Michael Kao joins Wealthion’s Andrew Brill to warn that next week’s signaled Fed rate cut will likely have unforeseen consequences: a resurgence of inflation and market instability amidst what he calls a “Vodka Red Bull” bifurcated economy. In this insightful interview, the retired hedge fund manager and writer at Kaoboy Musings defies consensus by arguing that a short recession could benefit the economy in the long run and that the coming rate cut is risky while inflationary fiscal pressures and supply inelasticities in oil and housing remain a significant concern.
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Michael Kao 0:00
I think that this September pivot is premature. I think he’s actually too early. I think we are going to see a resurgence of inflation. I think the economy we have is a confusing, bifurcated economy. Frankly, we need a recession to cleanse out a lot of these issues.
Andrew Brill 0:25
Welcome to wealthy and I’m your host. Andrew brill, as we get closer to a Federal Reserve rate cut in the middle of the month, at least one person thinks that cutting rates right now is a bad idea. We’ll discuss that and why right now. Please help me in welcoming to wealthion. Michael cow, he is a veteran investor, hedge fund manager over 30 years. Has his own website, which is a play on his name, which is Urban Cowboy. He also has a podcast which is chaos theory, also K, A O. Michael, thank you for joining me and welcome to wealthion.
Michael Kao 0:59
Excited to be on here the first time. Thank you. Yeah, true.
Andrew Brill 1:03
Absolutely. We’re glad to have you. And, you know, I like to start out Michael by asking everybody what their overall feeling is on the economy at this particular point in time.
Michael Kao 1:14
I think the the economy we have is a confusing, bifurcated economy and and, you know, I’ve written at length about this over the last year, really. And I think part of the confusion there, there’s a hope there, there seems to be one school of thought that the Fed is too late, and we’re about to go into a hard landing if he doesn’t relent, I’m in the really opposite school of thought, where I think, and I wrote a piece about about this, which I’m sure we’ll talk about, but I call Jay Powell pusillanimous Powell because he’s so worried About even a small slowdown, let alone a mild recession. And I think that it’s probably the contrarian viewpoint, but I think that this September pivot is premature. I think he’s actually too early. And you know, why are there smart people on both sides that are that that have opposite points of view. So I think that the macro confusion right now comes from this, this I call, I’ve been calling it a vodka Red Bull economy for a long time, right? And ever since the Fed started raising rates in March of 2022 it’s already been two and some years, you know, I would have thought that by, I originally thought by the end of December, by the end of 2023 the Fed’s dual mandates would actually come into conflict, and that we would start to see, We would see unemployment above four and a half percent and and material slowing of the economy. That has not happened in the aggregate. You’re definitely seeing pockets of weakness, but you have not seen the aggregate slowing, at least to the extent that I think we need to see in order to really get inflation tamped down. And again, this has to do with, you know, last year, I wrote a piece called The Four Horsemen of US economic resilience. And, you know, real quickly number horseman number one was that there are certain demographic and structural factors behind stickiness in certain parts of certain subcategories of inflation, especially shelter and labor, fiscal horse horseman number two is the big fiscal boost that we’ve had, and that Is the vodka Red Bull economy that I’m talking about, right? If, the if Jay Powell has been administering the monetary depressant Well, Janet Yellen, plus all of the spending bills combined, where we’re talking 2.2 trillion, between the three Biden bills Since 2021 that has, that has really, really countered the that that has provided the Red Bull stimulant, that’s countered the vodka depressant, and it’s created major distortions in the economy and all this macro confusion. Because, you know, when I, when I talk about, it’s not, it’s not as simple as a pure K shaped recovery, right? Most people are familiar with that idea that the wealth are getting wealthier and the poor are getting poorer through inflation. But it’s actually even a little bit more nuanced than that, because, and I’ve written about this in a number of my past pieces, but within the US. You have, I’ll broadly call it the haves versus have nots and, and, and then you can split it between the consumer and the corporate. On the consumer side of things, you have obviously Rich versus poor, but you also have leveraged versus unleveraged, right? So there, there are people who have, most people have locked in their their their mortgages, that maybe there are some few that have not. And then on the corporate side of things, there’s also this bifurcation between big versus small. And then there’s this bifurcation between levered and unlevered. And so the the percentage of floating rate borrowers here in the US is only about 25% in terms of overall corporate debt, but