Joseph Wang & George Goncalves on Rates, Tariffs, Fed’s Balance Sheet, and Yen Carry Trade
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The ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough. Thank you. Let's close this door. So happy to welcome to Monetary Matters, George Goncalves, head of U.S. macro strategy for MUFG, Securities America, and Joseph Wang, author of Central Banking 101 and publisher at FedGuy.com. Guys, so great to see you. How are we doing?

Doing great. Great to be back on with you guys and look forward to our conversation. Thanks so much for inviting me. It's great to see you again, Jack. Great to see you again, George. Likewise, Joe. I'm going to start with a very open-ended question. How do you see the Federal Reserve's game plan for 2025? Interest rates have fallen. They've done three cuts over two meetings. There are three cuts priced into 2025.

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

I think it's a whole bunch of prayer, actually. The reason is next year, there's going to be a lot of activity on the political front and the Fed just doesn't know what's going to happen. Now, on the one hand, you have things that are pretty stimulative, like tax cuts, right? I think everyone feels pretty comfortable that President Trump is going to extend his tax cuts, the Trump tax cuts, corporate taxes. But on the other hand, you also have a lot of

President Trump put a lot of tariffs on his first term, and he promises to do it in an even bigger fashion this way. And of course, there's also some commentary about potential impacts on migration. So if you're the Fed, you don't really know what to do because you don't really know what the president will actually do. Because oftentimes we say something on the campaign trail and we do something else in office, and you don't know what the economic impact is.

So right now, it seems like they're just in a wait and see approach. So I think the Fed is in a really tough position and they're going to be forced to be very reactive to what happens. So we hope for the best, I guess. George? Look, I think that this Fed, yes, will probably be in a wait and see approach as well. And I think that the animal spirits that have been unleashed post

the election if they carry on, which most likely they will. And if that translates into further economic activity and you have the fiscal sort of support waiting in the wings at some point as these policies get rolled out, it does argue for the Fed to go slower. It doesn't necessarily argue for the Fed to stop easing though. And I think that's the key distinction. And I think

like regardless of the outcome, but more so now they probably have to slow it down. But the Fed is going to need to be a bridge loan to the next administration's policy deployment. I mean, they can't wait. I think they can stagger their easing. They can do things on the margin. And they're going to be reacting to the news flow like everybody else is going to. But I don't think that this should be an environment where they stop because they're still restrictive.

There's other forces at play. And I think rates still have to come down for certain sectors and certain cohorts of the economy. So we're recording this late November. Do you think the Fed is going to cut in the upcoming December? Meaning currently the market thinks it's basically a coin toss. George, what do you think? So look, it is a close call.

Going into this easing cycle, they started off with 50 basis points. We were one of the few houses that had that call. We thought that they should make up for lost time, that they should have cut in July. They didn't do it. And then we had the elections. They cut right after the election. And in their forecast, they have an additional cut still lingering out there as part of their easing cycle.

Southern forecast, but the SEP estimates, the summary of economic projections that were released in September still have another cut out there. And so to kind of like fade

FATA complete to kind of finish the whole package, I think they should cut. I think most likely they will still cut, but we have some key data to kind of get through. We have the PCE, which is coming up soon, and then we have the NFP report. If those are not really off the charts in either direction, I think they should still cut. If it's a really, really strong environment of data and they feel good about pausing, they're going to have a very short window to communicate that. So look, I still think they should cut and deliver on it and not

come across as being political and just wait until next year to start to slow down the easing. So you're on team cuts, another 25 basis point cut in December 2024 that you referenced the summary of economic projections. Yeah. I mean, why have people been betting against the Federal Reserve saying what they're

what the Federal Reserve indicated it's going to do with the dot plot. You mentioned upcoming data, nonfarm payrolls, that's the labor market job data. And then PCE is inflation data. But just has the data been so, so hawkish that, I mean, why are people placing these bets? Well, look, I mean, the Fed speakers recently have been buying optionality by saying that they're not in a rush and that they can observe how the data is coming through. And they've been always data dependent.

I think the market has a tendency to kind of lean towards hawkish side that now that we have new information, new stimuli that the market views Trump's policies inflationary over the medium term, which again, that's debatable, which I'm sure we can get into later. But the market has this perception. It's kind of maybe permeating into Fed thinking as well. And that's influencing how things are being perceived. But look, it's still the jury's out on the inflation front.

And the jobs data was very weak in October. I just don't see how November is going to be a massive bounce back. It was during the survey week. But nonetheless, if it's 200,000 or less, they can still ease in December without coming across as if they're out of touch with reality. If it's like a 300 or 400,000 job sort of number, then OK, fine. Probably all bets are off at that point.

And that's why the market, I think, is in this kind of 50-50. But we have this tendency to believe that data is going to bounce back just because we have the election event behind us. I'm skeptical of that. I think that the trends of weaker economic activity don't just turn on a dime like that. And most likely, we get another weak report, which gives them a chance to cut and then evaluate in early 2025. Joseph, do you think the Federal Reserve is going to cut in December as well?

So I'm going to take the other side of that. I think the Fed probably won't cut. Now, George made some really good points. Now, it is going to come down to the data. As George noted, we could have

NFP data that really surprises to the upside or the downside that could change everything. So I don't think they're cut based on what I'm seeing from the most recent dot plot. So in September, we had a Fed dot plot. And as George noted, that was pricing in one more cut in December. But when I look at the economic projections in that dot plot, it seems like the Fed was really pessimistic. They were penciling in.

Looking at the median FOMC dot, a 4.4% unemployment rate, 2% GDP growth, and a 2.7% core PCE. Now, looking at the data so far over the past couple months, the unemployment rate has actually been fine. It went back down to 4.1. We did have a little bit of a scare there. It looks like, looking at the Atlanta Fed Now GDP, Nowcast, sir, it looks like we're going to have GDP growth comfortably above trend. And looking at the Cleveland Fed,

inflation now casting, it looks like core PC is going to be about 2.8%, 2.9%. And so based on the recent data, the economy has progressed better than the Fed expected in September. And that September forecast was conditional on a cut in December. So I don't think that we need that cut anymore. But again, as we've discussed, we could have

a non-farm payroll that was pricing to the downside that would probably lead to more cuts so and as chirpal and many other fed speakers have been suggesting there's some uncertainty as to what they'll do so right now the market pricing in 50 50 makes sense and i think the data in the coming weeks will lead to hopefully a more of a conclusive outcome

And Joseph, where do you see the data coming in? What is your economic view? As George briefly referenced, the non-farm payroll jobs data for the previous month was horrible. I believe only 12,000 jobs added, which if that is every single month, you're only adding 12,000 jobs. That is basically a recession. However, huge caveat that there was a hurricane and many other idiosyncratic factors that I believe actually bonds sold off on that day, which

which is really incredible to think of. So clearly the market thinks that was just a one-off and the labor market is still strong. What do you think, Joseph? So Georgia has been spot on on the weakening trend, but I think part of the weakening trend it has been doing is due to apprehension due to the election. Now, if you're a business, you're looking at the November election and you notice that Vice President Harris and President Trump had very, very different visions of

of the world. At the very least, there are differences in tax rates, but also differences in what industries the government was subsidized. So looking at business surveys, it seemed like businesses were very apprehensive and waiting to see what would happen before making any decisions on hiring or investment. And now that uncertainty has passed, I think that we'll find that some of the slower economic activity in the past few months was due to that apprehension. So I would expect some degree of

of increasing economic activity, if not simply due to animal spirits. But I think looking beyond that, looking beyond this brief month, though, I'm more downbeat about economic activity next year.

George, what's your economic view? And do you find looking at previous historical instances that before an election, people are apprehensive and spending and investment kinds to stall out and then after the election, it tends to increase again or not? Look, it does to a certain extent, but I am a bond strategist and a rate strategist by training. And I do think rates matter. They just have been mattering in different

capacities over the last couple of years. I mean, I'm not sure if it's okay to kind of pull up one chart to kind of make the point. Absolutely. You're kind of speaking to some of the ideas that you just heard from Joe. And this is, the jury's going to be out to see if this was truly the case that businesses were holding back because of the very, up until the point of knowing for sure who had won, it was a pretty contentious election.

