The Fed’s 2025 Gameplan | Joseph Wang & George Goncalves on Rates, Tariffs, and Fed’s Balance Sheet
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D, C, B is ready to do whatever IT takes to preserve the euro. And believe me, you will be enough.

Thank you. Closing door.

So happy to welcome to monetary matters. George pan, cul vis, head of U, S, macro strategy for M, U, F, G, security america, and josef wang aur of central banking one one and publisher at fed guo t. com. Guys, so great to see you how we .

doing doing. Great, great to be back on with you guys and look for our our conversation.

Thanks for inviting me. It's great to see again, jack. Great to see again, George.

Like you.

I want to start with a very open ended question. How do you see the federal reserves game plan for twenty twenty five interest strates have fall, and they did done three cuts over two meetings. There are three cuts Price into twenty twenty five.

So just was an election that is going to have uh, geopolitical and financial consequent. We don't know what those consequences right now. Joseph, start with you. What's the face game plan?

I think it's a whole bunch prayer. actually. The the reason is next year, there's going to be a lot of activity on the political front and the feed just doesn't know what's gona happen.

Now on the one hand, you have things are president ative like tax cuts, right? I think everyone feels pretty comfortable that person truck is going to extend his tax cuts, the trump tax cuts, corporate tax cut, corporate taxes. But on the other hand, you also have a lot of present.

Trump put a lot terms on his first term, and he promised as to do IT in a even bigger fashion this way. And of course, there's also some commentary about potential impacts on migration. So if you're the fed, I don't you don't really know what to do because you don't really know what the present actually do because often times we say something on the campaign, al, we do something else in office and you don't know what the economic impact is.

So right now, IT seems like they're just in a wait and see approach. So I think the fed is in a really tough position and they're going to be force be very reactive to what happens. So we will hope for the best, I guess.

George, look, I think that this this fed, yes, we will try be in a wait and sea approach as well. And I think that the the animal spirits that have been unleash post the election, if they Carry on, which most likely they will, and if if that translates into further economic activity and you have the fiscal sort of support awaiting in the wings at some point as they these policies get ruled out, IT does argue for the feed to go slower.

IT doesn't necessarily argue for the fed to stop easy though, and I think that's the key distinction. And and I think like like we got us of the outcome, but more so now, they probably have to slow IT down. But the feds is is gonna to be a bridge loan to the next administrations policy deployment.

I mean, they can't do they can't wait. Um I think they can they can stagger there if they're easing, they can do things on the margin. But if and they're going to be reacting to the news flow like everybody else is going to. But I don't think that they this should be an environment where they stop because they're still restrict of other forces at play. And and I think rates still have to come down for certain sectors and certain code boards of the economy.

So we're recording this late november. Do you think the fed is going to cut in the upcoming december, meaning currently the market thinks is basically a coin toss? George.

what do you think? So look, IT is a close cut going into this easing cycle. They started off with fifty basis points, and we were one of the few houses that had that call.

We thought that they should make up for the lost time, that they should have cut in july. They didn't do IT. And then we have they had we have the election.

They cut right after the election. And in their forecast, they have an additional cut still lingering out there as part of the southern forecasts. But the p estimates, the summary economic projections that were released in september still have another cut out there.

So to kind of the fed complete to kind of finished the whole package, I think they should cut. I think most likely they will still cut, but we have some key data to kind of get through. We have the P, C, E, which is coming up soon, and then we have the nfp report.

Those are not really off the charts in either direction. I think they should still cut if it's a really, really strong environment of data and they feel good about pausing, they're going have a very short winter to communicate that. So look, I still think this should cut and and deliver on IT and not come across as being political and just wait until next year to start to slow down the easing.

So your own team cut another twenty five basis point cut in the seven, twenty twenty four, the your references, the summary economic projections yeah I mean, why are have you people been bedding against the federal saying the what the federal or have indicated is going to do with someone the dot plot you coming get IT not from paris that the labor market job data and then P, C, E is inflation data, but just has the data been so so how ish that? But why are people placing these bets?

Will mean the fed speakers recently have been buying optionality by saying the third nine of rush and that they can they can observe how the data is coming through and they have been always that dependent. A I think it's like the market has a tendency to kind of lean towards hawker side that now we have a new information, new stimuli that, that the market views transplant is inflationary over the medium turn, which again, that's debate.

It's i'm sure we can get into later. Um but the market has this perception. It's kind of maybe permanent interfered thinking as well, and that's influencing how things are being perceived.

But look, the still the juries out on the inflation front and the jobs data was very weak in october. I just don't see how movements can be a massive bounce back. IT was during the survey.

We but nonetheless, if it's two hundred thousand or less, they can still ease in december without coming across as if they're out of touch with reality. If it's like a three hundred and four hundred thousand job sort of member, then O K, find probably all bets are off at that point. But and that's why the market this is this kind of fifty fifty.

But we have this tendency to believe that your data is gona bounce back just because we have the the election event behind this. I'm skeptical die. I think that the trends of weaker economic activity don't just turn on a dime like that. And most likely, we get another weak report, which gives them a chance to cut. And then you value in early twenty, twenty five.

josef, are you do you think if everyone is going to cut in december as well?

So i'm going to take the other side of that. I think the fed probably won't cut. Now George made some really good points.

Now it's going to come down to the data. As George noted, we could have any of data that, that really surprises to the upside, the downside that could change any everything. So I don't think they're cut based on what I am seeing from from the most recent doc lot.

So in september, we had a fed dop lot. And as George noted, that was pricing in one more cut in december. But when I look at the economic projections in that door plot, IT seemed like the fed was really pessimistic.

They were penciled in looking at the immediate F, M, C dot, a four point four percent on implement rate, a two percent G, D, P. Growth and a two point seven percent for P C E. Now looking at the data so far over the past couple months, the unemployment rate has actually been fine as good went back down four point one.

We did have a little bit of a scare there and looks like booking at the atlantic fed now GDP now caster IT looks like we're going to have GDP growth comfortable above trend and looking at the clever and fed inflation now casting looks like or P C is gonna about two point eight, two point nine percent. And so bashed on, uh, the recent data, the economy has project progressed Better than the fed expected at september and that september forecasts was conditional on a on a cut in on december. So I I don't think that we need that cut anymore.

But again, as we've discussed, we could have a non farm party role that was surprising to the downside that would promptly lead to more cuts. So and extra pol and many other different figures have been suggesting there are some certainty as what they do. So right now, the market Prices and fifty fifty makes sense. And I think the data in the coming weeks will lead to hopefully a more about conclusive outcome. And just where .

do you see the data coming in? What is your economic view? As George briefly referenced, the non from peril jobs data for the previous month was horrible.

I believe only twelve thousand jobs added, which if that is every single month, they're only at twelve thousand jobs. That is basically a recession. However, huge caviar that there was a hurricane. Other um is using cradd factories that I believe that he bonds h chy bonds sold off on the day, which is really incredible. Think of so clearly, the market thinks that was just a one off and the labor market is still strong.

What do you think? So the George has been spotted on on the weakening trend, but I think part of the victim trend has been doing is due to apprehensions to the election. Now if you are business, you're looking at the november election, and you notice that vice present errors in prison.

Trump had very, very different visions of the world. At the very least, there are differences in tax rates, but also differences in what industries the government was subsidized. So looking at business surveys, IT seem like businesses were very apprehensive and waiting to see what happen before making any decisions on hiring or investment.

And now that uncertainty has passed, I think that we will find that some of the some of the slow economic activity the past few months was due to that apprehension. So I would expect some degree of of economic increase in economic activity, if not simple to the animal spirits. Uh, but I think looking beyond that, looking beyond this brief, but though i'm more downbeat about economic activity next year.

George, wash your economic view and do you find looking at uh, previous a historical instances that before ign election, people are apprehensive and spending and investment kinds to stall out and then after the election IT. To increase again or or now.

And I look IT does to to a different step. But I am a trades in a rate strategy by training and and I do think rates matter that just have been mattering in different capacities over the last couple years.

