The Fed's Balance Sheet Plans Are Kryptonite For Risk Assets | Andy Constan

Scale is the blockchain that's truly built different Explore More at scale.png one of the world's best crypto conferences for institutional and professionals alike it's going to be a ton of fun I'm going to be there hosting a variety of different panels I'll be doing a fireside chat with Muhammad aleran a different macro panel with Jim Bianco and Joseph Wang and we're also going to be doing a live for guidance Roundup there where myself Tyler and Quinn will be chopping It Up live for the guys Emporium so make sure to get your tickets it's going to

sell out quick I know it it's going to be a ton of fun so come on out and yeah just hit the link in the show notes and you can go purchase your ticket today all right welcome back to another episode of Ford guidance and joining me today is repeat guest Andy constant of damp spring needs no introduction but I'll provide it anyway it's great to have you back on the show it's been a minute you're on a few months ago with me uh I think it was around August or something like that so yeah

great to catch up there is a ton going on I want to start off the conversation with this this term that you've you've coined I think as far back as a year ago of quantitative tightening 2.0 and really unpacking that idea and tying it to what was discussed in the FED minutes and and The key takeaway there is this idea that they mention in the minutes that they basically want to have the weighted average maturity of the Som portfolio which is effectively the FED balance sheet match the weighted average maturity of treasury debt outstanding so

I would love for you to just walk us through what are these key concepts of QT 2.0 and how does that relate to what was discussed in these minutes right so I I mean I guess the idea is first we Have to go back to what QE was where the FED bought um $3 trillion of um Securities and offset the fiscal spend treasury Securities they also bought MBS um and that created a and easing in financial conditions because it required the U it removed risk from the market so that private sector participants could uh recycle

that money into more risky assets and so you know that's how QE generally works it doesn't attempt to set an interest rate the economy and Its outcomes set the interest rate but it wants to uh when they're doing QE they're attempting to uh decrease the cost of the the amount investors would get in holding assets um so that they sell those assets and consume um and that stimulates the economy um and in QT it's the opposite they're attempting to um put push some of these bonds that they've bought back into the financial system which requires

investors to save more And um discourages consumption and that slows the economy and inflation and those are the big principles of QE and QT um QT 2.1 uh 1.0 started out fairly um meaningfully um in that as soon as the balance sheet was mentioned in December in the December fomc meeting in 201 21 essentially markets were assets were Kryptonite for almost nine months and to be clear when they mentioned it QT QE Continued for another three months then it paused and then it started not until May and then it was turned up in September so

all of the impact of QT happened in the first nine months when the market front ran this increase in supply of Treasury bonds what turned out to happen however and this is a very important concept regarding the differences between how quantitative tightening is done in say England and how it is done most everywhere else but In particular in the United States the difference between making Market outright sales which is what QT what I what I consider True Q QT and and what the you the UK has done or allowing your balance sheet to run off

and not reinvest principle and so that's what the United States did now of course for the ballany to run off and not get reinvested the treasury has to borrow money from someone to pay back the FED for its maturities and that is Absorbed by the private sector and so conceptually has a tightening impact as if the treasur the FED had made those outright sales into the market um but the choice the central the the the treasury makes is how do they finance the um feds runoff and over the course since QT started um treasury has

issued 52% bills which is a tremendous amount of bills they're forget what their existing bills stock is they just issued mostly bills and that what that did is It um competed with what money market funds would otherwise invest in which was the reverse repo program and essentially drain $2 trillion out of the reverse repo POS um um pool which went into bills which was then handed back to the FED who was in the process of allowing $2 trillion of their balance sheet to run off and so really nobody experienced a need to own this Duration

and so that was QT 1.0 and what we saw is it was really not effective at all in there were episodes where things happened like when in last two summers ago when the treasury decided to increase its coupon issuance but since then it it's been and even even between those events it was really um muted and so there really wasn't any QT that was done in the classical sense so what happens is then the treasury is stuck with when they're in issuing 52% Bills they're stuck with a climbing amount of bills as a percentage of

the total debt and uh secretary bessent and the and Steve Moran the um the uh chairman of the Council of economic advisors both deemed that um what was it called activist treasury issuance policy and they thought it was something that was essentially taking the the monetary policy level lever away from the fed and now they have all this duration sorry they have all these bills that they need To refinance and so that's the treasury the FED crafted its so the FED had a certain amount of runoff that it would tolerate and they capped any further

runoff at a higher amount uh so that any further runoff the proceeds were reinvested and the means to reinvest the way they reinvested focused on coupon bonds not bills they came up with it it was the same one they used when they reinvested um in the balance sheet um subsequent to 2008 and throughout even through 2019 it's always been the way they've reinvested um and so what they end up with is a portfolio that is heavier in coupons than the public market and so today the FED has uh what's the number 4.16 trillion uh us

treasuries and it has a weighted average maturity of 8.6 years while the treasury with all of its issuance has a duration a a Wham a weighted average maturity it's a concept Ex similar to duration um of 5.9 years and so the reinvestment policy extended the fed's balance sheet and they've in the minutes they said that they want to bring it back in and to bring it back in that means that they will buy fewer or no long-term treasuries forcing the treasury to to issue that ex the what they would what the FED would have bought

