Why Cross-Border Flows Matter More Than Rate Cuts | Capital Flows

Key Concepts

• Hawkish Fed: The Federal Reserve adopting a monetary policy stance that prioritizes controlling inflation, often through higher interest rates.
• Risk Curve: A spectrum representing the level of risk associated with different investments, from low-risk (e.g., government bonds) to high-risk (e.g., speculative tech stocks).
• Public Market Liquidity: The ease with which assets can be bought or sold in public markets without significantly impacting their price.
• Cross-Border Flows: The movement of capital between countries, influencing global liquidity and asset prices.
• Credit Growth: The expansion of lending and borrowing within an economy, a key driver of economic activity.
• Real Yields: The yield on a debt instrument after accounting for inflation.
• Credit Spreads: The difference in yield between a corporate bond and a comparable government bond, indicating the perceived risk of the corporate issuer.
• Liquidity Impulse: A measure of the net injection or withdrawal of liquidity into the financial system.
• Equity Breath: The extent to which a stock market rally is supported by a broad range of stocks, not just a few large ones.
• Floating Rate Debt: Debt instruments whose interest rate fluctuates based on a benchmark rate.
• Fiscal Impulse: The impact of government spending and taxation on economic activity.
• Monetary Impulse: The impact of central bank actions (e.g., interest rate changes, quantitative easing) on the economy.
• Factor Model: A statistical model used to explain asset returns based on various risk factors.
• Risk Curve Exposure: A company's or sector's position on the risk curve, often determined by its debt levels and cash flow generation.
• MAG 7: A group of seven large technology companies (Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta, Tesla) that have significant influence on market indices.
• Idiosyncratic Risk: Risk specific to a particular company or asset, not related to broader market movements.
• CDS (Credit Default Swap): A financial derivative that allows an investor to "swap" or offset their credit risk with that of another investor.
• JGBs (Japanese Government Bonds): Bonds issued by the Japanese government.
• Carry Trade: An investment strategy that involves borrowing in a low-interest-rate currency and investing in a high-interest-rate currency.
• TGA (Treasury General Account): The US Treasury's primary bank account at the Federal Reserve.
• Reverse Repo Facility: A tool used by central banks to absorb excess liquidity from the financial system.
• Current Account Deficit: A situation where a country imports more goods, services, and capital than it exports.
• Geopolitical Risk: Risks arising from political instability, international relations, and conflicts.
• Reserve Currency: A currency held in significant quantities by central banks and other major financial institutions as part of their foreign exchange reserves.
• NAFTA (North American Free Trade Agreement): A trade agreement between Canada, Mexico, and the United States.
• Treasury Companies: Companies that hold significant amounts of US Treasury securities.
• SPAC (Special Purpose Acquisition Company): A shell company that raises capital through an IPO to acquire an existing private company.
• High Beta Sectors: Sectors or stocks that tend to be more volatile than the overall market.
• GDX (VanEck Gold Miners ETF): An exchange-traded fund that tracks companies involved in gold mining.
• G10 Equity Index: Equity indices from the Group of Ten countries, representing major developed economies.

Macroeconomic Outlook and Fed Policy

The discussion begins with an assessment of the current macroeconomic environment, noting that the Federal Reserve is exhibiting a "hawkish" stance, leading to adjustments in the "far end of the risk curve." However, the speaker emphasizes that a recession is not currently on the table. The primary focus for investors should be on identifying specific "spots" for long or short positions, rather than broad market plays. A critical factor highlighted is the shift in "public market liquidity" driven by "cross-border flows and trade," which is considered even more significant than the Fed's actions.

The Credit Cycle and Equity Performance

The guest, Pepe, outlines his framework from the past year, which centered on the idea that "credit growth is really driving things." This perspective emerged from the Q1 drawdown, which was attributed to tariffs. The subsequent market reaction involved a dollar sell-off, equity sell-off, gold rally, and bonds being bid. As these tariff concerns were priced in, the market rejected lows. The key question then became the Fed's willingness to cut rates and whether commercial banks would use this opportunity to issue debt and take on more risk.

Key Observations from the Past Year:

• Falling Real Interest Rates and Credit Spreads: A rise in inflation expectations was accompanied by falling real interest rates and narrowing credit spreads, indicating a "positive liquidity impulse."
• Accelerating Equity Breath and Credit Spreads Falling: This positive liquidity impulse coincided with accelerating equity breadth and falling credit spreads.
• Aggressive Debt Issuance: Commercial banks were issuing a significant amount of debt, and market participants were aggressively taking on this issuance. IPO markets also saw increased activity.
• Resilient Growth: Despite a large number of rate cuts being priced in, economic growth remained resilient.
• Aggressively Long Equities: Based on these factors (Fed cuts, fiscal support, commercial bank debt issuance, falling real rates), the view was to be "aggressively long equities" throughout this credit cycle phase.

