The Ugly Truth about the Federal Reserve (w/ Danielle DiMartino Booth)


ED HARRISON: Danielle DiMartino-Booth, I’m
very excited to have this conversation with you. Because your name has been bandied about in
terms of a lot of the things that are happening with the Federal Reserve. But as you know, when I was talking to you
earlier, we’re going to be talking about investing ideas over the next six to 24 months. And we’ll get to some of the Federal Reserve
stuff at the end of that. I wanted to start out with your macro view
in terms of in the environment that we’re in today, what is the macro call that you
see for the say, the next six to 12 months? DANIELLE DIMARTINO-BOOTH: So, at the beginning
of the year, Quill Intelligence came out with its three big predictions for the year. One of them was that Germany would go into
recession, it looks like we’re just about there. The other was that the 10-Year Note would
get down to 2%. People thought we were absolutely nuts. And the third one was that despite all of
this, we saw the dollar strengthening. And we’re standing by all three of those calls
for the remainder of the year, despite the fact that our targets have largely been met. Mainly because if you look outside of the
United States, there’s every reason to believe that the United States will continue to be
the most attractive horse in the glue factory as my old boss, Richard Fisher, used to say. So, on a relative basis, we’ve got talks about
the European Central Bank relaunching stimulus, I think that Japan would certainly follow
them, Australia’s in a cutting move after an expansion that’s lasted almost 30 years
because China’s slowing to the extent that it has. So, if negative rates are going to be getting
more negative, then there will be a flocking to the 10-Year Treasury at the same time that
we know that there aren’t enough dollars out there. There’s simply a dearth of dollars, a dearth
of dollar funding, which is going to have investors continue to clamor to get their
hands on greenbacks. So, a lot of these things run cross current
to one another. But the overarching, I haven’t bought gold
in years. But a few months ago, I finally stepped back
in and said, we’re not going to be decoupling forever. Everybody on bubble vision who says that the
United States can indefinitely decouple from the rest of the world, I’m like, I’ve heard
that somewhere, like a decade ago, and it didn’t work out too well then. And I think that that’s why we’ve seen gold
pushing six-year highs here. ED HARRISON: So, let’s unpack that. That’s a lot in terms of the US economy, because
that’s where the rubber hits the road in terms of what you’re talking about. And you have a bevy of stats that you look
at that traditional macroeconomists aren’t getting into the weeds into these places. Tell me what are the things that are the most
salient for you in terms of where we are? Are we actually on the cusp of recession there? DANIELLE DIMARTINO-BOOTH: I think that the
US economy is definitely sliding into recession. And you mentioned where the rubber hits the
road, I like to think of big sell side, macroeconomists as saying, well, the car is running so it
must be fine. Well, they’re just looking at the headlines. If you look underneath the hood, there’s leaks
here and tubes breaking there. And the engine’s about to break down and your
transmission is about to fall out. And if you look at things like the Cass Freight
Index, when they were down month over month for three months in a row, and then four months
in a row, and then five months in a row, they held the line saying this could just be a
slowdown, like the industrials recession of 2015 and 2016, we could be coming out of it. But once they hit that six consecutive month
of year over year declines, we are a nation of consumers, we are what we buy. And if there are fewer trucks delivering whatever
Jeff Bezos is selling us, then that is a sign that a consumption-led economy is slowing. So, after that sixth consecutive month, Cass
came out and use the word contraction, that they see a contraction in the third or fourth
quarter of this year. And I can’t disagree with their assessment,
given the fact that even, even a labor market has started to show some signs of serious
weakening. ED HARRISON: Tell me about the labor market
in particular, because one of the things that I find interesting is the concept of revisions. That is, is that two things on that. One is the real time revisions that we say,
oh, by the way, the last two months, we revised them down, but also then the benchmark revisions
that we have now. So, in some senses, we’re not really seeing
the actual numbers that we will see once all the data come into play. DANIELLE DIMARTINO-BOOTH: And to your point
about benchmarks, I think we need to pay particular attention, because for a few years there,
we could just ignore them because they were being revised upwards. But that hasn’t been the case in recent years,
I wouldn’t expect that to be the case in the latest batch that we’re expecting. And on top of that one of the first things
that they teach you at the Federal Reserve is that lags matter, which we know they do. And the tightening that was unleashed that
ended in December, it’s still percolating its way through the economy in various forms. But also that backwards revisions really tell
us what inflection points are, that June non-farm payroll headline, it was fine. But we had what the Fed considers to be a