No, I am not sure if it's OK to kind of pull up one chart to kind of make the point you can speaking to some of the ideas that you just heard from joe, and this is the jury is going to be out to see if this was truly the case that businesses were holding back because of the other very at at the up, up until the point of of of knowing for sure who had one is pretty contentious election. And if you look at page ten, this is looking on on the on one size, the n if I B small business option optimism index of red line. The black line is the primary, but a justice for inflation kind of really get this the true sense of of the inflict cost for for businesses.

And as you can see that there's a is a decent correlation between rates and small business optimism. And and the coalition should be more like when rates are going down, typically only because the economy is decelerating and the fed is cutting to try to create some stimulus. And that's usually the time where you see the optimism heading lower.

Then when optimism is improving, rates can go up and the the fed arts to kind of just policy as the economy can handle IT. And that's that's a vote of confidence. When rates go up and the economy is strong and and optimism is high, that's the best environment that that's what most businesses are okay with as long as they can serve their debt.

That the tRicky part is if you look at what happened in twenty sixteen, twenty seventeen and trumps first election, first term, big Spike and optimism is so we're gonna really watch this small business optimism data in the coming months during the lame duck session as well as into the first to the second term into into the the next presidency. But also look at that black line. That's the the real cost of of rates for these small businesses.

It's pretty high. So high. It's been since really precious cal crisis. And I still argue that the high rates are biting into consumers and that even animal spits can get you can get you a long way. But the the ability to cash flow, the ability to actually service your debt if raised with this high and this proportionally really analyzing the small businesses more so than large companies, which are are really borrowing basically have fed phones because rates were so low out the curve and spreads and corp bonds are so tight that the small businesses are the ones i've been really feeling the pinch here from high rates and a change in administration won't fix that right away. So I do think that rates matter and that we will see where this takes us, but most likely that black wine has to come down, which means the first to the courage regards who is an office wait and store.

Does this chart. And for our listeners, if you are not on youtube but on apple pockets, positives, we got to get to look out for them as well? Or is this start showing a positive or a negative correlation between small business optimism and the inflation adjusted real rate?

There's A A relatively decent kind of core relation and a lead lag relationship up until basically twenty, twenty one. And then they broke down once we had those really large fed hikes and we were combatting inflation. In general, small business optimism has declined even and has stayed low for the last two or three years even though rates have risen, which would suggest we have a really viBrant strong economy that can handle these high rates.

And so that that's the disconnect has been a correlation breakdown over the last at two or three years. And I are you not just a function of a politics, but a function of the high rates are disproportionate, really holding back small businesses now at, at, at a time more so than ever. And we'll see will see if this of some changes in the coming months.

And so Normally when interest strates are high, you think that be bad for small business, but the reason is high is because the economies doing so well. So Normally, there has many positive correlation, which is somewhat paradoxical. And and now you're saying that the correlations broke down.

Yeah, look at me. In general, higher rates is not something that we should scarfed. I mean, higher rates are usually again, a vote of confidence, evidence that the economy can handle and and is strong enough to to kind of hold those rates. So the fact that we have high rates and conference has been low, that's really the anomaly here.

Yeah in one talking point that i've heard many people say over the years and i've said at myself is that short term interest strates don't really matter. What matters is the ten year because that's where all the long term, that's where all the couple, mark is pricing. I feel like long term rates that matters matters for the investment grade bond market.

So apple and amazon, who are always going to be able to need money and they don't really need need money. And then mortgage rates, which right now, like mortgage credit has been restrictive. Like if you get famously, I saw actually a bad bernie ten years ago in twenty thirteen, twenty fourteen, he got rejected your chair and got rejected for Morgans.

So like morg is not credit interest right now on on the march. Obviously, that could change. But I feel like so much of the leverage ectivity is in the short term in bank lending, and it's so far r plus two percent, so far plus two percent. So I don't know, do you think that I I think it's kind of B S. When people say the short term ge doesn't matter, what do you think you.

I think, exact exactly right? I mean, these the way the financial system IT works is that, well, different people bar at different rates. If you are large corporation like apple or something like that, you could follow a bond.

And sometimes the market gets really excited. Prices in a whole bunch of cut solute, you is well. And looking at credit spread, they're also very narrow. And so if you're a big company, you can actually still bara at relatively low rates.

But as George has been discussing and you know that as well, if you are small and medium business, most of your financing comes from commercial banks and they would be so for plus something. So they would be directly impacted by by where short rates are. So this rate high exeo has disproportionate impact with its small, small, medium size of businesses, and that's going to have a negative impact on their economic activity.

Look at these small, timid size enterprise, which we call S I me. That chart on the on the right, the red line is just kind of the average rate that these small businesses are claiming they are they're borrowing at, which is close to ten percent. That's the red line.

The black line is the I G. So the investment grade large s corporate amErica that where where in general corporate are borrowing at somewhere at five and a half, six percent. And that spread has really diverged in the last two, two plus years.

And that that divergence IT really kicked off after the regional banks gone into trouble. So really, the marginal lending into the U. S. Has not been coming from the banks, has been coming from the capital markets and or private credit.

But for the small businesses, which really still get of their working capital from the banking system, that divergence really started to break down in march twenty twenty three, which was the advent of the regional bank crisis. And we've kind of gone into this period of very little lending availability and or very expensive lending to the small businesses. And so i've been arguing that this the rich child does work.

The interest rate short rate channel is working probably working little bit too much for for these cohorts like small businesses and and the lower income and middle income households are really feeling IT more so than ever that they have auto loans h that are indexed. They have credit cards that are super high. So yeah, so rates do matter. They just matter in to different groups within the the economy.

And so George, when you say the interest state channels working a little bit too much, what you really mean is that there's a large percent of the miracle population and a large percent of a small business in the U. S. Who are being struggle by high interest rates.

Struggle is a little bit dramatic word, but that its registration are too restrictive. And maybe if they stay this restrictive, there could be a slowdown and A A potential recession. And also, you have to adjust all this by inflation. And so as inflation has been going down in real terms, these rates have been going up even more even as the Normal right goes down. So George, I guess, make the case for why you think that I think the fed funds you think is going to three percent, which is more than the market plays right now as well as what you view on recession.

So look, i've been my high side in terms of recession. Is that took IT down a little bit. The fed is gonna, as I said, a bridge loan to the next administration, depending on how fast that admins trip administration rolls out policies, how effective the sequencing of of these different policies. There are some unintended consequences that could happen.

And and you mention a few them, which i'm travel get into and and all these things are happening at the time where we've been very fortunate that government spending has been offering been propping up in any way certain parts of the economy and really running the economy hot, right? We've been running at over two percent GDP with a lot of government spending. If the idea is that we're going to become more efficient and we're going to retool the government and we're going to shift that around, yeah, you can have a lapse in activity.

I mean, and that can really seriously run the risk of of us dropping into a recession out of out of nowhere. I there is that risk and then there is the because we've been kind of the this growth has been masking the reality of the of the pressure that's been placed on these lower income, middle income households as well as small businesses. The long and variable labs lags of fatalities might all hit at once.

And in that big long and variable lags of hitting in early twenty twenty five as the first day is higher for longer because they are trying to figure out how these fiscal policies get implemented. The real, unfortunately, in situation will be that will be at the worst timing and really then maybe expose the weak weaknesses of some of these borrowers. Josey.

what's your economic outlook for for twenty and twenty five?

So I think a lot of IT is going to depend on the actions, but from from the government. So this is my read on how present trump would would approach his second term. So what i've noticed about president trump is that he really, really believes in terrace as a tool and the importance in reordering at the global economic system.

And he's a what a team that that is prety determined to do. So this is something that, so again, politicians and say many things, but this is something that president trump has been saying for a long, long time. And so I think he really blazin IT.

And we saw that he tried to do so during his first term. Now this is his second term. This is so he doesn't have to run for elections.

And mid term elections aren't for another two years. So he has two years to basically do what IT takes to reorder the world to the way that he thinks will work best. And I think that's going to be a very disruptive.

So I think he's going to hit the ground running. He's going to announce a lot of terrors. He's going to go big, and so he's going to use all the tools at a disposal.

And now I think that maybe the changes in economic system would in in the medium term, end up to benefit the american middle class. But that change is always very difficult. And I think we could see a lot of volatility that could dampen a business sentiment.