Recent Shift in Stance:

Over the past two to three weeks, there has been a shift, with more risk being priced in as real rates have risen. The Fed's pushback against aggressive December rate cuts has also contributed. Consequently, the speaker has moved to a "neutral" stance on equities on a short-term basis, adjusting to higher real interest rates. The current question is how much equities or Bitcoin will pull back before a potential recovery, and whether this will lead to a recession or simply an opportunity to "buy the dip."

Quantifying Credit Creation

The discussion delves into the challenge of quantifying drivers of credit growth. While fiscal and monetary impulses are relatively straightforward to measure, credit creation in the private economy often feels like a "black box." The speaker's approach involves monitoring the "balance sheet and factor exposure" of companies across major indices (S&P, Russell).

Methodology for Quantifying Credit Creation:

1. Company-Level Debt Analysis: Tracking how companies issue debt relative to their cash flows. An increase in debt relative to cash flows signifies a move "out on the risk curve."
2. Quantifying Risk Curve Shifts: Focusing on how the market absorbs corporate bond issuance and other debt, and how companies' balance sheets shift along the risk curve due to maturity walls or other factors. This involves assessing debt issuance relative to revenues and earnings, and the maturity structure of that debt.
3. Market Pricing of Risk: Observing how the market accepts and prices risk. For example, if the market is bidding up companies with higher debt and risk (further out on the risk curve) relative to higher-quality names like the "MAG 7," it suggests the market has sufficient liquidity to support these riskier entities.
4. Underlying Fundamentals and Sector/Factor Analysis: Analyzing the underlying fundamentals of companies and sectors to understand their position on the risk curve (increasing or decreasing debt relative to growth).
5. Capital Flows: Monitoring how capital moves along the risk curve, pushing equity prices higher or lower.

Observation: Since the April lows, companies further out on the risk curve (e.g., non-profitable tech names) have outperformed the MAG 7, contributing to an aggressive rally. A shift in this trend is now being observed.

The Fed's Hawkish Pivot and Market Stress

The conversation addresses the recent hawkish pivot from the Fed, which has led to a significant repricing of rate cut expectations for December. This pivot occurred despite a government shutdown and limited economic data.

Connecting the Dots:

• Floating Rate Debt Impact: The hawkish pivot and rising real rates are seen as negative for floating rate debt issuance, as fewer rate cuts are priced in.
• Fed's Stance Relative to Inflation: The Fed's current hawkishness is viewed in relation to inflation expectations. Earlier in the year, inflation expectations were rising, and the Fed was cutting rates. Now, inflation expectations are falling, and the Fed is being more hawkish.
• Lack of Recessionary Signals: Despite some funding market stress, the speaker argues that the current situation is not causing enough pressure for a recession. Evidence for this includes the yield curve not flattening significantly and long-term bonds (like TLT) not being aggressively bid as equities fall.
• Repricing Growth Expectations: The current market adjustment is seen more as a repricing of growth expectations rather than a collapse.

Drivers of the Fed's Pivot:

The exact drivers of the pivot are unclear, with speculation that it might be related to "buying optionality" or a strategic move by Fed officials. The lack of government data due to the shutdown makes it difficult to pinpoint specific economic triggers.

Recessionary Risks and Household Balance Sheets

The speaker dismisses the immediate risk of a recession, citing several factors:

• Household Debt vs. GDP: While public debt as a percentage of GDP has surged, household debt has been falling. This indicates that the household balance sheet is not overleveraged in the same way it was in 2008.
• Structural Risks: The bigger risks are identified as being around the currency and government debt, rather than a collapse in the mortgage market.
• Fed's Jackson Hole Stance: The Fed's shift to a more dovish stance after Jackson Hole was followed by a pushback against aggressive rate cut certainty at the last FOMC meeting.
• Bond Market Signals: The yield curve has not flattened significantly, which would typically signal a recession and the Fed falling behind.
• Alternative Data: Despite the lack of government data, alternative data sources do not show a collapse in economic activity.

Auto Loan Market Stress

Concerns have arisen regarding the auto loan market and increasing delinquencies.

