Matt King, Founder, Satori Insights, LTD

[00:00:00] Hello, this is Dean Curnutt and welcome to the Alpha Exchange where we explore topics in financial markets associated with managing risk, generating return, and the deployment of capital in the alternative investment industry. Efforts to understand the why of the motion and asset prices consume our attention and

[00:00:24] time in markets. To be sure, traditional sources of risk, namely the economy, the path of corporate profits and changes in the interest rate cycle do matter. But as Matt King argues, especially since 2012, we increasingly need to monitor what's

[00:00:40] happening in the financial plumbing where Treasury and central bank driven fund flows can be responsible for powerful liquidity dynamics. Sometimes serving as a headwind and at others a tailwind, flows like QE as well as changes

[00:00:53] in the TGA and reverse repo facilities influence the manner in which investors interact with risk assets. After a nearly two decades stint at City, Matt recently founded Citori Insights, an independent firm helping institutional investors navigate today's uneven and complicated waters of risk.

[00:01:11] A main aspect of our conversation is his take on the resilience of the US consumer and broader economy in 2023. This is set against one of the fastest tightening cycles on record and the Fed's QT program. Matt's work suggests that tying favorable asset price results in 2023 to this resilience

[00:01:31] leaves out a critical point. He states that while the Fed's balance sheet was not only reduced by roughly a trillion last year, markets wound up enjoying a trillion in new liquidity. His framework, tying a trillion dollar increase in reserves to roughly a 10% increase in

[00:01:46] the equity market, helps explain the dislocation between asset price performance like tighter credit spreads and traditional fundamentals like defaults. Through the lens of liquidity that Matt utilizes, the risk asset outlook for 2024 is less favorable.

[00:02:01] He cautions that the Fed may have done more on the hiking front than it should have, underestimating the impact of their balance sheet policies on asset prices. I hope you enjoy this episode of the Alfa Exchange, my conversation with Matt King.

[00:02:17] My guest today on the Alfa Exchange is Matt King. He is the founder of Saturi Insights, newly created firm really getting into the weeds on a lot of the technicals with respect to not just the economy but risk relationships and

[00:02:31] the interactions of these large entities called central banks. Matt, it's great to have you as a guest today on the podcast. Thank you very much for inviting me. Really looking forward to this conversation and exploring your unique framework for

[00:02:46] helping your clients think through the mechanisms through which asset prices move. Oftentimes, we just fall back on things like the economy and earnings and of course those are important but when you look under the hood there's a lot more going on especially

[00:03:05] given the degree to which central banks have become players in the market. So that's going to be a big topic of conversation for us. But of course just with respect to your framework, you've arrived at the way in which you think

[00:03:18] about markets over many, many years of doing this. So you were in an important seat at Citibank through the GFC and beyond. Why don't you walk us through a little bit of your background?

[00:03:30] We'll use that as a way to frame out the conversation in the here and now but I'm interested in getting to know your framework a little bit. So take us back to the beginning just in terms of how you got involved in markets

[00:03:39] and maybe we'll talk a little bit about some of the ways in which your framework came to be. I almost like to think of that as the good old days when I looked at the economy and fundamentals because those were what was driving market prices.

[00:03:51] And then it's the reason I've ended up where I am at the moment is because they no longer seem to be driving market prices. Let me go back a little bit. So one of the things I think is unusual is I'm not an economist.

[00:04:03] And what I mean by that is not only that I didn't study at uni, but many strategists I speak to say, here's what the economists are saying about the economy and here's what it therefore means for my market.

[00:04:15] And somehow I've never been able to do that either when I started out in macro strategy or then when I was doing credit strategy or now I'm doing macro strategy again. Somehow I've always focused more on let me get my head around this thing

[00:04:29] that seems to be driving all markets at the moment. And only once I've understood that can I then come back and form a market view. And maybe it's because of all that time that I spent doing credit

[00:04:40] and especially investment grade credit where there was a limited amount of upside and an awful lot of downside that inevitably it revolved around spotting market bubbles or spotting risks of things blowing up. And so it's been different things at different periods back in 99, 2000.

[00:04:55] I was looking at corporate balance sheets and thinking in terms of the leverage cycle or the leverage clock and phases of leveraging and deleveraging. And that's kind of what I mean by the good old days of thinking about fundamentals

[00:05:06] because I found at the time that getting my head around that and thinking conventionally and looking at how investors were positioned and looking for mean reversion, all those things worked and gave a useful signal. Gradually what's happened though is that not only that I had to spend

[00:05:23] 07 and 08 looking at CDOs and then looking at broker dealers and doing loads of stuff on Lehmanoff balance sheet repo and so on. But in general, I'd say over the last couple of decades, more and more of my work has focused on money growth or credit growth

[00:05:37] as a driver both of the economy and of markets. And then over the last decade or 12 years or so, in particular, I found that many of my favourite fundamental relationships were breaking down. And I think many investors have found this as well.

[00:05:55] Things that were expensive carried on getting more expensive or volatility looked low and yet carried on getting lower, even as measures of uncertainty were quite elevated. And as I've sort of tried to reverse engineer what I think has been driving markets

[00:06:09] in that period, more and more I've ended up focusing on central bank liquidity and the technicals of central bank balance sheets as the best way of understanding what's really driving markets. And then I've kind of backed out what the underlying theory might be thereafter.

[00:06:24] And as I say, I think that's the opposite of what many economists do. They start from the theory and then they're really surprised when markets seem to be doing something different. And instead, I always start from the markets

[00:06:32] and then I try and think what the theory could be afterwards. It's really interesting you reference this idea of expensive becoming more expensive. And of course, this drove the likes of Cliff Asnes and his team at AQR pretty crazy

[00:06:46] in the height of the meme stock episode of let's call it 2021 rates pin to zero. The cheap stocks relative to the expensive stocks, that dislocation was profound and painful for folks that were invested in the concept of buying cheap.