to the marketplace increasing the Auction sizes of coupon bonds and having the private sector absorb that and if they do what I expect they will do in terms of their reinvestment plan it's essentially 20 billion of 10-year equivalent Wham that will now have to be absorbed by the market per month and it'll take them basically five years to achieve their goal scale is the blockchain that's truly built different forget gas fees and waiting scale offers a seamless web3 experience with fast Fee-free transactions whether it's gaming AI or NextGen staps scale is here to power your

future Explore More at scale.png want to just clarify a little bit of of the why that they're trying to do this so it seems to me like they're basically trying to get their s portfolio back to how things were before 2008 before QE started to occur because right now their some portfolio it's heavy on the duration it's heavy on the NBS they've said that they don't want Any NBS on their book right now so I would love to just understand like why is it important to get back to that pre 2008 to get to get

the weighted average maturity to that fiveyear whereas right now it's at eight years well I think of it more as a a um a asset liability matching um the liabilities of the FED are the Bank Reserves the currency there used to be the RRP but that's almost zero now and those are the reserves for instance pay overnight repo well pay pay IB which is basically about the same as fed funds and so that floats with fed funds their assets are mortgages and 30-year bonds that ha that as we've seen creates tremendous p&l volatility not that

the p&l of the of the Federal Reserve is particularly important but if you own a 3% 30-year Bond and you're financing it your as your asset and your liability is paying for and a quarter perc you have a negative carry but if your liability was Paying paying four and a quarter and your asset was paying four and a quarter and they um moved relative to interest rates the same way you have a better matched portfolio and the p&l volatility associated with that portfolio Falls and so the Congress receives the profits from the fed's balance sheet

and now is not receiving profits in fact the FED is a accumulating losses that they'll have to Chew through before they'll ever Grant the um send back profit to the um Congress and allow them to use it to offset um the deficit so right now it's a very poor balance sheet composition for them mortgages you know there's no particular reason why they should own MBS to manage monetary policy they own MBS because there was A7 crisis that where no one would own MBS it's extremely uncertain to me why given the conditions in the housing market

during Covid why they chose to use MBS perhaps there were some MBS funds that were struggling but there this was nothing like the financial crisis and they bought almost as many and now they're stuck with them and those don't run off very much because unlike a maturing treasury a mortgage is a 30-year um principle and interest paying thing that doesn't mature until doesn't really end until 30 years and each year it um pays down some of the Principle which allows some runoff but what you hope for in a mortgage if you own it and you

want your money back is you hope interest rates fall so that it'll be refinanced or you hope there's significant homeowner turnover which will cause people to um relocate and refinance more and and close out an old mortgage and enter into a new mortgage and so that portfolio has remained has come off at a much slower rate than they anticipated and so that's The reason it's an asset liability matching and I mention it not because you know that's somehow my thinking it's what the central banks have told us they uh anybody who comments on the the

balance sheet mentions they don't want MBS anyone who comments on the balance sheet mentions they want um something that looks more like their liabilities what they've done is recognized that without asset sales a very shortterm balance sheet That has say for instance bills and twoyear and threee and fiveyear notes is impossible because they have already 1.5 trillion of 15 of five year oh sorry 15 year and longer bonds that are not going to go away without being outright sold so the step the first step in what I call QT 2.0 is stop reinvesting proceeds of

runoff in long-term bonds they seem to have made that shift and it's only and they have a Destination that is possible to achieve this Wham equal to the government that'll take five years to achieve it's a sensible First Step but it doesn't really correct their balance sheet and turn it into the thing that they say they want got it okay and just to be super clear that that reinvestment mechanic that's what you see them show up at treasury auctions because they're reinvesting into the long duration is that where it occurs yes every auction You'll see

that the the FED is uh has um maturities EX in excess of their $25 billion cap which is most nowadays when the cap was higher sometimes they wouldn't but pretty much now every month you have maturities that are greater than that the reinvestment is across all all treasuries issued in that month proportional to the treasury amount so if they issue 25 billion um 30s and 50 billion T they buy twice as Many tens as they buy 30s um and there's great confusion on this topic so I'll hit on it um the way it happens is

if the auction is for 25 billion and the FED has let's say 10% they want to buy two and a half billion of that auction they don't bid they say they bid but they really don't bid they don't put a price on it they are non-competitive and also they don't buy any of the 25 billion at the end of the auction it's Priced the 25 billion of bonds are awarded to the private sector and the treasury and the FED have a journal entry in which the treasury all of a sudden prints two and a half

billion more and the FED buys two and a half billion more so what happens is a total of 27 a half billion get printed so the FED isn't bidding at auction it's adding on at the price that the auction transpires at got it okay that's super helpful so basically because the fed's S Portfolio is quite duration duration risky right now there's this asset liability mismatch if we were to go into a crisis right now and they had to step in that would be a bit of an nightmare but if we can get to a point

