Episode Summary

If you can I’d stay away from that maybe, or maybe do, up to you, but where do we start, with top dot Jay Powell in the news today and the monetary policy and where do we want to go, everyone?

The Hi(story) of Jay Powell

[00:00:43]Adam Butler: I think we should start with the conversation that we were beginning off screen about Danielle, you were describing a conversation that you had with Richard Fisher early on in your career and about an enigmatic figure at the time, Jay Powell. And some really important takeaways, especially in the context of what everyone’s trying to figure out in terms of what’s going on in Jay’s head, and where he wants to take policy and the economy over the next few quarters. So if you wouldn’t mind, maybe let’s go all the way back to that and maybe recount that story just to set the stage.

[00:01:20]Danielle DiMartino Booth: Sure. So Jay Powell joined the Federal Reserve Board in June of 2012, and he was a really quiet figure for years and years. Just, he wasn’t, he was like, picture the opposite of Kashkari or Bullard. Just absolute opposite in terms of a media hound. So when Richard retired, I retired summer 2015, we ran into each other at a football game in Austin, Texas and ended up chatting in the lobby of the Driscoll Hotel there.

And he said, I want you to keep your eye on one person and only one person. There’s only one person left standing in that room. Now that I’m gone, now that Charlie Plosser’s gone. Jeremy Stein had left before, then Tom Koning had left, So there were really no dissenters left. There were just a bunch of yes men and yes women, especially to the yes woman herself, Yellen, at the time.

But he said, I want you to pay attention to Jay Powell because he’s the only person who’s still a thorn in the side of Bill Dudley, wanting to stop reinvestment. Jay Powell really wants to shrink that balance sheet. And he’s the last one who’s focused on that and just a thorn in Bill Dudley’s side. And I said, but how do you pay attention to somebody who’s quite as a mouse?

And which point, because Richard was a media hound himself. Yes. Still, and he said, just slowly follow this guy. He’s methodical. He doesn’t have to be there. He, when he left the Carlisle Group, he’s probably worth 125 million net worth. He didn’t, this is not a job that he needed. He, Jay Powell never needed the pension, never needed the health benefits. He’s there for a different reason, and we have to remember that about him. This is the person who worked with Warren Buffet to resolve Salomon Brothers coming out of the treasury scandal.

There, there are things about Jay Powell that nobody appreciates or knows, or even wants to know. They just want, Elizabeth Warren and Rick Scott, they just, they need a bad guy. They need a fall guy. They need somebody to blame on election day in 2024, and that’s to come full round trip. That’s who Jay Powell’s become. He’s the bad guy and he’s allowing himself to be the bad guy. So why? Why, is the question.

Other Fed Chairs

[00:03:17]Richard Laterman: I’m curious, have we had other Fed chairman that have not come, have not risen from the ranks within the Fed, but has come from a private equity background like Powell, or market background?

[00:03:28]Danielle DiMartino Booth: So William McChesney Martin, he ran the New York Stock Exchange and he was one of the few people to stand up to different administrations, different political parties, and was famously thrown up against a wall by Lyndon Baines Johnson in, outside of Austin, Texas. And, boys are dying in Vietnam and you’ve got to lower interest rates, and he did, for five hot minutes. He made that mistake.

But other than that, you also looked to sort of Paul Volker. He came up through the New York Fed, but he understood banks a lot. He was no PhD. He used to have, he used to bring all the PhDs, when he moved to Washington D.C., Volker, into a room and then trash the Phillips Curve for fun. This was a great guy. But you have very few, kind of, especially in modern history, who weren’t really kind of PhD types and McChesney Martin, Volcker and Powell, they’re kind of the standouts. And by the way, they’re also the most effective chairs in history, except people would argue that Powell’s the least effective.

What’s Driving Jay Powell

[00:04:31]Richard Laterman: So presumably you took Fisher’s advice, you followed Powell, and what kind of person is he, outside of what he has been for the last several years as chairman? What do you think is driving him?

[00:04:41]Danielle DiMartino Booth: I think I, God this sounds so cheesy. Sorry. I think it’s patriotism. I think he has a respect and a veneration for the United States’ standing in the world and where that’s going to end up becoming, what may come, what happens with China or not. So I think he’s a patriot or he would not be subjecting himself to this kind of torture, which, and you can see it in his face. He’s just somebody who’s, okay, I’m ready for the next shot. Hit me. And that’s public enemy number one.

He is, whether it’s Congress, whether it’s Wall Street, whether it’s his old private equity buddies. They were like, dude, after the pandemic, you expanded the main street lending program for our PE portfolio companies and now you’re driving us into the ground. There was a story on Bloomberg two days ago, PE’s getting, what, 39 cents on the dollar?

They’re just getting raped and pillaged, and it’s because, going back to August the 12th, 1987, Greenspan rode to the rescue within months with the crash of 1987. And he started filtering, hey, New York Bond, New York market’s desk. Go ahead and let the bond, all your bond trading buddies on Wall Street know that we’re about to inject liquidity into the system, so they don’t have to worry about the stock market going down anymore.

I’m here to save the day. My name is Alan Greenspan. I was never popular in high school, but I’m popular now. And, but it’s been since then that investors have had to deal with price discovery and they’re dealing with it now. Leveraged loan recoveries. I did a triple take, I wrote a whole weekly about it, that the depths of the great financial crisis we’re talking like 2009, 2000 recoveries were like 36 cents on the dollar for leveraged loans. Today, they’re 33 cents on the dollar. That’s your starting block. God knows where you’re going. And Jay Powell is, as long as he methodically continues one week at a time, one month at a time, to hold steady, it doesn’t matter if rates are rising or not, if you have to refinance into this shit show, excuse my French, what a mess. Because you’re doubling or tripling your financing costs, regardless of who you are.

[00:06:48]Mike Philbrick: A lot of naked swimmers.

[00:06:50]Danielle DiMartino Booth: Yeah. Leverage works in a zero interest rate environment. It falls to pieces in a normalized interest rate environment.

[00:06:58]Adam Butler: Back to that…

[00:06:58]Mike Philbrick: Go ahead Adam.