[00:07:04] You can say the same thing about, let's say, things like volatility or even economic volatility in the period leading into the GFC. The central banks were sort of back slapping themselves on the idea of the conquering the business cycle, the great moderation.

[00:07:19] We had a lot of leverage, but the VIX was below 10. Credit spreads were all time lows. And so my question is just around looking at these points in time and then thinking about the prices from two different angles.

[00:07:34] One is, OK, these things are very low or very high and they're likely to mean revert or the regime has just changed. You've suggested that some of the favorite indicators that you once looked at became less efficacious. And so you've got to adjust.

[00:07:50] What's the balance of looking at things and saying, man, these things seem dislocated and are apt to converge maybe to something more fundamental versus I got to throw out the toolkit here. The regime is just different.

[00:08:04] So the way I think about it is money growth has always been important. And sometimes I say, I just do two things. I look at how much money we're creating and where that money is then going. Money can go into different places.

[00:08:19] It can go into real economic activity. It can go into CPI inflation. But increasingly over the last three or four decades, it's gone into asset prices. But I think the critical thing that's happened over the last 15 years or so

[00:08:33] is that there's been a change in the driver of that money growth. It used to be a sort of organic activity. It used to be you and me choosing to borrow because we saw a good investment opportunity either in the real economy

[00:08:47] or in financial markets influenced by the availability of credit and the level of interest rates. And during that period, it had a greater tendency to be mean reverting because you and I and everyone else would look at it and say, oh,

[00:09:03] credit is too expensive or underlying asset prices are too cheap. And that's what created these mean reverting patterns. And indeed, the more everyone came to believe in the mean reversion, the more that was self-reinforcing. And you could have problems when too much leverage built up and so on.

[00:09:17] But in general, I think of that as, as I say, a sort of relatively natural, organic market in the real economy. What I observe is that even as interest rates came down and down and down over several decades, the underlying desire to borrow

[00:09:33] and especially to invest on the part of corporates and even households expenditure in the real economy and for capex and for hiring people and all the things that low interest rates are supposed to do. That desire came down and more and more of the borrowing that took place

[00:09:48] was used for financial engineering and ended up in share buybacks or ended up in real estate prices almost recently ended up with private equity. And then partly because that desire to borrow was coming down on the part of the private sector,

[00:10:03] this is where first central banks through QE and then more recently fiscal policy have become more important. And it's especially in this period of QE or central bank liquidity that what I observe is that that has come to dominate market movements

[00:10:21] because the fluctuations in central bank balance sheets, especially now they've become large, have just dwarfed whatever we saw going on with the private sector when the Fed adds or removes two or three or four hundred billion dollars of liquidity in a single week sometimes.

[00:10:36] There's nothing the private sector is doing on anything like that scale. And that's where for me not only has it therefore come to dominate asset price moves, but it is also much less likely to be mean reverting.

[00:10:48] And it's much more likely that actually because they've not been worried about asset price inflation, they're just saying, oh, there isn't any CPI inflation until recently that they've been likely to carry on with it. And indeed investors who were looking for mean reversion,

[00:11:03] who were value investors, basically they got forced out of business and things like momentum trading became much more important and added to that tendency. That for me is the breakpoint. It kind of occurs around 2012 almost regardless of which market you look at.

[00:11:19] So when you look at vol markets, 2012 is the point where day to day vol goes down and vol of vol goes up. And in credit 2012 is the point where corporates that start leveraging up and yet credit spreads decouple from them

[00:11:32] and are suppressed and you can find certain inequities as well. 2012 is the point where earnings revisions start being negative and yet the market doesn't sell off. It carries on rallying and re-rates higher. And that for me is really the pivot point where a lot of this market

[00:11:47] behavior changes and it does come back to central banks effectively pushing really hard and dominating the organic money creation that had previously been taking place in the private sector. Well, I love anniversaries with respect to markets. And so I can never help but just sort of look back,

[00:12:04] especially when they're to 10 year or five year or something like that. And so we're coming up on the 15 year anniversary of the Fed's first foray kind of officially into QE, at least in modern markets. Right? It's kind of a March 09 initiative.

[00:12:21] And boy, they've been at it for the most part ever since in a lot of ways. I guess what I would like to do is from that period, let's just say from 2012, as you talk about these relationships starting to become noticeable

[00:12:37] and for folks like you to be able to ascribe cause and effect. I think that's really what we're trying to do is understand markets and explain the why of especially asset price movements. So we had this period in the post QE era of low growth, low inflation,

[00:12:56] typically inflation that was persistently below target. And yet it didn't seem like both the QE and the low rates resulted in much else other than asset price inflation. Walk us through that period, let's say leading into COVID,

[00:13:13] that long lean period of low rates, low economic growth and low inflation. And just some of the insights broadly speaking that came to you and how those contributed to your overall framework. While everything has become more extreme during the QE era,

[00:13:31] I would argue that a lot of the phenomena we're seeing actually date all the way back to 1982. And that is the point where up until the early 1980s and then 2009 in China, but early 1980s in US and Europe.

[00:13:49] Money growth or credit growth had with a long and variable lag led to CPI inflation. Since the early 1980s, the central banks all abandoned money growth and credit growth precisely because they said even when there is credit growth,

[00:14:06] it doesn't seem to be leading to inflation on the same scale. They simply disregard asset price inflation and consider it different. Whereas for me, CPI inflation and asset price inflation are really two sides of the same coin. And not only that, but if I even make simple models

[00:14:22] where I put them back together again, the relationships that break down with money growth and CPI carry on with money growth and what I would call broad inflation, including some mixture of real estate and equities and CPI. And yet central banks simply turned a blind eye to it.

