Overall, big picture, I would say we're in a regime of Goldilocks where inflation is falling. Growth is still positive. We've seen some dispersion. We've seen some marginal weakening here or there. But you have to remember, interest rates are beginning to fall, which is going to do what?
It's going to help growth, right? It's going to provide a little bit of a safety net for growth to not just completely collapse. So that's what... That's what we're seeing and we're likely to see into the end of the year.
That's going to set the distribution for all your major assets in terms of, you know, bonds, equities, Bitcoin, every kind of other major asset within that framework. If you see the driver of those cuts as an expansion of credit risk, then you know, yeah, this is price in a recession. If you're seeing, you know, bonds bid as the dollar falls, gold rallies, equities rally, Bitcoin holds its levels and is likely to rally from here.
then that's not pricing a credit risk. That's pricing disinflation. That's still what the forward curve is doing.
That's still what the market is doing. It's pricing disinflation. Join the ongoing OM GenDrop campaign and be part of the future of regulated digital assets today.
Welcome back to another episode of On The Margin. And joining me today is Capital Flows of Capital Flows Research. What's going on? Welcome to the show.
Hey, thanks for having me on. I'm looking forward to this conversation today. Yeah, I am too.
You know, your work on your Substack, both on educational primers and macro... and just your views on markets, you know, started to really pop up on my feed over the last few months and just seen some really interesting views. So I just had to get you on the show and hear a bit more about yourself. So, you know, respecting the anonymity, we'd just love to hear a little bit of like a higher level of, you know, what are the areas of research that you focus on?
And you know, what's been a high level background of yourself? Right now, I currently run just a global macro strategy across all major assets, a lot of them focused in futures and then interest rate space. And my whole goal is I run a lot of systematic models on the economic data that we take place, that takes place in the US economy and then across just all economies in the world. Take that data, model it, have a clear understanding of all of the different moving parts, where they're moving, the tensions between them, and then... connect those properly with financial markets and understand all of the directionality and assets, the correlations, relative performance, all of that different stuff.
And then I work through just extracting returns from that. And my style of extracting returns and the goal of it is to get very high conviction views and take incredibly large concentrated bets on those. And then... have a time preference and a time period that's higher than the market at that moment. And in my view, the environment that we're in today in terms of what we have with active management or just different market participants is everyone has become shorter and shorter term in their views.
We can even see that recently, just everyone flip-flopping back and forth with small data prints like retail sales or unemployment or stuff like that. People don't really know how to... connect that or take a drawdown against it or whatever it might be or when to do that.
And so my whole goal is to be able to get very large trades on sides and then take the volatility of holding those after they've gotten on sides and hold that for a prolonged period of time. So my whole goal is to really take a lot of the maybe systematic rigor that maybe a lot of the bigger macro guys didn't have like 20 years ago or 30 years ago or something like that. And then be able to take the volatility profile that those types of guys did take. Whereas today, everyone's very systematic macro, vol control, drawdown limits, quarterly performance numbers they're trying to hit. And again, everyone has their own goals, right?
But I really come to it with that approach of extracting returns because I know the macro environment, that intraday timeframe that everyone's trading on, or even a weekly timeframe. It's just incredibly competitive. Yeah, so I approach it that way.
I feel like it's such an interesting framework to have. And that's something I really appreciate from some of the education primers that you've been writing about. And I just want to ask you what will seem like a very simple question, but I feel like it's something that, you know, a lot of folks, if you're somebody who's, you know, listening and you're, you know, a macro, you know. Maybe not quite a dilettante, but somebody who's just kind of getting into it. And, you know, your philosophy on macro, I feel like is quite interesting because when people first get into it and think, OK, I'm macro trading, I'm listening to a podcast and somebody says, oh, I'm bullish on bonds.
I'm going to go buy bonds or something like that. So what's like your philosophy on what actually is macro trading and trading the expectations versus like, you know, like you say, like a retail sales single data point comes in and, you know, you totally flip your entire portfolio bias or something. I think in general.
when I think about macro is you're trying to manage a lot of the big picture risks that take place. So if you think about someone with a regular portfolio, I know so many stories of people who you go through a crisis and you suffer a major drawdown, or on the other side, you have someone that's too conservative and they're maybe not allocated to equities or something like that, and then they're not able to meet. the outlays that they're trying to meet in life, whether that's a kid's college or you're trying to pay for a wedding or something like that. I know people that they didn't have the ability to pay for that stuff because maybe they had a perma bear or a permable argument in their mind and that was kind of latched onto there and that really impacted them.
And so what I think about macro is you're trying to really understand all the distribution of probable outcomes on both sides, on the upside and the downside. and aggregate all the relevant data points. And at any one time, I have a very clear risk-reward view on equities or on interest rates or on basically every major asset.
And I map those across different time horizons. And I say, how am I thinking about all of these different things? And part of the reason I started the Substack is I started that and wrote...