moment of truth, three consecutive months of downward revisions to the prior months. That tends to tell you that the unemployment
rate is heading up and that we’ve seen peak labor growth if you start to see these backward
revisions in real time. We’re not waiting a year for the benchmarks. We’re seeing them in real time right now. Three consecutive months running. ED HARRISON: Yeah. So, let’s think about this, the 10-Year Treasury
in that context, because what you’re talking about is a slowdown in growth in the United
States, and potentially a recession coming on to that. So, what does that mean in terms of your macro
thesis of the Treasury from here? Because we’re already near the 2% level that
you talked about earlier. Do you see that going even lower? Because we spoke to Garry Schilling, he’s
talking about 1%. DANIELLE DIMARTINO-BOOTH: I’m good friends
with Gary and I read some of his work. But if you think about what some of the prior
lows have been in the cycle, 1.65. If we’re actually going into recession and
we’ve bounced off these lows before when it was just a dress rehearsal, it’s just an earnings
recession, we’re going to be fine. We’re going to come out of it. Not once, but twice. And again, the major differentiating factor
between those earnings recessions and now is that we have residential construction that
is going down. 11.2% rate, the latest read over the prior
year. That was a huge tailwind during the industrials
recession of ’15 and ’16. We don’t have that as an offset. And that tells me that there’s no reason in
the world, if a larger proportion of the US economy is slowing that we wouldn’t break
through that 1.65 and keep going back towards 1%, especially again, given what’s happening
off our shores. ED HARRISON: And so actually, I wanted to
pivot to other things in the US economy when you said off our shores. Tell me about that. What is actually happening? You were talking about the second and third
largest economies- Germany and China, what’s happening there? DANIELLE DIMARTINO-BOOTH: Well, they’re exporting
powerhouses. And there’s a symbiotic relationship between
the two of them. So, you and I were speaking before about the
fact that you can’t urbanize an entire country twice. So, China’s checked that box. They won’t be able to pull the entire world
economy out. If you look at worldwide car sales in 2008-2009,
it looks like just a little blip and then off we went to the races. That was largely a reflection of Chinese strength. That was also seen in Germany, exporting millions
and millions of cars, BMW, Mercedes, Volkswagen, these massive brands rely on China as an export
market. And that is simply not there. And we’re beginning to see a trickle-down
effect. We’re seeing things like the beginnings of
rising unemployment in Germany. And Germans are beginning to talk about fiscal
relief and spending more. They’re the most prudent people in the world. They do not want to take debt on, but they
know that their economy is going to be needing it. And soon, and that there’s no way to turn
away from the fact that the bulk of their auto manufacturing is the internal combustion
engine when their main consumer, China, has changed over to electric vehicles. So, these are structural moves that we’re
seeing here. And there’s no reason to believe that given
the amount of investment that’s been made by these companies in the United States, think
of BMW in the South, think of the South Carolina presence of so many of these companies, Kentucky-
a lot of- it used to just be Detroit and the Midwest, but foreign, especially German manufacturers’
presence in the United States has been a huge benefit to the entire manufacturing sector. That’s going away, not disappearing. But it’s definitely decreasing at a time that
we’re seeing retail sales, retail car sales in United States, also on the decline for
the first six months of the year. Everything’s being flattered by fleet sales,
but don’t buy that. Don’t buy it when Fiat Chrysler comes out
and says we had a great month, by the way, one in four of every cars we sold was fleet. That is not a reflection of a strong US consumer. ED HARRISON: That is interesting. You talked about housing not being a tailwind. Now, we’re talking about autos not being a
tailwind. DANIELLE DIMARTINO-BOOTH: Two leading indicators. ED HARRISON: And then we’re talking about
the foreign sector as well, in terms of the fundamentals, I thought it was interesting
that you didn’t mention policy there. That you’re actually looking at the fundamentals
and you’re saying that the fundamentals are weak. But what happens when you add the policy in? The policy mix into that. Especially with regard to trade because autos
is a big part of that? DANIELLE DIMARTINO-BOOTH: Well, so I think
one of the most disturbing things to come out of the G20 is that it looks like the administration
might be moving its focus to the European Union. Nothing worse could possibly happen if you’ve
got those tariffs that are running 24/7 in China and you are to start to throw even threats
of tariffs to the EU. But it looks like Trump might have them in
his crosshairs, that would not be a beneficial development. But everything that we’ve seen shows that
this trade war is just going to be this constant drag, this constant source of uncertainty
that’s reflected everywhere, but the US stock market. ED HARRISON: And so, what does the Fed do