So next year, on the one hand, I think it's I feel pretty confident that will get the extension of tax cuts, maybe more tax cuts, but that will, I think, partially buffer the disruption, what will see both in geopolitics in international trade. So i'm thinking that next year probably won't be IT as good as this year, but IT will really just depends on both how person truck act and also how the other countries react to to the all this negotiation. But I think that's a pretty big headwind to economic actives next year. But on the right side, i'm guessing the federal response to this in a more dovish fashion. And so maybe this small, medium enterprises that we've been talking about and get a bit more reprise on their interest rate expense.

personal electric needs to say has says some very aggressive redick about terrorist. I'm going to put terrorists extremely high. There are politic elas who say that he's just going to use that as a threat.

He wants to reach an accommodation. So china is going to put, build up, build up the plants in in america, in china, all the company is gonna do. On this reassuring IT sounds like you actually think, no, the details will be quite high and you could be negotiating tool.

But you really the terrorists are going going to be there. How do you interpret the a effects of there? Of my very shallow understanding is IT stimulates internal production, but IT IT is instantiated es and punish es internal consumption.

So when people think about terrors, I think one hand lot hands, we hear that it's inflationary. And and I could also damp economic activity. I don't think of terms as being really inflationary.

Uh, the reason is that so when you have a tariffs and is paid by the importers, so what what could actually happen is there's an enough of moving parts that can actually to mitigate the the increases in Prices. For example, let's say that the U. S.

Is living terrace on china. Well, what happens is that the U. S. Currency strengths, as we've been seeing the past few weeks, and that strengthen and currency could mitigate some of the Price increases. So the chinese exposure could potentially lower their Prices in dollars.

But at the end of the day, even though they're receiving fewer dollars, the dollar has appreciated. So their their income in local currency terms is on change. So to say that one potential buffing channel.

So to be clear， that did not happen in twenty eighteen, the last time we had a terrible but that that could happen a for in other circumstances, another possibility when to come to terrible increasing Prices is that the importing business. So let's see the U. S.

Retailer just kind of eats IT in terms of lower margins rather than passing IT out to the consumer in terms of power consumer Prices. And that's actually what happened in twenty eight. So in twenty eighteen, we had terrible and the the important businesses just say that.

So we didn't actually to see too much consumer inflation. But more importantly though, even if we did have consumer Price inflation from cheerful IT would be a one time thing. IT would be a transit ory.

So IT would be an increase in the Price level rather than the rate of change. So IT wouldn't actually prompt in monetary Price response when IT comes to potential inflation impacts. However, what we also know is that I could dampen in business confidences and the last time, twenty eighteen, the trade war LED to retaliation.

Where are other countries imposed tariffs, exporting sectors in the U. S. And that actually did have an impact the exporting sectors. And so that could have some impact on employment in those sectors.

So I think that the impact, if if we do have a big chair for, would be to have a more easier monitary policy. Again, there is a scenario where we just say big terf, everyone kind of rose over and and just plays nice. We already hear noises from the european union suggestion that maybe they can buy a lot more U.

S. gas. But I think other other countries probably don't want to roll over, at least not right away.

They want to negotiate as well. So they have to put up at least some kind of resistance. So I think that would actually end up, at least briefly, that we would see terrorists on goods.

So you don't think that tabs are inflationary because there's a potential for the dollar to strength in and therefore, goods in they may be goods in yan and you want chinese, you want might go up, but in dollars, they wouldn't go up. That's interesting.

What do you the effect of of of terrorists on the internal production? Is this basically a lot of people who are protesting if argue that if you put a terf on china, you're gona incentivize production in the U. S.

And all the factories and manufacturing plants are going to be built in the U. S, which would be stimulative. What do you think of .

us so that that is possible? So if you think back to the ninety eighties in japan, for example, major, major exports to the us, a lot of people hear in washington were very unhappy with that. And now fast.

For today, japan's automatic ers have a bunch of adult factors in the U. S. So they're building a lot of cars in the U. S.

Now, my read on present trump is he's not so much ideologically opposed to china, but he'd be willing to cut a deal if, for example, byd, instead of just preventing them from selling cars to the us. If they were built to build factories in the U. S, he would be OK with that.

So there is that outcome where we could have a lot of chinese companies moving onshore into the U. S, building factories and selling cars like the korean suit, like the japanese too. That's definitely of a potential outcome.

So that would be very positive. But IT also be something that happens in the medium term. IT takes time to to build a factory and so forth.

What could be more immediate is simply for other countries to buy more good and services from the U. S. To try to less than the trade deficit.

I think in twenty eighteen from chinese perspective, that was purchasing more U. S. Commodities for all the countries that could be purchasing more U.

S. Military equipment. For example, south korea, us, as many bases there, they have a trade surplus with the U.

S, L. Maybe they could just buy more U. S, missiles and try to defend themselves.

Then you, you write a feed guide, calm, a piece called the great redistribution that president trumps desire to baLance trade is functioning efforts to baLanced distribution of profits between corporations and labor. So its success would be a market negative event that would be bad for the stock market exchange thinking there.

So again, when we look at the trade and say the huge trade deficit the U. S. has.

So let's take china selling a lot more goods and services to the U. S. And it's buying from the U. S. We think a bit it's often painted as the chinese are winning their earning a home bunch money from the U. S.

And so for and there is true th to that, but if you look a bit more into the details, you notice that a lot of times it's A U. S. Company, say apple, for example, building factories in china and then selling goods from china to the U.

S. So the people who benefit from that trade surplus, the chinese trade surplus part of IT is the chinese workers, but a lot of IT actually just goes to U. S.

companies. It's part of the mobilization effort by large west companies to reduce labor costs. So if we were to make that trade deficit go away, I think the losers of that would be course chinese workers and other foreign workers.

But a lot of a big part of the losses would be the profit margins of multi national. He was companies who are, of course, feature prominently in our big sock market index ists. And so if we do have this great reordering, at the end of the day, it's more income for U.

S. Labors, obviously jobs on shore. And that suggests, through highly bercow, narrow margins for big U.

S. companies. And narrow margins usually means lower stock Prices. Again, this this would be good, I think, for the american medical class, but may may not be good for sock crisis of these large .

multi nationals is very interesting. George.

what does on joe is spot on here on the number of fronts. I I think joe, you you are review that reassuring is hard rebounds ing trade if it's really just a functions between labor and capital and and this idea that a lot of the jobs U. S.

Were exported, received by U. S. Companies, right, not just foreign parties that are wanting access to to the U. S. Market marketplace in the U. S. economy. And and also in comparison to what we got during transits administration, the the like repeat rating dollars was easier because that's like a financial concept, is a lot easier to kind of encourage money to come in capital, come back home to the U. S.

But actually to a encourage a production and shifting that over IT probably does require some some tougher terrace, which took the joes point at the start of all. This could be very disruptive. And so the the question is our tips gonna just a negotiation tool.

What what kind of terrorist do we get? How they implemented is IT just as kind of joe ludi de? If if there are series of executive orders that kicked off at the start and they become effective immediately, then we have.

I think it's going to really started to take an impact and and this kind of more sangin outlook that the markets have right now, which is that this is a business friendly administration is coming in. It's gonna deregulation. It's going to be a strongly economy so on.

And so for if in order to get to that place, would I think if if trump wants to make present elect trump wants to make these more drastic shifts that were part of the campaign promise to really help out uh, U S. Households, that there might be some pain initially as you retook the economy, right? And so I think john brings up some really good points.

And the question is, can you do IT in a two year window, you know, the mid terms or two years away? I sensibly, you really started a campaign for them early twenty six. And in twenty twenty six we have U.

S. Is two hundred and fifty of anniversary, which is something that you many, many folks on the term sider are are looking forward to the two hundred fifty that univerSally, including ourselves, anyone here in the U. S.

But but just in general like this, the window seems like it's long, but it's not and it's heart these medium term initiatives to take time to implement. And and so I I look I know the view that the the terrorists are in welcome in different degrees. I'm not going to be I going to repeat everything that geo just went through.