I don't even know how many there are now, educational primers on every single aspect of macro and breaking down how to think about that. Because in the industry as a whole, you kind of have the institutional research side and those guys are sharing research that is directly connected to their clients, whether it's at any of the major investment banks. And sometimes there's conflicts of interest there. And then at the other side of the spectrum, you're going to have a lot of people shilling very bearish.
bullish narratives that are just on the extreme end and not really mapping the probabilities that take place incrementally. So my whole goal is, how do we have a clear line of thought between what is actually taking place in all the economic data and then connecting that to the real-time risk-reward assets and prices? And then that gives you the framework for taking high probability bets.
Nice. Awesome. So what are some of those components? I know you talk a lot about inflation.
growth, labor markets, liquidity as well, as well as this interchangeability between everything being boiled down to returns-based and risk based on either credit risk or duration risk. Can you expand a bit on some of those conceptual frameworks that lead into this broad idea of trading macro? Broadly speaking, if you're coming into macro, you break things down in terms of growth, inflation, and liquidity.
That's kind of your traditional way to break things down. The whole question is, how do you exactly map those? Growth just has to do with what are all the real activities that are taking place in the entire economy. And just the simple metric of GDP is the most comprehensive metric we have in terms of data that shows activity. And then just inflation, which is just the pricing of that activity, which is the amount of cash or nominal dollars you have in comparison to the amount of output that you have.
So just to put that simply, you have... the amount of goods and services that are being produced at any time, and then the amount of money or nominal demand that's chasing that to purchase those goods or services. And so we live in a nominal world where we don't always think in real purchasing power.
I don't think like, oh, my rent or mortgage payment is going up and down in real terms. I just think about it as, I made this amount of money this month or this year, and here's how much I need to spend. And I need to either make more or cut back.
my expenses somehow. But the market is always pricing both sides of that spectrum, the nominal and the real side. And so that's why we need to know growth and inflation. That's why we have those two different instruments in markets a lot of times to price both of those. With that being said, we have things like the Fed fund futures or the SOFR futures that price interest rates and the Fed's decisions on the forward curve, which is...
simply the market's expectation of what will happen in the future. There's kind of been this idea, and it's been beaten down more recently because people realize it's wrong, but this idea that whatever the... future expectation of the Fed fund futures or interest rates are, that's the real expectation that's going to happen, or that's what the truth is. Or you hear people talk about the bond market's the market of truth. There's really no statistical evidence of that.
If you look at what is expected by Fed fund futures or SOFR, and you look at that on a historical basis and compare it to what is actually realized, the spread is just huge. The bond market is in one in one sense, almost always just wrong, right? Like the amount of times it actually gets realized. That's something really important to keep in mind. And we've seen that recently where you have this little blip up in unemployment and then the market prices, 50 basis points for the September meeting, right?
A 50 basis point cut, which if you understand the actual probable outcomes of what's going to take place and what is actually taking place under the surface in terms of growth, you know that that's a very low probability, even though the market is pricing it as a high probability. And so that's where people over extrapolate this narrative of like, well, the market's pricing a recession or like bonds are pricing a recession, but stocks aren't. That doesn't... In all of the research I've done and all the models I run, that discontinuity doesn't exist. They're pricing different parts of the distribution.
They're pricing different parts of growth and inflation in the economy. And in my mind, there's no such thing as... well, this asset is pricing this, but this one is pricing something different.
You know, it's clearly you have a wrong view. That's how I think about it. You know, it seems like based on a lot of those models that you run and subcomponents that, you know, from what I've seen, been pretty correct on some of your market calls recently.
You know, when we're speaking now on August 19th, which is about, you know, a week ago, we were in a very different landscape in terms of markets. We saw the third highest fixed print overall. And it seemed like, you know, there's people talking about 75 bps emergency rate cuts happening. You were one of the few where I saw your vocally bullish at the bottom. So I'm just curious, what were some of those specific indicators that you were looking at during that time that made you feel confident that this might not be all that recession that people are starting to talk about?
In my mind of the kind of the mini liquidation that we had, that was, I would say, one of the clearest moments I've had where it's just like, this is such a clear buy. And there's a number of reasons for that. But.
The first is when you have a regime where just GDP is positive, just in general, and we don't even have to get super complicated. You can just look at the most recent GDP trend or the now cast or just anything, really. When that is positive, it is incredibly difficult for the market to go down, just in general. When growth is positive, it's difficult for the market to move into a bear market, to have a persistent trend down.
The only... kind of scenarios where we see that happen is when you have something like the Fed hiking, like 2022, where you have real GDP positive, but the Fed is hiking interest rates. We are literally seeing the opposite of that, where we're seeing the beginning of a cutting cycle.
So I know that, okay, GDP is positive. Even if everything was to collapse, it's not going to collapse at the speed that the market is pricing right now. So even if I am wrong, I know that I'm right in terms of the timing.
or there's a high probability that I'm right in terms of the timing. If you just look at where we're at with the level of growth, for it to deteriorate to justify that level of the S&P, we would need to almost have some type of external shock that just drags growth down. And we weren't seeing that.