the rest of the world is much, much higher. And so you’re seeing pretty big bifurcations in in financial performance between the cat the cat, you know, the the cash flush companies, the bigger ones generally, and then the the smaller cap, floating rate borrowers. And, in fact, my horseman, number three of us economic resilience was relative rate insensitivity on an aggregate basis, but, but again, because of the these bifurcations between the haves and have nots, you’re seeing certain pockets really struggle, CRE, especially office. Cre really, really struggling, smaller, smaller borrowers that rely on sofr based debt, right? Obviously, really struggling, but then it’s not creating enough of an aggregate problem. The last horse, just to round it out, the last Horseman of us, economic resilience is relative, relative energy independence. And, you know, even though oil prices have moderated quite a bit, which I’ve been, think, I’ve been saying that they should and they would, but, but, you know, overall, I think this OPEC policy, of of these premature cuts, I’ve also written about this at length, saying that this was, this is going to backfire on themselves, because they their OPEC chose to basically support prices. Saudi Arabia in particular, chose to support oil prices at a time when the Fed is still trying to tame inflation, right? And if you think about the problems facing both the Fed and OPEC, they both have relatively blunt tools. The OPEX tool is blunt in that they can only withdraw supply, and Saudi Arabia withdrew 3 million barrels per day to support oil prices. But guess what? Supporting oil prices is demand restrictive, but it also has the perverse effect of making keeping the Fed more vigilant on inflation. The Fed’s tool is also blunt in that, you know, I just talked about all these bifurcations. It’s not as if the Fed can actually through monetary policy, at least use a surgical knife and just alleviate the conditions for the have nots while not creating aggregate inflation. They’ve got one blunt tool, which is the Fed funds rate. And so my view is that if they especially with this fiscal tailwind, still going strong, at least up until now, the monetary depressant has kept that crazy vodka Red Bull cocktail from going completely awry, right? But now, if you start taking down that monetary depressant, I think we are going to see a resurgence of inflation. I think there’s a high likelihood of that by, and you know, the Fed is going to have to have, is going to have a hard choice by, by the second half of 2025
Andrew Brill 9:17
so, so you, in your article, you had said exactly that, that you thought, and contrary to popular opinion and and the market, who’s loving these cuts, you think he’s way too early. You think that inflation could actually rear its ugly head a lot sooner than we think, if he continue, if he lowers rates,
Michael Kao 9:38
yeah, and, and, you know, one, one of the key points that I made in my, you know, the return of PP, fusilanas Powell, right? One of the key points that I made, I think, that I really haven’t seen other people mentioned, is that we have a we haven’t seen a. Influence of supply inelasticities. In decades, we haven’t seen it like this, right? And I’ll name them real quick, right? Oil, we’ve got artificial supply inelasticity because of these aforementioned cuts by Saudi Arabia, right? And that can be solved, by the way, but I’ll talk about that later. The second thing is we’ve got supply and elasticity in freight rates driven by geopolitical risk in the Middle East. Third is that there is this much bigger secular near shoring trend, again driven because of great power competition with China, and that’s caused supply inelasticity in certain areas of manufacturing, Janet Yellen has been playing games with the QRA and restricting issuance of longer dated treasuries. So there’s a supply in elasticity in Treasury bonds that’s also stimulative, and there’s a structural under supply housing, that is another supply in elasticity, and then labor. So labor is probably the most controversial point because of especially given all of the recent revisions. But I believe that, you know, when I talked about my horseman number one, you know, the demographic and structural issues. I think when you look at the demographic pyramid, you know these, these charts that you know people like to do to show, show the age categories. I think it’s really interesting that the US and most of the countries of the West that won World War Two all followed very similar birth waves. You had this big baby boom generation, and then you had a relative, very smaller generation that followed, I’m that generation that’s Gen X. Well, it just so happens that that Gen X category of workers are in that. Call it 45 to 59 year old bucket. And I think that that’s really the most highly tenured part of the workforce. And when you when you actually dig into the unemployment, you see where the wage gains and the wage stickiness is coming from. It’s that category. So I think there is a demographic element that’s keeping the labor supply relatively inelastic where it counts for the macro economy. And then, by the way, just to round out that that demographic point and and how it relates to housing, there’s also a it. There’s a bulge at the 30 to 