where their their duration is lower and then we were to see a crisis in the future that would set them up for better success so that idea gets implemented it sounds like through through two means either through this reinvestment strategy that you just Described but then I want to ask you about is is that enough and you mentioned this idea of outright sales so obviously they have a pretty large book of of long duration on there um if we moved into this regime of QT 2.0 how much would like would they have to actually outright

sell into the secondary Market that duration as well right so the question is what the goal is if the goal is to have only if the goal is to have no MBS they have to sell MBS because they're going to have MBS for the next 30 year 25 years so if they want to have no MBS they have to sell them if they want to have no say for instance treasuries longer than years in maturity they have to sell them so the question is do they and so far they haven't indicated that they do they've

only said sort of an end goal is to have no mortgages and short duration treasuries that's their end goal they have this Interim step that they announced in the minutes of equal Wham um that's for later to decide whether they want to do that why is it a good idea well let's just say that there was a crisis so in a crisis the uh all bonds rally a lot the front end they cut rates a lot all bonds rally a lot and they decide to begin QE and let's assume interest rates are zero they've said

pretty clearly they're not going to do more QE until interest rates are zero We're back in a position where the FED is buying one and a half% coupons which unless the crisis never resolves they're going to be underwater on those things if you're going to be underwater in those things you'd rather not have a lot of them going in though those would rally which is an ironic bit Yeah if they own them now and then it went to 1% they'd be they'd be making money right right um they'd be back to break even or making

money yeah um but They're not looking to make money on treasuries they're looking to manage monetary policy so the basic concept is have a very flexible balance sheet before a crisis occurs because you don't know what you're going to need to do and you're know how easy it's going to be for banks to um find reserves and so you really want to Target things that you know you can buy when they have to be sold and so you know again not this is not meining this is what they say They want and it makes Central

Banking sense to have a clean balance sheet yeah so you know no matter which way you cut it more duration needs to come onto the market and be absorbed so I want to ask you who is that marginal buyer of that is it people that own riskier assets and sell them for that you know duration or is it you know commercial Banks I want to tie it into this discussion that we've been hearing about SLR exemption potentially Coming on because that could potentially be a pretty large buyer from commercial Banks so yeah like who do

you think is the marginal buyer at this duration right so there's a difference between in the person who comes up with the cash and the person who wants the risk and so right now so and also it's very important to recognize that the outright sales would drain reserves if the treasur if the FED were to make outside Outside out outright sales they would drain reserves so they simult and they don't want to do that reserves are they're not QT isn't over and probably shouldn't be over despite the minutes issue which we can come back to

um reserves are reaching a point where they're at their target I don't know what that Target is they've used three trillion 11% of GDP we're close and that's that three trillion is Bank Reserves plus reverse repo right and Reverse repo is likely to drain fully after TGA after the whole debt sealing nonsense occurs um nonetheless if they were to sell bonds outright they would um drain reserves and so this isn't what they're going to do if they were to sell bonds outright they would simultaneously buy bills or buy twoyear notes or three-year notes or fiveyear

notes whatever they choose they want to have in their ongoing SoMo portfolio the idea is to Get rid of the old the MBS and and long-dated stuff and turn it into two years and five years the best way to to do that is buy the fives and sell the 30s or buy the twos and sell the mortgages and so it'll be the the idea of QT 2.0 and the fed's own views are that it should be reserved neutral and so what is reserve if if Reserve neutral there isn't any stress on the F the funding

of markets caused by that all there is is a Removal of very low-risk assets from the market and which by the way have been oversupplied by the treasury issuance and a sell of longer dated riskier assets that whose that price moves around a bit more and who investors you know not all investors are willing to extend out to the long end of the curve and so I also think because the treas treasury has been under over supplying bills they've been under supplying bonds And so what you would have in that example is a steepening of

the yield curve as the TR as the FED bought short dated bonds driving their yield lower and sold longer dated bonds and mortgages driving their yield higher and that would have a tightening impact on the economy and markets because it would increase the discount rate for for um equities and other Financial assets real estate Etc and lower the price of all assets which would be a wealth effect Hit and so it is a monetary policy thing it it doesn't come Costless to swap out your long-term bonds so there would be a monetary policy impact if

they were to go ahead and do that idea right would that be called you know if if it's if it's Reserve neutral and you're selling the long end and you're buying the short end is that operation twist or would that be like reverse operation well operation twist they decided to stop buying the short end and start buying The long end in Greater size so it's you could call it operation reverse twist yeah yeah um okay so another major section of those minutes is you already alluded to it but there's this idea of a potential pause

in QT that got a lot of people excited and I think a lot of people miss this first part that we just dug into myself included but then when I came back further I was like okay this is more interesting um but there's also been this mention in there about a POS Of QT that's related to the debt ceiling Dynamic so I would love for you to just first off explain why are they debating a pause in QT at this juncture if there's also talk of like potentially a more powerful version coming on later and

and how does that relate to what's going on with the debt ceiling in the TGA right so one of there are two aspects of QT one is requiring the uh private sector to take on more riskier assets by selling long-term bonds they Didn't do that they used runoff and treasury muted it with bills so that never happened but the other aspect and one that many of the what many of the FED officials think is the primary driver of of um QT its impact its economic impact is the the drawing of reserves from the financial system