[00:14:39] And that's where for me, that's where we start this whole series of cycles where the end of the cycle was not given by too much CPI inflation. It was given by an asset price bubble bursting. And each time it burst at a lower and lower level of rates.

[00:14:55] And each time the central banks were surprised because they hadn't generated too much inflation. And yet each time in a sense, it was getting harder to encourage people to lever up with rates that were lower and lower because the system was kind of becoming

[00:15:08] saturated with debt and the debt was being used for everless productive activities. And this pattern effectively reached its peak, I guess, over the past 12 or 13 years of QE, where despite the zero rates and despite a certain amount of borrowing

[00:15:28] on the part of the private sector, as you say, the low rates were really not effective, not only at creating CPI inflation, but even at stimulating the sort of economic activity that people were imagining.

[00:15:40] And yes, Vananke and others referred to the savings glutters as potential drivers of this. For me instead, this has its roots in scalable technologies. And it was really about a lack of demand to borrow as the underlying driver.

[00:15:55] That is where the central banks felt they needed to step in and they were undoubtedly right to step in initially in 2009. But I think they underestimated the extent to which the technicals of their balance sheets ended up dominating market moves.

[00:16:13] And I think that they should have been much faster to withdraw. It's too strong, but to limit the effects of that rather than carrying on adding more and more stimulus just because CPI was still not on track. Most of what I observed during this period, as I say,

[00:16:32] is fundamental relationships breaking down. And I'm embarrassed to call large amounts of my work stupid, but almost stupid relationships taking over where to do the best job of explaining the S&P or to do the best job of explaining credit spreads.

[00:16:47] I don't need underlying fundamentals and at best the fundamentals end up being a lagging indicator. And instead, all I need is stupid technicals from the Fed and the other Global Central Banks balance sheets. And this is sort of hard to do on a podcast without charts.

[00:17:01] Usually I let my chart speak for me, but I shouldn't be able to explain the annual moves and certainly not the monthly moves in markets looking just at reserves and other technical factors on central bank balance sheets. But frankly, I can during all of this period.

[00:17:16] And I think that the way that even now the central banks turn a blind eye to that and think of it in level terms, the level of reserves and whether the reserves are abundant or not, I think they miss a lot of the point

[00:17:28] and they miss a lot of the stranglehold that effectively they have over markets. And this leads to a lot of the behavior that we see and the sometimes dysfunctional behavior that investors are forced into because of the way the central banks are still dominating market moves.

[00:17:43] I can't help but ask the question just around, let's just use the Fed and their awareness or level of awareness of analysis like yours and the direct tie in which you implicate in a lot of ways the Fed

[00:18:00] for better or for worse, in terms of market price movements. Do you have a sense that the Fed is very aware of this? You use the term turn a blind eye, which suggests an awareness but just not really wanting to acknowledge it.

[00:18:13] Is the Fed learning about its interaction with markets or it's just wants to stay to maybe simpler framework? So this is where I come back to what I said at the beginning about not being an economist and this is best responded to with a silly but true anecdote.

[00:18:29] So in I forget 2012, 2013, something like that, I had a meeting with the Fed and the EZB and the BOJ and lots of other national central banks. And when I walked into the meeting already then, the guy from the Fed said

[00:18:41] it was me and a few undermarket participants and various academic economists and the guy from the Fed said, oh, Matt, you're the guy with the charts that say it's all our fault. Meaning these correlations between basically reserves and market moves.

[00:18:55] And he laughed slightly nervously and he said, yes, yes, we've been able to reproduce them on our own data. So we know the effects are occurring, but they conflict with theory. So we're ignoring them entirely. And I've had subsequent conversations with other central bankers

[00:19:11] and usually with the financial stability people. But that theme continues to this day where another financial stability person seemed increasingly to be coming around to sort of my point of view. And I asked him, does this mean that you are beginning to think

[00:19:27] that changes in reserves really have an effect, et cetera? And again, he said, to be fair, while yes, I'm increasingly inclined in that direction, it would be fair to say my military policy bosses are again ignoring these effects entirely.

[00:19:41] This takes you back to all the jokes about economists walking down the street and seeing a hundred dollar bill and saying to one another there couldn't possibly be a hundred dollar bills lying in the street because somebody would have picked it up.

[00:19:50] And economics, you know, where I studied where as I say, I start from the data and I start from the charts and I try and think of the theory later. And if the theory doesn't match, well, I keep trying to come up

[00:20:00] with another theory and somehow economics is the discipline where it doesn't work like that, where the real world conflicts with the underlying theory, they just ignore the real world. I find it really bizarre. Well, let's dive into your assessment

[00:20:15] of the current set of conditions and sort of the implications for markets. You've spun out of Citibank in a very senior chief global strategist role. You've founded Satori Insights. Just tell us briefly about that hanging your own shingle. So congratulations.

[00:20:34] What's the emphasis, just big picture of the firm? So I'm doing what I've always done, which is writing about whatever I think is driving markets. And I hope that one day this will not just be technicals of central bank balance sheets.

[00:20:47] And indeed, I'm planning on doing a piece about scalable technology and the impact that's having not only on inflation or the lack of inflation, but even things like mental health and too much information and the market for research.

[00:20:57] But in general, I would say I focus on whatever it is I think is driving markets. And at the moment that is about money creation and about central bank liquidity. And hopefully I can continue to do this in exactly the way that people found useful previously.