39 year old bucket of people right now. That’s, I guess that would be, that would be considered, you know, millennials, right? That are in primary household formation age. So with, with, with respect to housing, you have a structural under supply. That’s creating a supply in elasticity, but you’ve also got relatively inelastic demand with respect to that cohort, right? So, so all of these things combined now, now I always like to say that the sword of inelastic supply cuts both ways. So when you have a when you have an inelastic supply curve, what it means is that supply curve is relatively steep, so that even a a even higher demand, sorry, a relatively modest amount, a modest increase in demand right represented by a right shifting of the demand curve can can create a a relatively disproportionate price response, and it cuts both ways. If you have a if you have a demand shift down, you could have a relatively sharp, you know, drop in prices. But what I fear now is that the return of pusillanimous Powell right is going to withdraw that monetary depressant that just leaves this, this fiscal tailwind blowing hard, and it’s going to shift that aggregate demand curve to the right again. And this is, and by the way, this is, this is when, when people say the Fed is too late, too late, too late. I always ask the question, too late for what? Exactly? Because, you know, it’s we’ve, we’ve been in over decades of, over the last several decades, of zero interest rate policy and QE, it’s as if the we can no longer tolerate any business cycles. What is wrong with a recession? A recession is what actually cleanses. Cleanses out, you know, inefficiencies and corporate rot. Begin with, right? So and, and, and, we need, frankly, we need a recession, to cleanse out a lot of these issues. Inflation is the biggest issue, right? Because everybody focuses on price change of of CPI, but forgetting that, you know, the CPI itself is the first derivative of price. Everybody’s focused on that second derivative, but the you know, the the average consumer consumes absolute price levels, and when you look at the cumulative compounding of inflation just over the last couple of years, it’s an enormous aggregate price jump like 30%
Andrew Brill 15:43
right? So do you think that, you know, given that everything was rolling along, just great covid hit, we pumped this ridiculous amount of money into the economy, and things turned around. You think Powell was too late in raising rates?
Michael Kao 15:58
Way too late. Way too late. Because, well, not only that, I think, I think 2021 monetary policy is, was one of the biggest policy errors that Jay Powell made, right because, because by then, by by 2021 especially late 21 the economy was already like rolling. I mean, we were, we had, we had huge asset bubbles. We had. That was the whole crypto craze, if you remember, right, nfts, etc. I mean, markets were on all time highs, and yet the Fed was still buying, you know, huge amounts of MBs every single month. And basically created this massive housing bubble that, then, and also, like, you know, oil was, was, you know, in a raging bull market. At that point, I was actually very bullish oil between the geo political policies of the Biden administration and and what the Fed was doing. But, but by the end of 21 I predicted that, you know, because of high oil prices and because of these asset bubbles, the Fed was going to be forced into a very aggressive stance. And I remember I got huge pushback at the time. It was a very contrary opinion. This is before the Fed even started hiking. I said the Fed is going to get very, very aggressive. And then all the pushback I got was, well, there’s no way he’s going to be able to raise rates above 2% because we can’t handle it. I mean, I remember I was, I was diligencing. I was diligencing a real estate deal at the time, and and the the I remember very clearly this conversation, which made it a deal breaker for me. The response, I was asking the sponsor, how they’re going to, you know, I noticed that, okay, they’ve got this warehouse facility. This, this to acquire the property, and it was all going to be floating rate, dead, right? And this was when, this was when, you know, so and, and I said, and this is late 21 that I was diligence in this deal. I said, What’s going to happen? Do you have plans on just turning that out? Or, like, you know, fixing, fixing that debt? The response I got was, oh, the Fed, we don’t see the Fed taking Fed Funds above 2% so, you know, we’re not concerned about it. And that was the end of the conversation for me. I said, I’m going to pass on this one.
Andrew Brill 18:29
I mean, well, that happened. Your forecast came true. They were more than double that, as a matter of fact. So it’s it was a good thing you passed on that. I want to ask you, it seems that the Fed is looking at and we get new numbers this week, CPI, ppi, and those, you know for the longest time, 2% 2% 2% and we’re not there yet, but all of a sudden they’re spooked by unemployment. Unemployment at 4.2 4.3% when 5% is considered full employment. Why getting spooked? Michael, why are they all of a sudden, oh, my God, we need to get and then you look at the last report of the number of jobs created, and you’re wondering, Hmm, why are they getting so uptight?