and so that's happened it hasn't actually hasn't really happened prior to QT starting we had something we hadn't had prior to 2019 2020 which is this reverse Repo account RRP account and that grew to over $2 trillion and is fundamentally very similar to Bank Reserves in that it is what they call um outside money it's outside the financial system it's outside the Private sector's Financial system it's within the treasury I actually think of it it's inside money but that's not what it's called um and it's really something that mostly money Market funds can invest in

it's very similar to Bank Reserves in that there's a a bank reserve has a depositor that's on the opposite side of that transaction who may need money one day not they don't want to borrow they just want their deposit back similarly RRP is like a deposit in that a money market fund if somebody wants to consume or buy a financial asset they can withdraw money from their money market account and turn it into those Things so the difference between the RRP and the bank reserve is when a back in the day before 2000 2020 when

we the US banking system had a fractional Reserve banking system it actually mattered that you had Bank Reserves you couldn't lend if you didn't have Bank Reserves today it doesn't really matter because we don't Bank Reserves are not necessary to lend that's a plumbing Thing that we probably should drop into but um money market funds don't lend they do a little bit in the private um repo Market providing financial leverage for high quality treasury bonds typically but they don't lend to you and me they don't lend to corporations they don't lend to construction they don't

write mortgages they just do this repo and and reverse repo with the fed or they buy t- bills banks are much more complex so the Idea is there they could if they chose to increase Reser um lending if they saw increases in reserves so that's why historically withdrawing reserves would be a tightening because when you withdraw the reserves Banks may be below their NE Neary fractional reserve and so that prevents them from lending or at least at a minimum makes them less certain that they want to lend and look for better deals in higher rates

um that's Not what's happening today but nonetheless Bank Reserves are an important aspect of the banking system because if you were to send me if you wanted to um buy this uh great hoodie I have on and sent me sent me a check from Bank of Canada or Bank of montre what what where you where your bank in wherever your bank in Canada um you would actually have to send me cash from a US Bank branch of TD to I don't want to get in the FX issue Um so let's say you had a Wells

account in New in San Francisco you would have to send me a check to Wells from Wells I would deposit it and now I'd have a deposit and you'd have my hoodi and less of a deposit and Wells would have to say wait we're going to have to transfer a reserve to uh Andy Andy's Bank in New York and so reserves are really important for transactions and so it is very important that the bank has the banking system has Ample reserves and QT the kind we saw all it really did was drain the RRP to

zero and has yet to touch the Bank Reserves so now the question is is there adequate Bank Reserves and most people including the FED would say yes but we don't know and we're getting close and so now the question is what happens during the um sh the shutdown the um the uh debt cealing well in that case the government can't issue any new Debt but it still has to spend so what it does is it spends its checking account and so just like you buying my hoodie they transfer Bank Reserves to all the people that

they are uh providing uh funding to all the spending that is happening in the economy and that means Bank Reserves rise because the fed the the the government is spending and they're using a account at the fed and that account moves money into the fed's bank reserve account Which flows into the banking system so that should be a good thing they should be able to do continue to do Q QE QT if that's draining reserves while the treasury is pushing reserves into the system the problem is that over the course of the next five or

six months as the TGA is spent down during the debt ceiling at assuming that sticks around until the last possible moment the moment that's resolved the treasury Will rapidly issue bills to build up its treasury general account and rapidly like in weeks and months not in half not in half years rapidly pull reserves out of the system and so you might overshoot during that refilling of the TGA the fed the um the the the treasury might pull so many reserves out of the system that you would have a that reserves would become scarce and that

would slow the potentially cause um stress when banks have Inadequate reserves and so for that reason they say okay well you know given that sort of volatility why don't we pause QT now I don't think it was a consensus by any stretch of the imagination it was just a some of the members so it's not clear that QT is going to end and frankly you know if they pass a a resol a Reconciliation which um representative John speaker Johnson just said that they're close on all this goes away and they just Continue to do QT

the way it is but you know there's some logic to them pausing the question though is once that goes away when do they stop what is the right level to stop QT a lot of people look at the RRP and say once that's zero you have to stop and the answer to that is we did QT when there was no RRP so and the by the way the purpose of QT is to withdraw reserves from the banking System and that and if you look at the feds New York fed um boards measure of the elasticity

of reserves they deem as of three days ago they deem reserves abundant not ample and my view is it's probably 250 to 500 billion extra that they could withdraw which I don't know if they will but if they did it would push uh QT into 2026 my guess is they'll keep it just as is they'll that they won't worry about the debt ceiling and we'll reach reserves of Three trillion and then they'll stop and that's been my view for many years now scale is shaking up the blockchain game with a gas free invisible experience it's

the perfect solution for developers and users alike forget unpredictable fees scale's Innovative model ensures smooth cost-free transactions saving users over $9 billion so far with over 46 million active wallets scale is proving itself as the go-to blockchain for gaming Ai and more explore the scale Ecosystem at scale. spacecosmos that ceiling drama a couple years ago and the difference there was that when this TJ rebuild came forth there was a lot more money in the reverse repo so they didn't have to worry about it as much because I don't know was not at all they have