given that because off-camera, before this, we were talking about the Fed’s dilemma and
so forth. And I think it all starts with December. Basically, that when December happened the
markets threw up, Jerome Powell came, and he was saying I repent, we didn’t really mean
it. DANIELLE DIMARTINO-BOOTH: January 4 th, Powell
pivot. ED HARRISON: And everything has changed since
then. And now, people are expecting even 50 basis
points of cut, 75 this year, is that really going to happen? DANIELLE DIMARTINO-BOOTH: I think that the
Fed would prefer that that not be what unfolds here. Who knows whether or not all of the bullying
from the White House caused them to hike rates in December, just to be able to show their
independence. Not say they’re independent of what the administration
is asking them to do, but to show it with a force of power by raising rates, even if
it’s going to hurt the economy. Now, that’s against the Fed’s mandate. So, but I think the conventional wisdom among
the hawks is that if we just un-ring that bell, if we just undo the damage from that
December hike, that we’ll be able to look forward and look to resume hiking rates by
2020, 2021. It’s not typically how things work. It really isn’t. But we have to bear in mind, rate cutting
cycles entail 550, 525 on average basis points of cuts. What? Do we have half of that now? So, they don’t have a lot to work with before
they’re sitting around that great big table at the Federal Open Market Committee and debating
negative interest rates. I don’t think they want to go there. Jay Powell doesn’t want to go there. But it’s why they’re trying to keep their
ammunition in reserve and toe the line and hope for the best and say, we’re going to
pull out of this. We’re just going to undo December on July
the 31st. And it’s going to make everything better. ED HARRISON: It sounds almost like they’re
in denial. Because when you’re talking about interest
rates going from 2% down to 1.6513% and the Fed’s talking about keeping rates on hold,
then that would suggest that you have a sharp deterioration in the economy and that the
Fed will at some point be forced to really unleash a torrent of rate cuts. DANIELLE DIMARTINO-BOOTH: But they don’t have
a torrent to release. So, there’s this underlying dilemma, but there’s
no denying, we just got a big layoff announcement at BNSF. We know that it’s not just the Cass Freight. It’s not just truckers. We’ve seen port activity come down. We’ve seen rail activity, intermodal activity
come down as well. So, we’ve got the first big railroad on the
wires now announcing layoffs. So, we’ll see a 12th consecutive month in
July of Challenger, Grey & Christmas layoffs increasing over the prior year. It used to just be a retail story that everybody
said whatever, JC Penney’s going out of business, Gap is going out of business. Who cares? This is just an ongoing story of the US consumer
moving to an ecommerce platform, no big deal. Fade the retail layoffs. But earlier this year, it shifted to auto
industry layoffs and industrial layoffs. And now we’re seeing layoffs in rails. And a few months ago, we saw technology layoffs. These are high paying jobs that make no mistake
were reflected. Again, look under the hood of the car. Just because the car is running doesn’t mean
that it’s about to- the engine block is not about to break in half. You’ve seen the average workweek, average
weekly hours- excuse me, average weekly pay. And I look at that instead of hours. Because I take home a weekly paycheck, you
take home a weekly paycheck, Americans take home a weekly paycheck. They don’t take them an hour at a time. And we’ve seen the growth rate on a six-month
annualized basis decrease from January’s 4% level, which was a great strong level to 2.7%
in July- excuse me in June. This is not a dress rehearsal. This is not a drill. This is the real deal. And we’re seeing weakness in the workweek,
weakness in temporary employment. These are all leading indicators of what’s
to come. So, if the Fed’s in denial, God help them. ED HARRISON: So, going back to your original
thesis, because I think we definitely have it covered that the 10-Year in that scenario
looks like a very bullish call. But what about the second part of that with
regard to the dollar? The US dollar, this is a relative value play
it sounds like vis a vis the Europeans because the picture that you’re painting there is
not a great picture for inflation or for the US dollar. Why are you slightly bullish on the on the
US dollar? DANIELLE DIMARTINO-BOOTH: Well, so I think
that Christine Lagarde has been called to serve at the ECB because she might be fighting
a war on two fronts. She could be facing a Brexit issue at the
same time that she’s looking at recession in Europe. And that will require bringing rates down
even further and relaunching quantitative easing which is unthinkable because they haven’t
even begun to normalize monetary policy there. But if we know that our next step is going
from -0.4% to -0.5% on overnight lending and that’s exactly by the way, what the German
bund market is telling you- that we’re going further into negative territory, that’s going
to keep US paper and the US dollar in a relative basis, much more attractive. And again, there’s that dollar funding. So, which is a whole different dynamic in
and of itself that there will be demand for dollars even if the Fed cuts rates. And I don’t think a lot of people are anticipating