But if if the terrace are spot starting, if we took him for going to talk like in in in trading terms, if if the mark, if it's a terabits going to start right at the start of the next administration, those are much more disruptive if they are kind of like conditional terrorists that are based on some sort of criteria being met over the next two or three or four years and they can be phased in. Those are less disruptive and and will be much more of a powerful negotiating tactic. I I would hope and I would think that's how they are going to go about IT. But if there needs to be maybe a tougher, tougher love initially to kind of send the message that, hey, we mean business on tariffs and they do come out with a kind of spot starting implementation at the start, then yeah, markets are in the wrong zip code.

We going to need a lot of three talks are going well, tweets, to make sure market is happy.

Just u reference early. You thought that terrace would be double h so why why do you think tariff s would cause the federal serve to cut interest rates? Or if there is potential inflation to look through the Price increases as transitory? That's exact quote from your peace.

Don't dem my understanding the first reserve just made huge mistake in twenty two and twenty twenty one of looking through inflation and calling a transitory. So in my perhaps they they would be more reduced to look at C, P, I. Inflation goes to eight percent. Is j pal really onna say that transaction? Why do you think terrific dish .

so terrify have that impacted on inflation? But they also have a negative them cacked on economic activity. If you are a standard central Baker, your your ideology is that these one time increases under the Price level, well, that's transitory, right? So you want to look through transitory factors because maybe as soon as you react to them, inflation is over.

Now tariff s again are one time Price increase in the Price level rather than an increase in the rate of change. And so according to standard central banking ideology, you would just look through that jacked rates are really a good point, but they were really wrong earlier. Now such baking ideology is you look through IT this provided that inflation expectations are stable because if you look through too many things, then inflation expectations get unanchored and then you're in you're in a lot of trouble.

Now so far, the fed has insisted that inflation expectations are angered. And if they continue to believe that IT seems like they should look through these one time increases in the Price level. Now on the other hand, now if you look at twenty eighteen, when we had our first trade war, there is a recently declassified memo from the fed researching the economic impact on on tiffs.

Now this suggests that the fed was concerned, what is all this trade uncertain ty going to do? Now the memo suggests that there is tremendous and policy charity. When IT come to terrace, they didn't see IT actually impacting business investments. But they were really worried that if this were to go on, we could have a dampening in business investment and that could hurt economic activity, which, of course, would push up the unemployment rate. So given that the fact would look through inflation impacts and that there is an increased risk to lower business investments, which could raise unemployment, IT seems like the right policy response to this is to have more cuts than expected if we were to have another trade war. So I think that again, this launch of new tabs would push the fed towards more rate cuts than the markets currently pricing.

And so just are what's your view on the the stock market? Last time we said you were you were quite cautious on the market because there was some election on uncertainty. But I I would thought that if trump got elected, what he did, that you would turn less version, more bullish.

What's going on? Yeah yes, so bright. Before the election, I wrote a piece to my reader suggestion that there was actually notable right now risk.

If you just looked at the election map, the math IT was actually a very, very high likelihood that there would be a red sweep, which is actually what happened, and red sleep. Obviously, the market would do you very market positive, and the market has reacted positively. Now looking at market center right now, IT seems a very, very ambulant really.

So I am thinking that we are probably maybe heading up to some sort of a blow off top because as i've been discussing, I think that the onset of the tub presidency will be pretty rocky for market. So at the moment, as we head into the seasonally positive december santilli area, given a positive sentiment, that seems to continue to do well. But IT does seem like potentially some sort of blow off top as we as we head into a lot more trade policy uncertainty in the first quarter next year.

And so that if you on stocks, what about bonds? The ten year note is at now four point three percent. Is that fair value to you? What do you say, Joseph? And in church.

So so as I suggested that I think that the market is being too hot, kh, that we will get more cuts than the market is pressing in. And so I think the ten year is going to head lower next year as we have a lot more volatile the markets and a lot more and surge the on the trade policy front, I I think this is a big deal that the market doesn't seem to be pricing in. Again, the market seems to be focusing on tax cuts and the very positive sentiment, deregulation. And so fourth, that's all valid, but we have to place some weight on the other stuff as well.

George, watch your of you on on bonds and let's use some several of your great chart.

Yeah, let's go to page forty six. If you don't mind, flip in there on this page on in this chart here and forty six, just for your readers and listeners, this is the fed funds rate, the black line. And australia, we'd love to do this where we call these hairline or superimposing yield curves on where the market was.

Pricing rates would be in the future from a certain starting point. And so all those little like red dot lines are different yield curves over like over time since the nineteen nineties. And many of us have uses these kind of charts in the past.

And you can see that the market usually either is too optimistic or too pessimistic. It's rare that we kind of meet a perfectly Price market based on what the fed delivers. Yell curve.

The current yell curve is on the on the right side and you see A A solid blue, which is the november twenty second when I we snapped to the curve. It's basically it's univerty curve because the market is pricing in red cutt, although they've been taken out. And then if you look at where it's kind of settled in that we're back to the same shape of a yield curve for the money market.

Sofa curves back what I was september of twenty twenty three when we had the ten year close to five percent, the fed backend was concerned about pilatre c conditions tightening. And in fact, we still have a lot more financial conditions easing. Since then, credit exposure or much lighter equities have made new highs. And now we have a curve that is implying that the first and have a shower path similar like we have twenty, twenty three.

I think that that of itself is an important kind of message from the market that that's the no landing, soft landing crowd now pricing into perfection that the feds going to be able to only cut two or three more times and that is going to be enough to avoid any sort of kind of economic weakness because and now and now in many ways, the no lenders and soft landers keep getting built up by by new information. And the new information now is that we're going to get fiscal policy, which is going to keep this economy in recovery going for longer. I think it's that all find good in the medium term.

But as we we're looking at rates, yeah, I do think that the fed has to cut more to offset any potential weakness that may that may develop, but also the fact that the higher for longer has been hurting those different areas of the economy. And so I do you think that, that this is probably misPriced by at least fifty basis point. And so the tRicky parts gona be that the ten year probably should trade in a range like four twenty five, four seventy five maximum. We didn't break above four fifty even with all of the excitement around the election.

If you go back a few slides back actually back to page forty five to slide before, you can see that the majority of the the right in the chart on the right here now is a chart of the ten year versus predictions markets odds of a red sweep um prediction websites odds of a red sweep and you can see that really starting in late of temple early october, that the bomb Priced in and took the trump one point of playbook from twenty and sixteen and basically that, well, the ads improving. Most likely that means higher rates and most of the adjustment took place in the belly to intermediate long term rates. So five year, seven year, ten year rates rose a lot more.

The curve sea. And but even with that, we barely got to we didn't get to four point five. We barely they were barely. Got there and we couldn't hold four point five. So yeah, the market is has Priced in a lot of the sort of kind of the trump trade one point out.

And if we get economic weakness as a as the economy retools and the fed cuts that we don't have to go about four point five, by the way, right? We can kind of we did top tick rates in the cube four of twenty twenty three. So it's quite possible that we can top tick rates also during this time period as well and that we actually end up rilling from here going forward. But I think that much more defined range in like four twenty five, twenty five for now, economic weakness, you could easily go under four percent. And and really the the real focus will be the two year more so than a ten year at that point.

okay. So currently the ten years at four point three percent you talked about in the short term, arrange of four point two five percent to four point seven five percent. So where are the lower and the range, which means in the short term, you are neutral to bearish on the time? That surprise me. So now we must be in the camp of a massive Stevens, right?

So look at me. I do think that once fiscal policy gets iron out and if IT is both stimulative as well as results in more treasury supply or even just a shifting of the composition of treasure supply, let's not forget a lot. The debt was issued in the in the in the front end of a lot of dead that's coming due next year.

If we have a kind of a shift by the new treasure secretary, which is also kind of flag, or if he gets confirmed, the scope is and also a bit of the view that there is a need to kind of turn out the debt that, that could hold up ten year rates more so than any other time period. So four twenty five, four twenty five is really a reflection of that view that we were in the lame duck session. We're heading into a new administration that could be more focused, Angel, on longer term debt than short term debt, and that should keep the rates curve higher if the Carry does weaken.

And we we can very clearly go on to four twenty five. So that's not a stopping point. But for the moments where we are right now that we Priced a lot of you euphoria, we public should trade in arrange.

George, I just love this chart that you have. I forget what you call that. I think of these things is tiny, little like Angel hair pasta, but red, little red curves.