So you basically say, okay, the regime is very bullish for equities. Interest rates are in the beginning of a cycle to be cut. And then on top of that, you have a huge implied vol premium.
where positioning is clearly getting blown out. A lot of the short-term guys are just going to take it to town. You have, like you said, the VIX print above 60. But Realize Vol was still incredibly low.
And then at the same time, you have all of this move happen during the Asia session, the overnight session. So if you... I don't like to be too retrospective, but if you go back on the sub stack that I'm running, like basically at the open... I just said, hey, listen, we're probably going to bid into the open.
That's just so likely because you just sold off two standard deviation, whatever look back you're going to use, multiple standard deviations overnight. You hit the London session and you bid, which makes sense because you're going to have mean reversion into typical Globex opens like that when you're sold off so much. And then when we came into the US open, immediately you hit that wall of volume and people are able to transact against size and you set a bottom.
So, you know, you want to. say, okay, anytime you have a positioning getting blown out in a regime where the macro doesn't justify it, in a regime where growth is okay. You just always want to take the other side of that.
You want to overlay some technical edge. You want to overlay some systematic models for executing those trades. But at the end of the day, the likelihood of a persistent bear market where we're going down 20% or something like that is just so unlikely.
Yeah, it's super unlikely. So is that where this idea of looking at returns and risk through credit risk or duration risk starts to come in? Because like you mentioned... Growth is positive. And, you know, the Fed is going to most likely start cutting rates in September.
The lower, you know, lower SOFA rates, lower Fed funds rate, that's obviously going to be positive for credit risk. Because, you know, if you just look at floating rate debt or something that's priced off that, that's obviously going to come in lower, which will improve things in terms of credit risk. It'll also most likely improve things in terms of duration risk, too. So is that how you look at things? Yeah.
So when I look at markets, I always think, how is... both the time value of money in terms of just inflation, duration risk, how is that being priced? And then how is the existence of those cash flows being priced?
So I've talked about this in some of my podcasts, but if you ever just run a basic model, like a DCF on real estate, or any very stable asset, you always know that your net present value is going to be based off of the discount rate that you use. And then it's also going to be based off of the future cash flows that you have. If those future cash flows begin to change, like you begin to move in a recession and people say, this company is not going to do well. We have some issues. The underlying cash flows are at risk.
That's going to change your net present value of that. You're going to price more risk. However, those cash flows, those future cash flows could just remain constant.
You could have a contractually obligated lease with some really high investment grade tenant or something like that. And the main way that the value of that asset is going to change. is through the discount rate, which is how am I discounting these future cash flows?
Anytime I come into markets, I'm saying, how is the market pricing that duration risk and that credit risk? And that's when you really get into understanding why interest rates move and why other assets move. Because there's this idea in markets that if interest rates are going down, that means there's a recession, which historically, if you look at that, there's kind of this logical phrase, in recessions, interest rates go down.
but interest rates going down doesn't mean there's a recession, right? It's this idea, if you just look at a long-term chart of the 10-year and overlay all the recessions, just look at how long the 10-year can go down without a recession. I mean, it's just like, and then people are using this into their financial indicators to predict recessions.
It's just a little misguided in my mind. So that's really that. That idea that you see on a macro basis is reflected in just the short-term data prints that you see as well. So if you have that big picture of what is likely in terms of the amount of credit risk that should exist and the amount of duration risk, then as you have these short-term spikes on retail sales or unemployment or whatever it might be, you know if you can take the other side of that spike or if you can take the other side of that dump.
And that begins to give you clarity as opposed to just moving off of like arbitrary technical levels. You actually have some logic behind, okay, I know that this move doesn't have durability behind it. Okay, let me overlay a technical edge that allows me to take the other side of it.
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Maybe we can shift gears a little bit into where we stand today with markets. And we can start with the short rates and also long rates and also Fed expectations. There's a lot of talk right now about a September rate cut.
Discussion really is just about how many cuts are going to happen, either 25 bps or 50 bps. I don't think anybody's really calling for no cut at all. What are you forecasting for September?
And how does that get reflected into your view on rates? I've been basically betting on a 25. basis point cut in September since that liquidation that we had where bonds bit a bit. The main thing that's going to determine interest rates here is about the aggressiveness we've seen in how it's pricing those stance of the Fed. So for example, we've seen bonds sell off over the past couple of weeks, even though we're going into an interest rate cutting cycle. The reason for that is because the market, the oscillations that you see, you know, the higher high or lower lows and, you know, lower highs and stuff like that.
And the trend and oscillation you'll see in interest rates during cutting cycles is all connected to the aggressiveness that the forward curve prices for those actions by the Fed. So overall, we're very likely to see a 25 basis point cut in September. It'd be highly unlikely to get a 50, given the information that we have and the stance of the Fed that we have right now.
Powell basically implied that. in the last FOMC. And on top of that, there hasn't been significant changes that have taken place in the macro environment in that period of time.