And if you look at page 10, this is looking at on one side, the NFIB Small Business Optimism Index, the red line.

The black line is the prime rate, but adjusted for inflation to kind of really get the true sense of the rate costs for businesses. And as you can see, there's a decent correlation between rates and small business optimism. And the correlation should be more like when rates are going down, it's typically only because the economy is decelerating and the Fed is cutting to try to

create some stimulus. And that's usually at a time where you see the optimism heading lower. Then when optimism is improving, rates can go up and the Fed starts to kind of adjust policy as the economy can handle it. And that's a vote of confidence. When rates go up and the economy is strong and optimism is high, that's the best environment. That's what most businesses are okay with as long as they can service their debt.

The tricky part is if you look at what happened in 2016, 2017, in Trump's first election, first term, big spike in optimism. So we're going to really watch this small business optimism data in the coming months during the lame duck session, as well as into the second term and into the next presidency. But also look at that black line. That's the

the real cost of rates for these small businesses, it's pretty high. It's the highest it's been since really pre-financial crisis. And I still argue that the high rates are biting into consumers and that even animal spirits can get you a long way, but the ability to cash flow, the ability to actually service your debt, if rates are this high and disproportionately

Really penalizing the small businesses more so than large companies, which are really borrowing basically at Fed funds because rates are so low out the curve and spreads and corporate bonds are so tight that the small businesses are the ones that have been really feeling the pinch here.

from high rates and a change in administration won't fix that right away. So I do think that rates matter and that we'll see where this takes us. But most likely that black line has to come down, which means the Fed has to still cut rates regardless of who is in office. Wait, I'm sorry, George. Does this chart, and for our listeners who are not on YouTube, but on Apple Pocket, Spotify, we've got to look out for them as well. Is this chart showing a positive or a negative correlation between small business optimism and

the inflation adjusted real rate? There's a relatively decent kind of correlation and a lead lag relationship up until basically 2020, 2021. And then they broke down once we had those really large

Fed hikes and we were combating inflation in general, small business optimism has declined and it has stayed low for the last two or three years, even though rates have risen, which would suggest we have a really vibrant, strong economy that can handle these high rates. And so that's the disconnect. There's been a correlation breakdown over the last two or three years. And I argue it's not just a function of politics, but it's a function of

The high rates are disproportionately really holding back small businesses now at a time more so than ever. And we'll see. We'll see if this optimism changes in the coming months. And so normally when interest rates are high, you'd think that'd be bad for small business. But the reason it's high is because the economy is doing so well. So normally there has been a positive correlation, which is somewhat paradoxical. And now you're saying that the correlation is broke down.

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

Yeah. And one talking point that I've heard many people say over the years, and I've said it myself, is that short term interest rates don't really matter. What matters is the 10 year because that's where all the long term.

That's where all the capital markets is pricing. I feel like long-term rates that matters for the investment grade bond market. So Apple and Amazon who are always going to be able to need money and they don't really need money. And then mortgage rates, which right now, like mortgage credit has been restrictive. Like if you get famously, I saw actually

Ben Bernanke 10 years ago in 2013, 2014, he got rejected. Chairman of the Federal Reserve got rejected for a mortgage thing. Mortgage is not a credit instrument right now on the margin. Obviously, that could change. But I feel like so much of the leverage activity is in the short term. It's bank lending, and then it's SOFR plus 2%, SOFR plus 3%. So I don't know. Do you guys think that's... I think it's kind of BS when people say the short-term rate doesn't matter.

What do you think, Josh? I think, Jack, you're exactly right. I mean, the way the financial system works is that, well, different people borrow at different rates. If you're a large corporation like Apple or something like that, you could float a bond. And sometimes the market gets really excited, prices in a whole bunch of cuts. So the 10-year yield is really low. And looking at credit spreads, they're also very narrow. And so if you're a big company, you can actually still borrow at relatively low rates.

But as George has been discussing, and you noted as well, if you are a small to medium business, most of your financing comes from commercial banks. And it would be so for plus something. So they would be directly impacted by where short rates are. So this rate hike cycle has disproportionately impacted small to medium sized businesses. And that's going to have a negative impact on their economic activity.

Look at these small to mid-sized enterprises, which we call SME. That chart on the right, the red line is just kind of the average rate that these small businesses are claiming they're borrowing at, which is close to 10%. That's the red line. The black line is the IG, so the investment grade in large U.S. corporate America, where in general, corporates are borrowing at somewhere at 5.5%, 6%.

And that spread has really diverged in the last two plus years. And that divergence, it really kicked off after the regional banks got into trouble. So really, the marginal lending into the US has not been coming from the banks. It's been coming from the capital markets and or private credit. But for the small businesses, which really still get a lot of their working capital from the banking system,

That divergence really started to break down in March of 2023, which was the advent of the regional bank crisis. And we've kind of gone into this period of very little lending availability and or very expensive lending to the small businesses. And so I've been arguing that the rates channel does work. The interest rate

Short rate channel is working, probably working a little bit too much for these cohorts, like small businesses and the lower income and middle income households are really feeling it more so than ever. They have auto loans that are indexed. They have credit cards that are super high. So yeah, so rates do matter. They're just mattering to different groups within the economy.

And so, George, when you say the interest rate channel is working a little bit too much, what you really mean is that there's a large percentage of the American population and a large percentage of a small business in the U.S. who are being strangled by high interest rates. Strangled is a little bit of a dramatic word, but that it's.

interest rates are too restrictive and maybe if they stay this restrictive, there could be a slowdown and a potential recession. And also you have to adjust all this by inflation. And so as inflation has been going down in real terms, these rates have been going up even more, even as the nominal rate goes down. So George, I guess make the case for why you think the Fed funds, you think it's going to 3%, which is more than the market believes right now, as well as what's your view on recession?

So, look, I've been on the high side in terms of recession risk, but I took it down a little bit. The Fed is going to be, as I said, a bridge loan to the next administration. Depending on how fast the Trump administration rolls out policies, how effective the sequencing of these different policies, there are some unintended consequences that could happen. And Joe mentioned a few of them, which I'm sure we'll get into. And all these things are happening at a time where

We've been very fortunate that government spending has been offering, been propping up in many ways, certain parts of the economy and really running the economy hot. We've been running at over 2% GDP with a lot of government spending. If the idea is that we're going to become more efficient and we're going to retool the government and we're going to shift that around, yeah, you can have a lapse in activity. I mean, and that can really seriously run the risk of us dropping into a recession and

out of, out of nowhere. Right. So I, there is that risk. And then there is the, because we've been kind of

This growth has been masking the reality of the pressure that's been placed on these lower income and middle income households, as well as small businesses. The long and variable lags of the Fed tightening might all hit at once. And that big, long and variable lags of hitting in early 2025 as the Fed stays higher for longer because they're trying to figure out how these fiscal policies get implemented. The real unfortunate thing

Situation would be that it would be at the worst timing and really then maybe expose the weaknesses of some of these borrowers. Joseph, what's your economic outlook for 2025?

So I think a lot of it is going to depend on the actions from the government. So this is my read on how President Trump would approach his second term. So what I've noticed about President Trump is that he really, really believes in tariffs as a tool and the importance in reordering the global economic system.

And he's assembled a team that is pretty determined to do so. This is something that's so, again, politicians say many things, but this is something that President Trump has been saying for a long, long time. And so I think he really believes in it. And we saw that he tried to do so during his first term. Now, this is his second term. So he doesn't have to run for election. And midterm elections aren't for another two years. So he has two years to basically run.

do what it takes to reorder the world to the way that he thinks would work best. And I think that's going to be very disruptive. So I think he's going to hit the ground running. He's going to announce a lot of tariffs. He's going to go big. And so he's going to use all the tools at his disposal. And now I think that maybe the changes in economic system would in the medium term end up to benefit the

the American middle class, but change is always very difficult. And I think we could see a lot of volatility that could dampen a business sentiment. So next year, on the one hand, I think it's, I feel pretty confident that we'll get the extension of tax cuts, maybe more tax cuts, but that will, I think, partially buffer the disruption we'll see both in geopolitics and international trade. So I'm thinking that next year,

probably won't be as good as this year, but it will.