Are where back in time for nineteen ninety tude to now where back then the market thought the fed would do so. In two thousand and nine, the market thought that by twenty thirteen, industries would be at four percent. Of course, by twenty thirteen, they were at still at zero percent.

So just could show how often the market is wrong. And then the blue dot verse read that doesn't really know that just so far verse your dollars. So you very simple things or so. And also just want to clarify earlier, you said that the curve is inverted. The very short term interest ate zero to two years is inverted because the market is pricing and cuts.

But the vast majority, the curve is actually now upward sloping, which is Normal in two and twenty two, that the Normal two ten curve, two thirty curve, whatever inverted meeting two year yell, was higher than the ten year yellow. Now the ten year is higher than the two year yield. And IT sounds like, George, because you're bullsh on the two year and not terribly blish on the ten year, at least in short, that you believe in a massive you're definitely the camp at the two ten spread, which has gone excited in version and is now at uh four races points, is is going to wide and significantly. Why do you think that is? And also proactive explain for our audience why do people care about the the two ten spread and and why do you folks such as your self as well and interests traders, why do they often trade the spread instead of the tribute, the absolute up down?

sure. Let's let's look at the next lide then, page forty seven. And so this is a really long historical account of of curves. And you can see there's uh kind of two different regimes.

I I sport I split up the world like before nineteen ninety and after nineteen ninety and IT looks like we're going back to the three hundred and ninety world where rate levels are high or all l equal. I don't think they were going to go back to zero back unless something really bad happens. So we going to have a higher rate environment, flatter curves, all else equal.

But still the potential first, a curve is steeping from this point forward and generally higher volatility as both your policies are changing real time, we have a lot of of kind of new things developing, so we're in in more uncertain world. So your curve, curve and rate ball should be higher. And that's what this charge shows you.

So the bottom part is showing you realized all was very high from the nineteen sixties until they basically the late eighties. And then a kind of stabilizing, you only had to arise in involve when you had like some sort of existential vent, like cove IT or two thousand eight or the doc m crash, right? And curves would would go anywhere from my negative twenty hours, or basically zero up to a two hundred, two hundred fifty basis points.

And that was really a function of the fed cutting rates, three, four, five hundred basis points. The short term, I would just move a lot faster than the long term rate, and that would then result in that curve spread widening word, the curve becoming steeper. Looking as you can see from the start like that, I think it's going to be hard to get back to the nineteen ninety to twenty world.

That is not impossible. But I think that we the curve could get up to seventy five to a one hundred basis point. So we're starting basically at four, five basis points of a curve slow right now. So that's still a decent amount of curve steeped ing and and IT matters for a number reasons.

One, and if if if long term rates are higher than short term rates as an economy in the market that expects future prosperity and that growth will will persist in that the forwards look Better, then the current enviro negative curves and verty curves are not a good reflection on where the economy is heading. So a positive curve is IT gives you that kind of attribute. But more closer to home in what IT means for the banking system, especially for a banking system that has not really been lending because the curve has been inverted, their funding costs are a lot higher than where they're able to land out the curve.

And so they're basically borrowing short and then lending long. The lower that government rates are. Even if there's a spread associated with a loan, you're not really picking up a lot of yield to land into the economy. So a steeper curve usually IT gets the banks engaged and allows and that creates more credit formation for the economy. There's other forms of create. A transformation has been happening while we've been waiting for this, but nonetheless, getting the banks engage things, probably part of some of the initiatives that we might hear from the incoming um administration, especially the focus on the regulation they would most like. They want the banks to be more involved in the really economy and having a steeper curve would would really help with that.

And so the curb inverted in the spring of twenty twenty two, we are thirty months after that and we're still not in a recession. Probably, who knows, but probably not what has has the inverted u curve hypotheses that an inverted ve ill curve is a predictor and property course of a recession, by the way, that that does have a good track record.

Has that been improvement? Is this is sample size of the invisible curve was wrong just the first? And George.

well, looks like it's been wrong. I agree with you, jack. I really like George's first chart as well because IT shows, as you've discuss me time on your show, that the bond market is wrong a lot, right? So and more importantly, I think there there are things that happened in the really economy and in the financial economy that make that past relationships less predictive of future, future events.

I mean, we have so many things happening right now, tremendous fiscal deficits. We have changes in the regulatory structure of the banking sector. So I would be had very hesitant to draw a conclusions from from these inverted yul curves, seven, thirty months that as you said. So maybe maybe the curve is is wrong.

George, or maybe we have touched on IT kind of dancing around IT before the start, that there isn't a one size fits all interest rates for every single american and or companies and that maybe some part some industries happen actually feeling recessionary pressures and some some groups within the U. S. Happened feeling what like feels like a recession.

We can know on aggregate, the economies been doing well. So I think I think it's it's too early. The jury still out. So i'm not going to i'm going to say that the yellow curve got this wrong. Yeah, I think we are some time in data tes data ates revise a lot mean.

And lately, they has been revised so often and and look and look at all these sort of historical analogs and studies that we do, especially as strategies and investors IT were trying to like fit the past to predict the future, which of course, is A A very difficult thing to do. And sometimes they take a life of their own right. And so in many ways, what what we've been, I guess, been fortunate throughout this two or three years because of the excess liquidity.

It's been just kind of sitting in the system. It's allowed us to kind of test all of these no hypothesis like we've been able to like basically every single possible like hypothetical scenario we've tested IT and IT hasn't broken the economy or the markets, and it's really bit because we've been floating in a sea of liquidity. That rate levels didn't really matter as much or the version of the curve didn't really, really exposed any weakness.

But doesn't mean IT wasn't there. IT was just being really masked over by the government spending and also additional liquidity that was pumped in right after coding. And I all that stuff is basically run its course.

And that's why I feel like now is like the more sensitive time where these long variable acts can really start to really show up. The fed were to take a weight and sea approach on fiscal policy. I think there would really be a potential policy mistake.

And maybe the inver curve in the high rates did slow economic activity, but they slowed growth from twelve percent growth, five percent of growth. And five percent of the growth is not a recession, is still A A good economy, George. So are you of the view that if industry tes stay where they are, four seventy five, maybe one or two cuts above four percent above four and twenty five minutes, say that that will continue to slow down the economy and ultimately lead to A A recession, that that three percent is necessary, efficient, sufficient cuts of cutting the fed funding from from where is four from four seventy five to three percent is necessary to avoid a slowdown.

I do. And if you can flip t backwards out to page twenty nine because there is one thing that but sometimes we are too smart for our own good or we attribute our success to our recent actions, and in reality, rather just got lucky. Or again, there's that the pool of liquidity has been out there.

But what i'm showing you here on page twenty nine, very simple chart, but there's two things just for those that are listening. Top panel. There's a the first funds rate, which is a black line.

And then the red, red, red line is an interest rate of the feds kind of r star from there from their model, the William lombok model and the plus inflation to kind of bring you back to nominal terms. It's kind of animal G P vers f rate kind of analysis. And the bottom part is the spread between the red line, the black line to try to see how long does the fed stay restrictive.

And as you can see from the ninety eighties, the fed is typically always in is has more than easing the inherently more double ish. And that, that's been really helping our economy maintain the strengths and growth over decades. They they only really had really nailed the rate levels in ninety five and ninety nine.

When neutral was rates were basically five percent and roughly five five a quarter. That was the kind of the right speed limit for the economy. But outside of that, it's rare for the fed to have rates meaningful ly above either inflation and or above like this kind of our star proxy. And I think that we just got lucky that nothing has happened yet, but that doesn't mean IT won't in the future. And if you go to the next page, I try to take that analysis and compare like the spread differently.

Tie, which is the top part of a how restructure was the fed at its peak during each of these hiking cycles? And then at the bottom panels, like how long did rate Steve restrictive above this kind of proxy r start the the the way of the markets pricing and the feds, even the even the feds own current forecasts, which will most likely get updated in december. But the black bars measure the time of rates were restrictive.

The thousand and nineties, we had a roughly like twenty six or seven months from what I can tale. And and IT currently, we had had the fed above some sort of neutral for about fifteen months, even though they cut seven, five basic points are still higher than what we conserve to be neutral. And the fed's own forecasts suggest it's going to take them seventeen months to get to neutral.