That's how I think about that. I think in terms of if you just look out at the SOFR curve for 2025, I think we have a much more reasonable pricing for cuts. I think we're going to probably hit 2% inflation, maybe Q1, Q2. of next year.
And that'll kind of determine how fast we get cuts. And then I think from there, it's all going to depend on the spread that the Fed targets between Fed funds and inflation. So the higher growth is, the more the Fed can hold the Fed funds above the level of inflation. So if growth is really high, then they can say, oh, well, inflation is at 3%.
We'll just hold at 4% will have 100 basis points spread. Yeah. Overall, big picture, I would say we're in a regime of Goldilocks where inflation is falling.
Growth is still positive. We've seen some dispersion. We've seen some marginal weakening here or there, but you have to remember interest rates are beginning to fall, which is going to do what? It's going to help growth. It's going to provide a little bit of a safety net for growth to not just completely collapse.
So that's what... That's what we're seeing and we're likely to see into the end of the year. That's going to set the distribution for all your major assets in terms of, you know, bonds, equities, Bitcoin, every kind of other major asset within that framework. Yeah, we'd love to basically take that story along the ride for those other asset classes. And, you know, maybe we could stop the ride over in the world of long bonds.
So 10, 20, 30 year type 10ers. What are you seeing there? Because to me, it feels like there's, you know, there's some people that are saying. It's being priced for recession.
Others I see saying that it's priced for a series of normalization cuts, but still positive growth. What do you see in terms of expectations of what's priced there? And do you see any value in it? I wouldn't necessarily say we're seeing this clear indication from the bond market that we're priced in a recession. I mean, we saw that a little bit in the aggressiveness of the September cuts.
But at the end of the day, if you think about it, if the bond market is priced in a recession, you're going to see a negative stock bond correlation. That means you're going to see bonds bidding and equities falling, right? You'll see credit risk expanding. So that kind of connects to if you see the driver of those cuts as an expansion of credit risk, then you know, yeah, this is price in a recession. If you're seeing bonds bid as the dollar falls, gold rallies, equities rally, Bitcoin holds its levels and is likely to rally from here.
then that's not pricing a credit risk. That's pricing disinflation. That's still what the forward curve is doing.
That's still what the market is doing. It's pricing disinflation. I mean, you'll know.
People will be losing their socks when the market starts pricing a recession. And it's overall, and you look at this historically, recessions don't come out of nowhere. You don't just come in Monday morning and you're just like, oh, I guess we're going to price, we're going to have a recession this week.
So much of it is an incremental process. where you have the probabilities shift incrementally. It's just, if you've run any type of systematic macro model or just anything that has a marginal degree of statistical significance in it, you see the probabilities of a recession building over a three to six month time horizon before real GDP begins to really tank and go negative.
So I think that's... That... I think in terms of bonds, we still need to see the curve uninvert. We saw it uninvert marginally. But the thing that's going to cause a real bid in bonds is when you have two things.
One is the short end. is, you know, pricing a reasonable expectation of the Fed's actions, right? So the forward curve is saying, you know, here's what the Fed is going to price. Here's what the Fed is going to do.
And, you know, I would look at that and say, okay, that's reasonable in what they're going to do. And on top of that, the second is that the curve is uninverted, right? We need to see the curve uninvert to be able to allow capital move out that duration risk curve.
Because right now, I can put money in, you know, T-bills. and receive a higher yield than the 10-year or 30-year still. So I'm not incentivized to take on duration risk.
And no major institution is incentivized to take on duration risk when there's a lower yield, especially people that are primarily targeting yields, which is the majority of the people in the fixed income space. You know, it sounds like a lot of people often think that for that value to come to the long end, we need to see long-end yields go higher and see a bit of a bear steepener happen and turn premium expand. But it sounds like you're saying it's more so the bull steepening where the short rate will come lower.
That'll give value to the long end. Do I have that right? I'm not opposed to the bear steepener.
Maybe we have that for like a week or two or something like that. But if you think about what has caused the bear steepener over the past couple of years, it's primarily been the whole QRA supply thing, right? In both it actually taking place and then the risk of it being priced, right? And that happened a couple of times. We saw a drawdown in 2023. We saw a little bit this last year with a bear steepener.
But at the end of the day, If you just look historically, the bear steepener is very overall, especially driven by supply, difficult to take place for a long period of time. So could we have a bear steepener here or there where long rates move up? Yeah, maybe.
I think the bull steepener is just much more likely. I think as we move into the end of the year, we're going to reprice expectations to what the forward curve is pricing. We're going to be a little less aggressive in the Fed's actions.
That's going to cause the curve to maybe flatten a little bit. And then as we move into the end of the year, in the beginning of 2025, that's when we're going to uninvert. And that's when we'll be able to have more durability behind a bull steepener where you have the short end and the long end rallying at the same time and the curve uninverting. So that's right. As of right now, that's that's my view.