But it really just depends on both how President Trump acts and also how the other countries react to all this negotiation. But I think that's a pretty big headwind to economic activity next year. But on the bright side, I'm guessing the Fed will respond to this in a more dovish fashion. And so maybe the small, medium enterprises that we've been talking about get a bit more reprieve on their interest rate expense. President-elect Trump, needless to say, has...

said some very aggressive rhetoric about tariffs. I'm going to put tariffs extremely high. There are political analysts who say that he's just going to use that as a threat. He wants to reach an accommodative deal so that China is going to build all the plants in America instead of China. All the companies are going to do on this reshoring. It sounds like you actually...

think, no, the tariffs will be quite high. And it could be a negotiating tool, but really, the tariffs are going to be there. How do you interpret the effects of tariff? My very shallow understanding is it stimulates internal

production, but it disincentivizes and punishes internal consumption. So when people think about tariffs, I think on one hand, a lot of times we hear that it's inflationary and it could also dampen economic activity. I don't think of tariffs as being really inflationary. The reason is that so when you have a tariff and it's paid by the importers,

So, what could actually happen is there's a number of moving parts that can actually mitigate the increases in prices. For example, let's say that the US is living tariffs on China. Well, what happens is that the US currency strengthens as we've been seeing over the past few weeks.

And that strengthening currency could mitigate some of the price increases. So the Chinese exporter could potentially lower their prices in dollars. But at the end of the day, even though they're receiving fewer dollars, the dollar has appreciated. So their income in local currency terms is unchanged. So that's one potential buffering channel. So to be clear, that did not happen in 2018, the last time we had a tariff war. But that could happen in other circumstances. Another possibility is

when it comes to tariffs increasing prices is that the importing business, so let's say the US retailer, just kind of eats it in terms of narrow margins rather than passing it out to the consumer in terms of higher consumer prices. And that's actually what happened in 2018. So in 2018, we had tariffs and the importing businesses just ate that. So we didn't actually see too much consumer inflation. But more importantly, though, even if we did have consumer price inflation from this tariff war,

It'd be a one-time thing. It'd be transitory. So it'd be an increase in the price level rather than the rate of change. So it wouldn't actually prompt a monetary policy response when it comes to potential inflation impacts. However, what we also know is that it could dampen business confidences. And the last time in 2018, the trade war led to retaliation where

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

I think that the impact, if we do have a big tariff war, would be to have a more easier monetary policy. Again, there is a scenario where we just say big tariffs, everyone kind of rolls over and just plays nice. We already hear noises from the European Union suggesting that maybe they can buy a lot more U.S. gas.

But I think other countries probably don't want to roll over, at least not right away. They want to negotiate as well. So they have to put up at least some kind of resistance. So I think that would actually end up, at least briefly, that we would see tariffs on goods.

So you don't think that tariffs are inflationary because there's a potential for the dollar to strengthen and therefore goods in, they may be goods in yen and yuan, Chinese yuan might go up, but in dollars, they wouldn't go up. That's interesting. What is the effect, sorry, of tariffs on Chinese?

the internal production is basically a lot of people who are pro-tariff argue that if you put a tariff on China, you're going to incentivize production in the US and all the factories and manufacturing plants are going to be built in the US, which would be stimulative. What do you think, Joseph? So that is possible. So if you think back,

to the 1980s in japan for example major major exports to the us a lot of people here in washington were very unhappy with that and now fast forward to today japanese automakers have a bunch of auto auto auto manufacturers in the us so they're building a lot of cars in the us now my read

on President Trump is he's not so much ideologically opposed to China, but he'd be willing to cut a deal if, for example, BYD, instead of just preventing them from selling cars to the US, if they were to build factories in the US, he would be okay with that. So there is that outcome where we could have a lot of Chinese companies moving onshore into the US, building factories and selling cars like the Koreans do, like the Japanese do. That's definitely a potential outcome

So that would be very positive, but it also would be something that happens in the medium term. It takes time to build a factory and so forth. What could be more immediate is simply for other countries to buy more goods and services from the US to try to lessen the trade deficit. I think in 2018, from Chinese perspective, that was purchasing more US commodities. For other countries, it could be purchasing more US military equipment. For example, South Korea,

And the U.S. has many bases there. They have a trade surplus with the U.S., so maybe they could just buy more U.S. missiles and try to defend themselves. And then you write on FedGuy.com a piece called The Great Redistribution that President Trump's desire to balance trade is functionally an effort to balance the distribution of profits between corporations and labor, so its success would be a market negative event. So it would be bad for the stock market. Explain your thinking there.

So, again, when we look at the trade, let's say the huge trade deficit the U.S. has, so let's say China is selling a lot more goods and services to the U.S. than it's buying from the U.S., we think of it, it's often painted as the Chinese are winning, they're earning a whole bunch of money from the U.S. and so forth. And there is truth to that. But if you look

a bit more into the details, you'll notice that a lot of times it's a US company, say Apple, for example, building factories in China and then selling goods from China to the US.

So the people who benefit from that trade surplus, the Chinese trade surplus, part of it is the Chinese workers, but a lot of it actually just goes to U.S. companies. It's part of the globalization effort by large U.S. companies to reduce labor costs. So if we were to make that trade deficit go away, I think the losers of that would be, of course, Chinese workers and other foreign workers. But a lot of a big part of the losses would be

the profit margins of multinational U.S. companies who are, of course, featured prominently in our big stock market indexes. And so if we do have this great reordering, at the end of the day, it's more income for U.S. laborers, obviously jobs onshore, and that suggests through higher labor costs, narrower margins for big U.S. companies. And narrow margins usually means lower stock prices.

Again, this would be good, I think, for the American middle class, but may not be good for stock prices of these large multinationals. That's very interesting. George, what are your thoughts on this? Look, I think Joe is spot on here on a number of fronts. I think, Joe, you are of the view that reshoring is hard, rebalancing trade if it's really just...

a function between labor and capital and this idea that a lot of the jobs in the US were exported overseas by US companies, right? Not just foreign companies that are wanting access to the US marketplace and the US economy. And also in comparison to what we got during Trump's first administration, the

like repatriating dollars was easier because that's like a financial concept. It's a lot easier to kind of encourage money to come and capital to come back home to the US, but to actually to encourage production and shifting that over, it probably does require some tougher tariffs, which to Joe's point at the start of all this could be very disruptive. And so the question is, are tariffs going to be just a negotiation tool?

What kind of tariffs do we get? How are they implemented? Is it just, as kind of Joe alluded to, if there are a series of executive orders that get kicked off at the start and they become effective immediately, then we have, I think it's going to really start to take an impact and this kind of more sanguine process.

outlook that the markets have right now, which is that this is a business-friendly administration that's coming in. It's going to be deregulation. It's going to be a stronger economy, so on and so forth. If in order to get to that place, which I think

If Trump wants to make, President-elect Trump wants to make these more drastic shifts that were part of the campaign promise to really help out US households, then there might be some pain initially as you retool the economy, right? And so I think Joe brings up some really good points. And the question is, can you do it in a two-year window? Even though the midterms are two years away, ostensibly, you really start to campaign for them

early in 2026. And in 2026, we have the US's 250th anniversary, which is

It's something that many folks on the Trump side are looking forward to that 250th anniversary, including ourselves, anyone here in the US. But just in general, the window seems like it's long, but it's not. And these are medium-term initiatives that take time to implement. And so, look, I'm of the view that the tariffs will come in different degrees, different

I'm not going to repeat everything that Joe just went through, but if the tariffs are spot starting, if we're going to talk like in trading terms, if the tariffs are going to start right at the start of the next administration, those are much more disruptive if they are kind of like,

conditional tariffs that are based on some sort of criteria being met over the next two or three or four years, and they can be phased in, those are less disruptive and will be much more of a powerful negotiating tactic. I would hope and I would think that's how they're going to go about it. But if there needs to be maybe a tougher love initially to kind of send the message that, hey, we mean business on tariffs, and they do come out with a kind of spot starting strategy

implementation at the start, then yeah, markets are in the wrong zip code. We're going to need a lot of trade talks are going well tweets to make sure the market is happy. Joseph, you referenced earlier, you thought that tariffs would be dovish. So why do you think tariffs would cause the Federal Reserve to cut interest rates? Or if there is potential inflation to look through the price increases as transitory? That's a

exact quote from your piece. In my understanding, the Federal Reserve just made a huge mistake in 2022 and 2021 of looking through an inflation and calling it transitory. So in my view, perhaps they would be more reticent to look at CPI inflation goes to 8%. Is J-PAL really going to say that's transitory again? Why do you think tariffs are dovish?

