A Liquidity Masterclass: Preparing For A Credit Cycle Downturn | Darius Dale

Name: A Liquidity Masterclass: Preparing For A Credit Cycle Downturn | Darius Dale
Uploaded: 2023-04-01T13:00:05.000Z
Duration: 1 h 56 min 49 s

Introduction

In this section, the host introduces the guest, Darius Dale, and they discuss his recent bachelor party.

The host welcomes Darius Dale, founder of 42 Macro, to the show.

They briefly discuss Darius's recent bachelor party in Miami.

Don't Be a Hero

In this section, Darius explains why he recommends not being a hero in the current market environment.

Darius recommends not being a hero due to where we are in broader cycles that matter to asset markets.

He mentions that while liquidity is important for the cryptocurrency community, there are other cycles such as growth and inflation that have yet to play out.

Extrapolating signs of a fresh bull market from short-term pumps can be dangerous given these traditional business cycle processes have yet to play out.

Inflection in Liquidity Cycle

In this section, Darius discusses the inflection in the liquidity cycle and how it affects risk assets.

The number one signal on Darius's screens is an inflection in the liquidity cycle.

The Fed's balance sheet has grown considerably in recent weeks as a response to emergency lending due to the banking crisis.

However, if you subtract emergency lending programs which must be paid back and are collateralized, net liquidity has not risen and is continuing to trend lower.

There may be pain ahead for risk assets particularly in the second half of 2021 and potentially even into early 2022 once we get past repricing near-term growth dynamics.

Interpretation of Fed Balance Sheet Data

In this section, Darius explains how to interpret data related to the Fed's balance sheet.

The right way to interpret data related to the Fed's balance sheet is to not Occam's razor it.

The Fed's balance sheet has grown considerably in recent weeks due to emergency lending programs, but net liquidity has not risen and is continuing to trend lower.

It is important to consider the broader cycles that matter to asset markets such as growth and inflation.

Understanding Liquidity in Financial Markets

In this section, the speaker discusses the importance of understanding liquidity in financial markets and how it is affected by quantitative tightening.

Two Broad Buckets of Liquidity

The speaker suggests that focusing narrowly on the public sector side of the equation is a mistake as deflation in private sector liquidity is likely to continue.

The two broader buckets of liquidity are public sector and private sector balance sheets.

Narrow money growth in the US economy is contracting at -5.8% YoY, which is concerning. World narrow money growth on a PPP basis is also contracting just shy of 1% YoY.

Refinancing risk levels are at their highest since 2008.

Emergency Lending from the Fed

Emergency lending from the Fed to help banks raise cash buffers and support deposit outflows is not good liquidity. It does not create bank deposits that hypothecate themselves through the financial system in the form of rising stock prices or asset values.

While emergency lending may be a lifeline to banks, it's hardly stimulative like what was seen in 2020/2021. The reverse repo facility was intended to be temporary but could become permanent if there continues to be strain in the banking sector.

Government Programs and Bailouts

In this section, the speaker discusses government programs and bailouts and how they can lead to continued dependence on them.

Dependence on Government Programs

Once you give people free money or a free lunch, they will want more. This leads to continued dependence on government programs and bailouts.

The speaker agrees that the emergency lending program will likely become permanent due to continued strain in the banking sector.

The Constant in Crises

In this section, the speaker talks about how crises change in shape and size but fear and greed remain constant. He also discusses the transition from greed to fear.

Fear and Greed

Crises change in shape, size, and magnitude.

Fear and greed are constants in crises.

The transition from greed to fear is a significant issue.

Bank Term Funding Program as Permanent Residents on Fed's Boundary

In this section, the speaker shares his opinion that the bank term funding program (BTFP) will eventually become permanent residents on the Fed's boundary. However, he believes that getting there requires pain.

BTFP Becoming Permanent Residents

BTFP will eventually become permanent residents on the Fed's boundary.

Getting there requires pain.

Big Problems Require Big Solutions

In this section, the speaker talks about how big problems require big solutions from the government. He also discusses how he thinks we're going to have to face some significant problems before we get rate cuts, QE, and other liquidity extensions.

Big Problems Require Big Solutions

You don't get big solutions out of thin blue air; you get them as a response to big problems.

We're going to have to face significant problems before we get rate cuts, QE, and other liquidity extensions.