Yeah, so it seems like the long is just sort of in no man's land right now. I'm curious if you've ever done much research in terms of what's priced into long bonds in terms of Fed rate cut expectations versus it actually happening. So what I'm saying is right now, the whole bond market is priced in a certain degree of cuts. And whether if you want to go buy the long end, you know, in expectation of those cuts actually happening, do yields tend to fall in tandem? the short rate comes down or is it all largely priced in and it sort of just chops around?
That's kind of a complicated question. I'll say two things about this. I think that's a great question because so much of that is about how to manage that duration risk.
So one, I actually did a whole conversation about this on my sub stack with Prometheus Research. That really breaks down this dynamic where you have the short end and the long end. and how to relate those two things.
I'll give you the cliff notes, but at the end of the day, you're going to have interest rates made up of whatever the realized Fed funds rate is, whatever, or we're talking about the long end, realized Fed funds, your short-end expectation and term premia, right? This kind of term that everyone throws out, no one knows it really means, but at the end of the day, term premia is going to be based on your... inflation or nominal GDP number or something of that sort, which is the premium that you receive to take additional duration risk. In other words, where is the yield curve in relation to that short end?
Where are long end rates compared to short end rates? So when I take a view on the long end, it is made up of what's my view on the short end? What's my view of... Fed expectations or the forward curve expectations for the Fed?
And then what is my view on the curve given some models that I run on there, basically understanding the attribution of different regimes, so bull, bear, flattener, steepener, and then how does that connect with the different economic data and things like that? When I think about my macro framework, If you have a view on growth and inflation in the economy, and you have that connected to the short end, and then you have that connected to the long end as well, every other asset that you have is, in one sense, a derivative of that view. Right.
Because that every single other asset has some type of duration risk in it. Right. That's why, you know, the Nasdaq can correlate with bonds so much or why you see relative performance there, because those are, you know, longer duration, you know, equities in a sense compared to, you know, like materials or, you know, some other kind of sector like that.
So what I would say overall is, you know, that curve is going to be what allows people to take a. additional or less duration risk in comparison to the short end. What's up, everybody? Just want to take a second out of the show to talk about the next major BlockWorks conference that's happening.
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Yeah, I love that explanation and the time to equities. And, you know, we'd love to double click onto that further in here. What do you what do you look at for equities?
What do you think has been driving this bull market over the last year and a half? Because, you know, it's been at a time where Fed funds is, you know, pretty, you know. the highest it's been in a long time, especially, you know, it's above the inflation rate by most measures. So what do you think has been driving it higher?
Because there's been a lot of people that have been looking at it and seeing that, you know, it's just been an earnings story, an earnings expectation story. And now that the rubber is going to meet the road, we're not going to meet those earnings expectations and we're destined to go lower. I've seen talk about how, you know, it's just in a regime of high nominal GDP growth, you know, revenues and earnings are a nominal. metric, it's going to make sense that those earnings will expand and equity should do well because they're nominal assets. So how do you look at equities and where do you see them today?
When we think about equities, there's going to be two primary drivers, right? Your earnings function and you can say earnings expectations or realized earnings or whatever. And you can take a view on if those come in above or below expectations, but you're going to have your earnings component and you're going to have your valuation component, right? There's a couple different ways to measure each of those. But at the end of the day, your earnings component is going to connect to growth in the economy.
Right. So as people buy more things in the economy, as that remains positive, you have those, you know, that GDP transmit into if you want the kind of like technical thing like GDP transmits into, you know, corporate profits and corporate profits transmits into earnings. And then that begins to, you know, distribute.
against different sectors and that, and you kind of take each of those sectors and say, how much does that contribute to the index? And so when we look at that, we see overall earnings remain positive, right? So that's going to be just a key thing to keep as a framework, right?
And then that's on the one side, you have earnings. And then the other side, you just have your valuation component, right? Which is how much of a premium in terms of PE or dividend or whatever it might be, how much of my pain? for those earnings, to have exposure to the change in those earnings. And that valuation component is just driven by macro liquidity.
At the end of the day, those are the two drivers for equities. What we're seeing and what we have seen is that growth has remained incredibly positive. If you remember in 2023, everyone was expecting a recession. Economists'expectations for a recession were some of the highest they've ever been.
And... you had net positioning in the S&P 500 and all major indices as net short, like extremely net short. And so you had both of those things taking place at the same time, the interest rates were at highs, right? So you basically had everyone expecting cash flows to deteriorate and interest rates or this net liquidity impulse at a very extreme level in terms of negative.
What has happened is we've unwound all three of those. We've shown that a recession isn't likely and that the cash flows have validity. And then on top of that, we've seen interest rates come down, which has allowed you to price a higher premium on those cash flows.