So tariffs have that impact on inflation, but they also have a negative impact on economic activity. Now, if you are a standard central banker, your ideology is that these one-time increases into the price level, well, that's transitory, right? So you want to look through transitory factors because maybe as soon as you react to them, the inflation is over. Now, tariffs, again, are a one-time price increase.

increase in the price level rather than an increase in the rate of change. And so according to standard central banking ideology, you would just look through that. Now, Jackie raised a really good point, but they were really wrong earlier. Now, central banking ideology is you look through this, provided that inflation expectations are stable, because if you look through too many things, then inflation expectations get unanchored. And then you're in

you're in a lot of trouble. Now, so far, the Fed has insisted that inflation expectations are anchored. And if they continue to believe that, it seems like they should look through these one-time increases in the price level. Now, on the other hand, now, if you look at 2018, when we had our first trade war, there is a recently declassified memo from the Fed

researching the economic impact on tariffs. Now, this suggests that the Fed was concerned. What is all this trade uncertainty going to do? Now, the memo suggests that there was tremendous policy uncertainty when it comes to tariffs. They didn't see it actually impacting business investments, but they were really worried that if this were to go on, we could have a dampening in business investment and that could hurt economic activity, which of course would push up the unemployment rate. So,

Given that the Fed would look through inflation impacts and that there's an increased risk to lower business investments, which could raise unemployment. It seems like the right policy response to this is to have more cuts than expected if we were to have another trade war. So I think that, again, these launch of new tariffs would push the Fed towards more rate cuts than the market is currently pricing.

And so, Joseph, what's your view on the stock market? The last time we said you were quite cautious on the market because there was some election uncertainty. But I would have thought that if Trump got elected, which he did, that you would turn less bearish and more bullish. What's going on? Oh, yes. So.

Right before the election, I wrote a piece to my reader suggesting that there was actually notable right tail risk. If you just looked at the election map, the election math, it was actually a very, very high likelihood that there would be a red sweep, which is actually what happened. And red sweep, obviously, the market would be very market positive and the market has reacted positively. Now, looking at market sentiment right now, it seems very, very bad.

ebullient, really. So I'm thinking that we are probably maybe hitting up to some sort of a blow off top, because as I've been discussing, I think that the onset of the Trump presidency will be pretty rocky for markets. So at the moment, as we head into this seasonally positive December Santa Rally area, given the positive sentiment that things should continue to do well, but it does seem like

potentially some sort of blow off top as we head into a lot more trade policy uncertainty in the first quarter of next year. And so that's your view on stocks. What about bonds? The 10-year note is at now 4.3%. Is that fair value to you? What do you say, Joseph and then George?

So, as I suggested, I think that the market is being too hawkish, that we will get more cuts than the market is pricing in. And so I think that the 10-year is going to head lower next year as we have a lot more volatility in the markets and a lot more uncertainty on the trade policy front. I think this is a big deal that the market doesn't seem to be pricing in. Again, the market seems to be focusing on tax cuts and the very positive sentiment, deregulation and so forth. And that's all valid, but

we have to place some weight on the other stuff as well. - George, what's your view on bonds? And let's use some of several of your great charts. - Yeah, let's go to page 46, if you don't mind flipping there. On this page, in this chart here on 46, just for your readers and listeners, this is the Fed funds rate, the black line. And us strategists, we love to do these, what we call these hairline or super imposing yield curves.

on where the market was pricing rates would be in the future from a certain starting point. And so all those little like red dotted lines are different yield curves over like over time since the 1990s. And many of us have used this kind of these kind of charts in the past.

And you can see that the market usually either is too optimistic or too pessimistic. It's rare that we kind of meet a perfectly priced market based on what the Fed delivers. Yield curve. The current yield curve is on the right side and you see a solid blue, which is the November 22nd when I re-snapped the curve. It's basically, it's an inverted curve because the market is pricing in rate cuts, although they've been taken out.

And then if you look at where it's kind of settled in at, we're back to the same shape of a yield curve for the money market. So for curves back what it was September of 2023, when we had the 10 year close to 5%, the Fed back then was concerned about financial conditions tightening. And in fact, we still have a lot more financial conditions easing since then. Credit spreads are much tighter. Equities have made new highs.

And now we have a curve that is implying that the Fed's going to have a shallower path, similar to like what we had in 2023. I think that that's that in and of itself is an important kind of message from the market that that's the no landing soft landing crowd now pricing into perfection that the Fed's going to be able to only cut two or three more times. And that is going to be enough to avoid any sort of kind of economic weakness that

And now, in many ways, the no-landers and soft-landers keep getting bailed out by new information. And the new information now is that we're going to get fiscal policy, which is going to keep this economy in recovery going for longer. I think that's all fine and good in the medium term. But as we're looking at rates...

I do think that the Fed has to cut more to offset any potential weakness that may develop, but also the fact that the higher for longer has been hurting those different areas of the economy. And so I do think that this is probably mispriced by at least 50 basis points. And so the tricky part is going to be that the 10-year period

Probably should trade in a range of like 425, 475 maximum. We didn't break above 450, even with all of the excitement around the election. If you go back a few slides back, actually back to page 45, the slide before, you'll

You can see that the majority of the chart on the right here now is a chart of the 10-year versus predictions markets odds of a red sweep, prediction websites odds of a red sweep.

And you can see that really starting in late September, early October, that the bond market priced in and took the Trump 1.0 playbook from 2016 and basically said, well, the odds are improving. Most likely that means higher rates. And most of the adjustment took place in the belly to intermediate long term rates. So five year, seven year, 10 year rates rose a lot more.

The curve steepened. But even with that, we barely got to we didn't get to 4.5. We barely I think we barely got there and we couldn't hold 4.5. So the market is has priced in a lot of the sort of kind of the Trump trade 1.0.

And if we get economic weakness as the economy retools and the Fed cuts, we don't have to go above 4.5, by the way, right? We did top tick rates in the Q4 of 2023. So it's quite possible that we can top tick rates also during this time period as well and that we actually end up rallying from here going forward. But I think that much more defined range of like 4.25, 4.75 for now is

economic weakness, you could easily go under 4%. And really, the real focus will be the two-year more so than the 10-year at that point. Okay. So currently, the 10-year is at 4.3%. You talked about in the short term, a range of 4.25% to 4.75%. So we're at the lower end of the range, which means in the short term, you are neutral to bearish on the 10-year. That surprised me. So you must be in the camp of a massive steepening, right? So look, I mean, I do think that

Once fiscal policy gets ironed out and if it is both stimulative as well as results in more treasury supply or even just a shifting of the composition of treasury supply, let's not forget that a lot of the debt was issued in the front end. There's a lot of debt that's coming due next year. If we have a kind of...

a shift by the new treasury secretary, which is also kind of flagged, or if he gets confirmed, Scott Besant has also been of the view that there's a need to kind of term out the debt, that that could hold up tenure rates more so than any other time period. So 425, 475 is really a reflection of that view that we're in the lame duck session. We're heading into a new administration that's going to be more

focused potentially on longer term debt than short term debt. And that should keep the rates curve higher. If the economy does weaken and we can very clearly go into 425. So that's not a stopping point. But for the moments where we are right now, I think we've priced in a lot of euphoria and we probably should trade in that range. And George, I just love this chart that you have. I forget what you call it. I think of these things as tiny little like angel hair pasta, but it's red little

Red curves are where back in time from 1992 to now, where back then the market thought the Fed would do. So in 2009, the market thought that by 2013, interest rates would be at 4%. Of course, by 2013, they were still at 0%. So it just goes to show how often the market is wrong. And then the blue dot versus red dot doesn't really matter. That's just so for versus your dollar. So very similar things. And I also just want to clarify earlier, you said that the curve is inverted. The very short-term interest rate curve

zero to two years is inverted because the market is pricing in cuts. But the vast majority of the curve is actually now upward sloping, which is normal in 2022 that the normal 210 curve, 230 curve, whatever, inverted, meaning two-year yield was higher than the 10-year yield. Now the 10-year is higher than the two-year yield. And it sounds like, George, because you're bullish on the two-year and not terribly bullish on the 10-year, at least in the short term, that you believe in a massive

You're definitely in the camp that the 2.10 spread, which has gone exited inversion and is now at four basis points, is going to widen significantly. Why do you think that is? And also perhaps just explain for our audience, why do people care about the 2.10 spread? And why do folks such as yourself as well and interest rate traders, why do they often trade the spread instead of just trading the absolute up or down? Sure. Let's look at the next slide then, page 47.