And the market doesn't even have them getting to neutral. Al, as we have now roughly three point seven five as the resting place for interest rates Priced into the sofa curve, and I think that the neutral is still closer to three. And so the longer they dragged this out, the longer they keep rates above neutral.

I think now we IT will start to expose the fragile lies that are out there in the economy at a time where we'll see you like how the next administration roles out. Its its various fiscal policies and tariff. S there's a lot of balls up in the air. I just went through a lot of assumptions and this idea that we're gona soft land this thing without the feed actually easing further, I think that that's going be uh, hard, hard to do.

Those are those are some phenomenal chart. So going back the red line is our star plus C P I. So the neutral r star is the neutral real rate of interest plus actual inflation.

So it's basically our star plus. C P I is the level at which interest strates would be, where they are neither stimulating economy nor restricting economy. So right now, current interest rates are higher than that level, meaning that they are a restrictive, which is quite rare.

And then your second chart just shows, number one there, one hundred thirty nine business point of a spread. So that's a pretty big spread compared to history. And IT stayed that way for fifteen months.

We and typically only days there for seventeen months. But what is this story at this doted line, doted bar line on the right of two, three, three to current. So fifteen months that were the spread and positive. And now that said.

that shaded seventeen months is what's currently projected in the S C. P. Forecasts as of september. But they think they're going to get down to roughly three percent sometime deep in twenty twenty six at the end of twenty twenty six. So a full twenty twenty five, a full twenty twenty six that they're gona only cut for three or four times per year to get down towards low three percent and that that they're be able to achieve that without having to accelerate the cuts. And that by doing and in doing so, they're not gna.

We're not going to see any economic weakness where I going to see a recession that we're just gonna fly path over the next basically eighteen months, seven and eighteen months into six and get towards their version of neutral, which maybe has changed, we don't know, but I still think they believe it's three percent or less, and it's going to taking others nearly a year and have further to get there. And that will be the longest time ever. We've never done that. And ninety four, ninety eight, twenty six months, this would be basically thirty two months above neutral.

Wow, as a George, you sound quite confident and may perhaps you not wildly bullish on the on being the two year because of course, you have to use leverage and interest rate rate now are high. But maybe I mean, what kind of trades would would inform this view like buying calls on the two year or selling puts on the two year, basically betting that interest stator going to decline? I really about the .

year and look in general. But the problem is, as we all know, and this is the issue, it's it's timing as everything and and we're in this sort of again, this during the lame duck session, and we don't know the fiscal policies and how they are going to be rolled out and the markets just taking away and see approaches to so I think that it's will come down to the data and and if if the animal spirits are not able to rekindle activity and if we're still seeing effect is a kind of dragon their feet to cut, if they started to cut slower and we get the negative unintended consequences of some of these policies from the physical side that we can we see the econic decel ary further in the first half of of twenty twenty five.

And therefore, the markets for to fill that out. But like it's not going to be, we're now in a much more difficult environment because IT feels like the market doesn't believe rates can stay under four percent. And until that changes, is is hard to put on that trade.

And I think that it's it's Better to be mindful of the implementation risks, the unended consequences. And then if you believe that the us economy is decelerating and won't be able to benefit from these policies right away even at the end of being great for the medium term. In the short run, we can still see deceleration or further declaration in the U.

S. Then the two year will will catch your bid. But at this point, it's little more tRicky.

And just just yes or no, you also are a quite a yes.

yes. I think we the fell cut more than the market expects.

Thank you. So it's interesting that both of you are kind of an aligned on this this issue. And just also on my previous show for guidance, earlier in the year, you had a great call that stocks would crush bods. Not only did IT make a great headline and great copy, but IT also happened to be right, which we we value here on the now monetary matters. Sounds like you're kind of the other cap twenty five bonds will crash stocks or you're not willing to go that far.

Well, i've actually quite proud of my S M P. Six thousand call last december. So looks like what we're going to do that such a pretty crazy. So I think going forward, IT really is about what the government does. I think we focus too much on what the fed is doing.

What we've learned over the past the year is that, as George noted in, is really good chance what made policy pretty restrict or according to conventional models. And at the same time, C, N, B, C has do point on their website, right? S, N, P, going into the mood, credit is very narrow.

GDP growth continues above trade. So what's happening here? So I think that the story that is because of the significant physical deficit, physical simulation, is the way that I agree with.

So I would focus less on on the fed and thinking about the future and more on what the administration will do and plus congress. So that introduces that a political dimension makes IT very hard to predict. So next year, I think we just have to listen more closely to to what present truth is tweet than what your own power was saying .

in a press conference. wow. And so you're not ready to make the will be a lot of uncertainty in stocks. But to make the call that bonds without perform stocks, you have to be both bullish on baLance and barnish on stocks. He says that you don't have quite that level of confidence, right, or my run.

So I ll just add this extra dimension about bonds. So like George mentioned, there is this uncertainty. I asked you what the new charactery circuitry best will do. Now he he did do a podcast where he was critical of secretary yelling, issuing a whole bunch of bills rather than couponing, again, putting down ward pressure on longer dated fields.

Now that he's in the seat, is he going to issue in a more traditional way, that is to say that we would have more coupon supply? Or is he going to be mindful of present trumps love of the stock market and also have to continue what what secretary yelled did? So there are all these moving party that I think that makes IT difficult to make a judgement.

But you know, even if we do have yellow go down, I don't think you would go down a whole lot because at the end of the day, the fiscal spending continues to be very strong. Now if we we do actually end up with, say, a three percent physical deficit, a tremendous amount of. Cuts and wasn fraud, then that could change the story. Right now, I am still focusing on what are the political side would do.

And so depending treasure got best in, he has a three, three, three plan. He he talked about that basically at the decreased the national deficit to three percent of GDP, have the economy grow at three percent, and then also increased oil production by three million barrels per day, just so on that national deficit. So guys, what what the current deficit is that? What six or seven percent of G D P. Getting down to three percent would be a net tightening. Do you think that would be contractionary?

absolutely. I think that a big part of our economic growth policy in the financial markets is due to the seven person fiscal deficit that at the moment is projected to continue indefinitely. So I think that as a big part of why the fed, even though they rest rates a lot, wasn't able to get the outcome the desired.

Now if we were to reduce that, I think the short term, that would be negative for financial markets and the economy. Longer term though, if we could redistribute those resources, let's say, a government workers moving out of spending the day in meetings and sending funny cat pictures and going out into the a economy in doing more productive jobs, that would be very good for for the economy in the medium term. But again, all this restructuring can not just changing the global economic order, but maybe restructuring the federal government that short term, a lot of disorder, a lot of volatility, but long term positive for the country.

So we really have to see what are not they are able to do what they want to. Now looking just at photo to government. Now, elon in vivek, very well known Operators are already rolling out their plan.

IT seems like they want to make all the federal workers go back to the office. I'm sure they'll get some nutrition just by that. But the government accountant office has also suggested that we have maybe three to four hundred billion in just outside fraud in the federal budget every year.

So maybe just by reducing that, that would be that would be able to rein in the deficit as well. So it's not just about cutting spending, but it's also about just being more efficient. And so in the medium term, I think that's that's good for the U. S. Economy, but in the short term could be volatile.

Yeah and a lesson there that if the pentagon stops buying inflated products, that with inflated valuations, you know, something costs ten ways to make, is sold to depending on by by company at at five thousand dollars. That might not be good for the stock market because that company is in the begin in is, however IT IT probably good for america. Okay, just let's now move on to pumping.

Its funny job you said, not focus on j, not focus on the fed. What really matters is, is prompt and the overall economy, the fiscal but that pic said, let's talk about one of the most arcane aspects of the federal serve, which is the baLance y got industry policy we've talked to, but that also is baLance. IT did started enormous amount of quantity easing from a march twenty twenty until the spring of twenty twenty two.

Since then, there has been decreasing its baLance sheet. IT has slowed th Epace a t w hich i s d ecreasing i ts b aLance s heet. So now I believe its holdings of treasuries are going there by twenty five billion per month maximum and of see more by security of a maximum of thirty five billion per month.

Are they selling these things? Know they're just letting them roll off and not adding them them back. Joseph, tell us, what is your view for the first georg of this phenomenal chart? I were saying how the U.