• Sensitivity to Auto Loans: Companies with high exposure to floating rate debt and those sensitive to auto loan performance (e.g., used car markets, companies holding auto loans on their balance sheets) have seen some pullback. Ally Financial is mentioned as an example of a publicly traded company with exposure.
• Consolidation by Large Banks: The speaker believes that any delinquencies will likely be consolidated onto the balance sheets of larger commercial banks and private credit funds, which have ample liquidity.
• Post-SVB Vibe: Since the Silicon Valley Bank (SVB) failure, there's been a trend of larger players acquiring assets from smaller, defaulting entities.
• Limited Transmission to Consumer: While not a reason to be long auto companies, the speaker does not believe the auto loan stress will significantly transmit to the broader consumer economy.
• Real-Time Data Correlation: The ability to correlate publicly available real-time data with economic indicators allows for directional insights even without complete government data.

Market Reflexivity and Trading Strategies

The discussion highlights the reflexive relationship between the market and the economy, where they influence each other.

• Market Reflecting the Economy: The idea that the market simply reflects the economy is challenged. Instead, they are seen as functioning "reflexively."
• Dispersion in Market Performance: Over the next three to four months, market movements are expected to be less one-sided than the strong upside impulse from April to August. Greater dispersion between stock performances will lead to extrapolation by both bulls and bears.
• Picking Spots: The current stance is to be "real specific about which spots that you're taking longs or shorts in," emphasizing the need for more targeted trading strategies.

MAG 7 Capex and Leverage

The recent pain in MAG 7 related stocks, particularly those tied to AI narratives, is examined.

• Idiosyncratic Issues: The issues in these names are considered largely idiosyncratic.
• Shift to Levered Basis: The AI capex boom, initially funded by profits and free cash flow, is now transitioning to a levered basis with companies issuing bonds and increasing leverage.
• CDS Ramps: An aggressive ramp-up in Credit Default Swaps (CDS) for some of these names has been observed.
• Extrapolation to the Broader Market: There's a concern that market participants are extrapolating these specific issues to the rest of the market or economy.

Speaker's View on MAG 7 Capex and Debt:

The speaker believes that the underlying capex and debt taken on by MAG 7 companies will be manageable. They do not foresee major defaults or situations where these companies become unprofitable due to excessive leverage. The interconnectedness of MAG 7 companies, with them "dipping in each other," is seen as a smart strategy by CEOs to utilize the entire capital stack and feed off each other, similar to how Michael Sailor approaches Bitcoin investments. This behavior is compared to historical practices during the Gilded Age.

Geopolitical Support for MAG 7:

The US administration is expected to continue supporting MAG 7 companies through regulation and investment, as their investments are directly linked to geopolitical relationships, particularly with Taiwan and China. This is framed as a national security imperative.

Geopolitical Landscape and Trade Dynamics

The geopolitical situation is identified as a significant driver of liquidity that is often overlooked.

• US Investment in AI: The US administration, regardless of the president, is expected to support AI investment due to its link to national security and geopolitical competition with China.
• China's Economic Strategy: China is focused on exporting goods and services to prop up its economy, particularly due to its real estate crisis. Infrastructure investment is a key sector in China.
• US-China Trade Tension: The US aims to establish a competitive edge, using tariffs as a negotiating tool. The debate over whether tariffs are inflationary or deflationary is considered less important than their role as a negotiating tactic.
• Dollar's Reserve Currency Status: The dollar's status as the reserve currency is seen as the reason for high equity valuations, even with higher real interest rates compared to five years ago.
• Current Account Deficit: The US has a historically negative current account deficit, indicating it imports more than it exports.
• Trade as a Driver of Liquidity: The speaker believes that shifts in trade are the primary driver of liquidity, explaining the rally in gold over the past year as it prices in this change in regime due to geopolitical risk.

Key Takeaway: The biggest factor to get right is how public market liquidity is shifting due to cross-border flows and trade, which is considered more important than the Fed's short-term policy adjustments.

Cross-Border Flows and Yen Carry Trade

The discussion touches upon the importance of cross-border flows and addresses concerns about a potential yen carry trade unwind.

• Short-End Liquidity Plumbing: The speaker finds discussions about short-end liquidity plumbing to be "boring" and less impactful on public market liquidity compared to cross-border flows.
• Yen Carry Trade: The idea of a yen carry trade unwind is questioned. Historically, yen carry trade unwinds have been associated with falling JGB yields, a falling Nikkei, a rallying yen, and widening volatility. Currently, JGB yields are rising, which is the opposite of what would typically precede a carry trade unwind.
• Monitoring Tools: The speaker suggests monitoring tools like the CME's "watch skew" on the yen and Nikkei, and JGBs, to identify potential carry trade unwinds.
• Connection to China: The cross-border function is seen as more connected to the situation in China.