And so this is a really long historical account of curves. And you can see there's like a kind of two different regimes. I split up the world before 1990 and after 1990. And it looks like we're going back to the pre-1990s world where rate levels are higher or else equal. I don't think we're going to go back to zero bound unless something really bad happens. So we're going to have a higher rate environment.

Flatter curves all else equal, but still the potential for curves to steepen from this point forward and generally higher volatility as both policies are changing real time. We have a lot of kind of new things developing there.

So we're in a more uncertain world. So your curve and rate vol should be higher. And that's what this chart shows you. So the bottom part is just showing you realize vol was very high from the 1960s until like basically the late 80s. And then it kind of stabilized and you only had a rise in vol when you had like some sort of existential event like

COVID or 2008 or the dot-com crash, right? And curves would go anywhere from like negative 20 or basically zero up to 200, 250 basis points. And that was really a function of

the Fed cutting rates, three, four or 500 basis points, the short term rate would just move a lot faster than the long term rate. And that would then result in that curve spread widening or the curve becoming steeper looking as you can see from this chart. Like that, I think it's going to be hard to get back to the 1990 to 2020 world. I mean, it's not impossible. But I think that

The curve could get up to 75 to 100 basis points. So we're starting basically at four or five basis points of a curve slope right now. So that's still a decent amount of curve steepening. And it matters for a number of reasons. One, if long-term rates are higher than short-term rates, that's an economy and a market that expects future prosperity and that growth will persist and that the forwards look better than the current environment. Negative curves, inverted curves are not...

a good reflection on where the economy is heading. So a positive curve, it gives you that kind of attribute. But more closer to home and what it means for the banking system, especially for a banking system that has not really been lending because the curve has been inverted, their funding costs are a lot higher than where they're able to lend out the curve.

And so they're basically borrowing short and then lending long. The lower that government rates are, even if there's a spread associated with the loan, you're not really picking up a lot of yield to lend into the economy. So a steeper curve usually gets the banks engaged and allows and that creates more leverage.

Credit formation for the economy. There's other forms of credit transformation that's been happening while we've been waiting for this. But nonetheless, getting the banks engaged, I think, probably is part of some of the initiatives that we might hear from the incoming administration, especially if they're focused on deregulation. They would most likely want the banks to be more involved in the real economy. And having a steeper curve would really help with that.

And so the curve inverted in the spring of 2022, we are 30 months after that, and we're still not in a recession, probably. Who knows, but probably not. What has the inverted yield curve hypothesis that an inverted yield curve is a predictor and perhaps a causer of a recession? And by the way, that does have a good track record. Has that been disproven? Is this a sample size of the inverted yield curve was wrong? Joseph, you first, then George.

Well, looks like it's been wrong. I agree with you, Jack. I really like George's first chart as well, because it shows, as you've discussed many times on your show, that the bond market is wrong a lot. Right. So and more importantly, I think there are things that happen in the real economy and in the financial economy that make that past relationships less predictive of future relationships.

future events. I mean, we have so many things happening right now, tremendous fiscal deficits. We have changes in the regulatory structure of the banking sector. So I would be very hesitant to draw conclusions from these inverted yield curves. It's been 30 months, as you said. So maybe the curve is wrong. George?

Or maybe we kind of touched on it and we're kind of dancing around it before at the start that there isn't a one size fits all interest rates for every single American and or companies and that maybe some industries have been actually feeling recessionary pressures and some

Some groups within the US have been feeling what feels like a recession, even though on aggregate, the economy has been doing well. So I think it's too early. The jury's still out. So I'm not going to say that the yield curve got this wrong yet. I think we have some time and data gets revised a lot. I mean, and lately data has been revised so often. And

And look, a lot of these sort of historical analogs and studies that we do, especially as strategists and investors, we're trying to fit the past to predict the future, which of course is a very difficult thing to do. And sometimes they take a life of their own, right? And so in many ways,

What we've been, I guess, been fortunate throughout this two or three years because of the excess liquidity, it's been just kind of sitting in the system. It's allowed us to kind of test all of these null hypotheses. Like we've been able to like basically every single possible hypothetical scenario, we've tested it and it hasn't broken the economy or the markets. And it's really been because we've been floating in a sea of liquidity that rate levels didn't really matter as much or the inversion of the curve didn't really matter.

really expose any weakness, but doesn't mean it wasn't there. It was just being really masked over by the government spending and also the additional liquidity that was pumped in right after COVID. And all that stuff has basically run its course. And that's why I feel like now is like the more sensitive time where these long and variable lags can really start to really show up if the Fed were to take a wait and see approach on fiscal policy. I think that would really be a potential policy mistake.

And maybe the inverted curve and the high rates did slow economic activity, but they slowed growth from 12% nominal growth to 5% nominal growth. And 5% nominal growth is not a recession. It's still a good economy. George, so are you of the view that if interest rates stay where they are, 475, maybe one or two cuts above 4%, above 425 basis points, let's say, that that will continue to slow down the economy and ultimately lead to a recession that

That 3% is necessary. Sufficient cuts of cutting the Fed fund rate from where it is, 475 to 3% is necessary to avoid a slowdown. I do. And if you can flip backwards now to page 29, because there is one thing that sometimes we are...

too smart for our own good or we attribute our success to our recent actions. And in reality, we either just got lucky or again, there's that pool of liquidity that's been out there. But what I'm showing you here on page 29 is a very simple chart, but there's two things just for those that are listening.

Top panel, there's the Fed funds rate, which is a black line. And then the red line is an interest rate of the Fed's kind of R-star from their model, the Williams-Lombok model, and the plus inflation to kind of bring it back to nominal terms. It's kind of like a nominal GDP versus Fed rate kind of

analysis and the bottom part is the spread between that red line the black line to try to see how long does the Fed stay restrictive and as you can see from the 1980s the Fed is typically always in an ease like has more of an easing they're inherently more dovish and that that's been really helping out the economy maintain its strength and growth over decades this they they only really had

really nailed the rate levels in 95 to 99 when neutral was rates were basically 5%, roughly five and a half, five and a quarter. That was the kind of the right speed limit for the economy. But outside of that, it's rare for the Fed to have rates meaningfully above either inflation and or above like this kind of R star proxy rate.

And I think that we just got lucky that nothing has happened yet, but that doesn't mean it won't in the future. And if you go to the next page, I try to take that analysis and compare like the spread differential, which is the top part of how restrictive was the Fed at its peak during each of these hiking cycles? And then at the bottom panels, like how long did rates stay restrictive above this kind of proxy R star?

The way the market's pricing and the Fed's, even the Fed's own current forecasts, which will most likely get updated in December, but nonetheless, the black bars measure the time of rates were restrictive. The 1990s, we had roughly like 26 or so months from what I could tell. And

And currently we had the Fed above some sort of neutral for about 15 months, even though they cut 75 basis points. They're still higher than what we consider to be neutral. And the Fed's own forecast suggests it's going to take them 17 months to get to neutral. And the market doesn't even have them getting to neutral because we have now roughly 3.75 as the resting place for interest rates priced into the SOFR curve. And I think that the neutral is still closer to 3%.

So the longer they drag this out, the longer they keep rates above neutral, I think now it will start to expose the fragilities that are out there in the economy at a time where we'll see how the next administration rolls out its various fiscal policies and tariffs.

There's a lot of balls up in the air. I just went through a lot of assumptions. And this idea that we're going to soft land this thing without the Fed actually easing further, I think that's going to be hard to do.