It's allowed valuations to rise. And then on top of all of that, you have positioning unwind, where people realize they shouldn't be net short and they have to unwind that. And that's why you've seen a rally in 2023 and this year, because people were net short and you have to unwind all that positioning and all of that.
people will talk about, oh, the market shouldn't be going up. Statistically, when you look at it, every move in the market that we've seen year to date makes complete sense on a macro basis. Some of the stuff was a little difficult to understand in the present. And retrospectively, we can see it with a little bit more clarity.
And we're like, okay, that makes sense why that happened. We just didn't have the information at this time. But overall, equities, if you just think about what we would need to see on a forward-looking basis for a bear market, We would need to either see inflation reaccelerate so the Fed starts hiking again. Doesn't seem likely right now, especially into the next three, four months.
So that's kind of off the table. The other thing is just some type of deterioration in cash flows and growth. And that doesn't seem super likely right now either. When we look at all the metrics, when we look at just kind of all the different growth data that we have in GDP and the line items there, is there some weakening in some sectors?
Yeah, sure. But is that... causing a contraction that is going to shift the probabilities where we're going to say, hey, this is so great that it's going to be actually greater than the Fed cuts that are going to take place. The impulse from negative growth is going to outweigh the impulse from these rate cuts and actually cause the S&P to go down.
That's unlikely right now. That could change, but right now, that's very unlikely. Yeah.
It feels like... Basically, if you just take the S&P 500 as the proxy to equities, it feels like everybody in it was caught offside to what was the economic reality. And over the last year and a half, we basically reversed back to what is the economic reality.
So it feels to me like what you're inferring is that we're at relatively fair value. You've done a great job of explaining the unlikeliness of some of those left tail risks. I'm curious, what do you see on the right tail risks in terms of?
further upside. It feels like we're in line with the economic reality. So what do you see could bring us higher?
I mean, I think at the end of the day, if you look back at every major melt-up and bull market where you have huge moves, that happens when two things are taking place. Number one is your earnings expectations are rising rapidly and your valuations are expanding at the same time. So if you look at... I kind of did an article on this recently in a podcast. But if you look at the period of time in 2000, when you had that huge rally in the late 90s up to 2000, that took place as earnings expectations and valuations rose.
And if you look during that time, real rates were falling. The Fed had a positive stance in terms of liquidity, like overall cross-border liquidity, all of these other things. were allowing valuation multiples to expand because liquidity was positive on a macro basis. And at the same time as that, you had earnings rise rapidly. So I still think that's completely possible here.
I mean, we saw that in 2021 as well. I think overall, we are seeing larger and larger moves in equities because passive is taking a larger ownership, right? You see like the concentration in all of the MAG7 names, right?
And those are helping so much of the performance of everything. And as you have passive take a larger and larger share, the overall market has greater inelasticity, which means that price can get just so much higher. So there's a very reasonable outcome where we have earnings just accelerate because growth continues to expand and valuations begin rising because those cuts by the Fed cause liquidity to turn positive and a lot more positive.
If the Fed started doing QE again, right? Or if the Fed started, if we have some mini crisis like SVB, that's, you know, the Fed is going to come in and step in, right? They're going to throw some liquidity at the system. And we've already seen how fast they move, right? Like the SVB crisis showed everyone that there's a safety net, right?
It doesn't mean you can't lose money in markets. It doesn't mean you can't get blown out of a position. But it shows on a macro basis, the Fed is there, right?
Even when they're doing a hike still, right? It feels like a lot of people have finally clued into that. And now the discussion is around like, how soon do I jump in and buy the dip before the Fed comes in?
I see some comments these days where people are trying to figure out, okay, even if we get a recession, it's obvious what's the liquidity bazooka is going to be coming down at some point. So I'm just going to buy in. Do you think that ever gets to this reflexive point where... you just see i mean maybe that's what we saw last week we're just like we get these crazy v reversals and you know the idea of these long-winded 2008 style recessions aren't a thing as much anymore and they're more like the 2021 where it's just like down you know var degrossing liquidity comes in and then we just returned up only afterwards yeah so i definitely think you can have a 2008 type of scenario again but um just just broadly speaking i don't think it's a high probability right now but i think like on a on a fundamental basis.
The interesting thing is when we think about the Fed cutting and how that provides support. we always need to say, what are the impact of those interest rate cuts? And how do those map against the impulse of growth?
So let's say you have this kind of like scale of one to 10, where you have how much of a liquidity impulse are interest rate cuts providing? And then we have another scale of one to 10 to say, how much is growth deteriorating or expanding? And then we basically say, whatever those numbers are, let's add them together and see what the net is. So if...
The Fed is cutting interest rates, and that causes a positive liquidity impulse. You have to say, okay, let's say it's causing a positive liquidity impulse of like five. Okay, well, what's our growth impulse?
Is that a negative one, negative two, negative five? And then we take that number, compare it to the liquidity one, and say, what's the net effect? And asset prices are the things that price. the relative difference between those two impulses. That's why you can have the market actually collapse when the Fed's cutting because the growth impulse is so much greater.
So I think there's going to be a time in the future. I don't know when this is. Maybe it's a couple of years, five years, 10 years. I don't know. I don't really care.