Phase Two Credit Cycle Downturn as Catalyst for Liquidity Extensions

In this section, the speaker talks about how he thinks phase two credit cycle downturn is the catalyst for getting rate cuts, QE, and other liquidity extensions.

Phase Two Credit Cycle Downturn

Phase two credit cycle downturn is the impact of tighter monetary conditions on the real economy and asset markets.

Phase two credit cycle downturn is the catalyst for getting rate cuts, QE, and other liquidity extensions.

Inferring from BTFP

In this section, the speaker talks about how we can infer something from BTFP as it relates to the liquidity cycle. He also discusses how private sector liquidity cycles are headed for a deep and severe downturn.

Inferring from BTFP

We can infer something from BTFP as it relates to the liquidity cycle.

Private sector liquidity cycles are headed for a deep and severe downturn.

Climbing the Mountain of Asset Market Pricing Terms

In this section, the speaker uses a mountain climbing metaphor to explain how investors often overlook the challenges of moving from one step to another in asset market pricing terms.

The Challenge of Moving from Step Two to Step Three

Investors often overlook the challenge of moving from step two (public-private sector money deflation) to step three (rate cuts and QE).

Climbing down into the valley of despair is necessary before climbing up to step two.

Negative events occurring in the real economy must happen before reaching step two.

The Painful Journey Down the Mountain

The journey down involves going through a painful valley that requires hiking back up.

Monetary policy works with long and variable lags, which are supported by actual statistics.

Catching up with those long and variable lags will involve small bank deposit outflows and raising cash to meet those deposits.

The Process of Tightening Monetary Policy

The Fed tightens monetary policy to tighten credit conditions among banks so they can tighten credit commissions in the real economy.

Small bank liquid deposits count for roughly around 30 percent of total bank deposits. They are drawing down at around six percent from peak to present, which is a sharp drawdown by country mile in history.

Credit Crunch in Small Banks

In this section, the speaker discusses how small banks are incrementally pulling back on credit and how this will lead to a credit crunch that will spread throughout the real economy.

Small Bank Loans and Leases

Growth rate of small bank loans and leases has been cut in half in the last few weeks.

This number is going negative in our opinion, which almost has to go negative as a result of these deposit outflows.

Small banks account for roughly 40% of the loans and leases in the real economy.

They account for 67% of commercial real estate lending.

Tighter Regulation

Talks to lower the systemically important financial institution threshold which would ultimately cause them to raise more capital and hold more capital against their loan books.

This will force other banks to change their lending standards, practices, and ultimately raise a lot more capital.

Reflexivity

Tightening credit standards raising spreads on loans etc. is reflexive because when I tighten credit for you Mike you're going to spend less money.

It's reflexive on the way up it's reflexive on the way down.

Crisis in Small Regional Banking Sector

In this section, the speaker talks about the crisis in small regional banking sectors and non-bank lenders that have less regulation and are more comfortable taking risks.

Credit Contraction

The credit contraction they're seeing in banks is equivalent to something like a rate cut.

This is coming in the private sector of the economy as opposed to the public sector.

Shadow Banking Sector

Non-bank lenders that have less regulation and are more comfortable taking risk.

Credit, Loans and Leases

This section discusses the impact of credit, loans and leases on the commercial real estate market.

The Next Shoe to Drop

Commercial real estate is the next shoe to drop.

There will be various pockets of the economy and segments of the commercial real estate market that will be impacted.

Office Space

Office space is a big concern.

Record low occupancy rates have already been reached.

It's more of a 2024 story as it will take time for loans and leases to mature.

Higher rate regime and lower occupancy regime in office space will be starting to hit the tape.

Pullback in Credit

This section discusses how banks are raising cash by pulling back on lending, which could lead to issues in non-bank lending.

Borrowing from FED

Companies are borrowing money from the FED on an emergency basis to raise cash.

Banks start pulling back when they raise cash instead of lending to the real economy or other banks/non-bank lenders.

Shadow Banking

Non-bank lenders are saddled with collateral requirements going up in repo markets.

Collateral scarcity is rising, which affects non-bank lending that finances itself exclusively in repo markets.

Big players include hedge funds, insurance players, credit funds etc.

Lifeblood of US Economy

This section discusses how non-bank sector provides most of the lending in US economy and how it finances itself through repo markets.

Non-Bank Lending

Most lending (67%) comes from non-bank sector.

Non-bank lending finances itself exclusively in repo markets or pension funds.