to yeah it could just swap over but this time if that were to occur it's basically where where are those where are those Bank Reserves coming from do you think well so when if if the Um treasury wanted to rebuild its TGA from zero to some number all they would do and the reason why they hold money in their checking account is in the event that markets are closed for 5 days they want to make sure they can continue to honor all their debt maturities their spending obligations net of taxes they just don't want to

have a September 11th type event where you had the markets Clos so they keep a checking account so what does it mean to rebuild that Checking account up to it's about 800 billion um from zero um where does the money come from what happens is it comes from Bank Reserves assuming the RP zero what happens is they sell an A treasury of some sort let's say it's a bill the buyer has a bank deposit and sacrifices his bank deposit for a t- bill now they have a t- bill asset instead of a bank deposit asset

And the bank settles the transaction with the government by shifting a reserve to the Federal Reserve and so that happens that's that happens all the time any anytime where a non where a bank itself for its own account or a nonbank um investor not a not a financial investor a non-bank nonfinancial uh um investor like you or me buys a treasury bond that's how it works the bank sends a Reserve to the bank to the the the um the FED for the bond or Bill that's bought and so that's what happens when that's the only

thing that happens when the government decides to increase its checking account when the government funds its deficit and I wrote this in this in the piece when the government funds its deficit um that whole thing happens with the bond so a reserve goes to the to the Government for the bond but then the government spends the money and the way they spend it is a deposits created at a bank and a reserve comes from the FED to offset that deposit so it's the finan the deficit financing is neutral to reserves the only thing that can

drain reserves is the TGA being built the RRP coming down or fed selling an asset and that's what QT is and that's why it drains reserves got it okay so Just to clarify you know this 40 odd minutes of a monetary Plumbing talk effectively you know we're getting down to a point where reserves are still abundant but we still need to be a little bit careful for these idiosyncratic events such as if the debt ceiling continues all the way to the X date which I think you have is like early Midsummer something like that August

mid August mid August so so if if that happens there there could be these Little hiccups in which case you know we might have to you know pause QT do some of these OS syncratic things um or the death ceiling gets solved and it's just you know steady as can be continued QT um and effectively we get to this fork in the road which it sounds like is your characterization of QT 2.0 which is that okay we end this first phase but then we're going to this next phase is which is that we want to

normalize the duration of the somma book um which has A whole bunch of you know that that and eventually holding 23% T bills financing the government with 23% t- bills is a risk that secretary bessent said he doesn't like yeah yeah so either the treasury may have to sell duration shift their port twist their portfolio and the FED May is twisting its portfolio Olio when they changed their reinvestment strategy but may want To twist it more and so for now there's this meaningful overhang of duration and your question was who's gonna buy it and I

think that's that's the you know that's The $64,000 Question um why do people buy treasuries well they PE buy treasuries because they're a nice diversifier for a um long um asset portfolio that they're also good for trading and speculation and banks for instance and hedge funds like carry and So you'll find a lot of uh inventory building up in Banks and hedge funds on a that's levered and so very p a very powerful amount of demand per unit of risk um when the curve is positively sloped but it's really not right now you know it's

is is it it is positively sloped but it's not very sloped it's nowhere near as sloped as it normally is and so purchasing it for carry is not a great trade right now so I don't see a lot of Demand from that them on the other hand there has been continuous Demand by real money Pension funds and in particular insurance companies for duration for a long time and you see that in Futures which are the currently the um largest long in history of Futures by real money asset managers and you see it in um receivers

which are an interest rate swap in which they synthetically on a levered basis own bonds and if you look at any of that you'll find in both Cases both Futures and receivers these people have such significant demand for duration that they pay an extremely high price for leverage um that they can lock in for term so there's demand there that demand isn't going away now that demand tends to be oriented toward incomes because when you're talking about pensions and you're talking about insurance companies and to some extent when you're talking about mutual funds income generates

Inflows changes in income generate changes in inflows right now we have a very strong economy with strong income and thus we're a lot of passive manufactured savings is going into all assets and so as long as the economy St stays strong we should see that inflow um other important people are Europe um well let's call it the rest of the world which includes China which and um the Saudi and the Middle East and Japan and each of those guys are not Buyers so you have Banks who are not buyers well that's not true Europe is

a little bit of a buyer but as far as I can tell it's mostly in bills um China's not a buyer Asia generally is not a buyer the Middle East is not a buyer banks are not it's Banks and hedge funds don't want the carry yet because it's not attractive enough and so the demand is coming from Real Money unlevered hedge um insurance companies and Pension funds and I think there's Going to be a mean a meaningful widening or steepening or increase in the term premium of longer dated um bonds as the overhang gets worked

through as as I said the first step is um the reinvestment change the second step is depending on the budget deficit what the treasury will do if the budget deficit comes in they'll issue less bills and they'll term out the debt by keeping bills constant but that will be a pressure on long-term interest Rates if the deficit grows they're definitely going to have to increase the coupons to term out the debt these are five year 10year flows and then the last one of course is if monetary policy required tightening the TR the FED might actually