Michael Kao 19:22
Well, I think look, the same recency bias that’s afflicted you know, the whole view on rates can is applicable to unemployment, right? Because if you if I just have a huge problem with this train of thought that we are supposed to be measuring against a standard that with with with respect to interest rates, that standard is zero, because that’s what we’re used to for, you know, 1520, years or whatever, and then with unemployment, we’re measuring. Against an all time low standard of call it three, three and a half percent, as you point out, right if you, if you take a much bigger historical look, you know, four and a half to 5% is relatively normal, and interest rates, like at 4% four and a half percent are relatively normal. So, like, I would say that, you know, with with Fed Funds here, we are just slightly restrictive and and now they’re going to remove, it’s as if we’re at the 10 yard line. And then the Fed is deciding to run the ball backwards. It’s, it’s so I think, I think it’s, you know, and I, and I’ve done some interesting studies on that 1981 period, which obviously was characterized by much, much higher rates. But in that period, what I found so interesting is that, you know, if you recall beginning of 1981 was right after Volcker’s appointment, and he came in and basically took Fed Funds up to like 19% and then, you know, that was at the end of 1980 I think. And you know, the very quickly the economy went into recession. And then by, I think, January of 1981 or February of 1981 was when he started cutting. And it was, it was a premature pivot, because he started cutting, and for the first three or four months, it looked like the right thing to do, but then you started seeing CPI, which started the year at 12% and got down to just below 10% but then by the fifth month, it started inflecting higher and shot above 10% again. And when the Fed there, the Fed’s dual mandate was truly in conflict, right? Because there was a there was already a severe recession, but yet we still had double digit inflation. The Fed there chose to address the recession, and what happened after that was that the long end of the bond market rebelled, because it just said that, you know what? You know, the bond market doesn’t care necessarily about the recession. It cares about inflation expectations becoming unanchored. And so obviously, look that. And what’s crazy, and I put out a tweet this morning, is that I’m just contemplating the second order effects of a premature pivot by Powell. You know, back then, that premature pivot caused a sort of combo bull, Bear steepener of 300 basis points on the 30 Can you imagine the 300 basis point shift in the 30 year? I mean, look now I would think that the the if we get like a bear bull steepener, which I expect, obviously, you know, you figured the and the present analog might be a third of that. But still, even if we get 100 basis points, they’re both steeper in the 30 year. That’s that’s a potentially large amount of duration. That’s a duration hit that could have interest, you know, pretty, not so nice, impacts on long, long, dated assets and the iron. The irony is that in I think it was August of 2022 when the Fed was, you know, maybe six months, five months into its rate cuts, rate hikes, I wrote a kind of a controversial thread saying that, you know the case for a bear steepener. And my idea at the time was that, you know, if the Fed along with Treasury, it would need Treasury’s help in trying to bear steepen the yield curve. And the idea was that if we could get a engineer to bear steepener that, let’s say, had a long end at five, five and a half, 6% maybe the Fed could have then capped Fed funds at three, three and a half percent. You then have a normally shaped yield curve instead of this completely manipulated yield curve that we had prior to the Fed hikes, and maybe we could have avoided some of the regional banking issues that we had in early 23 right? It could, and because it would have what I think that they’re steep, what. I think longer, higher long term yields will do is that they will have a reverse wealth of wealth effect. They will depress long term asset prices more. Obviously, that didn’t happen. Instead, Treasury went the other way, right. If anything, the Treasury has suppressed long yields. And so we had, we had this, this crazy inversion. And so what, I think it’s a the travesty of the situation is that not only did we have a regional banking crisis, not only do we have very high short rates that are costing the American taxpayer a lot of money because the again, Treasury has decided to fund most of our budget deficit with the issuance of bills. Um, that that, and now, if Powell reverses course prematurely, we’re going to have a combo bull, Bear steepener Anyway. So it’s, in a way, it’s sort of like the worst of all worlds, which is, you know, it’s just frustrating to see, to see the policy makers do do this.