Those are some phenomenal charts. So just going back, the red line is r* plus CPI. So r* is the neutral real rate of interest plus actual inflation. So it's basically r* plus CPI is the level at which interest rates would be where they are neither stimulating the economy nor restricting the economy. So right now,

current interest rates are higher than that level, meaning that they are restrictive, which is quite rare. And then your second chart just shows, number one, they're 139 basis point of a spread. So that's a pretty big spread compared to history. And it stayed that way for 15 months. And typically, it only stays there for 17 months. But what is this? Sorry, this dotted line

dotted bar line on the right of 2023 to current. So 15 months where that spread's been positive. And now how do you get to- That shaded 17 months is what's currently projected in the SEP forecast as of September. But they think they're going to get down to roughly 3% sometime deep in 2026, at the end of 2026. So you have a full 2025 and a full 2026 that they're going to only cut

or three or four times per year to get down towards low 3%. And that's, that's, they're going to be able to achieve that without having to accelerate the cuts. And that by doing, and in doing so, they're not going to, we're not going to see any economic weakness. We're not going to see a recession that we're just going to glide path over the next, basically 18 months, 17, 18 months into 2026 and get towards their version of neutral, which maybe has changed. We don't know, but,

But I still think they believe it's 3% or less. And it's going to take another nearly a year and a half further to get there. And that would be the longest time ever. We have never done that. In 94, 98, it was 26 months. This would be basically 32 months above neutral.

Wow. And so George, you sound quite confident and perhaps you're not wildly bullish on being the two-year because of course you have to use leverage and interest rates right now are high, but maybe, I mean, what kind of trades would form this view? Like buying calls on the two-year or selling puts on the two-year, basically betting that interest rates are going to decline.

It sounds like you're pretty bullish on the two-year. Look, in general, I am. But the problem is, as we all know, and this is the issue, it's timing is everything. And we're in this sort of, again, during the lame duck session, and we don't know the fiscal policies and how they're going to be rolled out. And the market's just taking a wait-and-see approach too. So-

I think that it's going to come down to the data. And if the animal spirits are not able to rekindle activity, and if we're still seeing a fed that's kind of dragging their feet to cut, if they start to cut slower and we get the negative

unintended consequences of some of these policies from the fiscal side that we can see the economy decelerate further in the first half of 2025. And therefore, the market will sort of feel that out. But look, it's not going to be, we're now in a much more difficult environment because it feels like the market doesn't believe rates can stay under 4%.

And until that changes, it's hard to put on that trade. And I think that it's better to be mindful of the implementation risks, the unintended consequences. And then if you believe that the U.S. economy is decelerating and won't be able to benefit from these policies right away, even if they end up being

Great for the medium term. In the short run, we can still see deceleration or further deceleration in the US. Then the two-year will catch a bid. But at this point, it's a little more tricky.

And Joseph, just yes or no, you also are quite bullish on the two-year, right? Yes. Yes. I think the Fed will cut more than the market expects. Got it. Thank you. So it's interesting that both of you are kind of in alignment on this issue. And Joseph, also on my previous show, Forward Guidance, earlier in the year, you had a great call that stocks would crush bonds. Not only did it make a great headline and great copy, but it also happened to be right, which we value here on now Monetary Matters.

Sounds like you're kind of in the other camp that in 2025 bonds will crush stocks or you're not willing to go that far. Well, I'm actually quite proud of my S&P 6000 call last December. So it looks like we're going to do that. It sounded pretty crazy back then. So I think going forward, it really is about what the government does. I think we focus too much on what the Fed is doing. And what we've learned over the past year is that, as George noted in his really good charts, what the Fed does.

made policy pretty restrictive according to conventional models. And at the same time, CNBC has Dogecoin on their website, right? S&P going to the moon, credit spread is very narrow, GDP growth continues to be above trend. So what's happening here? So I think the story that it's because of the significant fiscal deficit, fiscal stimulus is a story that I agree with. So I would focus less on the Fed and thinking about the future and more on what the administration will do.

And plus Congress. So that introduces a political dimension, makes it very hard to predict. So next year, I think we just have to listen more closely to what President Trump is tweeting than what Jerome Powell was saying in his press conference. Wow. And so it sounds like you're not ready to make the there's going to be a lot of uncertainty in stocks. But to make the call that bonds will outperform stocks, you have to be both bullish on bonds and bearish on stocks. It sounds like you don't have quite that level of confidence, right? Or am I wrong?

So I'll just add this extra dimension about bonds. So like George mentioned, there is this uncertainty as to what the new Treasury Secretary Besant will do. Now, he did do a podcast where he was critical of Secretary Yellen issuing a whole bunch of bills rather than coupons, again, putting downward pressure on longer dated yields. Now that he's in this seat, is he going to

issue in a more traditional way? That is to say that we would have more coupon supply? Or is he going to be mindful of President Trump's love of the stock market and also have to continue what Secretary Yellen did? So there are all these moving parts here that I think it makes it difficult to make a judgment. But

Even if we do have yields go down, I don't think it would go down a whole lot because at the end of the day, the fiscal spending continues to be very strong. Now, if we do actually end up with, say, a 3% fiscal deficit, a tremendous amount of cuts and waste and fraud, then that could change the story. Right now, I'm still focusing on what the political side would do.

And so impending Treasury Secretary Scott Besant, he has a 3-3-3 plan. He's talked about that basically decrease the national deficit to 3% of GDP, have the economy grow at 3%, and then also increase oil production by 3 million barrels per day. Just so on that national deficit. So the current deficit is at 6% or 7% of GDP, getting down to 3%.

would be a net tightening. Do you think that would be contractionary? Yeah, absolutely. I think that a big part of our economic growth buoyancy in the financial markets is due to the 7% fiscal deficit that at the moment is projected to continue indefinitely. So I think that's a big part in why the Fed's

even though they raised rates a lot, wasn't able to get the outcome they desired. Now, if we were to reduce that, I think the short term, that would be negative for financial markets and the economy. Longer term, though, if we could redistribute those resources, let's say government workers moving out of spending the day in meetings and sending funny cat pictures and going out into the economy and doing more productive jobs, that would be very good for the economy in the medium term. But again,

all this restructuring and not just changing the global economic order, but maybe restructuring the federal government. That's short-term

a lot of disorder, a lot of volatility, but long-term positive for the country. So we really have to see whether or not they're able to do what they want to. Now, looking just at the federal government, now, Elon and Vivek, very well-known operators, are already rolling out their plan. It seems like they want to make all the federal workers go back to the office. I'm sure they'll get some attrition just by that. But the government accountability office says,

has also suggested that we have maybe $300 to $400 billion in just outright fraud in the federal budget every year. So maybe just by reducing that, that would be able to rein in the deficit as well. So it's not just about cutting spending, but it's also about just being more efficient. And so in the medium term, I think that's good for the U.S. economy, but in the short term, could be volatile. Yeah, and a lesson there that if the Pentagon stops buying

inflated products that with inflated valuations, you know, something that costs $10 to make it's sold to the Pentagon by a, by a company at $5,000. That might not be good for the stock market because that company is in the big indices. However, if it,

probably is good for America. Okay, now we'll move on to plumbing. It's funny, Joseph, you said, let's not focus on J-PAL, not focus on the Fed. What really matters is Trump and the overall economy, the fiscal. But that being said, let's talk about one of the most arcane aspects of the Federal Reserve, which is its balance sheet. It's got its interest rate policy. We've talked extensively about that. Also, its balance sheet. It started an enormous amount of quantitative easing from March 2020 until the spring of 2022. Since then, it has been decreasing its balance sheet.

It has slowed the pace of what is decreasing its balance sheet. So now I believe its holdings of treasuries are going down by $25 billion per month, maximumly, and of agency mortgage-backed securities of a maximum of $35 billion per month. Are they selling these things? No, they're just letting them rolling off and not adding them back.

Joseph, tell us what is your view for the Fed? I mean, Georgia's got this phenomenal chart. We're saying how Fed, U.S. Treasury holdings are poised to rise. Help me understand how might that happen?