Collateral requirements and margin requirements are going up, which affects non-bank lending.

Big Banks

Big banks are also raising cash.

Total commercial bank cash increased by $393 billion dollars, which was on par with the largest weekly increase.

The Ripple Effects of Raising Cash

In this section, the speakers discuss how the decision to raise cash will have ripple effects and lead to a contraction in credit and the economy.

Disproportionate Impact on Small Regional Banks

Small regional banks are likely to be disproportionately affected compared to larger banks due to their relationships with small businesses.

If there is a disproportionate amount of stress on these small banks, it could lead to a negative reflexivity loop that hits them harder than larger banks.

This could potentially lead to changes in unemployment rates as smaller firms struggle.

Tightening Monetary Policy and Economic Downturns

The Federal Reserve's tightening monetary policy in early 2022 was meant to accomplish certain goals, but it can also lead to economic downturns.

In any economic downturn, those who have taken on the most leverage and are poorly managed will go bust.

The credit channel for small business America vis-a-vis regional banks is getting broken, which could impact large firms as well.

Seeds of Credit Contraction Already Being Sown

There are already seeds of a credit contraction being sown due to tightening lending standards on commercial and industrial loans for small firms.

Respondents are reporting slower demand, which is similar to what was seen during COVID.

While there is still resiliency in the economy, we're starting to see things break down.

QE and the Investable Inflection in the Liquidity Cycle

In this section, the speaker discusses his opinion on quantitative easing (QE) and the investable inflection in the liquidity cycle. He also talks about how most people are not good traders and advises them to have patience.

QE and Recession

The Fed won't do QE until there is a severe contraction in the economy.

The Fed is implicitly targeting a mild recession.

The Fed will only supply unencumbered liquidity vis-a-vis QE if the recession turns out to be less mild than they thought.

Investable Inflection in Liquidity Cycle

We are at a tradable inflection, not an investable one.

Most people watching this program are terrible traders.

If you're not a great trader, sit out and wait for the actual signal.

Have some darn patience investing.

Resilient Economy and Recession

In this section, the speaker talks about his view that the economy will remain resilient for longer than consensus thinks. He also discusses how more tightening than investors would have thought could make the downturn worse.

Resilient Economy

The economy will remain resilient for longer than consensus thinks.

Tightening more than investors would have thought has already been realized in data.

Downturn Worse Than Expected

More tightening could contribute to a worse downturn.

Consensus understanding of how much extra tightening we got is going to contribute to the downturn.

It's appropriate to start stress testing portfolios for a more significant recession.

The Relationship Between Recessions and Asset Prices

In this section, the speaker discusses the relationship between recessions and asset prices.

How Asset Prices Behave Around Recessions

The market cycle is separate from the business cycle.

Bear markets tend to bottom around three months before or after the inflection point in the growth cycle.

Bear markets tend to bottom around one month after the inflection point in the liquidity cycle.

The Pause Pivot and the Likelihood of a Recession

In this section, the speaker discusses his opinion on why he thinks the pause pivot will not work in preventing a recession. He cites various indicators that suggest a recession is likely to occur in the second half of 2023 or the first quarter of 2024.

Too Close to Recession

The speaker believes that we are too close to a recession for the pause pivot to work.

Various indicators such as continuing claims as a percent of total labor force and the spread between leading and coincident indices suggest that a recession should commence sometime in the second half of 2023 and the first quarter of 2024.

The tightening of repo market conditions and bank deposit outflows could be pulling forward this timeline.

None of the pivots (pause, actual, or panic) will come anytime soon because it's too close to recession.

Actual Pivot

An actual pivot to rate cuts and QE is not going to come until we're perhaps in phase two credit cycle downturn in actual markets.

The markets are going to have to grab J-Pal by the collar and say Mr. Powell stop pausing and start cutting rates and doing QE.

The "we need drugs" moment is going to happen in the second half of this year.

Market Expectations vs. Fed Guidance

In this section, the speakers discuss how market expectations have been increasingly diverging from Fed guidance over time due to increasing prevalence of forward guidance channel. They also talk about how there's been a withdrawal of that cocaine and how the market is now expecting a pivot.

Market Expectations

The two-year is pricing in differently from what the Fed is saying they're going to do.

The difference between what the bond market thinks the Fed is going to do right now versus what we're talking about here could be interpreted as the market taking a firm tug on the arm.