Andrew Brill 26:14
It’s uh, so many questions out of there. But if, what happens? What if what you’re saying could happen, and the long, the long debt could could increase by that full point where it went up three, 300 basis points last time. What do you think that’ll do to real estate? Because, you know, we’re in a bubble now where prices are so high, but if we’re now, you know, if the mortgage rates go up again, prices eventually, it actually could have a decent effect, because prices would have to come down.
Michael Kao 26:48
That’s, that’s what I mean. I mean, I think that the right now, with, with, with this premature pivot, right? It’s, remember our earlier discussion about that inelastic supply curve in real estate, right, right? And and facing a relatively inelastic demand, demand curve, and now with the Fed, with the Fed’s premature pivot, it’s going to goose demand again, and it’s going to juice prices. I think that’s of all the different categories of inflation. I say keep an eye out on shelter inflation, because I think the Fed is start is going to goose that, that part of a part of it again. But if I’m right, that that the bond market eventually rebels, then that is the equilibrating mechanism, right? Because the bond market ultimately longer, rates ultimately are going to determine mortgage, mortgage rates at least, you know, at least in our country, right in the US. You know, people care about the 30 year mortgage.
Andrew Brill 27:53
So if the bond market rebels, Michael, what on earth happens to our debt which isn’t decreasing anyway,
Michael Kao 28:01
that that is the problem, right? I I made a comment to somebody’s tweet this morning. They’re talking about, you know, Janet Yellen. I think it was Steve neurons talking about Janet Yellen. Days might be, might be numbered soon. And I basically said, you know, I really think that she’s going to go down in history. It’s one of the most negligence. Of the most negligent treasury secretaries, because her policies have really been detrimental for the country, I think, and the all of this front loading of the debt, those chickens are going to come home to roost. And it’s, you know, it’s some the next Treasury Secretary is going to have a tough, tough job ahead of him or her.
Andrew Brill 28:51
So come next week, I guess we’re expecting a rate cut. How big a cut Do you think comes and do you think Powell will do something like, you know, he was so deliberate in in waiting and waiting and waiting for the numbers? Do you think he goes small and says, you know, let’s see what happens? I mean, we have an election coming up. The next Fed meeting is right? Is literally the day after Election Day, yeah. So what do you think he does here?
Michael Kao 29:21
You know, I sure hope so. Because, you know, I many months ago, maybe six months ago, I wrote this piece called, you know, dipping dots, where I was saying, you know, I, you know, this, this activation energy for the Fed to actually, I didn’t, I didn’t think that Fed would hike. I didn’t think the data would really allow him to hike. But it looks like, you know, as I wrote in my recent piece, it looks like that. You know, this time I’ve, I’ve basically poo pooed every past call for the for the Fed to hike. And there have been, as you know, you know, the yield curve itself has forecast a premature pivot, like eight times, I think, during this hiking cycle. So. And I’ve, I’ve correctly poo pooed every single one of them this time. I believe that he will, he will cut and but I think that he’s only going to cut 25 because to do anything above that, I think is, I don’t, I don’t think the 25 is justified. So I think 50 would be really quite drastic. I’m not sure what would I mean. The one thing that we didn’t even talk about Andrew is that, you know, the credit markets, right? So the credit mark, so most of my hedge fund career was spent in the credit markets. I pay a lot of attention to credit markets. Credit markets are wide open. I mean, they are wide open. We’ve, I’ve been having some online debates with various people about, you know, default, default rates. There’s some measures that are showing that default rates are spiking, and then there’s some measures that are showing that the default rates are, are very, very benign. Well, I, I’m in the camp that again, there’s it comes back to this macro confusion, right? I think some of the smaller borrowers are facing problems. But is it enough to tilt the macro economy into recession? No, even on the week, even on the week of the worries over the yen carry trade, the week of August 5, I remember very clearly that, you know, vix had blown out to 60 plus. And you know, everything is, everybody’s freaked out. And I’m, I’m watching all the different credit aggregates that I watch, whether it’s, you know, high yield ETFs bank loan, ETFs, I’m watching clo close in funds. I’m looking at BDCs, right business development companies. They were all they were a little bit softer, but there was zero panic. And so that actually made me fade. I was on vacation, but it made me fade a bunch of the extreme readings in the VIX, and also what the bond market. But again, you know, it’s Mark capital markets are wide open. Credit markets are wide open right now, and that’s not the type of situation where you want to squander your hard earned bullets, the Fed earned these bullets to have essentially 525 basis points in its back pocket to address a real issue later, I would hate to see them basically again, turn back at the 10 yard line and reverse course and squander those bullets, you
Andrew Brill 32:45
think, and I know you’re a subscriber to Merton’s model, where you look at debt versus assets and stuff like that. When Powell came out in Jackson Hole and said, Yeah, I think it’s time to cut the market went crazy. Everybody happy, the s, p and the small caps. It seemed like everybody ran out and borrowed money, figuring, you know what, we’ll borrow money now we’ll refinance because we’ll be able to, as rates come down. That worries you, doesn’t it completely?