make outright sales but it's you know it's 100 billion add it all up and assume it's done slowly over five years it's 100 billion of extra duration to absorb a month and our estimates are that it'll be around somewhere between 25 and 50 basis points higher in term premium but at the same time the tightening that will happen will allow the FED to ease and so you might actually see short-term interest rates fall and long-term interest rates instead of going up by 20 or five or 50 basis points only go up a little and there's

your steepening Earth steepens so when I look at all those things listen it's just step one I'm not sure that QT 2.0 is coming um I think it has To come from the treasury standpoint and it will come if inflation stays sticky because I really don't think the FED has any interest in hiking ever again and if they were to use their balance sheet if they were to make outright sales that would be a effective monetary policy in the event that inflation were to and growth were to stay as strong as they are and they

wanted to keep inflation lower but those are the sort of things I'm thinking about and think it's like 25 or 50 basis points of term premium now that translates into basis points of term premium translates roughly into a multiple point and so you know what's a multiple point it's about 5% on the value of equities so it's not a big deal you know we're not going to crash that's going to depend on economic outcomes we're not going to rip that's going to depend on economic outcomes based on them making these choices but it's a headwind

it's a 25 to 50 basis point headwind on the long end of the curve and it's a 5 to to 10% headwind for Equity prices and so that's how I add it all up awesome I love that um something that you mentioned in there that is very pre this idea of where does the deficit go and how does that relate to treasury issuance I think is is really key because as we've gone through you know a couple weeks ago we got the First qra with uh with the bin team involved and They had basically guided

towards no change in coupon issuance as the stands that on its own sounds like okay you know he's you know yelling 2.0 but you make this this important Insight that it actually depends on where the deficit heads because if the deficit decreases that changes the the percentage of bills and if it increases that also changes it so yeah how do you relate that towards this guidance in terms of qra issuance right so think about it this way the Government issues a bunch of stuff and the the the spending funds that stuff the deficit funds that

stuff I call it the circle of life every dollar of spending creates a dollar of savings which creates a dollar of mechanical demand for treasury assets if you only have 50 cents of spending you only have 50 cents of savings you only have and you only have 50 cents of of coupons of of of obligations for sale if you have $2 of Spending deficit increases you have $2 of savings and you have so this they always always net but risk doesn't net if you under Supply let's say you're only had two choices bills and 10year

bonds if you under Supply bills you're go and overs Supply long-term bonds 10year bonds you're going to steepen the curve if you overs Supply bills and under Supply coupons you're going to flatten the Curve they've been flattening the curve they've been suppressing long-term interest rates by under supplying what matters is that ratio of bills to bonds not the total quantity because the total quantity gets funded regardless regardless of the deficit the total quantity gets funded in that circle of life so what I'm saying is that now you can say okay let's say they never increase

coupons again what will the outcome be so they Continue to offer per quarter 1.1 trillion gross which is what they're offering now and the rest whatever it is is in bills in the event that the deficit Falls they still offer the 1.1 trillion a quarter but they end up offering less bills which means they're oversupplying the market with Bill With Coupons relative to bills that's a steepener if they keep coupons the same and the deficit Rises well they Have to make it up with bills and so there's more bills and the same amount of coupons

that's oversupplying the bills market and under supplying the coupon market and so if you're going to keep it constant the deficit will determine whether you're going to be extending the debt meaning if the deficit Falls and you keep it constant you extend the duration you're Turing out the debt if the deficit Rises and you keep coupons Constant you are uh relying more on bills so we have to know what the deficit is going to be and the coupons It's a combination of those things not one or the other that'll determine whether the treasury is terming

out the debt or not what they've said they didn't say they're they said terming out the debts going to be a long is a long way off and the reason why is it takes a long time you Know what has happened the 52% bills they've issued over the course of the last three years um is 1.4 trillion more bills than normal if 20% is normal it's 1.4 trillion bills more than normal how are you gonna you're certainly not going to ter out the debt quickly you're not going to sell 1.4 trillion 10 years you're just

not going to do that they only only sell 210 years per quarter they only sell 1.1 trillion in Total so it's going to take five years in my view even if they just increase coupons per auction by a 100 million B um bonds per auction let's assume the deficit is neutral in that case the coupons stay the same the bills stay the same if they were to increase by a 100 billion that would take what 12 1.2 trillion 1.4 trillion it would take 14 quarters so it's going to take a long Time to term out

the debt it's a it's a headwind it's not a sudden decision um and so that's what I think they mean by a long ter time but what I'm more interested in is listen the deficit does matter it matters if expenditures come down thus the deficit comes down down with neutral tax policy that has an impact on growth it doesn't have an impact on what we've been talking about which is the terming out at the debt if deficit comes Down and they reduce coupons they're not turning out the debt if deficit comes down and they keep

coupons the same they are turning down the out the debt and so that's the way I'm looking at so now we're starting to get into the realm of the impacts of all of this with the economy and market so I want to ask you obviously understanding where the the the deficit is headed is also a story of understanding where the economy is headed so you mentioned earlier there About how the turn Prima is likely to head up 50 bases points or so um I want to ask you about how do you what's your framework for