China's Export Strategy and Global Impact

China's strategy of exporting goods and services is having a significant impact globally.

• Export of Cars: China has exported a massive amount of cars, significantly impacting the German industrial base.
• Free Market Debate: The speaker critiques the notion of purely "free markets" when one country (China) can exert leverage over others (Germany) through economic means.
• US Non-Involvement: The economic consequence of the US not being actively involved in global trade dynamics is that China can systematically hollow out other countries and leverage them into joining its pacts.

Trade Dynamics and Constraints

The conversation explores the constraints and game theory involved in US-China trade relations.

• US Constraints: The US president has limited options, especially when direct intervention is not feasible. Trade is a complex dynamic with many economic and financial market components.
• Trump's Toolkit: Tariffs are identified as a key leverage point for Trump, used as a negotiating tactic.
• China's Constraints: China's primary constraint is its own economy's ongoing issues. They have a closed capital account and manage their currency.
• Dumping Treasuries: The speaker does not believe China will dump US Treasuries, as this would fundamentally alter the trade relationship they seek to maintain.
• Economic Warfare: China's strength lies in economic and clandestine warfare, not overt aggression.
• Backroom Deals: Global changes are often conducted through "backroom conversations," with only select information released to the media.
• Jared Kushner's Book: The book is cited as an example of how public communication (e.g., Trump's tweets) can diverge from actual information and backroom deals. This highlights the complexity of negotiations and the role of intermediaries.

Asset Class Allocation and Trading Strategies

The discussion shifts to tradable asset classes that reflect these macroeconomic and geopolitical views.

• Fading Rare Earths: The speaker suggests fading (betting against) the rare earths trade, as significant premiums are already priced in.
• Gold as a Long-Term Play: Gold is considered a good long-term play due to geopolitical disorder, though it has been choppy recently. Gold miners are also seen as a viable option.
• Bitcoin's Performance: Bitcoin's rally from April lows was primarily driven by public market liquidity and treasury companies' activities. However, it has underperformed the S&P 500 and other high-beta sectors recently.
• Bitcoin as a Risk Asset: The speaker maintains that Bitcoin is fundamentally a risk asset, not a safe haven, citing its sell-off during the tariff sell-off while gold rallied. The burden of proof for Bitcoin to be a reserve asset is on Bitcoin itself.
• Treasury Companies at a Discount: Many treasury companies are now trading at a significant discount to Net Asset Value (NAV).
• Conditions for a Bottom: A potential bottom for these names might be set by a macro shift with a top in real rates. Outperformance of Bitcoin over the S&P and treasury companies over Bitcoin would be key indicators.
• Alternative to Bitcoin: Gold and gold miners are presented as better ways to express views on geopolitical disorder.
• Active Trading and Volatility: With central banks actively managing their portfolios, there is increased volatility, creating opportunities for active traders who can identify ranges.
• Currency and Interest Rates as Drivers: High valuations mean that price changes are more determined by liquidity, FX, and interest rates than underlying fundamentals.

US Equities and Global Valuation

The elevated valuations of US equities and other G10 equity indices are discussed.

• Global Interconnectedness: All G10 equity indices exhibit similar elevated valuations due to interconnected cross-border flows and carry trades.
• Reinvestment of Dollars: Foreigners reinvest dollars earned from US imports into US assets, primarily equities and public debt, rather than the housing market as in 2005-2007.
• Tail Compression: The market is characterized by "tail compression," leading to both melt-ups and meltdowns, rather than a slow, stable grind up.
• Active Management of FX Flows: The strategy involves actively managing exposure by mapping changes in FX flows directly to the S&P 500 and equities across the risk curve.
• Short-Term Neutral Stance: The current stance on equities is neutral due to positioning risk.
• Opportunity in Higher Beta Sectors: There is potential to go long higher beta sectors if carry trades and cross-border flows do not unwind, especially with potential Fed rate cuts next year.
• Equity Rotation: The market is seeing an equity rotation, with sectors like healthcare and utilities performing well while tech lags, indicating a complex interplay of factors.

Conclusion and Resources

The conversation concludes with a summary of the key takeaways: the importance of cross-border flows and trade over Fed policy, the need for specific "spot picking" in investments, and the reflexive relationship between the market and the economy.

Resources:

• Website: capitalflows.com
• Twitter: @globalflows
• Substack: capitalflows.com (daily publications)

The speaker also mentions running equity and bond strategies based on their models and participating in discussions like this one. Congratulations are extended for the guest's Substack success.