[00:21:12] And the response I've had from clients suggests that they do find it useful. What I think is a little bit odd is that there are not more people doing what it is I do. And while there are some other people that look at central bank liquidity,

[00:21:25] nobody seems to control for currency effects or do it in quite the same way as I do. And hopefully that means there continues to be a market for it. But I will adapt my approach according to what I see as driving markets.

[00:21:37] But for the moment, that is central bank balance sheets and money creation generally. All right. So you let off a recent webinar that you hosted. And of course it's backed by all of your research. But you start by trying to answer a particular question,

[00:21:52] which is what were the causes of the 2023 resilience? You note it was justifiable for folks to expect pretty significant economic slowdown, just given that the degree of the tightening cycle was reasonably without precedent, 500 plus basis points in a very short period of time. That's a lot.

[00:22:14] And so our economics 101 textbook would tell us higher rates. It's going to crimp demand. That's going to cause some sort of economic growth slowdown, perhaps take inflation down with it. And so that really wasn't what happened, just at least on the economic growth side.

[00:22:32] So why don't we start there? As you step back and do a review of 2023, equity market was up a lot, inflation came down a lot, rates stayed up a lot. Not a mix a lot of people would have expected.

[00:22:46] Give us the postmortem from your perspective on some of the why of that resilience in 2023. So as you say, almost everybody ended up being surprised. And partly that was the extraordinary amounts of fiscal stimulus, especially in the US.

[00:23:05] And partly it was the massive shifts in the economy between growth, between good spending and services spending and jobs in the good sector and jobs in the service sector that we had post COVID. And all that has been written about a great deal.

[00:23:19] But I think the general idea that the big surprise was the resilience of the consumer and that markets were simply reflecting the resilience of the consumer not only misses out a critical point, but also neglects the way in which on many of the charts that I look at

[00:23:42] the strength of markets exceeded what you would have expected to see from the resilience of the consumer and led the resilience of the consumer and the patterns in spending by more than you would have anticipated just in terms of markets being semi-efficient.

[00:23:58] And for me, the big surprise that was critically important for markets in particular is that everyone thought and many people continued to think that the central banks were doing QT and draining liquidity and everyone expected them to drain about a trillion dollars worth

[00:24:14] of liquidity just as they've been doing during 2022. But what actually happened during 2023 for a variety of different reasons is that central banks basically added about a trillion dollars worth of liquidity. And on the framework that I track where a trillion dollar change

[00:24:31] in reserves is roughly equal to 10% on the equity market, depending on that swing conceivably accounts for a large proportion of the net rally that we ended up having inequities and in credit spreads. But not only that, also this leading of fundamentals

[00:24:47] and all this dislocation to some extent with fundamentals. The fact that defaults are rising and yet credit spreads in many cases are ignoring that. And the fact that uncertainty about the economic outlook is high and people expect to grow slow down and yet volatility,

[00:25:00] at least way from the bond market remains really very low. All of these are QE like phenomena. These are things that we saw during that 2012 QE decade. And not only that long term pattern, but even as I say, the month on month moves throughout the year

[00:25:19] coincide too well with or follow too closely changes in central bank liquidity and the details of central bank balance sheets. And that for me is the critical factor that came first and that fed through into confidence and wealth effects and helped prop up the economy.

[00:25:37] And the outlook for this year, especially for markets, remains very closely intertwined with these ongoing technical features of central bank balance sheets. So a couple of follow up questions there. One is this relationships, this delta of let's call it a trillion dollars

[00:25:53] in global reserves and that's translating to something on the order of a 10 percent move in equity markets, reserves versus equity markets. That correlation or that cause and effect, you seem to suggest it's pretty tight. So I'd love for you to just comment on that a little bit

[00:26:10] in periods where it held up really well. And then I'm curious, is there a country by country breakdown of this? In other words, within a specific country, whether it's a let's just use developed markets around the world. Their central banks are active also.

[00:26:25] Does it hold up country by country? Do you step back and look at it more on a global basis? Give us a little bit more on that. Yes, I would argue you need to look at it globally.

[00:26:36] There are periods where especially in the US, you can just look at the Fed. But one of the reasons that people don't as a rule do that is because they look back over the longer term and they say, well, these correlations break down.

[00:26:48] And what they miss out is the fact that during the previous tightening cycle, a lot of the reason why markets continue doing well is because the ECB and the BOJ were doing QE. And if you add those in, then actually markets or risk assets keep doing

[00:27:02] well until 2018-2019 when that liquidity stopped. And so I would argue when this is done properly, looked at globally and by looking at the changes in individual central bank balance sheets and aggregating without FX effects, actually the correlations are good and stable.

[00:27:22] It's still a little difficult to measure. The lags are sometimes very short and other times it might be a month or two. But overall those relationships I find very persuasive and a large number of institutional investors do as well.

[00:27:39] And I know because they ask me for the data. In addition, I think another mistake that people make is they quite naturally look at the asset side of the balance sheet. They look at the securities holdings of the central banks and assume that is

[00:27:52] the right measure to take. And the Fed themselves do this and they say, oh, we continue to drain securities and they assume that you can ignore other factors that have an impact on reserves unless reserves are becoming scarce. I would argue exactly the opposite is true.

[00:28:09] The way this works is technically you'd call it the portfolio balance effect. I prefer to think of it as how much money is the private sector got relative to how many assets are available to absorb that in general reserves are the best measure of this.

[00:28:23] And when all you do is correlate the global reserves changes with changes in equity markets or changes in credit spreads, you end up with good and consistent relationships. You had pointed to this idea that the Fed was embarking upon

[00:28:39] roughly one trillion in QT and what we got instead was roughly a trillion in QE. And so that implies a filler of two trillion, the trillion that you were going to do but didn't. And then a trillion that you wound up doing in terms of easing.