understanding where the economy is headed I know you've you've left the higher for longer Island um heading you know sailing the the slow down SE what is driving that framework is it the increase in term Premia and then how does that these dynamics that we just talked right so as as you rightly said I coined this Term hire hirer for longer Island and I was the cast away on that island I have the beard to match now finally but and what that was was just a very bullish outlook for the economy um in particular um

nominal GDP a combination of all the government spending all the subsequent income um and what was a um productivity Miracle has kept me extremely bullish the uh economy until um recently and what happened it wasn't The election um you know that has it has its impact and we'll come to that but it was um in September we had seen rapid ter premium uh contraction and asset rallies expecting that the Fed was going to cut but significantly um and that started kicking through to the economy and so I expected the economy to be strong the in

Q4 even stronger but I also noticed that starting in September term premium Started expanding and they reached a level that they had not yet reached and for me we've seen a couple of episodes of this um where ter where term premium gets very very high very quickly this happened most notably right before Halloween in 2023 and but it didn't last and so its economic consequence this tightening just didn't last and the easing that came on Halloween when Yellen was um decided not to increase coupon sizes Despite an increasing budget deficit that resulted in um assets

rallying and then the Fed was also very doish that for now for almost six weeks now and I started noticing this in January actually it's been longer than that since December really we've now had this persistent higher term premium and I think that that will slow the economy also unlike the times in the past the FED is 100% on pause uh in fact the market until just recently was even More hawkish than the FED expecting one cut in the the next 18 months um and so that's a tightening I don't spend a lot of my

energy worrying about the front end of the curve in terms of its economic impact in this current economy which is so built on asset wealth and low long-term financing that's been locked in during covid um but it is high and is staying High um and so that was a tightening and that had nothing to do with politics that got Me to a point where I say this is going to make a mark in January I looked at consensus and GDP for Q two and wrote that I expect it to be 100 basis points lower than

it than consensus which by the way is around four and a half% and so that's a Slowdown that's a real slowdown based on financial condition tightening then we get to the um Trump administration's agenda and there are a series of policies they're all fairly obvious uh you've talked About a million times one is immigration which will slow the amount of Labor growth labor Supply which is anti-growth and and and inflationary full stop there's no other way to turn that then you have um tariffs which I don't want to get really in the Weeds on tariffs

they are anti-growth whether they're inflationary depends on who pays for the Tariff and what the currency markets do do and whatever but in aggregate anti-growth um and they create Frictions and so I thought we were going to get tariffs maybe we're not um certainly No One Believes that tariffs are coming ever since um Mexico had you know did its fenal thing and Canada did its thing and all of a sudden no tariffs maybe there and the reciprocals of gotten waved in and now we're back I don't know maybe there're no tariffs but if there are

tariffs that's anti-growth my view is it's inflationary but it's also 100% A change in price levels not an ongoing inflation deficit Cuts expenditure cuts which we know that that's we've got um expenditure Cuts in the reconciliation bill on um SNAP food stamps income assistance in medic over the next 10 years it's a trillion and a half um those are expenditure Cuts those are anti-growth um the tax savings one would say that would be progrowth um if you believed in supply side trickle down which it's not Clear to me exists but that's a different point doesn't

matter all the tax is is not an imp it's not a growth impulse it's a maintaining of the existing policy so that's the budget reconciliation and then you have Doge um and I'm let me be clear I am 100% believer in cutting waste and finding fraud and cutting that in a efficient way that itself doesn't become a machine that becomes Expensive um and they're going to have some success um but it's anti-growth you might not like the growth that you're getting from the government spending wastefully or um people stealing the government's money but that wasteful

spending and stolen money spends in the economy the same way as perfectly honest money and creates consumption and so if you cut government expenditures like the ones I mentioned And the ones that we're talking about with Doge um that's anti-growth so the only thing left and I am very optimistic about this um the only thing left for progrowth policy is deregulation um deregulation is a is is is free from a standpoint of creating productivity and potentially very expensive in terms of what it may do to the environment what it may do to conditions for both

consumers and the people that manufacture stuff well you Know we have regulations for a reason um eliminating those re reason uh uh regulation is PR growth and so I am very optimistic that we will be see significant deregulation and if we do that's the offset to other wise anti-growth policies and you add all those things up you have a now I don't know if any of them going to implement it but if you if everything that Trump wants he gets and he Tariffs you're in a position where you're gonna have an anti-growth Impulse at the

same time as you have a um uh tightening of financial conditions and at the same time as expectations for growth are very high okay so let's let's take that and talk about how that impacts risk assets because if if you're telling me that the economy is's gone from red hot to to medium and to that end we get the short rate cuts that you mentioned fed funds Down a bit um obviously the the the long end side of things and and what could happen with the balance sheet would would be a drag but overall when