S. Treasury holdings are Price to rise. Help me understand how how might that happen.

So I like that chart to you had George. So so jack, what you're getting at is as the fed does Q T, it's reducing the bound of reserves in the baking system. And now the fed wants to drink its baLanced, but IT doesn't want to reduce reserves so much that the being system can't function.

The fed is great that if they do Q T for too long, that will lead to some plum ming issues. So a lot of people are trying to figure out just when when the fed sub Q T. And I think the best cometary we can get from that is speeches from Roberto peri, who is the suma manager at the new york fed.

And he's come up with a set of indicators where he's washing to see when we might get to the lost count of our reserves. And according to his metrics, everything is a OK. We can continue to shrink the baLances.

He has some slight concern over elevated report rates, but IT doesn't seem like it's a big deal. So based on his discussions, that looks like we can continue. Q T, just for a few more months.

What I would be washing personally is the level of bouncers in the reverse rip of facility. There are a lot of prominent officials who look at that as a proxy as to how much excess reserves there are, excess liquidity there is in the financial system. And so that's been coming down.

When that gets closer to zero, I think it's the time that we should think about ending qt. But even if we end qty though, that doesn't necessarily mean that the fed church baLances will decline. And and George, we has a great .

chat that explains why the one that says without resorting to Q, E, A fence holdings could start to rise. And so there's a lot going on with this start, a lot of assumptions of my own as well as what we've been hearing from various feed facials as as just have went through. This is three lines.

The top line is the overall portfolio of charges ies of mortgagees as the grey line. The black line is the treasury's only, and then the red line is the feed holdings of mortgage ages. And then we had this period where the qt was inactive in in early twenty two, mid twenty two and implemented.

And it's been the current policy ever since there was an adjustment earlier this year to a slower sort of kind of pace that kind of tape bring the Q T um and the but the vantage is still shrinking. The the the the stylized, a forecasts that I show here does play off this idea that there is a minimum level reserves that the system is IT. IT needs mean especially both rolt to the size of the banking system, which is growing with GDP and just related to the size of the economy, like I think we're getting close to IT.

The good news is if that has a number of new tools like the standing rep of facility, which can serve as a relief valve for any potential fictions that may that may arise or the need for liquidity, I do think that will probably get a complete end of Q T sometime next year because we're getting close to the point where bank reserves are started to get impacted. It's quite possible that IT, as long as the R, P is kept open, that there's may be some residual usage of IT as I can kind of a sweep kind of function during the day for parking cash. So I am not sure if he needs to go all way to zero.

But either way, it's going to get pretty low. And that plus the ongoing shrinking king of of the portfolio through these bonds rolling off the curve, that will bring us to a point where reserves are going to get maybe too low. And what i'm showing you here on the future projections are there is a couple different ways they can start to expand the portfolio of treasuries.

They could allow the mortgage portfolio to continue to drink. And I want to get to that point and how that could have because the issue is now more dedicator are very high. There is really there's no incentive to refinance unless you really need to move or buy a new home or or life circumstances force you to to to change your home and not going to play.

Move is so like we have a very captive sort of market market, but there is some natural prepaying and shrinking of marriage over time if we get like the perfect scenario, the perfect scenario is the and you kind of mention best view of the three, three, three. If you get a retooling of economy, slightly lower inflation, more efficient government, more efficient government, lower energy Prices, all else equal rates can stay between, let's call IT, three and four percent that don't have to go to five percent. And we can actually see interests had lower, which would then allow mortgagees to come down if if banks get more regulating relief, that might see additional bank lending and a turnbull of of mortgages es, and that might get either even further prepare of existing mortgage holdings, which would allow the facts portfolio of mortals to keep shrinking.

And then they could take that those proceeds instead of extinguishing reserves, which would be what Q T would do. And then that would kind of hurt bank liquidity on oil equal, they could take those reserves, redeploy them back into treasuries. So take mortgage money as IT comes due, put IT back into treasuries via through what the fed will get allocated treasuries through add on process in the actions they don't competitively bit for, they just get an allocation towards IT.

But IT helps finance U. S. Government on the less. And I do believe at some point there can be much more a need for coupon passes, which was the old way. And I know joe knows this very intimately of how to sort of increase reserves or skip about the portfolio stable over time. So I just went through a lot of technical monkey stuff to explain how the F N, Q, T eventually get to a point where they redeploy the money for mortgagees into treasuries as well. Stop letting the treasuries mature and take that money also buy new treasuries or get allocated new treasuries at the auction, which would then help our financing situation from the fed perspective as well.

I just had to jose to George point. So fit speaker has have been talking about not just having a treasury only portfolio, so that would mean, as George is, charge show that they would take in principal repayments from M, B, S. And reinvented in the treasuries.

But officials have also suggested that in the future, maybe we're gone to hold them more bill heavy portfolio. So going forward, maybe they would reinvest those proceeds into a more trade bills is going forward. So that's the possibility as well as so far that speakers haven't given a lot of detail on the future of the baLanced, but I expect them to proper tok more about this as we approach the end of qt.

So that's really interesting. That is a treasury only portfolio, but a built only portfolio, a built mostly built portfolio. That so mostly compound of short term treasury y and and yeah I mean, people say the fed baLanced is seven trillion dollars that use now one and it's it's not it's what does the federal serve own? I the bank of japan in the early two thousand did a tremendous amount of point to the easy, but they just bought is missing a lot of short term treasury bills.

And yet you have if you have a, if you create a, bankers are with the duration of one day to buy a treasury bill with the duration of one day is is not nearly as native or various as buying something that a twenty year treasury bond morgues back security or equities, Morgan x security will continue to decline. The rate which they decline has to do the prepayment rate. The prepaid rate is probably up from its low of eighteen month ago, but is not up much because why would you move if you have a three percent mortgage and more trades are currently at seven percent? okay.

And but then they're going to slowly perhaps redeploy them defector, redeploy them into treasuries because they don't want the overall level of liabilities, the reserve which the liability of the federal reserve at the assets of the banks that they buy them from to go be on go below the lowest comfortable level of reserves. Joseph, what is your estimate and the other monetary policy warks estimates of the lowest comfortable level of reserves? Because i'm looking at reserves now there at three point two trillion.

I know perhaps some people acted at three trillion. So can we only do two hundred billion more, which is what? Three months?

Well, first time I would add this note about why the food wants to build heavy portfolio. So one of the things that we saw over the past two years is that the fed has a huge portfolio of longer dated treasuries, but its liabilities are reserves, right? As you note, jack, that's that's immediately liquidity.

And as they increase the shorter interest rates, they were Operating under negative interest margins. So the fed, what is basically losing a lot of money. Now that doesn't really impact monitary policy, but that makes them look bad if they had all the asset side and more bill heavy portfolio the next time around, when they hike rates and the bill will also go up.

So there's less by gap between their access and liabilities when IT comes the interest expense. So they won't have as big an Operating loss, which is good politics. Now about when the about what loca is, I actually have no idea.

I feel I feel like the financial system, provided that we can drink IT slowly, can really just adapt to to lower level reserves. Its it's really not a big deal. More importantly, the demand for liquidity by the big sector is something that is going to very through time, right? Even just changes in sentiment can impact that.

So I think it's a really bad idea to have this entire Operating framework where the fed is trying to guess what local or is and just stop U T. Right at that point now, the E C B has been doing something that is much, much smarter. What they're doing is trying to make reserves in most a more demand drivers m rather than supply driver system.

So what their design is that, you know, they have no idea what local is. They're just going to make IT really easy for bank to bar from the E, C, B whenever they need reserves. So that means they don't have to guess or local is by adJusting the supply, they can just set IT up so that if the bank can needs reserves, they can borrow IT from from the fed. While I hope maybe the fed would change the Operating framework to be more like E C B, so they won't have to go through all this guest work, which is, at the end of the day, not not very precise.

It's been so great talk speaking with you both covered a lot of topics. A final top I want to talk about this is japan. George, I know you ve got a lot of insights on this.

There is the currency between U. S. Dog in the japanese.

And then there is the differential and in the interest rates all across the curve between the dollar rates and the yen rates. So it's very complicated. Has of consequences.

