that is it's due to the Williams, the HLW, the whole, I don't know what it stands for, but the Williams. I always forget that, too. Yeah. And that model, if you look at it from their own website, this is not my chart, this is their chart, has broken for 15, 16 years at this point. You know, it broke in 2010. It doesn't, it's clearly not connected to what the economy is doing anymore And yet they continue to do to look at that So let just use logic here for a second If you think the neutral rate is 3 and we at 4 as a policymaker you have a bias at all times to say bad things will happen. If we stay here, bad things will happen. So unemployment will go up, growth will soften, and inflation will go down. Why? Because were well above neutral, 150, 160 basis points above neutral when they were at four and a half. Right. And so even now they think they're above neutral. And this is the cause of their error. If you look at a record of their SEP forecasts, they have consistently overestimated unemployment, consistently underestimated inflation and underestimated growth, all due to this horrible model that needs to die. There are other ways to look at neutral. And so I'll talk about them now, unless you wanted to chime in. Okay. So the other way I look at it, the Fed has another model. Again, you don't have to look at my models. The Fed has their own model. It's the Lubick-Mathis model. The Lubick-Mathis model has boundaries to it, but it lands about 4.3%. Why I like this model is it was around 4.3% or 4.5% prior to the GFC, went down in the GFC, and went up this cycle. So it looks like it's a very adaptive model to economic conditions. You can look at the market's estimate. The market's estimate, I look at 10-year forward one-month OIS rates. That's well beyond the time horizon of any cycle, well beyond the time horizon of any monetary policy cycle. That is sitting at 4.3%, 4.4%. Again, that went down in the GFC and it went up and has stuck there for a couple of years now around 4.3%, 4.5%. And then the way I would prefer to look at it is look at the economy. And we talked about this a little bit earlier, but you look at industrial production, you look at manufacturing, you look at durable goods, to look at new home sales. When we were at five and a half percent, now they think neutral is three, right? If we're at 250 basis points above neutral, you would expect all of the interest rate sensitive sectors to contract, right? To get really ugly. You expect to see employment really getting, you know, like people getting fired and laid off in these sectors. You would expect construction employment to fall apart. You expect all of these things to fall apart. That didn't happen. What actually happened was they stagnated. They went sideways for three years. And so that tells you you were mildly restrictive, but you were not deeply restrictive, right? So let's just go with my estimate of four and a half percent on the neutral rate. At five and a half, you were mildly restrictive. That's not enough to break the whole economy, right? And then now you've gone down where you're below that neutral. As soon as they went below four and a half percent, all of these sectors have taken off. Industrial production broke out of its kind of sideways action. ISM manufacturing, and it looks like it has more to go. If you look at trackers, durable goods has exploded since they cut rates last year. New home sales has gone to a new level since they cut rates last year. All of these are interest rate sensitive sectors. The economy is telling you that clearly they responded to the rate cuts of last year and immediately. And then last but not least, why don't you look at something like a Taylor rule? You know, the Taylor rule, there's many variations of it. Every single one of them is like four to four and a half to five and a half. Every single one. Not one of them is where they are today or below where they are today. I think that's telling. The Taylor rule is not a neutral rate estimate, to be clear. It's basically telling you, what do we need to do to get inflation to 2% and employment to full employment, which is already there. I have my own rule based on financial conditions. You have a chart of it. And basically, this uses only financial conditions, doesn't use employment, doesn't use inflation rate, just uses financial conditions. It's had a very good track record of leading. It's had some misses, but it's had a good track record of leading the big moves in the Fed funds rate. And what's interesting about it is it was 50 bps above policy rates to start the year. And it's now 100 bps above policy rates to start the year. So by them sitting tight, they're loosening according to this model and according to the Taylor rules. They're loosening. That's why I call it passive easing. As long as they sit tight, they're actually easing policy because the rules are saying, no, now you need to go even higher than you did before because you're sitting tight. And if you keep sitting tight, maybe I'll go to 150 and maybe we'll go to 200 So the Taylor rule and my FCI rule are all screaming, hey, get on with it. You're late at this point. Amazing. We're going to have to clip that out as a lecture in the future for people who want to understand the nuances of the new Troy. Because I think it's wildly important. I fully agree. um okay so if you have a market where we're seeing inflation pick up higher both cyclical reasons and then you add on headline inflation um at a time where the fed is going to be slow to the curve most likely once again and they're sitting on their hands i'm curious about how you think about where the highest conviction trades or asset classes are for the remainder of the year i I imagine there's some bond shorts related or sprinkled in somewhere related to that. But yeah, I would just love to hear about how you think about that. Yeah, I've been basically telling clients since I didn't nail the perfect bottom, but my financial