[00:06:59]Adam Butler: Yeah, no, I was just going to, I was going to say the same thing. You mentioned that he was, while he was a bit a quiet individual and was a little bit on the outside, back in that 2012 to 2014 period, you mentioned that he was one of the only ones to state publicly, his skepticism about how the Fed was going to back away from these multiple QE oriented balance sheet expansion policies that have been put in place by Bernanke and then Yellen. Do you think he’s finally feeling like he’s in a place where he can decisively walk this back and he’s going to see that through?

[00:07:39]Danielle DiMartino Booth: So, he was pointedly asked in, hats off to a Politico.com reporter, finally broached the subject of the balance sheet, this last press conference after the pause. Does pause necessarily lead the discussion to when are you going to stop doing QT?

And he was like, nope. He was not that dismissive, but he ain’t talking about it. So he is, he’s very methodical when it comes to the balance sheet and every, whatever the day that falls after the, it typically, it’s the 30th or 31st of the month. Whenever that treasury maturity date is depending on the month, but every H4 that follows that.

So it’ll be like July 6th this month, that 50 billion roll off and it’s steady. And my mentor, Lacey Hunt will say, and it’s manifested in M2 growth or the lack thereof. It’s most negative since 1937. It’s manifested in other deposits liabilities pre Silicon Valley.

It was already negative year over year. So it’s working. Whatever it is that he’s doing, it’s working. It’s just working really slowly and he’s good with that. He’s way happy with retail investors, keeping the stock market going and zero date options. He’s happy with all of this because it gives him cover to keep going.

Poisoning the Fed Put

[00:08:57]Adam Butler: Interesting. So that dovetails nicely with, I was, a quote in a recent Daily Feather stood out for me, where you said that Powell knows darn well he’s not combating inflation, but rather looking for cover to maintain high rates to methodically poison the Fed put into its grave. Wow. Is this central to your thesis that Powell is rewriting the rules of engagement and attempting to walk back the financialization Fed put moral hazard model of the past few decades?

[00:09:24]Danielle DiMartino Booth: Look let’s do some Socrates here. In 2018 before junk bond issuance froze for 41 days, forcing the Powell pivot. That’s the boogeyman. You cannot have the capital market. You can have the capital markets be crippled, which they are right now. You cannot have ’em freeze completely.

You’ve got to have somebody out there floating a deal, Carnival Cruise Lines, whoever it is that keeps selling junk. But he is extremely methodical about this. But go back to 2018 when he took rates back down to zero. What did he have to play with? 250 basis points. Now, let’s say he’s decided, because he reads me, that two percent’s the new zero. Let’s just say zero interest rate policy. ZIRP is a tool that’s being tossed out of the toolbox. Didn’t work, screwed up things, encouraged speculation, blah, blah, blah. Let’s get rid of it. Toss it. Great. I’ve got 300 basis points or more, depending on what happens in July, to work with, to get me down to the new floor of two.

Now, that doesn’t work for people who want a zero interest rate environment, because that’s what’s made the wealthy wealthier, is because you can play all kinds of weird games at a zero interest rate, in zero interest rate environment.

But let’s say he knows that he’s already got 300 basis points, 50 basis points more than he had to lower last time. When the actual, when the unemployment rate finally pulls up, which he knows is going to happen, he’s not stupid. He sees Indeed.com job postings are down 22% year over year. He sees true IFL 2.38% right now. He’s not stupid and he certainly knows that he’s been burned by his Board to a crisp with this inflation business and their models and everything that had left, transitory. All this has left him bitter towards his own staff and rightly, but he knows, and he knows he can get rid of QE. He just can and throw that out of the toolbox right there with it. And by the way, as a little bonus round, when he does eventually lower interest rates, he can just let those mortgage backed securities roll off the balance sheet as they prepay and just have that occur in the background as well, and get the Fed out of the credit easing business.

It’s against the Federal Reserve Act of 1913, by the way. No credit easing. You may never purchase the paper of a government sponsored enterprise. It’s in the verbiage of the original 1913 Act. But he knows he can get rid of three tools at once that are broken, if he’s calm, if he’s the quiet guy in the background who just steadily keeps going.

[00:11:51]Adam Butler: So, do you think the market’s taking him seriously?

[00:11:52]Danielle DiMartino Booth: Hell no. But the credit market is what it’s going to take?

Credit Market Signals

[00:11:54]Adam Butler: Okay so what signals are we seeing in the credit market that lead you to believe that credit managers are starting to believe that Powell is going to see this through?

[00:12:04]Danielle DiMartino Booth: Try selling the mezzanine tranche of commercial mortgage backed securities. Just try it for fun. See what happens. Yeah. Because nothing, because you can’t. So right now, banks are in the position that they actually have to hold onto the equity and the mezzanine tranche. All they can sell is the Triple A. That’s why issuance is down 85% year over year in that market.

[00:12:24]Adam Butler: But is, what if that’s isolated just to the commercial real estate market? We know commercial real estate is in a major bind. They’ve seen this successfully extended pretend so far. Yeah. Is this going to come home to roost eventually?

[00:12:35]Danielle DiMartino Booth: You think are bankruptcies, whatever there are right now, 211 year to date bank bankruptcies, companies with more than 50 million in liabilities. Is that a figment of my imagination? That has nothing to do with the commercial real estate market and those leveraged loan recoveries, 33 cents on the dollar. That also has nothing to do with the commercial real estate market. This is not an isolated asset class. It’s just nothing has broken in the aggregate.

You can still sell HYG ETF if you want. And high yield spreads. They look beautiful, right? Because what do they reflect? They reflect the handful of liquid companies that are trading. That’s about it. You don’t see what’s in the middle. That’s not trading. It’s simply not out there. But that doesn’t mean it’s trading. That doesn’t mean the liquidity’s there.

Quick Pivots

[00:13:24]Richard Laterman: You’re painting a picture that there’s this inherent trade-off between the health of credit markets and the health of the treasury market because to some extent if he’s not really fighting inflation, he’s actually trying to retrench, take away some of these heterodox tools that have skewed and distorted the functioning, particularly on the long end of the treasury market.