Just about the floor is yours. What do you want to ask George give? But he is all this now. What do you want to know about japan?

And and last time, I mean, japan was just in the headline couple of months ago, right? The and Carry trade seemingly having some volatile and George and seed has a lot of insect. Maybe he could tell us.

H you know, is your concern about the your Carry trade going forward? And what's like what's the demand like by japanese investors for things like treasuries? Since we do have a large fiscal deficit, japan has been a big buyer of treasuries in the past few years.

Look a lot to also impact on that. Let's go to page fifty four and let's look at relative policy. Rate differentials between the U.

S. In japan is what you're seeing here on this chart. The top panels comparing fed funds, again, it's now in red instead of a black.

It's the short term interest rates in the U. S. Is the red line.

The black one is jane bowsy rates, which has had some movements but very little since nineteen ninety nine, two thousand, right? We've basically been in a close to zero bound plus reminds a few hikes every so often or every couple decades and and only recently has a bad japanese story to try to Normalize rates. And what i'm that's the top part of the chart.

The bottom part of the chart is the markets and interpretation of where short term rates will be in the future for each country, the U. S. Versus japan.

And then I take IT even one step further and compare IT to real rates in the U. S. Versus real rates. interpret. And I did this to try to make this point, like why do you put on Carry trades to begin with? You're going to pick up a higher yield, a higher a Better performing market somewhere else.

You borrow IT in the cheapest currency, which has the the lowest interest way, and you will deploy that capital somewhere else in the world that bottom spread tries to capture that. The concept of what's your Carry pick up in real terms after you adjust for inflation and when you think about IT in that in that way and you compare, uh, that's the great line, which goes back even further back into the ninety nineties. You can see that when the spread gets really, really wide, things do break outside the U.

S. This has also been also an interesting sort of dimension that we haven't really seen major stresses outside the us. I mean, during the August, which people said IT was the Carry online is more like a Carry trade adjustment. You don't unwind the Carry trade.

I mean, Carry trade is is pretty structural and IT doesn't go away that that quickly or two or three days that those are in the weaker hands, marginal borrowers and more leverage specular flows that probably got on wounds based on the data in what we've seen since August. But nonetheless, that spread that grey line measures, that kind of relative value pick up between us in japan and the us is still rates are high here and they haven't been really cut that much. We only had seventy five business points of cuts and rates are much higher here than they are japan.

Each time that this spread has been this wide or has an even been this wide, you have the asia of financial crisis in ninety seven ninety nine. You had the starting points of the global financial crisis. You had IT during two thousand fourteen, two thousand six, when your asia access to dollars was getting really expensive, not just for japan, but your broader asia, including china.

And you had oil markets really getting in trouble during fifteen and sixteen. So like, things do happen when this spread gets really White, IT has been White for quite some time. The the Carry trade, the adjustments that happened in the summer probably were not the full extent IT.

And so this really creates a another dimension that is worth keeping eye because it's not just the fed policy, just not does not just impact local U. S. And the and the U.

S. Economy is the U. S. Is a reserve currency, is a it's part of the global your payment system.

The dollar being the reserve course is super critical to that. And there is a lot of lending and borrowing takes place outside of the U. S.

Banking system in globally. And so when these sort of differentials are as well as they are now, IT could start to also expose some of those fragilities. So I was saying that the higher for longer applies not just to U.

S. Borrowers, but also global borrowers. And now if the fed takes longer to cut, IT might expose those those weaknesses. And perhaps that sort of palace that we're looking for a risk off is going to come from outside the us, not from in the us.

So I do think this is a super important thing to keep track of that the rate differentials, relative movements in the curve and in the curves, but also the relative movements in the the, the effects, apparently es around the world. A very strong dollar also tends to break things too. So they are all kind of linked together.

But I I think that, that to mie is is, is what i'm watching. I don't think the Carry trade was on round. I think IT was an adjustment.

That's my person of view, and I think that i'm watching this. And in many ways, if the fed cut as much as what was Priced in pretty before the election outcome, that could have helped out the B. O, J. anyways. And now he really does put some of the honest back on the bank of japan to have to raise rates, which then increases their costs of funding for a lot of any sort of trays that are based on borrowing cheaply. So I could get into a much more tRicky spot for for investors that borrow money.

And then why is that that when the the the one year forward dollar sus japanese yen rates get to a certain level that that tend to trigger crisis? For example, you on the charge you to mentioned nineteen ninety seven, I was understand that he was those high rates cause a lot of pain in the super high yielding countries like thailand and russia. The riskier ones, not the safer ones. Tell tell us about that.

Well, because a lot of that money that is bore gets redeploy back into emerging markets, not just into us or into U. S. Dollar and nine a debt within these emerging markets.

And and it's again, it's also index off of the U. S. As well. So it's more to trying to capture the the spirit of is is the Carry really that attractive outside of this funding currency? And when IT really is really high, IT creates certain behaviors where there is like a concentration risk of certain trades get done and that could be what exact based the problem and and I and yes, so I I think it's we look we get the benefit of history.

We we have the benefit Better monitoring with the benefit of more data now. And people are are watching this sort of dynamics. But you know, it's been I think IT may be postponed because of all this excess liquidity that's been circulating around the world.

Now if the festival to take longer to cut and the dollar stay stronger, oil s equal and the need for dollars to repay back loans or whatever the case may be from overseas, go up that or stays up. And people were banking on lower rates to build them out. I mean, there was like A A number of different industries like the commercial real estate, housing and global investors, they like to borrow and and that we're hoping for lower rates in the us. To help or if the longer that takes to show up, IT could create eventually either a margin call and or the need to actually sell assets to pay back your loans.

And then George, a lot of people thought when the federation rates in twenty twenty two and and twenty twenty three, oh, japan is going to be buying so many treasuries uh, because you are so I nope. As you point out on on this chart, actually when the curve is uh, super inverted, IT costs more to hedge than IT. So it's actually not attractive. But japanese purchases of treasury bonds has been going up. We can see in the purple line, do you think this will continue?

And why 说的是 this is the other side of the coin。 And this is also true for jane's investors that have a big uh, explosion to the U. S.

markets. And this is comparing the tories are very simplistic. It's comparing the annualized hedging cost if you need to hedge your effects almost one hundred percent, which really get happen rarely implemented. That's the black line, which you can see kind of tracks very closely fed funds.

And so it's a cost of Carrying calculation with your if your your funding cost is higher than the yield you're gna get on an asset, you're not gonna really buy IT, right? Because what's the point of doing that trade? So when the curve is steeped and when rates are lower or else equal, that allows for that kind of yield curve of transformation of borrowing cheap and then redeploying that money out the curve, it's no different in many ways.

IT is very similar to how regional banks work in the U. S. Or any sort like a typical banking model. Try borrow as cheaply as you can, and then find the highest yelling asset or loan in this case would be the treasury market or mortgages or or U S. credit.

If the fed were to stop short here and not cut rates further than these hedging costs are still pretty elevated. A be most likely um a slowdown overall investments coming from japan, uh, all l equal a lot more that goes into the equation. But this this at this stage, hedging costs are are going to play a role and the and where the market believes rates will eventually stabilize that.

And is there enough of a yell pick up to actually come back into the U. S. B. market?

I didn't know that the cost to hedge of currencies from from Young dollars is so corrected to fed fun, that is. But if I did know, it's like basically of very, very similar charge. So the fed people, the fed needs to cut rates in order to lower the cost and incentivize japanese buyers.

Jove, George, thank you so much for coming on. People can find you, Josie, on twitter at fed guide twelve. Your website, of course, is fed guides that com, your book central banking one one is investigated.

The classic has grown today as the day I was published. They will go. But people can find you on twitter at bond strategies. But you, almost all of your opinions and insights are for institutional clients of M, U, F, G. To tell us, if people are institutional liens, how can they get touch with you?

Yeah sure. They can. They can reach out uh to either there are sales forest person that covered by M F G and or reach out and try get on the distribution is rearch x.

And thank you, everyone, for two watching reminder, it's not just on youtube. Monitor can be found on apple podcast spot if you're losing an apple podres and spotify and we reference charts are available on youtube. Sorry about that for now until next time they skin guys.

Thank you. Just closed the door.