So I like that chart too you had George. So Jack, what you're getting at is as the Fed does QT, it's reducing the amount of reserves in the banking system. And now the Fed wants to shrink its balance sheet, but it doesn't want to reduce reserves so much that the bank system can't function. The Fed is afraid that if they do QT for too long, that will lead to some plumbing issues. So a lot of people are trying to figure out just when, when the Fed stop QT,

And I think the best commentary we can get from that is speeches from Roberto Perli, who is the SOMA manager at the New York Fed. And he's come up with a set of indicators where he's watching to see when we might get to the lowest comfortable level of reserves. And according to his metrics, everything is A-OK. We can continue to shrink the balance sheet. He has some slight concern over elevated repo rates, but it doesn't seem like it's a big deal.

So based on his discussions, it looks like we can continue QT just for a few more months. What I would be watching personally is the level of balances in the reverse repo facility. There are a lot of prominent Fed officials who look at that as a proxy as to how much excess reserves there are, excess liquidity there is in the financial system. And so that's been coming down. When that gets closer to zero, I think it's the time that we should think about ending QT.

But even if we end QT, though, that doesn't necessarily mean that the Fed's treasury's balances will decline. And George has a great chart that explains why. So, Jack, if you want to pull up that chart, the one that says without resorting to QE, Fed's holdings could start to rise. And so there's a lot going on with this chart, a lot of assumptions of my own, as well as

what we've been hearing from various Fed officials as Joe just went through. This is three lines. The top line is the overall portfolio of treasuries and mortgages. That's the gray line. The black line is the treasuries only. And then the red line is the Fed's holdings of mortgages.

And then we have this period where the QT was enacted in early 2022, mid 2022 and implemented. And it's been the current policy ever since. There was an adjustment earlier this year to a slower sort of kind of pace, the kind of tapering the QT. But the balance sheet is still shrinking. The stylized forecast that I show here

does play off this idea that there's a minimum level of reserves that the system needs, especially both relative to the size of the banking system, which is growing with GDP and just relative to the size of the economy. I think we're getting close to it. The good news is the Fed has a number of new tools like the standing repo facility, which can serve as a relief valve for any potential frictions that may arise or the need for liquidity.

I do think that we'll probably get a complete end of QT sometime next year because we're getting close to the point where bank reserves are starting to get impacted. It's quite possible that as long as the RRP is kept open, that there's going to be some residual usage of it as like a kind of a sweep kind of function during the day for parking cash.

So I'm not sure if it needs to go all the way to zero, but either way, it's going to get pretty low. And that plus the ongoing shrinking of the portfolio through these bonds rolling off the curve, that will bring us to a point where reserves are going to get maybe too low.

And what I'm showing you here on the future projections are there's a couple different ways they can start to expand the portfolio of treasuries. They could allow the mortgage portfolio to continue to shrink. And I want to get to that point and how that could happen because the issue is now mortgage rates are very high. There's really no

there's no incentive to refinance unless you really need to move or buy a new home or life circumstances force you to change your home, you're not going to probably move. So we have a very captive sort of mortgage market, but there is some natural prepaying and shrinking of mortgages over time. If we get the perfect scenario, the perfect scenario is, and you kind of mentioned Besson's view of the 3-3-3. If you get

a retooling of the economy, slightly lower inflation, more efficient government, lower energy prices,

all else equal rates can stay between let's call it three and four percent they don't have to go to five percent we could actually see interest rates head lower which would then allow mortgages to come down if banks get more regulatory relief they might see additional bank lending and a turnover of mortgages and that might get either even further prepays of existing mortgage holdings

which would allow the Fed's portfolio of mortgages to keep shrinking. And then they could take those proceeds instead of extinguishing reserves, which would be what QT would do. And then that would kind of hurt bank liquidity on all else equal. They could take those reserves, redeploy them back into treasuries. So take mortgage money as it comes due, put it back into treasuries via through what the Fed will get at.

allocated treasuries through add-on process in the auctions. They don't competitively bid for it. They just get an allocation towards it, but it helps finance the U.S. government nonetheless. And I do believe at some point there's going to be much more a need for coupon passes, which was the old way. And I know Joe knows this very intimately of how to sort of increase reserves or to keep the portfolio stable and

over time. So I just went through a lot of technical wonky stuff to explain how the Fed could end QT, eventually get to a point where they redeploy the money for mortgages into treasuries, as well as stop letting the treasuries mature and take that money also buy new treasuries or get allocated new treasuries at the auction, which would then help our financing situation from the Fed's perspective as well. I'll just add to George's point. So

The Fed speakers have been talking about not just having a treasury-only portfolio. So that would mean, as George's chart showed, that they would take incoming principal repayments from MBS and reinvest that in the treasuries. But Fed officials have also suggested that in the future, maybe we're going to hold a more bill-heavy portfolio. So going forward, maybe they would reinvest

those proceeds into more treasury bills going forward. So that's a possibility as well. So far, Fed speakers haven't given a lot of detail on the future of the balance sheet, but I expect them to probably talk more about this as we approach the end of QT. So that's really interesting. Not just a treasury-only portfolio, but a bill-only portfolio, or a mostly bill portfolio that

So mostly composed of short-term treasuries. And yeah, I mean, people say the Fed's balance sheet is $7 trillion. Now it's $1 trillion. It's what does the Federal Reserve own? Because I think the Bank of Japan in the early 2000s did a tremendous amount of quantitative easing, but they just bought, as my understanding, a lot of short-term treasury bills. And yeah, if you create a bank reserve with a duration of one day to buy a treasury bill with a duration of one day, it's not

It's not nearly as stimulative or not stimulative at all as buying something that's a 20-year treasury bond or a mortgage-backed security or equities. Mortgage-backed securities will continue to decline. The rate at which they decline has to do with the prepayment rate. The prepayment rate is probably up from its low of

18 months ago, but it's not up much because why would you move if you have a 3% mortgage and mortgage rates are currently at 7%. Okay. And, but then they're going to slowly perhaps redeploy them into the Federal Reserve, redeploy them into treasuries because they don't want the overall level of liabilities, their reserve, which they're the liabilities of the Federal Reserve and the assets of the banks that they buy them from to go beyond, go below the lowest comfortable level of reserves. Joseph, what is your estimate and

The other monetary policy wonks estimates of the lowest comfortable level of reserves, because I'm looking at reserves now, they're at 3.2 trillion. I know perhaps some people estimate it's at 3 trillion. So can we only do 200 billion more, which is what, three months? Well, first, I would add an additional note about why the Fed wants to have a

Bell heavy portfolio. So one of the things that we saw over the past two years is that the Fed has a huge portfolio of longer dated treasuries, but its liabilities are reserves, right? As you note, Jack, that's immediate liquidity. And as they increase the short term interest rates, they were operating under negative interest margins. So the Fed was basically losing a lot of money. Now, that doesn't really impact monetary policy, but it makes them look bad.

If they had on the asset side, a more bill heavy portfolio, the next time around when they hike rates, then the bill yields will also go up. So there's less of a gap between their assets and liabilities when it comes to interest expense. So they won't have as big an operating loss, which is good politics. Now,

About what low-calorie is, actually, I have no idea. I feel like the financial system, provided that we can shrink it slowly, can really just adapt to lower levels of reserves. It's really not a big deal. More importantly, the demand for liquidity by the banking sector is something that is going to vary through time, right? Even just changes in sentiment, okay?

can impact that. So I think it's a really bad idea to have this entire operating framework where the Fed is trying to guess what low-clore is and just stop QT right at that point. Now, the ECB has been doing something that is much, much smarter. What they're doing is trying to make reserves a more...

demand driven system rather than a supply driven system. So what they're designed is that, you know, they have no idea what local or is they're just going to make it really easy for a bank to borrow from the ECB whenever they need reserves. So that means they don't have to guess what local is by adjusting the supply. They can just set it up so that if a bank needs reserves, they can borrow it from, from the feds. Well, I hope maybe the fed would change the operating framework to be more like the ECB. So they won't have to go through all this guesswork, which is,

at the end of the day, not very precise. It's been so great speaking with you both, covered a lot of topics. The final topic I want to talk about is Japan. George, I know you've got a lot of insights on this. There's the currency between the US dollar and the Japanese yen. Then there's the differential in the interest rates all across the curve between the dollar rates and the yen rates. So it's very complicated. It has tons of consequences. Joseph, the floor is yours. What do you want to ask George? He has all this...