I piece a lot of those together it it it sounds like a decent outlook for risk but I know you disagree with that premise so I would love to hear about you know why why doesn't this set up a situation for Goldilocks environment why is it actually not that great for risk I guess the way I think about um assets is Whether they respond to growth or inflation and what the um discount rate does um and the economy's been on fire and stocks have been on fire it's without a doubt Pro a progrowth asset now

you might say that it's entirely the FED keeping monetary conditions easy and okay I I think it's partly monetary conditions are easy and so multiples are staying high and not converging in fact expanding in general Um but if you look at earnings like actual earnings that have occurred they've been strong earnings are growing that is real growth nominal growth but growth and expectations for earnings which are in that multiple p in that PE in the valuation expectations are also high and so if those um expectations come in the the numerator that you use to Discount

um based on change in interest rate is going to shrink the flow the Income flows from owning stocks conceptual income flows from loaning stocks is going to come down faster than the discount rate Improvement and so that's negative stocks now I don't know about you know you've got you've got this um I don't live in a under a rock or anything um I am aware that there is a great deal of sentiment that when interest rates are cut that's good for a risky assets you you have Literally have to be in a cave to not

recognize that that but the question is why if interest rates are lowered because they were too tight and that will allow for future growth and improves the discount rate that's a good thing if they're lowered because growth is slowing too rapidly and they're not lowered fast enough to offset this fall and growth that's not good and so you know I don't know where We are um firstly we're not expected to cut rates a lot um and frankly this comes down to what my portfolio looks like um my principal risk right now is long um what

what are called sufur Futures which are short-term interest rate um Futures tools that allow you to bend on the path of interest rates conceptually it's like owning a levered position in a 2-year note because in the event that that happens That interest rates are in the event of a Slowdown interest rates are going to get cut and so I win I'm short equities because I expect that interest rates are going to get cut but not enough to really vert their their price not to be cut at all but not enough to stimulate the economy until

equities fall primarily because inflation isn't beaten yet um And the Slowdown will affect the Top Line but not do much in terms of long-term interest rates that are on its discount rate and so I'm short stocks but listen if they cut rates just because I'm going to lose money on my stocks but I'll still make money on the twos so sort of like what happened in September like that was that was a cutting you know 100 bips of cuts that weren't like we didn't see that huge grow slowdown that you talked about so We still

saw equities rip right now let me be clear the reason why I don't think we saw a slow a Slowdown is because long-term asset prices and Bonds were um low in yield and low in and more relevantly low in term premium and so it's the term premium that does the tightening and it wasn't tight and so not surprisingly we had four four months of strong growth got it um and so what would it take for you to get excited About the long end here is it just once that term premium expansion I'm sort of excited

about the long end I listen I've been short bonds for a long time but in particular I got very short the day of the FED meeting in September I covered I covered in late Jan mid January I was on TV and CNBC and said I covered do I go long I think and it's been the case that since the bottom in the high in yields which was sometime last in early February I guess the entire curve has Moved up so it didn't matter what Bond you owned you could you as long as you were equal

duration meaning equal leverage in each of the points the whole curve moved 25 basis points lower in yield so you won in any bond you wanted I think the next move is going to be a steepener and so sure I like bonds if the growth slowdown occurs they're going to make money I just think twos are going to make more money but it's not it's not anti- Bonds I wouldn't be short Them yeah it's just a cleaner trade on the like it's cleaner to just own the two versus to own the 10 um for me

even yeah even though there's lower duration on that right for for most of your viewers they're going to look for a longer duration assets like TLT um which is a retail ETF there is a levered way of buying two years called T anyway we don't use tickers but things like that and that's perfectly fine as well um I guess my point on bonds is That I do expect this 100 billion I believe there's a hundred billion a month overhang on the long end of the yield curve for the next five years I'm just going to

stay away yeah because listen if the economy strengthens I'm definitely losing money on bonds and if the economy weakens for now with pricing where it is where you only have two cuts priced in for the next 18 months you don't have this Supply issue that is overhanging the Market in fact you actually have a and coming from the reinvestment and coming from the twist that will support those long sh dated bonds so I much prefer them um I I'm not holding my breath expecting step one of QT 2.0 to turn into this treasury actively or

passively extending their duration and um the FED actively selling assets um but it's an overhang I mean like if you're if you're owning twos where I I Don't know if it's exactly where the like effective funds rate is that but is is your downside there just If the Fed starts to talk about hikes yeah oh definitely I mean two that's a good symmetry you know don't get me wrong twos have downside you know we could we could be back up at five and a quarter percent if inflation takes off but let me tell you something

TL long bonds are would get destroyed yeah in the event that inflation causes A hiking cycle now people are calling for a hiking cycle people don't believe in that the economy has any chance of slowing down and that and by the way I could easily be back on high for longer Island if there is no Doge there is no tariffs there is bigger deficits the immigration is a la immigration stays where it is causing labor supply problem I could get um I could get back into the FED could hike but that's not where I'm now

Andy That was a wicked conversation um where can folks go to read more of your research if they haven't seen it so damps spring.com is my um is is my principal company I also partner with um Nick jovanic at um a um company called two gray beards.com and of course I'm at damps spring on Twitter awesome thanks for joining again Andy it was a pleasure