[00:28:56] And I think this points back to your work on reserves, but I would love for you to just high level if you can provide some detail on that two trillion that effectively overwhelmed the proposed trillion of QT. How did we come about that?

[00:29:11] Maybe talk a little bit about whether it's the TGA, the Treasury's interaction with its Fed account, how did we come to such a big divergence between this proposed QT and what you're arguing is was actually easing on the portfolio balance effect.

[00:29:29] So it was different things at different points last year. Early in the year, BoJ purchases were significant. If you remember, yields globally have been under upward pressure. They were struggling to maintain yield curve control as they did so and ramped up their purchases. They expanded their balance sheet.

[00:29:45] They expanded reserves in Japan and that correlated not only with Japanese equities doing better, but some of that liquidity flowed back into global equities and US equities and asset prices as well. Then later in the year, yes, the BoJ became less significant, especially as

[00:30:03] yields were no longer under upward pressure. And that is where the Fed balance sheet became more important. And the most important factor there was RRP, the Reverse Repo Program. So what we saw is that money market funds chose no longer to hold money at the Fed

[00:30:25] and went and bought T-bills in particular or they lent money on private sector repo. And effectively, what that did is it improved that balance between how much money the private sector has got and how many securities are available

[00:30:37] to absorb that money and that more than entirely offset the ongoing roll off of the securities on the asset side of the Fed balance sheet. And those factors in combination gave us this big global swing. This is where it gets technical because there are multiple different moving parts.

[00:30:53] More recently, there's been the BTFB and similarly, that was also a significant factor with the post SVB interventions. There has been different things at different periods. But looking at the global change in reserves gets you 95% of the way there

[00:31:08] and creates this good explanation for what markets are doing. And while I do try and forecast this with all the moving parts, sometimes it's difficult. Some of the reason I think it's compelling is even if you haven't got a good forecast,

[00:31:19] even if you're just looking from one week or month to the next at here's what central banks have done with their balance sheets. Actually, that still gives you a really good signal for markets. As you look back on 2023 and explain the robustness of the economy

[00:31:36] in the face of higher rates, you highlight a couple of relationships. Tech and tech stocks, which we were told were really vulnerable to higher rates. That kind of relationship broke down gold versus yields, broke down. You highlight job openings versus the S&P.

[00:31:52] In general, there's this theme of risk outperforming the fundamentals. And so one of your conclusions, and this is where I wanted to take the conversation next, is that the economy has less momentum than it might appear to based on some of these metrics.

[00:32:10] That to me seems cautionary with regard to the degree of the lags that might actually ultimately matter in terms of rate hikes making their way into the economy. So why don't you walk us through as you look at the here and now

[00:32:24] and then thinking forward a little bit, the economy, Fed policy, and then of course inflation. What's on your mind now? What might the market be missing? What are you concerned about? So roughly speaking, I think the Fed and all the other central banks raised rates

[00:32:44] significantly more than they should have done because they underestimated the supportive impact of their balance sheet policies on asset prices, some of which then trickled back through into the real economy. And I think that in time it will become apparent that the real economy

[00:33:04] has less, let's call it organic momentum than might have been thought. And conversely, markets, as I say, have been pushed more by central bank balance sheet liquidity than is widely recognized. And I would say the ideal thing would have been to have supported markets much less.

[00:33:21] You still need to act as a backstop, but you don't really want to be inflating new bubbles and pushing asset prices higher and higher and recreating some of the issues around inequality that have been such a feature of the last few decades.

[00:33:33] I think we begin to see this in terms of rising delinquencies and rising defaults in some segments of the economy. That said, it's complicated by a couple of different factors. Firstly, even if the momentum was coming from a boost via markets and a boost

[00:33:51] from fiscal policy and the COVID related savings, which are finite and at some point run out, nevertheless, while that's going on, there is still a lot of support and then more than anything, it's becoming complicated now

[00:34:03] by the dovishness of the central banks, not only with respect to wanting to raise rates because inflation is coming down, which I'm very sympathetic to, but also because of their dovishness with respect to balance sheet policy where they are likewise backing away from QT.

[00:34:20] And even if I don't think they're necessarily analyzing it correctly, the outlook to my mind is moving more towards a soft landing than I had imagined previously, but more than that, it's moving back towards where we were for

[00:34:36] the last decade or two, which is there might not be as much momentum in the economy as you would like, but actually asset prices continue to do really very well because central banks consider that to be next to no negative consequences

[00:34:49] with pushing asset prices higher and they underestimate their own impact on markets and role as a direct driver of that. Of course, there's been conversations among the central bank folks about QT recently and this idea that we can start to dial it back.

[00:35:10] You had pointed to in 2023, this idea that we're doing a lot of QT, but not really just with regard to its overall impact via the RRP and reserves channel in terms of them lightening up on QT now set against some of these other

[00:35:27] dynamics that you carefully track on the reserves front, the global reserves front. How should we think about central banks with respect to their impact on markets via this portfolio balance channel? Let's say over the next six months or so.

[00:35:41] In general, I think of this as a bullish factor for the next couple of months. It may become a bit less bullish thereafter, but it's still not really becoming bearish. And that forces investors to be more bullish than they would have been on the basis

[00:35:58] of fundamentals, but more than anything, I think we need to continue monitoring this to understand the moving parts because as far as I can see, these central bank liquidity technicals still have a stranglehold over markets. Specifically, what do I mean by that?