Michael Kao 33:15
Yeah, it’s, it completely worries me. That’s, that’s exactly it. I mean, it’s, it’s, it’s that, back to that shelter inflation part of it, and that’s, and that’s just one of so many different, you know, supply in elasticity again, you know, I’ll say something that I said in my in my palette post, I said that, you know, we haven’t seen, it’s not just one, it’s, I think, like eight different supply in elasticities that I enumerated, and it’s the confluence of all of the above. And given that the fact, given that the Fed has only a blunt tool, and we have no signs of aggregate stress, right, what he’s going to do is that he’s going to alleviate a small amount of stress in certain have not pockets, but then juice the aggregate demand curve, and I think create a Second inflation wave. To me, this is Team transitory Redux
Andrew Brill 34:25
in the lower income class is hurting a lot because of inflation. You think that that’s going to get, that’s, it’s just going to it’s going to widen the divide and really divide, it
Michael Kao 34:38
absolutely is, because there. Okay, so inflation, I’ve also said this a lot, inflation is the most regressive tax there is. And not only is it, is it regressive in that it hurts the poorest, you know, decile of the of the income distribution, but it also hurts 100% of the population. Situation. So I get that it sounds a little bit callous to say that we need a recession, or we need unemployment to go to four and a half to 5% but look when, even if unemployment is at 5% it means that 95% of people are still employed. But when you if you do something that juices inflation back up it, it affects 100% of the people. There was a there were somebody made a comment that I responded to, maybe, I think, last week about credit card delinquencies on the rise, showing how you know the beleaguered, you know, cash strapped consumer really needs relief from the Fed. And I said, this is all wrong. It’s all wrong because number one, okay, first of all, credit card delinquencies are not in A a signal of aggregate credit stress, it’s who who actually pays interest on their credit cards. It’s only the people that are most cash strapped, that are living hand to mouth, where they basically where all of their income is eaten up by food, transportation, rent. That’s inflation. It’s inflation that’s causing the upsurge and credit card delinquencies. So that’s the biggest irony of that like to draw a conclusion again, this is, this is why the the confu, the the MA, the bifurcation between the haves and the have nots is creating these like distortions that’s making, I what I fear the policy makers to to enact poor policy choices. Because it’s not, it’s, you know, juicing inflation back up worsens that situation, it does not better that situation. Michael,
Andrew Brill 37:02
how quickly do you think that could happen? You know, we, not only do we, we have pal lowering rates, we have a presidential election. Both of these presidents are going to spend money like crazy. Or potential presidents, I should say, are going to spend money like crazy. So the debt is going to continue to go up. We need to finance that somehow. But let’s say he goes for a 50 basis point cut come next week, how quickly do you think inflation can creep up? And I know that there’s a lag time between what they do and how it takes effect, but do you think we’re looking at the end of this year, possibly beginning of next year? Are we looking at next summer as look, oh, my God, we have to raise rates again. I
Michael Kao 37:45
think, yeah, I think that. Let’s see. It’s September now. Yeah. So I think, like a six to nine month lag is reasonable. I think that by i i again, if the Fed really does anything close to what the yield curve is forecasting him to do, I think that there will be a resurgence of inflation unless, okay, so, so there is an interesting there. I wrote a, I wrote a thread. A couple weeks ago. I called it, you know, this, this was when Donald Trump was talking about how he wanted a weaker dollar, remember? And right? And so, so I So, I wrote a thread. I’ve been, as you know, I’ve been my choice of the strong moniker for the strong dollar has been US dollar wrecking ball. And I wrote this thread that says, Okay, well, are we actually going to transition from the US dollar wrecking ball to the US dollar pickleball, meaning a downgrade of, you know, a downgrade of the dollar strength to a weaker dollar. Well, I basically outlined three different paths. I see right there’s, there’s one path which is kind of like a forced devaluation path, kind of like a Plaza Accord too. I don’t see that path happening, because if you remember the plaza Accords of 1985 first of all, that that happened when DX y was 165 DX y is right now, 101, and it that also was because, you know, the dollar truly was way too strong. And it was at the US behest to get, you know, I think