that. And by the way, even if we have deflation. You can still keep a floor underneath gold
prices. Because if you look back at the past few decades,
even in deflationary times, if deflation has been a mirror image of the fact that there’s
turmoil in the economy, gold is still treated as a safe haven. ED HARRISON: So, that was my next question
actually. DANIELLE DIMARTINO-BOOTH: I’m jumping in front
of you. ED HARRISON: The third part of your thesis
about gold. Obviously, if you have zero rates, you’re
not losing interest income by holding gold. But you’re talking about gold as a hedge of
uncertainty. Not necessarily inflation, per se. DANIELLE DIMARTINO-BOOTH: No. It’s much more so to work inside of the Fed
for almost a decade. And you learn a lot about correlations. And correlations line up during times of market
turmoil. And there are very few places to hide when
you have Greek sovereign paper trading right there alongside the 10- Year US Treasury,
when you have a chunk of European junk bonds with negative yields. So, it’s not just so much that risky asset
prices are going to line up but not in a good way. It’s the extent to which they’re going to
line up, which I think is going to push a rush into gold with people to seek just pure
portfolio protection. ED HARRISON: And going back to the whole European
thing in terms of what could cause this unleashing of- we need to go to safe havens. We were talking earlier about Deutsche Bank,
I think that the question for me is when you compare it, let’s say, to Bear Stearns, or
something like that, in 2008, is are we prepared for what could happen with an event like Deutsche
Bank? And is that an event that could happen that
Deutsche Bank could go bankrupt, or they’re too big to fail, and therefore, they’ll be
built out in some capacity? DANIELLE DIMARTINO-BOOTH: I think Deutsche
Bank is too big to fail. And I think that that’s pretty well acknowledged,
plus Germany’s got a lot of money. So, I wouldn’t expect for that to happen on
their watch. But the question is, and Raoul Pal’s spoken
of this extensively, written of it extensively, is whether or not there’s any a contagion
effect. With Deutsche Bank, you’re not just moving
a bunch of derivatives from one place to another, which was a Bear Stearns event. You’re talking about over-the-counter traded
derivatives, and nobody can really put a value on what they are. I’m not a big Deutsche Bank expert. But what I can tell you is that because so
much of the financing in the current cycle has moved into the shadows, we’re sitting
on $2.5 trillion of private equity, dry powder. Because so many world markets have moved on
to corporate bond platforms and away from the conventional banks that you could argue
might be stronger, not in Europe. But you can’t tell me, I can’t tell you. If you asked me today, Danielle, where is
systemic risk going to happen? I have no idea. I didn’t know that Landesbanks were going
to be the problem, that they were going to be the holders of subprime. I’d never heard of a German Landesbank holding
subprime bonds. But that was the problem back then. And it’s interesting that we’ve seen a few
hedge funds here and there have liquidity issues overseas, and now, we see the Deutsche
Bank. History never repeats itself. I appreciate that. But you hear these things, and you start to
go, God, remember when HSBC released that? Because they bought that American subprime. Remember Bear Stearns hedge funds? And they just seem like, little ripples at
the time. But within several months’ period, we know
what happened. And then we had our Lehman moment. So, I don’t know if Deutsche Bank can be contained
or not. I think that the conventional wisdom is that
we will be able to move the bad assets and to contain the risk of contagion. I hope that that is the case. But I couldn’t tell you. ED HARRISON: We can use Deutsche Bank as a
proxy for any bad thing that would happen. And ultimately, the central banks are going
to be involved in containing the risk. But the risk today seems to be that the central
banks, their independence is under fire. You probably saw just a while ago, Art Laffer,
who I found it somewhat- I was surprised that he was saying basically, central banks should
not be independent, that central banks should be under the auspices of the legislative and
executive branch. What do you think of what Laffer was saying? DANIELLE DIMARTINO-BOOTH: Well, central banks
certainly shouldn’t be under anybody’s control. They should be accountable for their actions,
and they should be more disciplined in their approach. And I’ve advocated for this forever. I wrote a whole darn book about it. But I would say that the dual mandate has
caused an inordinate amount of mission creep at the Fed and that they have kept rates too
low for too long to honor that second mandate of maximizing employment. And that has caused all manner of mischief
and malinvestment and boom and bust cycles. And it all, to me, ties back to that second
mandate. I think Congress needs to remove it. And to put the Fed back simply on- look, the
ECB is purely on an inflation mandate. And for them to be lender of last resort in
times of true crisis, not saying that quantitative easing is going to be part of the conventional
toolbox going forward. These were emergency measures when we went
into the last crisis. And we’re being told now that it’s just normal. ED HARRISON: What could you see the central