[00:36:12] So this is easiest to analyze in terms of the Fed and it gets a little bit technical again, it's easier with charts. But the change in reserves is roughly equal to the change in securities

[00:36:24] minus the change in the reverse repo program and minus the change in the Treasury general account. So when liquidity is coming out of the Treasury general account or out of RRP and coming back into markets and back into the private sector, that's bullish for risk assets.

[00:36:43] And roughly what I would expect over the next couple of months is for RRP to carry on coming down. And for the Treasury general account, often we get a seasonal factor there where that comes down until people start paying the taxes in April.

[00:36:56] And both of those are likely to continue providing support to reserves and pushing them higher. And that to me looks like a bullish factor that's then being aided by the Fed's willingness to talk about reducing the rate of QT.

[00:37:14] Once we passed March, some of those seasonals will change. Already they've changed. They've basically eliminated what was an arbitrage on the BTFP and the BTFP itself is likely to expire around about then. And so the tailwind from March is likely to reduce.

[00:37:34] But even there I find it hard to become, despite often relatively elevated valuations, as you say, especially in things like the tech sector, I find it hard to become too bearish when they're sounding so

[00:37:45] dovish. I don't think that the rate easing when we get it will do an enormous amount because as I say, I don't think the private sector is responding to this. But if they're also clearly super nervous about taking reserves to too

[00:37:57] lower level and underestimating the extent to which increases in reserves may directly boost asset prices again, it's difficult to have to bearish an outlook on the back of this, almost regardless of what I think about the economy. And mostly my economic view ends up following my market view.

[00:38:16] Well, let's talk a little bit about market prices themselves. You have a statement here about the easing of financial conditions, that having reversed the impact of some 300 basis points of rate hikes. You know, I look back to I think it was November of last year and kind

[00:38:35] of set off this incredible rally in both the long end of the bond market and the stock market. It's not supposed to happen that way, at least in the old days of risk gone and risk off.

[00:38:46] These things are supposed to move in the opposite direction, but they seem the stock and bond market to be joined at the hip. And so when we look at financial conditions, they all go the same way. They all ease or tighten at the same time.

[00:38:59] When you look at credit spreads, rates, the S&P, even the dollar, it's sort of one asset. And so we have had this easing of financial conditions, at least over the last two or three months or so. How does that feedback into your views?

[00:39:15] Does the easing of the long end and the lowering of mortgage rates as a prime result of that lower 10 year yield, is that a tailwind for economic growth? How should we think about the wealth effect of stocks and then also just the lower price

[00:39:34] of the cost of credit in terms of how they impact economic growth? So several thoughts here. That correlated market move, the everything rally, I would argue, is the direct manifestation of everything I've been describing, where the single factor

[00:39:52] driving everything is portfolio balance driven by central bank balance sheets rather than underlying fundamentals. And it's not proof that that's happening, but it is the main phenomenon that we observed all the way through the last 15 years or so of QE.

[00:40:07] And it's exactly what we stopped observing when we moved away from QE during 2022 and have come back to. And that's a manifestation of the stranglehold the central bank still have. The way I think of the long end rally and or the rates dynamic generally

[00:40:27] is not quite pushing on a string, but still close to it. Let's change course ever so slightly and talk about underlying drivers of the last few decades of rates rally and the potential reversal in that and where we stand at the moment.

[00:40:42] Most people argue that the disinflation that we had previously was because of globalization and now we're getting de-globalization is running in reverse. Or sometimes people bring in demographics as well. While that presumably played some role when I look at the data on when we had

[00:41:01] the disinflation and when globalization has measured by an increase in trade really picked up, it doesn't match slightly. And the thing that matches much better to my mind is the shift towards scalable technologies and firms investing not in traditional equipment and structures, but in things like intellectual property.

[00:41:21] And the reason I mention all of this is because over those decades, even as rates went lower and lower, the desire to invest on the part of firms, especially in those traditional, non-scalable segments like equipment and structures went down steadily.

[00:41:39] And what investment there is or what borrowing there is has gone towards things like real estate markets. As I see it, when you look at the latest borrowing numbers, what's striking is the lack of desire to borrow. And that's not really surprising at these rate levels,

[00:41:55] but I don't think it will be stimulated by a return to lower rates nearly as much as most people are imagining. And even where you have pockets of strength like US real estate, I would argue that's got much less to do with suppressed demand and much

[00:42:11] more to do with constrained supply than is sometimes recognized. And you see that in the mismatch between US housing markets and then much weaker housing markets elsewhere in the globe. As we return to those lower rates, I'm a little alarmed at how quickly the market

[00:42:27] has priced this in. But in a sense, I think of the rates market as being more rational about this because it's reflecting this lack of underlying desire to borrow, which was a real phenomenon. To my mind, still is a real phenomenon because of the way that firms are

[00:42:45] only really interesting in investing in these scalable technologies and things like AI, and while that causes individual pockets of the economy to have strong amounts of investment, generally the aggregate amounts are really quite weak versus history. And I would expect them to remain weak.

[00:43:00] Some part of your work, as we talked about, is bubble spotting. There's some corollary there in terms of trying to carefully detect whether a financial accident may be brewing. And certainly that was the case in the pre-GFC period.

[00:43:16] There's the old Herbert Stein quote, if something can't go on forever, it will stop. And I've seen in some of your work and analysis, some thoughts, at least on US government debt, we got the quarterly refunding coming announcement.

[00:43:31] Some folks point to, I want to say, it was late August of last year where the Treasury's borrowing intentions caught the market off guard. You saw this Bear Steepening episode in the US rates market, which was a little

[00:43:47] scary, set against the stock of government debt or the stock of government debt that is already out there, $30 trillion, not a small amount. What's your view on US government debt as a risk factor for markets? Where do you see that going? While there is a potential tipping point,

[00:44:08] which we came close to in the UK under Liz Truss, and while globally it is true that what's alarming is the large amount of debt across sectors and increasingly the large amount of debt and the deficits for governments. In general, if we can keep away from war,

[00:44:27] I think we are further away from the point where supply creates a great big problem and creates a backup in yields. And in general, I am less sympathetic to the idea of yield curve steepening than many investors that I speak to.