Yep. We saw with SVB quickly, I don’t know what it was, at five or six months of QT were unwound with the liquidity facilities. It wasn’t quite a pivot, but he saw, he was staring at the face of this abyss and he was like, okay, we gotta put some liquidity back on. So to what extent, you seem to think he’s very serious, but an event like SVB takes place.

He’s forced, his hand is forced to some degree. Has QT resumed? Has he been able to neutralize the effects of that SVB credit line and what’s it going to take for the next crisis? How quickly could he pivot?

[00:14:18]Danielle DiMartino Booth: It was apparent with Silvergate and Silicon Valley, First Republic. It was apparent that the systemic risk had been at least flashed. So you did need to come in with the backstop. But there was always this verbiage, and it was a two thirds of a page memo that described, you can bring us your treasuries, bring us your mortgage backed securities. We’ll give you a hundred cents on the dollar. But there was a line in there that said, this will not be free. And now we know what it is. Now we know why Congress grilled him to a crisp about raising capital requirements. If you want to play, you’re going to have to raise capital in this environment. With the KBW Regional Stock Index yesterday closing at its lowest on record below where it was, the slow bleed continues in the regional banking system, but it’s not, it’s been contained for now.

What will he do if there are more bank failures? I don’t know. But if, for a $2 trillion facility to have a 5% uptake, banks have figured out that there’s nothing free about it, or it wouldn’t be a hundred billion that was outstanding. It would be the full 2 trillion, and they would have their hands on that excess liquidity. They’re not honing up to it because they don’t want to raise capital in this environment.

Regional Banks

[00:15:32]Adam Butler: So six months down the road, Powell and company keep rates where they are or God forbid the dot plot plays out and we’re 25 to 50 basis points higher than this. And we, and there’s, all the communications suggest that it’s going to stay there for many more quarters. What is going on in the regional banking system at that point?

[00:15:54]Danielle DiMartino Booth: So right now you’ve got garbage trading in commercial real estate, because when you’re talking about regional banks and small banks, you’re talking about commercial real estate. It’s not the interest rate differential that’s going to be the killer. It’s the fact that the collateral underlying the loans is N/A. You don’t know what the value is because right now the collateral backing those loans, you’re seeing garbage trade, jingle mail, some mall in the middle of San Francisco, downtown, whatever. You’re seeing garbage trade and you’re seeing pristine A-plus properties trade.

You’re not seeing anything in the middle. Because I speak to bankers directly and they’re like, we’re hoping that rates come back down to zero, so we actually don’t have to trade that stuff in the middle. But the maturity wall is this year, and that’s the problem. So if you’re talking about the next six months, if you can just hold on for six more months, then the middle’s going to trade because it’s going to have to trade.

And that will take out quite a few players and we’ll see what the FDIC, will see what Yellen, if she’s still there, we’ll see what they do. But he has tried to enforce the separation principle saying, what happens in the banking system is going to run parallel to and not influence in the least, monetary policy. He’s trying to hold that line, very nuanced. But he’s trying to do it and so far he’s succeeded. Like since March of 2022. They got a little bit of credit.

Labor and Rates

[00:17:21]Adam Butler: Yeah, no, agreed. What is the economic sensitivity of the commercial real estate book versus the rate sensitivity? The only reason why we get any kind of 250, 300 basis point of reduction in rates is if we’re staring down the barrel of a major uptick in the unemployment rate. And probably the, not just initial cracks but we’re a fair down, a fair ways down the road in a, some kind of credit crisis. What are these banks thinking is going to come along and help to patch it up. Even if we get back to 2% or zero rates, it’s because we’re in a financial crisis and a major recession. How do those things balance off, relative to policy rates?

[00:18:04]Danielle DiMartino Booth: So, I think in such an environment – so you’re talking about kind of 300 basis points from now of easing, that banks feel that they might be able to survive that kind of an environment. So remember right now you have, you basically have misfeasance or stupidity going on at Bureau of Labor Statistics. You can’t tell me that all of the Bloomberg economists that are, who are asked every month, that all of them have been wrong for 14 months running and that 37% of non-farm payroll creation in the last 12 months has come from a birth/death model. You can’t tell me with a straight face that makes any sense at all.

And yet it’s a good thing to be able to hide behind it. The Department of Labor has finally thrown in the towel. They’re allowing real data to be reported on a week by week basis. If you look at continuing claims across the nation for the last three months running April, May, June, 90% of the US population is living in a state with rising continuing jobless claimants.

These are not people who have applied for unemployment insurance. These are people who have been, who’ve qualified and they’re collecting. 90% of the nation’s population three months in a row. An economist would tell you that’s a trend, but yet Jay Powell can still hide behind the job openings numbers that he knows are specious and broken, and they also emanate from the Bureau of Labor Statistics.

He can still hide behind that, which means when we do have an unemployment rate uptick, it’s going to be a shock. And maybe this 0.3 percentage increase is not an aberration. Maybe we should be paying attention to the fact that the unemployment rate in the state of California, the nation’s most populous state, is up a half a percentage point.

So the data is there if you know where to look. But by the same token, it’s not what’s on the front page of some major newspaper, because you’re still seeing that 3.7%, lowest since 1969. It’s all still good at the surface.

[00:19:56]Adam Butler: So what’s the track record for claims diffusion? Sorry. Yeah. Danielle, what’s the track record for claims diffusion like that? Like you said, 90% of states you’re in recession, already. You’re not flirting with recession.

[00:20:05]Danielle DiMartino Booth: You’re not flirting, Yeah. And when April hit that 90% percent threshold, you’re like, okay, is it going to come back down or is it going to stay up? Let’s wait, and let’s wait this out. And it’s stayed high for three months, stayed high.

Sector Strength and Rates

[00:20:20]Adam Butler: Are you at all surprised by the strength in some of the sectors that we have classically perceived and which mechanically you would think would be the most interest rate sensitive and how resilient they’ve been? These housing starts numbers and permits numbers and commercial construction spending.