the g5 to come together and forcibly devalue the dollar, to kind of, you know, kind of correct some trade imbalances, right? So we don’t have that situation. And plus, you’ve got, you’ve got China. China’s got this, because they cannot drive their centrally planned economy with through the real estate channel. Anyway. Anymore, they have now turned all of their state resources to what I call their runaway assembly line. It’s their industrial capacity, right? So they are trying to export their way out of this, and it’s putting pressure on the most export dependent countries. And again, this is another I should have written. I should have added a Fifth Horseman of US economic resilience, which is the US, at least on an export perspective, is one of the least export dependent countries. But not so for the EU and Germany, and not so for Japan. So I don’t think that these other economies are necessary. Necessarily want to see a weaker dollar, because that doesn’t help them, right? They need a weaker currency to help their export sector, right? So, so that’s path one to a weaker dollar, which I again, if they did that, though it would be reflationary. Path two is the premature pivot, which is what we’re discussing right and path it’s already weakened the D, x, y, from around like 107 recently down to around 101 but I’m not sure that the dollar is going to weaken that much more from a premature pivot now, unless, unless Powell goes crazy, I still think that the US economy is one of the strongest, if not the strongest, in the world, relative to the the other large economies, China is an outright deflationary mode, and so these other central banks still need to outdo the Fed. So so that leave a path number three, which I call my golden path, to a weaker dollar, to the US dollar pickleball, USD pickleball, and that is, I think it’s an elevated risk, especially if Donald Trump takes office, which is addressing at least one of the key supply in elasticities, which is oil. I could see Trump brokering the deal between the US and Saudi Arabia and saying, Hey, in exchange for you restoring your full production, going from 9 million barrels per day back to 11 million or 12 million barrels per day, we will finally give you that security guarantee that you’ve been after for decades. And why, why that makes sense to me is I think Saudi Arabia has painted themselves into a corner where they don’t have a viable exit strategy in a in a globally weakening economy, they’re losing market share both to us, shale, as well as to Russia, Iran, the UAE, etc. Well, they’re the only major producer that has enough spare capacity to make up for lost price with increased volumes, they could actually be revenue neutral with the price of oil down 20% okay, but by by actually pumping More. But why it makes sense for the United States is that it also defangs the the economies of Iran and Russia, who obviously are two of our biggest geopolitical adversaries, right? And in fact, low oil prices, as my good friend Alex Davos, pointed out, are probably going to be the main the potentially, what stops the Russia, Ukraine war. So so that’s that is a path that I think is interesting, and if something like that happens, it at least solves one of the major supply in elasticities that concerns me with with a premature pivot.
Andrew Brill 44:07
So it’s interesting Michael that that OPEC said, you know, we’re going to cut production. We want to drive the price up. Last I checked oils under $70 a barrel. So whatever they did didn’t work.
Michael Kao 44:20
Well, they floated a trial balloon, and it totally backfired, right? I mean, they wanted to see it was clearly a trial balloon, and they withdrew it. But the market’s like, Okay, well, I mean, they basically, they said that, okay, we’re going to delay by two months. And I, and I kind of issued a sarcastic tweet about that. Oh, so in two months, an extra two months, the global economy is going to be that much in that much better shape, right? They’re trapped. They’re trapped. You know, it’s interesting because, like, I liken Saudi Arabia to the Bank of Japan. They have. Both painted themselves into a corner with poor policy choices, and so now they they need to figure out a way, a way out. And I think this oil for security guarantee deal is kind of a face saving exit. It’s not going to be good for every other oil producer, but at least for Saudi Arabia, it can be revenue neutral, and they get a security guarantee against, frankly, their their biggest, you know, Shia rival, right? You’ve got, there’s this, this Sunni Shia rivalry is has gone, gone back centuries, and that’s not changed. Now,
Andrew Brill 45:42
some view the dollar, you know, wanting to weaken like Trump. They want to weaken the dollar. They think it’s better for domestic manufacturing. It’s better for exporting US goods. What you know, but if we devalue the dollar, not good overseas.