What do you want to know about Japan? My gosh, tons. I mean, Japan was just in the headlines a couple of months ago, right? The yen carry trade seemingly having some volatility. George in his seat has a lot of insight. Maybe he could tell us, you know, is there a concern about the yen carry trade going forward? And what's the demand like by Japanese investors for things like treasuries, since we do have a large fiscal deficit?

Japan has been a big buyer of treasuries in the past few years. Sure. Look, there's a lot to also unpack in that. Let's go to page 54 and let's look at relative policy rate differentials between the U.S. and Japan is what you're seeing here on this chart. The top panel is comparing Fed funds again. It's now in red instead of black.

It's the short term interest rates in the US is the red line. The black one is Japan's policy rates, which has had some movements, but very little since 1999, 2000. Right. We've basically been in a close to zero bound plus or minus a few hikes every so often or every couple of decades. And only recently has the Bank of Japan started to try to normalize rates.

And what I'm that's the top part of the chart. The bottom part of the chart is the market's interpretation of where short term rates will be in the future for each country, the US versus Japan. And then I take it even one step further and compare it to real rates in the US versus real rates in Japan. And I did this to try to make this point of like, why do you put on carry trades to begin with? You're trying to pick up a higher yield, a higher

a better performing market somewhere else, you borrow it in the cheapest currency, which has the lowest interest rate, and you redeploy that capital somewhere else in the world. That bottom spread tries to capture that concept of what's your carry pickup in real terms after you adjust for inflation. And when you think about it in that way, and you compare, that's the gray line, which goes back even further back into the 1990s,

you can see that when the spread gets really, really wide, things do break outside the US. And this has also been also an interesting sort of dimension that we haven't really seen major stresses outside the US. I mean, during the August

which people said it was the carry unwind. It's more like a carry trade adjustment. You don't unwind the carry trade. I mean, the carry trade is pretty structural and it doesn't go away that quickly or two or three days. Those are the weaker hands, marginal borrowers and more levered speculative flows that probably got

unwound based on the data and what we've seen since August. But nonetheless, that spread, that gray line measures the kind of relative value pickup between US and Japan. And the US is still, rates are high here and they haven't been really cut that much. We only have had 75 basis points of cuts and rates are much higher here than they are in Japan. Each time that this spread has been this wide or hasn't even been this wide, you had the Asia financial crisis in 97, 99. You had

the starting points of the global financial crisis. You had it during 2014, 2016, when Asia's access to dollars was getting really expensive, not just for Japan, but broader Asia, including China. And you had oil markets really getting in trouble during 15 and 16. So things do happen when the spread gets really wide. It has been wide for quite some time.

The carry trade adjustments that happened in the summer probably

We're not the full extent of it. And so this really creates another dimension that is worth keeping an eye on because it's not just the Fed policy does not just impact local U.S. and the U.S. economy. The U.S. is a reserve currency. It's part of the global payment system. The dollar being the reserve currency is super critical to that. And there's a lot of lending and borrowing that takes place outside of the U.S. banking system globally.

And so when these sort of differentials are as wide as they are now, it could start to also expose some of those fragilities. So I was saying that the higher for longer applies not just to U.S. borrowers, but also global borrowers. And now if the Fed takes longer to cut, it might expose those those weaknesses. And perhaps that sort of catalyst that we're looking for a risk off is going to come from outside the U.S., not from in the U.S.,

And so I do think this is a super important thing to keep track of that the rate differentials, the relative movements in the curve and the curves, but also the relative movements in the FX currencies around the world. A very strong dollar also tends to break things too. So they're all kind of linked together. But I think that to me is what I'm watching. I don't think the carry trade was unwound. I think it was an adjustment.

That's my personal view. And I think that I'm watching this. And in many ways, if the Fed cut as much as what was priced in before the election outcome,

that could have helped out the BOJ in many ways. And now it really does put some of the onus back on the Bank of Japan to have to raise rates, which then increases their cost of funding for a lot of any sort of trades that are based on borrowing cheaply. So it could get into a much more tricky spot for investors that borrow money. And then why is it that when the one year forward dollar versus Japanese yen rates get to a certain level that that tends to

trigger a crisis. For example, on the chart you mentioned 1997, I was understanding that it was those high rates caused a lot of pain in the super high yielding countries like Thailand and Russia, the riskier ones, not the safer ones. Tell us about that. Well, because a lot of that money that gets borrowed gets redeployed back into emerging markets, not just into US or into US dollar denominated debt within these emerging markets.

And it's, again, it's also indexed off of US as well. So it's more trying to capture the spirit of is the carry really that attractive outside of this funding currency? And when it really is really high, it creates...

Certain behaviors where there's like a concentration risk of certain trades get done. And that could be what exacerbates the problem. And yeah, so I think it's, look, we've got the benefit of history. We have the benefit of better monitoring. We have a benefit of more data now. And people are watching this sort of dynamics. But, you know, it's been amazing.

I think maybe postponed because of all this excess liquidity that's been circulating around the world. Now, if the Fed were to take longer to cut and the dollar stays stronger, all else equal, and the need for dollars to repay back loans or whatever the case may be from overseas go up, or stays up and people were banking on lower rates to bail them out. I mean, there was like a number of different industries, like the commercial real estate, housing, and global investors that like to borrow money

and that we're hoping for lower rates in the US to help out, the longer that takes to show up, it could create eventually either a margin call and/or the need to actually sell assets to pay back your loans.

And then George, a lot of people thought when the Fed raises rates in 2022 and 2023, oh, Japan is going to be buying so many treasuries because yields are so high. Nope. As you point out on this chart, actually, when the curve is super inverted, it costs more to hedge. So it's actually not attractive. But Japanese purchases of treasury bonds has been going up. We can see in the purple line.

Do you think this will continue and why? So this is the other side of the coin. And this is also true for Japanese investors that have a big exposure to the US markets. And this chart is a very simplistic chart, but it's comparing the annualized hedging cost if you need to hedge your FX almost 100%, which rarely gets implemented.

That's the black line, which you can see kind of tracks very closely fed funds. And so it's a cost of carry calculation. If your funding cost is higher than the yield you're going to get on an asset, you're not going to really buy it, right? Because what's the point of doing that trade? So when the curve is steeper and when rates are lower, all else equal, that allows for that kind of yield curve transformation of borrowing cheap to

and then redeploying that money out the curve. It's no different. In many ways, it's very similar to how regional banks work in the US or any sort of like a typical banking model. You try to borrow as cheaply as you can and then find the highest yielding asset or loan. In this case, it would be the treasury market or mortgages or US credit.

If the Fed were to stop short here and not cut rates further, then these hedging costs are still pretty elevated and it'll be most likely a slowdown overall investments coming from Japan, all else equal. I mean, obviously there's a lot more that goes into the equation, but at this stage,

hedging costs are going to play a role and where the market believes rates will eventually stabilize at. And is there enough of a yield pickup to actually come back into the US bond market? I didn't know that the cost to hedge currencies from yen to dollars is so correlated to Fed Fund. I didn't know it was basically a very similar chart.

So the Fed needs to cut rates in order to lower that cost and incentivize Japanese buyers. Joseph, George, thank you so much for coming on.

People can find you, Joseph, on Twitter at FedGuide12. Your website, of course, is FedGuide.com. Your book, Central Banking 101, is a masterpiece, a classic. It's relevant today as the day it was published. There we go, George Goncalves. People can find you on Twitter at Bond Strategist. But almost all of your opinions and insights are for institutional clients of MUFG. Just tell us, if people are an institutional client, how can they get in touch with you?

Yeah, sure. They can reach out to either their Salesforce person if they're covered by MEFG and reach out and try to get on the distribution list and the research portal. Thanks. And thank you everyone for watching. Reminder, it's not just on YouTube. Monetary Matters can be found on Apple Podcasts and Spotify. If you're listening on Apple Podcasts and Spotify and we referenced some charts, those are only available on YouTube. Sorry about that for now. Until next time. Thanks again, guys.

Thank you. Just close this f***ing door.