But there's going to be a time in the future when there's a little bit of a growth scare. Something like that happens. The Fed cuts.
We rally in the market, and then we just keep dumping because... the growth impulse that is negative, when you actually move into some type of recession, is so much greater than what the Fed can even do with cuts. And eventually, when they step in and buy assets and stuff like that, that will set a bottom. But at the end of the day, it depends on how fast is the Fed going to do that? How much strength are they going to do it with?
Because they're trying to moderate their actions too. And they're trying to match that with the strength of deterioration that we see in growth and financial markets. So I think about it more as like, how do we map those two impulses together?
Because at the end of the day, this kind of... I mean, again, I think the Fed has set a safety net for the market. They've clearly done that. The market believes that.
I believe that. I'm long. But there's going to be this sneaky period of time where people are going to think that and believe that and they're going to get washed and taken to town on their trade because...
they're not mapping that against how much deterioration there actually is. Yeah, I think understanding the impulse is so key. Just anecdotally, I remember in March 2020 when the last crash was happening and there is the Fed.
I can't remember the perfect sequence of events, but the Fed cut rates to zero. We kept dumping those next days and I started to see discussion about, oh, the Fed put us dead. The Fed has lost control. And it just took a couple more days and a few more of those impulse actions. We had to see basically QE infinity.
We had to see them start to actually buy corporate debt. which is just a whole crazy idea. But I think it's a really apt point to understand the level of impulse that is required before you step in.
Absolutely. Yeah. Is your sense of that kind of the same in terms of how much of a Fed put there is? Or what are your thoughts on that?
I think so, for sure. I think it's this mix between that and expectations of that monetary impulse. So I agree, a 25-bits cut in September is overall not going to do all that much.
compared to some of the other tools they have in the toolkit. So yeah, it's a balance. I want to spend the rest of the show here just talking a bit about Bitcoin and the crypto space, because it's very rare to find somebody who's macro first that also has a pretty sophisticated framework and insight into Bitcoin. So I want to open up to you. How do you view Bitcoin in terms of a macro asset?
And what are the drivers for it? Because I think this is something that we've seen. Some folks take over some macro indicators like FedNet liquidity that became popular looking at, you know, QE and the Fed balance sheet.
So what do you think drives the returns of Bitcoin and what's your overall framework and philosophy for it? Absolutely. So I've I've written some articles on all of this. I've written some kind of Bitcoin primers and then I just wrote a thread on it, you know, breaking all that down.
It's on my sub stack and Twitter. But what I would say is this. When we approach any asset.
whether that's Bitcoin or anything else, we have to understand, okay, here are the popular narratives that people are saying that's driving it. And then we need to say, what is actually driving it? How do we create a framework of, in a sense, falsifiability, right?
If you kind of have this like, you know, your basic, you know, scientific hypothesis framework where you say, how do I, you know, you know, create a framework that says, if X, this is true, then this is going to be true. And how do I say, you know, falsify my view if I find out that I'm wrong. And a lot of the Bitcoin narratives are...
simply take a stance that's unfalsifiable. They just say it is what it is. It's like a circular argument of it is the new reserve currency.
It is this. And they don't have any falsifiability for it, which actually tries to elevate it to a level of philosophy that is on this meta level, which is wild to me. But that's beside the point.
So when I think about Bitcoin, when you say what are the actual drivers? So. A lot of people will say it's going to be used to denominate goods and services in or something like that. Right now, we don't see that.
We see goods and services maybe being denominated in dollars and you pay with Bitcoin, but they're not being denominated in Bitcoin. And there's not enough goods and services being transmitted through to cause any noticeable change in the float. Right.
So if you're going to say like Bitcoin is going to be used as. currency, like an actual currency, like the US dollar to buy goods and services, then we're going to see a rise in goods and services being transmitted through that as a transaction layer. And we're going to actually see the float get constrained by that.
We haven't seen that basically at all. So we've seen it a little bit maybe here and there, but not enough to move the price. What we have seen is Bitcoin as a liquidity release valve, where it is being used in some capacity similar to gold. It is being used when we have an expansion in just macro liquidity.
So that's where a lot of people have talked about, okay, that's why people have shifted their narrative of like, okay, maybe it's not going to be transmitted for good and services, but it's going to be a reserve asset. And that's why we have the ETF and all this other stuff. So that is kind of where I fall a little bit more. I think it has that, in one sense, reserve asset function.
Maybe people want to hold in their portfolio. But what we see. historically, even pre-2020 and during the 2017 and that whole rally and things like that, is Bitcoin is fundamentally a liquidity release valve. And as liquidity in the financial markets expand, for example, like real rates, when inflation is above just the level of interest rates and things like that, Bitcoin reflects that.
differential. In the same way that the dollar can move up or down against a currency to reflect a purchasing power differential, Bitcoin does the same. And we see that in its connection to macro liquidity. The whole question is, how do we define macro liquidity? Because everyone has this different view of macro liquidity.