[00:44:45] With previous bubbles, it was sort of easier because it was more obvious what was the asset class people were piling into. It was more obvious what was the source of the underlying debt. And over the last 10 or 15 years, despite this odd and correlated

[00:44:59] market behavior that you were describing and suppression of volatility, the excesses have been relatively evenly spread across asset classes. So, yes, we can look at crypto currencies like Bitcoin that also tend to correlate with central bank liquidity.

[00:45:12] And yes, we can look at the tech sector and some of the AI and the magnificent seven sum of the valuations there are becoming extended. But in general, I would say the excesses have been more broadly distributed than previously.

[00:45:27] And to the extent to which there is a single excess, yes, you probably would pick government debt. But there, too, it's not like investors have been piling in with expectations of outsized gains. It's mostly been pension funds and insurers buying because they are trying to match liabilities.

[00:45:42] When I look historically at bouts of runaway inflation and runaway sell-offs in government bonds, typically it's not the inflation in itself that precipitates these. It's a run on a currency as leading to imported inflation and then leading to, yes, a big rise in things like term premium.

[00:46:05] And while that is a lingering risk, mostly I find that we are further from that point that people tend to imagine. In general, when you look at the link between rising government deficits or rising debt levels and bond yields, it's almost the opposite of what

[00:46:23] you would imagine. It's not that as governments borrow more and more, the bond yield backs up while there can be a tipping point and it can be arrived at really quite suddenly. Most of the time it's the exact opposite.

[00:46:35] And you look at places like Japan that have elevated levels of debt and have for decades tried having outsized stimulus packages. While there is still that risk lurking in the background, most of the time the supply provided that the proceeds are recycled

[00:46:52] in the economy, it's much less of a problem and you get much less of an increase in term premium and much less of a yield curve steepening than you might have thought. And that I think is what is going on at the moment.

[00:47:03] You see governments cheapening up relative to swaps. So there's a move in asset swap spreads. But for the yield levels themselves, they are much more influenced by the underlying aggregate desire to borrow on the part of the government and the private sector together.

[00:47:18] And in general, as I say, that's really quite subdued at the moment. Not only do I not see a problem, but if anything, I'm biased towards long-end yields coming down further. I'm biased towards term premium has already moved back negative. And I would say staying negative.

[00:47:35] And yes, I do worry about the politics of uncontrolled deficits over the longer term. Just for now, there too, as we've just seen in the latest refunding announcement, actually the amounts of borrowing are going down. And that in itself is supportive.

[00:47:49] The immediate market dynamics are probably more determined by RRP. And on top of that, another of the charts in my presentation just shows the link with government tax revenues and then previous equity market moves. And the fact that you generated so many capital gains during the course

[00:48:02] of last year is yet another factor that is likely to be bringing the deficit down in the near term. So when it comes to bubbles, it's always terribly difficult getting that bursting point. You can identify the risk. And I think people are right to do so.

[00:48:15] But for me, that bursting point is still some way away. And you need to look at the politics and you need to think in terms of trust. And it can all change very suddenly. But I still don't think, especially in the case of the US,

[00:48:26] that we are that close to that point. We study episodes of the national crisis because we want to learn from them. We also have to really understand that each of these cycles, each of these periods of time are unique in their own right.

[00:48:40] There's some rhythm to episodes of crisis. But the regulatory environment changes the way in which people think about consuming risk changes, the setup of trades themselves that live and breathe within the market changes. I'd love to get your assessment just as you look at asset prices,

[00:48:58] whether it's we've talked a little bit about both the short end of the government bond market and also the long end risk assets. What strikes you, let's say first is maybe in Congress, where you're kind

[00:49:11] of scratching your head and saying that price is clearing at a level that's inconsistent with some of the fundamental framework, including the balance sheet framework that you're utilizing. What are head scratchers for you just in terms of asset prices right now?

[00:49:27] I would say both the aggregate level being more elevated than it should be. And then to some extent, the distribution. So in terms of aggregate levels, whether we're looking at rates markets and saying, oh, there's a bit too much easing priced in that doesn't into forward curves,

[00:49:47] into real yield forwards. And that doesn't seem to match with central bank rhetoric. And similarly, when we're looking at equities relative to earnings, especially in the growth equity segment or when we're looking at credit spreads again approaching cyclical lows, when people are still very

[00:50:02] uncertain about the outlook for the economy, all those levels seem not hugely off, but they seem over inflated. And I think there's a straightforward reason for that. It's because, as we said, we've effectively pumped in more money relative to the volume of assets that's available to take it.

[00:50:18] And so that's pushed up prices across the board. That creates some degree of vulnerability, but it's relatively evenly distributed across the board. And as we were saying, the central banks more or less plan to carry on providing that support or if anything, inflating them further still.

[00:50:34] The second thing is a distributional issue. So when we look for the impact of rate rises and or when we look at corporate balance sheets, the aggregate numbers are often hard to interpret because there is lots of cash on the balance sheet of Apple or Alphabet.

[00:50:55] And at an aggregate level that conceals the vulnerability of the equivalent of Evergrande or the highly indebted companies or some of the private equity companies out there in high yield space. And yet what you really need to look at is the underlying distribution.

[00:51:11] In general, when you do that, obviously companies with more debt or individuals with more debt or small companies rather than large companies are all likely to be more vulnerable to the rate rises that we've had and anything other than a rapid return to easing.