conditions models nailed it. Let's just say the second inning of this. So I think we bottomed April 9th or something like that. And April 13th, I wrote to clients. and I basically told him buy every single dip that there is in risk assets until or if oil breaks or the bond market breaks or the Fed gets serious. You need one of those things to stop this. And I think they're going to have an epic melt up. And I was telling them that then and it started and I don't think it's anywhere near finished. I think risk assets can go in a parabolic fashion. And this is going to anger people on X who haven't participated in the rally and they're still fighting it. I understand that. I understand the arguments they're making. I think they're misplaced, but I understand where they're coming from. They're not, you know, stupid people. They have well-sounded arguments, but they're missing that policy is too loose. And when policy is too loose, like a 2021 and to a lesser degree today, risk assets are just going to go parabolic. and you see earnings expectations are exploding, right? And so you have everything you want to see this epic melt-up continue until or if oil goes to 150 or the 10-year goes to 550 or something like that. I think it has to go to new highs or the Fed turns around and gets really hawkish. We don't want cuts in the language pretend hawkish. That's neutral, okay? we are going to deal with inflation for as long as we are. I like to look at the best central bank that I've seen is the RBA, the Royal Bank of Australia. And they have responded and said, look, inflation's picked up. Unemployment came down. Clearly, we were too premature with our rate cuts. We made a mistake. They didn't have any qualms in saying we made a mistake. We need to tighten policy. They've hiked three times already. They're looking at inflation expectations. They're worried about second order impacts from a second wave of inflation in five years. And they just tightened policy. They didn't wait. And I think they will be much better off than the Fed, which is just saying, we're just going to sit tight and wait and see and blah, blah, blah. And I think that just tells you, as long as they have that mindset, risk assets should continue to go parabolic, in my opinion. It may get very violently parabolic 2000 style until the Fed wakes up. So that's how I look at it. The dollar, I've had a bias to be short the dollar, but I kind of have to caveat that I think that's ending. The dollar weakens when you're too loose, but it also has limits to it. And I think that's important is that one of the biggest drivers of the dollar is rate spreads. And so, you know, we've priced Bank of England, the Bank of Australia, New Zealand, and the ECB. All of them were priced or there are priced to hike rates or have delivered hikes in Australia. But there's a limit to how much we can price on their end. Right. They're not going to price 500 basis points of hikes. Like we get it. So if they've already priced enough, then the only rates that can really move are the U.S. rates. And if they go up, then the dollar will strengthen. And so I'm starting to think and I'm going to be writing about FX for clients in the next couple of days. I'm starting to think that we may run short term, at least the course on dollar weakness. And so I just think it's a few things that you need to have in your portfolio. One is risk assets. Buy every single dip until they get serious or oil breaks. Secondly is identify the commodities that are needed in this economy and where we have supply chain issues. And so, for example, COHO. Now, this will surprise people. I don't think gold and silver are going to participate as much because we don't need those commodities. If we have a shortage of supply chain issues, we need copper for data centers. We need copper for other things that we build in the economy. We don't need gold or silver. They're replacements for the dollar and they had their great story. I just think that story is not intact right now. But we need agriculture. Maybe we need sugar or wheat or whatever it may be. identify the commodities that are in short supply, have those as well as risk assets. Hedge your book with oil upside, hedge your book with bond shorts or rate hike bets, whatever suits your fancy there. Hedge that so you have yourself covered, but be long risk assets and have those hedges. Amazing. Great breakdown. Sounds a lot like my portfolio, so I like it. um and and by the way vix upside i mean when the vix is in the 17 angle you know don't get silly about it you know don't don't bet on lower vix from here you know bet on higher volatility because it can't really go much lower than here and we're we're moving one to one and a half percent every day in the market i mean i think we all should be like yeah yeah well said all right danny always great to have you on get the update on what's going on in the world appreciate it as always where can folks go if they want to see all these new models that you've been working on so my i'm i'm very active on twitter post every day sometimes very sarcastically dannydiane5 is my twitter handle uh from there you can find the link to macro musings by danny d that's my research service where i you know basically go through detailed macro thematic views a lot of models a lot of quantitative frameworks and then i tie it to markets like I just did and say, you know, here's where I think the asset class exposures make sense. You know, here's the expressions I like. I'm very focused on derivative markets as well. And we have a very, you know, active and vibrant chat room where I update all my positions in real time, you know, to clients with my active trading style of them. And so you can find me there and, you know, come join us. More of the merrier. Amazing. All right. Well, Danny, always great as always to have you on Forward Guides. Appreciate it. Thank you. thank you so much for having me have a good one Felix go Hepsko