And first, someone takes the Fed balance sheet, and then they take reserves, and then they take the TGA, and then they have all these weird calculations. And then you're at this point where it's just like... I don't even know what these guys are doing, but I'm just going to hold it and hope for the best.
So at the end of the day, Bitcoin is driven by two things in terms of liquidity. It's the price of money and the quantity of money. The price of money is just going to be interest rates. And you can look at that against nominal and real rates in Bitcoin. And you can just run a simple regression or correlation analysis, whatever you want to do, on how those things relate.
you'll see that there's actually a pretty reasonable correlation between those two. And if you say, okay, that's one input. And then the other side is just the quantity of money in the system, which is just how much is in terms of the sovereign authorities and private sector liquidity, which is the Fed, the Treasury, and then private sectors, commercial banks. And you can kind of throw a couple other things in there. What's the net impact of the quantity of money in the system?
For example, the simple one that everyone talks about is The Fed can keep interest rates at an elevated level or a low level, but then they can move QE and QT, their Fed balance sheet, up and down. And that needs to be priced by the market somehow, right? And that's going to be priced in financial assets, Bitcoin and gold and things like that. So I really come to Bitcoin from that perspective to say, map it against macro liquidity, which I have some pretty good models for. to track all the sources of it.
And then after you have mapped it against macro liquidity, overlay some positioning things where you see, okay, Mt. Gox has been selling, you see the US government selling for some of these seizures, Germany selling, and you say, okay, I know why these deviations are taking place. I know why you're having a idiosyncratic move that doesn't have macro durability. Actually very similar to the S&P 500, right?
We saw positioning unwind. Yeah. And- It's not supported by the macro regime in the sense of its durability. And I'm saying, oh, I'm going to take the other side of that. So that's kind of how I approach it right now.
Nice. So do you think that's what's been happening recently where, you know, it seems like based on your framework of, you know, the price of money and the quantity of money, those are going to be heading in a positive direction for Bitcoin. But we've seen it be quite sluggish over the past couple of months.
And it seems like there's been these idiosyncratic deviations from where macro is headed. So is that what you're seeing right now? And is that going to resolve itself soon?
What do you think is going to happen over the next, you know, six to eight months? Yeah. So in my mind and like the strategies I'm running.
you have the deviations. If you just look at the correlation between Bitcoin and let's just say every major risk asset that's also impacted by macro liquidity, it's deviated a little bit from the NASDAQ and the S&P 500. You can look at some more high risk sectors in terms of quality and junk and things like that. But overall, we've seen Bitcoin deviate marginally from broad risk assets. It's still up year to date, but we've seen it deviate.
If you look at all of the price action during that time, it has... Each time it's deviated from broad risk assets, it's always been, year to date, an idiosyncratic driver, which is one of those situations where you have the Mt. Gox thing or Germany or something like that. If you think about how that driver is being transmitted through the float, they have X amount of Bitcoin.
They can't sell Bitcoin forever. That needs to be absorbed by the other players in the macro environment. which is still fair.
Bitcoin is a different asset than everything else, so its risk needs to be priced differently. That's why you don't want to just blindly look at the correlation to the NASDAQ or ES and just say it's just going up. If those idiosyncratic drivers, in terms of those things causing it to deviate from risk assets, if those don't have durability behind them, which it doesn't seem like they do, theoretically, you can just have continuous large players come on and just sell. That's still possible. So you still want to use risk management and be wise about it.
But eventually, the macro environment is one that is accommodative enough to allow that supply to be absorbed by the market. When we see all other risk assets rallying and Bitcoin holding its level, that tells me that the macro environment is actually absorbing that supply. It's actually not breaking down.
It's just holding its level, which is a sign for how you need to think about the information that's being priced into it for that supply that's coming online. So overall, bullish on Bitcoin as we stand right here. I shared a risk reward last week for I think we're going to remain above that liquidation level that we saw. It's about $49,000, $50,000 area. That's a pretty clear signal.
in terms of positioning unwind. Everyone got washed there. And all of this idiosyncratic positioning from the news from Mt. Gox and all this other stuff is coming to an end.
The macro environment remains bullish. And in my view, over the next 12 months, there's a very high probability that we'll move up and hit around 100K, I think, in the next 12 to 18 months. So I am long.
I think if we moved below that 50K point and we closed below that, I'd be stopped out of the trade and I would say that my view was wrong and I would reanalyze things. But for now, I'm maintaining a bullish view. Well, look, I really enjoyed our conversation. I love the way you think about Bitcoin as an intersection of as a macro asset.
If folks want to hear more about you and read up on some of your research and educational primaries, where can they find you? Absolutely. So.
You can go on my website and my sub stack. It's just capitalflowsresearch.com. And then I'm also on Twitter at global flows. But yeah, I really appreciate being on here.
It's cool to chat with you and bounce ideas back and forth and talk about different macro views. Awesome. Yeah, likewise.
Thanks again for joining. Yeah.