We’ve got this hockey stick type growth dynamic going on in some of these sectors that you would expect to be especially hurt by the sustained high rates. What do you think is going on under the surface there that explains why we see such resilience? Or is this some sort of data anomaly that, is that where the numbers that are reported are not accurately reflecting what’s actually happening?

Maybe it’s year over year and last year was especially low. Or is there any, are there any of these other effects that are obfuscating or otherwise complicating the interpretation?

[00:21:15]Danielle DiMartino Booth: Comparables are playing a huge role right now cuz housing was just in the pits a year ago. So comparables. That’s a very good point you bring up. Buddy of mine pointed out to me Dodge Construction a few days ago, and he’s, have you seen this residential real estate? Actual construction is down 24% year over year. And I’m like, what gives with Census? And he said, Census takes a survey of home builders who have permits in order to impute what starts are.

And I’m like, that sounds like an economist at the Fed. But when you see the Dodge Construction data, you see this hockey stick that you’re describing, what is it? Gee, Ford’s constructing a $1.5 billion electric vehicle plant. The amount of government funded construction going on right now is enormous.

Private residential, not so much. And this is data that came out Monday. So it was, it, again, I like to speak to people on the ground. That’s why I like Indeed.com. They’re not imputing squat, they’re just talking to companies. I like to talk to Dodge Construction because they’re talking to 10,000 construction firms. I’d rather hear about what people are actually doing rather than what the Census Bureau is imputing.

[00:22:34]Richard Laterman: But I’m just also why you cited Truflation, because they’re pinpointing around several tens of thousands of data points as opposed to a narrow survey that can be skewed and often is.

[00:22:44]Danielle DiMartino Booth: And if you think Truflation’s methodology is flawed, then check out where they think UK inflation is at 13.06%. So it’s not that they’re mis-measuring, it’s just that things are slowing down so fast. Here again, just like leveraged loan recoveries being at 33 cents on the dollar. Going into a default rate cycle. S&P Global told us on Tuesday that in the aggregate, not sub-prime, in the aggregate, automobile delinquencies are starting this household default rate cycle from the highest level in the history of mankind.

Starting pre-October, student loan repayments. God help us when that arrives and somehow the administration has managed to make an August 29th deadline. When the moratorium finally comes off, since April of March of 2020, they’ve somehow managed to make August 29th into, you don’t actually have to start making payments until October.

So there’s a lot of time that’s been bought. The employee retention credit, Getrefunds.com, $20 billion is being pumped into the US economy every single month. The IRS has been flagged. Have you noticed there’s a lot of fraud going on? How do you know, how are you going to verify that people had Covid interruption through the third quarter of 2021 in a program that doesn’t expire until 2025, but yet they’re just taking US taxpayers for a ride.

It’s going straight into the hands of the wealthy and they’re, that’s why you’ve got all these kids in first class because you’re pumping $20 billion a month into the US economy in fiscal spending that nobody wants to talk about. The sell sites. There’s been a goods to services handoff, and I’m like, bullshit. There’s been $20 billion given to wealthy people every single month, and they’re spending it. Good for them.

[00:24:30]Adam Butler: Yeah. Maybe the market is perceiving that the IRS is going to have to hire an army of new auditors to go out and investigate all the fraud that’s taken place on the $20 billion a month program.

[00:24:42]Richard Laterman: Hotly negotiated in Congress.

[00:24:43]Danielle DiMartino Booth: When it hit the front page of the Wall Street Journal a few weekends ago, then it got real. So because for all the $200 billion in excess marginal liquidity that’s been pumped in through this program, they’ve only processed a million of these claims.

They’ve got another million that are sitting there, and these Getrefunds.com innovation taxes. They’re collecting 25%, which is, wow, this is not an ambulance chasing situation here. These are your tax dollars. Theoretically, if you qualified, a buddy of mine made it really simple. You guys know Mike Green, buddy of mine, made it really simple.

If you needed the money, truly, and you were a small business owner, you long since have gotten it or you went out of business. People collecting this money. Now they have no, they no business collecting it, and yet it’s a really big form of stimulus that’s being pumped into this economy.

The Treasury Market and the Fed

[00:25:32]Richard Laterman: Yeah. I wanted to circle back to something we were discussing earlier on, the health of the Treasury market. To what extent is Powell and the Fed having, are they having to over-manage monetary policy because of actions by the State Department? Particularly the sanctions that were imposed early last year. There have been some talks about, there was this, people at the Fed or at the Treasury questioning that they weren’t consulted in terms of these actions.

Not that State would necessarily do it but that maybe at the margin there’s been a reduced appetite by foreign buyers. There seemed to be a smaller appetite or perhaps you have not noticed that to some extent. No. Would that have forced them?

[00:26:10]Danielle DiMartino Booth: You see it in the TIPS data, but no, that idiosyncrasy would not have forced the Fed to take action. The fact that Basel has pushed 50% of trading into the hands of hedge funds in the Treasury market, that is a real issue for the Federal Reserve. That’s a big issue for the Federal Reserve, much bigger than what you’re describing because now that we’ve got rates that are staying high, you’re seeing foreign investors, foreign central banks, come back into our Treasury and they’re fighting with life insurance companies and public pensions that are like, oh my God, it’s yield.

What the hell’s that? I’ll take that all day long and on Sunday, because I can finally match my liabilities to my assets. So that’s where our auctions have been so strong. But the functionality of the Treasury market, that’s a big deal for the Fed. When a buddy of mine who trades levered Treasuries, he is calling me at three o’clock in the morning on March 20th, 2020, is there’s no bid for the long bond. And I’m like, pardon me? That’s, it’s the long bond there. Of course, there’s a bid for it. That’s the risk-free, that’s the world’s risk-free asset. And that’s the moment that haunts Jay Powell. Big time.

Betrayed Trust

[00:27:17]Adam Butler: So say more about that, Danielle, because you were mentioning that earlier, before we began our chat online and you mentioned how Cohen and Griffith and Diamond betrayed Powell’s trust right, in March of 2020. And Powell learned some really valuable lessons there. Maybe just expand on your interpretation of those events and what do you think Powell learned and how does that inform his current stance?