banks doing? If we did have an event like the Deutsches
of the world happening, what would be the things that they could do that you think would
be justified? DANIELLE DIMARTINO-BOOTH: Yeah. Ed, again, it’s hard to say because you’re
asking me about systemic risk in a different way. When we had the junk bond market seize up
at the tail end of 2018, when there were no junk bonds issued for 41 consecutive days
of record, we saw that withdrawals spiked, we saw that spreads spiked. And there were a lot of rumblings about the
underlying collateral and these exchange traded funds trading by appointment only. And yet you’ve got instantaneous redemptions. So, there’s an inherent conflict there in
the structure. And that’s one of the few things that Janet
Yellen on her watch ever mentioned specifically was bond ETFs, bond exchange traded funds
becoming potentially problematic. How is the Fed supposed to go in and manage
something like that? Buy corporate bonds? It’s hard to say. And that is definitely something that was
fiercely debated on the inside during the crisis yearswas what would the next step be
because few people realize that the Fed owned an inordinate amount of the mortgage backed
securities market, which they’re trying to get out of, and they own 40 and 50%, of certain
Treasury issues. So, it wasn’t that Bernanke found his inner
hawk and said, I’m ready to taper because you know what? By golly, I can do this. I’ve got my big boy pants on. It wasn’t that. It was the mechanics of the underlying markets
that was really starting to cripple under the stress of there being a price agnostic
buyer grabbing all the paper that it could so the taper needed to be done. That leads the question of what would be next
for the Fed? Do they go the way of Switzerland? Do they go the way Japan? Do they start buying up all kinds of things? And I think that that’s what the stock market
hopes. ED HARRISON: So, a lot of the things that
you’ve been saying, really, they hold together really well. And one of the keys, for me, at least is that
it’s about the fundamentals. And the fundamentals having deteriorated for
a number of months now. But what would you say what would you need
to see to see that actually, you know what, this trade, that is the 10-Year trade, the
gold trade, or even the dollar trade, they’re not working, the fundamentals have changed
in some capacity, what is it that you would need to see? DANIELLE DIMARTINO-BOOTH: Well, at Quill Intelligence,
we actually had to step back from one of the calls that we made because of the tariffs,
and the threat of the tariffs, causing this torrent of panic buying of American companies
trying to get in front of the threatened and then impose tariffs. So, they were stockpiling. So, we saw activities at the ports spike. We saw a temp temporary employment spike. We saw initial jobless claims come back right
back down. We had a double bottom in September and in
January. And that had to do with the fact that if you
were manufacturing this country, or if you were an importer of textiles, or tennis shoes,
you had to get off your duff and buy things and buy things immediately. And that was why the freight costs went through
the roof. And it was an extremely unexpected amount
of stimulus that went surging into the economy and caused this big Q1 GDP number that was
in many ways built on that inventory, on that stock building. So, we had to pull back from that. So, if somebody can pull a rabbit out of their
hat, I don’t know if China can do that. They threw almost a trillion dollars at the
world economy in the first quarter. And it hadn’t moved the needle very much. So, if there’s something that might come out
of the administration, for example, or a surprise infrastructure bill, something of that magnitude
that was unexpected, that stopped the trends that we’re seeing from deteriorating further,
then we would have to revisit our thesis for sure. ED HARRISON: And one final question on that,
because I know beforehand, we were talking off-camera about the New York Fed’s- their
prediction or how could you put it- their trans recession? DANIELLE DIMARTINO-BOOTH: The New York Fed
recession probability model, yes. ED HARRISON: And the number that they’ve gotten
to, 32.9%, we’ve never had a number that high without a recession. DANIELLE DIMARTINO-BOOTH: It’s at a 12-year
high. There’s no wiggle room there. And what people need to realize is it doesn’t
need to be at 40% or 50%. When the New York Fed’s model was at 40% last
time, we were in recession. It was in the rearview mirror, we were already
in the soup. So, when a metric like this starts to hit
something like 12-year highs, it is time to pay attention because it doesn’t matter what
the stock market is advertising, pay much closer attention to the message in the bond
market. ED HARRISON: Well, we’ll have leave it there. I have to say that you make a very compelling
argument. Thank you, Danielle DiMartino-Booth. DANIELLE DIMARTINO-BOOTH: Thank you very much. ED HARRISON: Danielle’s investment idea is
to take a defensive posture by overweighting Treasuries. She recommends the 10-year benchmark and sees
it eventually breaking record lows. Danielle also recommends the US dollar as
a currency that will benefit from recessionary liquidity flows. Finally, Danielle also believes gold will
benefit as the downturn create systemic risk that will induce investors to seek a store
of value.