[00:51:26] And some of that I think is priced in so triple C's have a big discount in high yield space, for example. I think, though, that it should be rather broader than that. There should be more of a discount on things like high yield and within equities.

[00:51:42] Even if I'm bullish about the underlying fundamentals on things like AI in general, I think there's too much in the price for those. But these are all phenomena where I cannot trade my growth versus value view on the basis of fundamentals.

[00:51:54] I have to trade it on the basis of the central bank liquidity. And I cannot trade my high yield versus investment grade view on the basis of the fundamentals. I have to trade it on the back of the central bank liquidity and to the extent

[00:52:05] to which that is likely to remain supportive for at least the next couple of months. More or less, I would see those phenomena continuing. It's really interesting on the corporate credit side of things. And so certainly during that just unbelievably low rate period of,

[00:52:24] let's call it mid 2020 all the way through well into 2021. I think I'm remembering August of 2021. Maybe that's when SVB was buying the bulk of its treasuries. But I know the 10 year touched down to something like 120 basis points in nominal

[00:52:40] yield, that's a year and a half after COVID basically. So there were some extraordinary low rates and companies and individuals took well advantage of it in terms of their own balance sheet profile. So they've termed out this debt and you seem to suggest that

[00:52:57] there's vulnerability for a segment of the population of corporates to ultimately having to refi it considerably higher rates, but from a broader systemic risk standpoint of the maturity wall as they love to call it. You don't see that as a substantially big risk at this point.

[00:53:18] Not really, no. My favorite high yield strategists always say it's never the maturity that makes you default, it's your cash flow disappearing. And while, yes, you always get some form of maturity wall, mostly I don't find that a useful way of analyzing vulnerabilities by the time

[00:53:38] you get to it. Typically companies have already done something about it, even if it means pledging all their assets away in such a way that recovery rates on default end up being really low and that is some of what we've seen over the last decade.

[00:53:48] So for me, the key here, whether it's high yield or whether it's equities is understanding the outlook for earnings. And I'm sort of torn on this front. In principle, there could easily be a vulnerability related to corporate profit

[00:54:04] margins, companies were very good to begin with at passing on price increases and suppressing underlying labor costs and to the extent to which wage growth is lagging and is sticky. What you might expect is that now that the inflationary pressures disappear or

[00:54:23] reverse and yet underlying wage growth is somewhat sticky, there could be a point where corporate margins are really quite squeezed and earnings growth comes down sharply and then the market is disappointed and ultimately you get things like defaults coming through.

[00:54:36] And in general, that has not happened and there could still be a lingering vulnerability, but especially in the US companies have done a good job of containing wage growth and margins remain relatively elevated. In addition, just coming back to high yield space and leverage loan space,

[00:54:54] in addition to the straightforward terming out, covenants have been so relaxed versus history that again, it's almost hard to force companies into default. When they do end up defaulting, the recovery rates end up being very low.

[00:55:09] But actually those defaults take longer to occur than you might have imagined. And so even though you see it in the Senior Loan Officer Survey, that banks have been tightening lending standards and they're slowing down the pace at which they're tightening lending standards, but they're still tightening

[00:55:22] them. And even though until the last decade or so, that would have been your perfect lead indicator for defaults. And some of these defaults are coming through in a lot of what we've seen over the last decade is the market rallies

[00:55:33] first and then the fundamentals and the defaults end up responding thereafter. And to some extent, that's what we're getting this time round as well. If it were a simple case of providing a counter cyclical stability on the part

[00:55:45] of central banks and a consciousness of what they're doing and reassuring everyone, we're not going to let things fall apart and have a negative debt deflation spiral on the one hand, but we're not going to inflate massive asset price bubbles on the other.

[00:55:56] Then I'd be entirely sympathetic to it. Instead though, we're getting it in this very asymmetric fashion where it forces people like me into being bullish regardless of what I think about the underlying fundamentals. And yet you're left with this lingering nervousness that you're only buying

[00:56:12] because of those technicals or you're only buying because everyone else is buying because of those underlying technicals. And so there's an underlying fragility and ultimately this makes for a much more fragile market than an organic natural market where we were all

[00:56:26] investing independently based on our own independent decisions about the fundamentals. That shows up in other places as well, like in vol markets, day to day volatility away from raise is low. But out of the money skew is elevated or day to day vol is low.

[00:56:39] And yet vol of vol is high and we moved away from those phenomena during 2022 under proper QT, but now we're coming back towards them. And that sort of herding that everyone gets forced into is I think the major

[00:56:53] risk factor for markets, but it's still a very difficult one to analyze, especially when the central banks are intent on doing more of it. We're looking at each other. The central banks are looking at us. We're looking at the central banks.

[00:57:03] I think Bernanke once called it a hall of beerers. It's complicated, it's reflexive in a lot of ways. Certainly, I think one of the premises of this discussion has been when there's this disconnect between the fundamentals that are traditional that we look at

[00:57:22] relative to the asset price performance, we've got to dig deeper. And it looks to me very much that your framework is very focused on trying to find that new cause and effect. This idea that central banks are a real big driver of asset prices for better or

[00:57:40] worse, I think is a really important concept to try to get your arms around. So, Matt, I really enjoyed the conversation. Existing and potential clients can find you on Satori, S-A-T-O-R-I-Insights.com. Thanks for being a guest on The AlphiX Change. This has been outstanding. Thanks for having me.

[00:58:00] You've been listening to The AlphiX Change. If you've enjoyed the show, please do tell a friend. And before we leave, I wanted to invite you to drop us some feedback. As we aim to utilize these conversations to contribute to the investment

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