[00:27:40]Danielle DiMartino Booth: You have to disentangle the Diamond episode from the hedge fund episode. Not QE was forced by the JP Morgan’s of the world. There’s only one, right?

By them stepping back and withholding their balance sheets, that forced not-QE in the repo market. Now, what happened after the pandemic hit was the trade simply wasn’t there. The arbitrage wasn’t there, the profit wasn’t there, and you had hedge funds step back that now have a 50% footprint in Treasury trading, whereas that used to be their sole purview back in the good old days of broker dealers, who have access to the window at the Federal Reserve Bank of New York.

But regulations made it more onerous and costly for banks to hold these Treasuries, to trade these Treasuries, and it became a business line of these massive hedge funds who are not, they’re not beholden to the US government. They’re not, you’re not going to close the discount window to them. They don’t have access to it in the first place.

And that’s why, rare moment here, that’s why when Janet Yellen says gee, the non-bank system’s 240 trillion globally, and that’s bigger than the 180 trillion conventional banking system. And you’re like, yeah, Janet, it is. And it’s not regulated at all. And it’s bigger than what you do regulate. So that’s, it’s when these types of situations occur that you realize, as Jay Powell, we hold too much of the Treasury market. Our footprint’s too big in times of stress.

There wasn’t enough liquidity, there wasn’t a big enough footprint to maintain the functionality of the risk free asset. People are like, why does he not want to talk about quantitative tightening? And I’m like, because he understands that the Fed’s footprint’s too big. $8 trillion is too much. It’s got to occur in the background for the Fed to slowly but surely put trading back in the hands of natural players, not fast money guys.

And if we’re going to change the name of the Eccles Building to the Powell Building, we will eventually see central clearing of Treasuries and have that be in the national purview. And by the way, if you have that, you’re not worried about China or the reserve currency status. You have control over clearing. You are matching buyers and sellers in a central location, oh, I don’t know, a stock. So if he can do that, it will be, it will cement his legacy.

[00:30:11]Adam Butler: But it seems to me that you can’t really have a situation where Powell begins to mop up liquidity through QT, without changing the relative proportion of holders and traders of, within the Treasury market. You can’t have one without the other. If you’ve introduced regulations that make it onerous from a balance sheet standpoint for the banks, which have typically had a symbiotic relationship with the Treasury and the Fed, and there’s an implicit responsibility there to make a market and to be the buyer of last resort.

That’s the whole tale, right, of the Treasury auction. If that is no longer in place and we’re reliant on these fast money traders, what is the impact of the Fed continuing to persist? With this quantitative tightening agenda without also changing regs to make sure that you do have a stable and functioning Treasury market and you’re not vulnerable to these kinds of stress events where fast money traders walk away, and there’s no bid in the world’s reserve assets.

[00:31:16]Danielle DiMartino Booth: It’s beyond changing regulations. If the Fed harnesses central clearing of Treasuries, that’s changing the law.

Central Clearing

[00:31:24]Adam Butler: Does that go, does that, is that enough that there’s central clearing? Maybe, describe mechanically how central clearing addresses the problem. Because I don’t, I’m not sure it’s perfectly clear to me.

[00:31:35]Danielle DiMartino Booth: So, when you don’t have a bid for the long bond in the middle of the night, an Asian trading, that means that one side of the trade has faded, not there. When you have central clearing you have both sides of every trade. You’re going to ensure that every trade can be executed and cleared and settled.

So it’s, you’re literally taking the market over. Some would say, wow, that’s, capitalist, United States of America, democracy, blah, blah, blah, blah, blah. I guess what…

[00:31:59]Adam Butler: But is the Fed making both sides of that market or the Treasury making both sides of that market? Who’s guaranteeing it, or is that not an essential dimension?

[00:32:06]Danielle DiMartino Booth: It’s not a guarantee as much as it’s a match. You’re changing how the market operates.

[00:32:11]Adam Butler: You still have to have alluding to again, your ex…

[00:32:13]Danielle DiMartino Booth: You’re not just extricating hedge funds from the business. You’re taking the business line away from broker dealers as well. So this is not, it’s not a 25 or 50% situation. It’s a regime change where you’re no longer relying on the banks that you used to, and, or the hedge funds that you are now forced to. You’re not relying on either cohort.

[00:32:36]Richard Laterman: It seems central would help. Definitely, I think what Adam is alluding to is maybe the balance of incentives that would drive natural bidders to the long end of the curve.

And I’m reminded of Russell Napier’s, I’ve been listening to him for some time and more recently he’s been talking more and more about the coming financial repression that we have lived through in previous times, which is what Adam was alluding to when he talks about regulation, right? Forcing insurance reinsurance, changing the game to force banks back into, I don’t know if it’s, if would have to go through a rethink of Basel to some extent, but the fact of the matter is there is a concern with regards to the health of the Treasury market, much like we’ve seen the writing on the wall with the JGBs, right? I think that’s that, that’s the main concern here, without a doubt.

[00:33:22]Danielle DiMartino Booth: And again, this is something that would be revolutionary and that the bank lobbies would not want.

[00:33:30]Adam Butler: Yeah, making markets and Treasuries are obviously a massive profit engine.

[00:33:34]Danielle DiMartino Booth: It’s not. No, it’s very unprofitable.

[00:33:38]Adam Butler: Oh, okay. It’s a very, so why would they not want it?

[00:33:45]Danielle DiMartino Booth: Because it’s powerful. It’s powerful. They hold, they sit in the power seat. If you take that away from them, that’s one lever they don’t have against you. But if you think about, if you think about what’s happening right now with private credit stepping in where private equity was, where securitization markets are dying from a lack of issuance. If you take all of this to its end point, you’re going to have private credit buying companies for pennies on the dollar from private equity. They’re going to put somebody into these companies who’s going to run these companies for years. No leverage. Full covenants.

It sounds like a bank loan. It looks like a bank loan. It’s just got a 15% yield. But what does that company look like on the other side of coming through this? Have they been completely bent over like a private equity firm would do? Gordon Gecko styles, stripped of their assets, loaded up with debt. Next stop, Chapter 11. Or have the companies actually been rebuilt to where they no longer have to deal with being bailed out by private credit, they can go to a bank and get a loan and banks can make loans.

So if you follow this all the way through, banks can get back into the business of being banks and you shrink the footprint of the non-bank financial system. You end up making winners as banks as well. If you hold on, if you hold on. Yeah. If you’re not one of these regional banks, that’s going to go poof in the night. Make it because you’re up to your eyeballs in bad CRE paper, like one bank in a state that’s borders with the state of Texas, that’s, the majority of its book is skyscrapers in Manhattan. Oops.

Interconnected Banking Systems

[00:35:19]Adam Butler: But it seems to me that the banking system is more interconnected than that implies, right? Are you suggesting that it’s possible to have isolated regional banks with offside commercial real estate or loan books that enter Chapter 11 or enter liquidation without materially impacting the all, the financial, the credit markets in general? Because I, we haven’t really seen that in the modern era.

[00:35:49]Danielle DiMartino Booth: No, this is also, and I’ve actually said that we’re going to be watching short episodes of It’s a Wonderful Life. That you’re going to see bad regional players go away. And that won’t necessarily be systemic if it’s one at a time and it’s controlled. And you’re going to see small community banks survive because you’re going to have communities who Ford has taken away their Ford dealership, Walmart’s taken away their main their stores on main street.

They’re going to draw the line and keep their bank alive. So you might end up with a situation where you still have the community banking fabric that’s unique and a good thing to the United States, and a smaller regional footprint that is more regulated and they need to truly be regional banks or they’re national banks, but they’re not regional banks that are pretending to be regional banks that are actually national banks because they want to be national banks.

I think you take, they’re, people are always like, doom and gloom, Danielle. I’m like, no, there’s actually a way to have a happy ending. Here’s, you’re going to have to do it in a normalized interest rate environment and in that environment,  banks can be banks again.

Securitization Markets

[00:36:56]Adam Butler: No, I love that vision. Absolutely. It sounds like a really incredible place to get back to. I wonder how it impacts the securitization markets. What percentage of it goes away? But the securitization market is a multi-trillion dollar market in the asset backed space.

Just commercial real estate on its own. We obviously, it seems to me obvious anyways, that will require a pretty substantial amount of pain in the short and intermediate term to mop up those bad loans. Those assets change from weak hands to strong hands. As you say builders and operators get put into the driver’s seat of these businesses in place of capital structure engineers and the banks and the real estate companies and the operating companies of America and potentially around the world.

Instead of becoming engines of financial engineering, become regular operating companies of banks again, but in the process we wipe out a very substantial portion of the debt markets. And all of those debts are backed by assets. And there’s a chain here, right? So walk me through how you get from A to B.

[00:38:11]Danielle DiMartino Booth: I never said it was going to be pretty, but you’re watching banks exit lines. For example, in autos, they’re not tightening lending standards. They’re shutting down divisions. They’re like, we’re going to get out of this for a little while. Why? Because on Monday we learned that the average juiced car loan in America is a hundred and got 125% loan to value. So the writing’s already on the wall.

You already know that there’s rot in that market, that a lot of these loans are going to go very bad. And that’s what we saw months ago when new car dealerships started making loans to people with another car loan, knowing they’re not going to pay to fix the lemon that they bought at the peak of the pandemic that they owe more on than it’ll ever be worth. They’re gonna walk away from that car. It’s going to be repossessed and they’re going to make good on my new loan. That is like not due diligence if you’re, but I guess it…

[00:39:03]Richard Laterman: It has to be slow moving enough for Powell’s plan to work. Because if you have a cascading effect, some of the actions that you’re describing seem to have pretty substantial economic slowdown implications.

So it presumably at one point, it’s the old change happens gradually. Then suddenly, eventually there’s going to be a tipping point where there’s going to be a major slowdown that is going to force them to ease once again. And then we’re back. It’s recursive to some degree. Unless you suspect that there’s an enough time dilation for this event to take place and keep rates higher with some cover from other data points.

[00:39:44]Danielle DiMartino Booth: So to extend on your metaphor, the frog realizing he’s being boiled, occurs around Thanksgiving or so. That’s when you, that’s when the student loan repayments that actually physically began in October.

You start to see people saying, what am I going to do here? Rent, car, credit card, what am I paying? And those decisions will be made because whatever it is, the average of $393 student loan payment, people are just going to run out of money. So that aha moment you can see, and that’s why there is such a white hot panic in the administration right now to try and figure out another way to work around actual repayment starting.

But I think the Supreme Court’s about to put a kibosh on all of that. But to your point, that could be a breaking point. But nobody would’ve ever thought that you would get through the holidays with Jay Powell still on hold and go back to what we originally were talking about. He doesn’t have to go to the zero bound anymore. He’s got ample basis points to ease substantially, but not go back to the zero bound.

Is 2% Zero Bound?

[00:40:48]Adam Butler: So is 2% materially different than the zero bound?

[00:40:50]Danielle DiMartino Booth: Oh yes, absolutely. And you’re seeing it, you’re seeing it in, I go back to recovery rates. You’re seeing it in where private equities trading hands, because the math only worked in a zero interest rate environment.

You put any normalization out there at all, and the deal would’ve never been underwritten to begin with, or at least to the extent that they were. Evaluations would’ve never gotten as overstretched as where they are today, had we had a 2% floor. It’s just materially different.

Free is free. Borrowing for nothing is borrowing for nothing. You don’t even have to whip out a spreadsheet to do that. You just do it and you, the only thing you’re figuring is, making sure. And the reason we’re seeing such a bloodbath is because 94% of these leveraged loans at the peak, which was last year, by the way, had no covenants.

So even if a company that you’re invested in is going bad, you can’t do anything about it. You’re completely unprotected by covenants. So when these companies go away, they don’t go into restructuring. They liquidate, and that’s what we’re seeing from a zero interest rate era, because when it’s zero, you write the rules.

When it’s two, you still got something to put into your little HP. Okay. I just aged myself like a thousand years.

CLOs, Tranches and Deflation

[00:42:05]Adam Butler:Only to those who understood it though. So I got, so what’s happening to the equity tranche and the triple C tranche of, in the CLO market right now, is there is there no bid in the equity tranche of the CLO market? Where are they, where are those pricing right now?

[00:42:21]Danielle DiMartino Booth: It’s ugly. It’s ugly. It’s really ugly. You’re seeing, triple, quadruple the yields on these puppies. But more to the point who needs them? Who wants them when private credit can come in and do a real job, except you don’t want to be the guy who’s being bought out by private credit. You don’t want 33 cents on the dollar, 36 cents on the dollar, whatever.

[00:42:43]Adam Butler: Yeah. They don’t want any of these to price. But if with the CLO, if the Triple C tranche or the I guess the Triple A tranche is still, priced basically par here, right? Yeah, they’re not able to roll any more deals.

[00:42:56]Danielle DiMartino Booth: The National Life Insurance regulator came out a few months ago and said to life insurance companies, you can’t buy mezzanines anymore.

And B, we don’t really think that AAA is triple A. We don’t give a damn what the credit rating agencies say. So you’ve, part of what’s going on here is you’ve hamstrung an entire buyer class by making life insurance companies step away from these markets. And they don’t need it anymore. They can go put it in a one year Treasury.

[00:43:22]Adam Butler: All this sounds pretty deflationary to me too, though.

[00:43:22]Mike Philbrick: Like, thanks. I just, is inflation even the issue, that’s what you, I guess but then, why the dot plot’s so aggressive, like they know that…

[00:43:34]Danielle DiMartino Booth: The dot plot reflects that he’s got most of the people on board with his mission.

[00:43:38]Mike Philbrick:Right? Except, oh, so that’s messaging.

[00:43:40]Danielle DiMartino Booth: Yeah. Except for … being dated. I see … being dated or the two dots on the very bottom that didn’t want to, that don’t want to change policy. They’re it. And who the hell listens to her? Look what happened in her backyard. It was like Janet Yellen let her inherit her backyard.

Countrywide used to be here. Now it’s Silicon Valley Bank. Don’t pay attention to anything if they’re green. And that’s how you regulate biggest district on the planet.

[00:44:03]Adam Butler: …

[00:44:03]Richard Laterman: But I guess, to Mike’s point, as inflation does come down, doesn’t he start to lose a little bit of the cover? Because even if his true intentions are, he’s aiming at a bigger picture, he is doing so under the cover, under this narrative of flying, fighting inflation and citing Volker’s book or a particular speech so many times. I heard you talking about this the other day. So as core PCE starts to lay by, because we’ve had this bifurcation, right? The manufacturing side of things have already keeled over for some time, but the service sector continues to work through a lot of the fiscal stimulus of the last couple of years.

But presumably that will also start to fade as tightening continues. So I think that the, this cover of inflation for his stated goal or unstated goal is, starts to wane soon.

[00:44:48]Danielle DiMartino Booth: No. Yeah. He, this is a battle against time. It is because it’s almost impossible at this stage. Last night I stepped away from Bloomberg for an hour when I got back, it was BlackRock, Ford, and there were three major companies that announced, that had announced layoffs. Yeah. And there’s nothing more deflationary than, I think Amazon over the weekend announced its fourth big round. So yeah, when you’re talking about aggregate income getting hit by people losing their jobs, that’s deflationary.

And he does not have forever. He doesn’t, but he’s got some really funky things going on. Manheim moves the CPI with a two month lag. Woo-hoo. That’s why you saw used car prices up, even though they’re falling in real time. New York City is an 11% portion of the shelter inflation. That’s the last place on the planet that rents rose aggressively. So that’s going to come through with a lag as well. He’s got some funky aspects to the construct of the CPI that will allow him a little bit more cover. But you’re right, the clock is ticking.

Buying Time

[00:45:47]Adam Butler: So if the subtext of Powell’s policy objective is to, as you put I,t methodically, poised, and the Fed put into its grave is, do you expect Powell to start citing more and more esoteric data points in order to continue to provide cover for his objective and buy him time to suck more and more of the oxygen out of this market?

[00:46:16]Danielle DiMartino Booth: He is already done it once, right? You go on Haver Analytics and try and look up super core inflation. Doesn’t exist. He created that puppy because he drilled down and drilled down until he found one aspect of inflation that does not go negative in recession.

And he is, what’s that? Let’s make up a cute name for it. So he can’t do that too many times. He can’t. That’s why he knew he needed to pause in June, which is why the day that the JOLTS data came out. The job openings data came out hotter than what was expected. He sent his minions out. You immediately had Williams and Waller, his chief lieutenants out, saying no, we’re going to pause, we’re going to pause.

He knew he needed to not hide behind the job openings data that day because he knew that he needed to pause in June. So he’s paying really close attention to each data release.

[00:47:03]Mike Philbrick: What happens in July?

[00:47:04]Danielle DiMartino Booth: Your base effects may help you in July, keep inflation higher than it should be. But you might have one more month of Manheim pressuring the data upwards. But you’re running out of time. The only thing that’s on your side right now is existing renewing leases are higher than they were a year ago. New leases are not, and you’ve got more multifamily supply coming online than you have since the early 1980s.

Messaging, Shelter and Refinancing

[00:47:33]Adam Butler: Yeah, so when he loses cover, there’s a relatively quick shift in messaging, or he’s going to maintain more hawkish messaging. I’m just wondering cuz because the minute the market detects even an inch in the direction of a dovish shift, I think for example, the home market’s going to go ballistic.

Home prices are going to go crazy again, right? Because you’re going to, there’s going to be this anticipation of this whole refinancing wave. Again, all of the homes that were actually bought and built over the next, over the last, 18 months, two years, everyone’s going to be able to refinance those, that are expecting to refinance those at 1%, 2%, like you said, two and a half, 3% lower rates over the next, six to 12 months. What’s that going to do to shelter as a input to inflation.

[00:48:30]Danielle DiMartino Booth: So it’s funny you asked that question. Buddy of mine who’s in mortgage banking, his entire career, a client said, guess where you would need the Fed Funds rate to be to ignite a refinancing wave. I said, I don’t know. Tell me. Because remember it got down to two and half percent, remember? He said you’d need the Fed funds rate to be at negative 1.5%. Now if he holds the line at two, it ain’t happening.

[00:48:53]Adam Butler: So walk me through that. Yeah.

[00:48:56]Richard Laterman: Not clear.

[00:48:57]Adam Butler: Yeah. Do you have any intuition about why that, why it’s so low?

[00:49:00]Danielle DiMartino Booth: Because two-thirds of the mortgages are somewhere in the 3% range. You’ve got to get rates way, you’ve got to go beyond ZIRP. Execute Powell, hang him in a public spot, put his head on a stick in front of the… The stock of

[00:49:16]Richard Laterman: The stock of mortgages are still way too low. Yes, exactly.

[00:49:19]Mike Philbrick: Think of all the refinancing we did at zero. We’re there for a decade. Yes. What about all the year mortgages? The stock of mortgages that is going to be above this rate is extremely low.

[00:49:29]Danielle DiMartino Booth: Two percent is not enough. You can refinance all you want if you’ve got a good, steady job and income.

[00:49:35]Richard Laterman: But a broader question is policy mix. So even if he is pulling out the lever of interest rates at the short end at the Fed fund rate. Presumably he’s still aiming to reduce, to continue on with QT and to remove some of these unorthodox tools from the table. So he’s going to be using the interest rate tool, maybe a little bit more aggressively in order to take away the QE lever and some of the other repo facilities and things along those lines.

[00:50:01]Danielle DiMartino Booth: And you’re watching Yellen steadily, quietly, you’re watching a reverse repo facility slowly empty out. It’d be interesting to see what happens on June 30^th. Quarter end is always a big time for that particular facility. But you’re watching money market funds buy Treasury bills, so you’re, you’re defanging that facility effectively.

The New York Fed put out a projection in April. That said, we anticipate that the balance sheet will be 5 trillion by the end of 2024, and then we’ll pause on QT. Jesus. What if they’re serious? And then it’s at eight, now it’s at eight. And then you actually get prepayments. And what if the Fed just lets those mortgage backed securities roll?

So if Powell survives, this is what you’re talking about. If Powell survives, that’s all you’re talking about. Because if the peanut butter hits the fan and they find a way to fire him for cause, God love Donald Trump, the New York socialist, who he is. He tried to fire him multiple, on multiple occasions and failed.

If they can figure out how to fire Powell for cause and they put a progressive in, in place to run the Fed, and you have central bank digital currency and universal basic income, and everybody’s happy, Danielle’s living in Florence, Italy. So it, but that’s the only way you could really do that. But if he survives, he could let those mortgage backeds roll off as interest rates come down and prepayments eventually go up. If he survives.

Succession and Legacys

[00:51:21]Adam Butler: What’s the longest he stays? Is he on his second mandate already?

[00:51:22]Danielle DiMartino Booth: He’s on his second term and he, and they can renew. Remember Alan Greensman was in office for 19 years. I don’t think, he’s 68 years old. He’s exhausted. And this is an endgame that, we’ve never normalized interest rates not in our careers. So he doesn’t have to hold on for much longer for it to be longer than any of his predecessors.

[00:51:43]Richard Laterman: Who follows in his footsteps? Like how does his legacy, how is his legacy maintained? If this is a direction that the Fed, presumably a portion of the Fed as represented by the plot and some of the other more vocal members. Now, how does this continue on who, who’s next, who’s filling in if he succeeds?

[00:51:57]Danielle DiMartino Booth: I would have to say Waller. That’s my best guess, if he succeeds. But again, you’re talking about, you’re talking about a red wave and the lobbyists who represent private equity in the banks saying, oh, we don’t mind losing that money. We’re good. So you be, now you’re talking about politics and I cannot predict that.

[00:52:16]Adam Butler: Yeah, okay.

[00:52:17]Mike Philbrick: I think that’s a pretty good point. We’ve been here for an hour. I don’t want to, I don’t want to pick up for Danielle’s whole Friday.

[00:52:23]Adam Butler: Yeah. Fair point.

[00:52:24]Mike Philbrick: Is there anything, any final thoughts that you have, Danielle, that we haven’t covered that you want to, we’ll get to where everyone can find you again, because we want to make sure that they can get in touch with any final thoughts that you have, that you didn’t cover or you want to emphasize.

[00:52:36]Danielle DiMartino Booth: So even if we do get to this kind of heart attack moment around Thanksgiving, when student loan repayments actually manifest as something really ugly in the economy, I don’t see fiscal stimulus, fresh fiscal stimulus coming until Q2 of 2025, after the election. So I think people should bear that in mind in their calculus, in terms of riding in with an Elizabeth Warren type of progressive type of policy. Not with this Congress that’s already had, its, it could be a tough couple of years, It could be on the fiscal side it could be a tough couple of years. And I think, yeah. Let’s see.

[00:53:06]Adam Butler: Yeah.

[00:53:07]Mike Philbrick: All right. And on that cheery note,that’s going to create tremendous opportunities for everybody.

[00:53:14]Danielle DiMartino Booth: And obviously, you make money in these environments. Yeah. There’s always somebody who’s got dry powder who comes in and buys this stuff. Yeah.

[00:53:18]Mike Philbrick: And again QI Research on Substack, @boothsubstack.com, on Twitter @DeMartinoBooth.

This is where you can find this lovely lady and all her cohorts and her content and whatnot. I encourage you, top 50 people on FinTwit as well. Absolutely. Get into that knowledge and thank you so much, Danielle, thanks for coming.

[00:53:42]Danielle DiMartino Booth: Great. Appreciate it. This has been, Happy Friday guys. This was enjoyable.

[00:53:46]Richard Laterman: Have to have you back on.

[00:53:47]Mike Philbrick: Yeah, absolutely. Have you back on and we’ll get you out here to Cayman. Let’s get it done.

[00:53:50]Danielle DiMartino Booth:Yes. Let’s, I like beaches. Okay. A great weekend guys.

[00:53:53]Adam Butler: Have a great weekend everybody. Thank you.