Michael Kao 46:01
Exactly. That’s why. That’s why I think, you know, some people have been floating this notion of a second Plaza cord. I just, I completely discount that. It makes no sense to me, right? Because, you know, it doesn’t really help the us when we are the least export dependent major economy in the world. It really doesn’t help us to have a weaker dollar, but it definitively, it arrests this equilibration that needs to happen. I call the US dollar wrecking ball. Ultimately, it’s an equilibrating mechanism. By having a strong dollar, it actually exports our inflation, and potentially imports some of China’s deflation. Now, if you actually have an artificially weaker dollar, just for whatever reason, right? Think about what that does. It’s going to arrest that equilibrating mechanism, right? It’s going to re import inflation into the US and so, so it just doesn’t make any sense to me at all that would happen. And if it did happen, then it would be reflationary again, because it hasn’t. The fact hasn’t changed that rest of world’s economies are weaker than the US, and they still need to outdo the Fed. So so this is, this is the Uber reflationary outcome. If Powell is aggressively cutting right and weakening the dollar, it will give the other central banks, it will force, I think, the other central banks to similarly cut aggressively. And if you have this global, this competitive cutting cycle, how can that not be reflationary, right?
Andrew Brill 48:03
They’ve already started cutting before the Fed, well,
Michael Kao 48:06
they’ve had to. That’s, that’s, that’s something that I’ve said for a long time, that the rest of the world needs to out Hawk, sorry, outdove the Fed. And we’ve seen that happen. We’ve seen, you know, and it’s, it’s not surprising some of the economies that that started cutting first, they tend to be the economies like, for instance, like Bank of Canada and Bank of Australia. They’re the ones that have a vast preponderance or floating rate mortgages, right? And so again, I go back to my four horsemen of the US economic resilience. Horseman number three, relative rate in sensitivity, both on the consumer and on the corporate level. The corporate when I said that 25% of US corporates have floating rate debt, I believe in Europe it’s 75%
Unknown Speaker 48:54
Wow, yeah. So
Michael Kao 48:57
the transmission mechanism for monetary policy is totally uneven across global economies. When we talked about the bifurcations, right, that all this messed up vodka Red Bull policy has done within the US, it’s created bifurcations within the US. But the other big bifurcation that it’s created is it’s created a bifurcation between the US and the rest of the world. And for that bifurcation to correct itself, we need the dollar to remain relatively strong. And if the Fed does something to change that, it’s going to arrest that equilibration and potentially create a competitive, cutting dynamic, which will definitely be reflationary, my opinion. So
Andrew Brill 49:46
short of going out and drinking vodka Red Bull, how am I and sticking my head in the sand, Michael, how am I protecting myself? How are our viewers protecting themselves for what’s to come? Um,
Michael Kao 50:00
this is one of the hardest things, because it, this is a really difficult macro backdrop and, and I can tell you that, okay, so you know, for myself, right? I I’m, I’m, I’m probably different than a lot of people in the Twitter sphere that tend to be, you know, trading that were their primary risk assets or trading. I’m really a now a family office investor, and six years retired from active management, I trade for fun, but in my trading account, even I have, I have essentially a very concentrated book. I have a one part of my book is what I call a macro cap structure ARB, where I’m long some clo equity closed end funds that are yielding almost 20% and I know this management team very well, very high quality manager. I’ve also written at length in the past about why I think clo structures, at least broadly syndicated loan. Clo structures are very, very resilient. So I like being long that to generate positive carry, but against it, right? I will have put, okay, you know, off and on in various sectors. Like, for instance, all year long, I’ve been shorting every geopolitical spike in oil by buying puts on the X, O, P, that’s been the right trade. I don’t have that on right now. I have on. I use my positive carry to also buy to short. For instance, the hyg index, which is like on, which is the high yield aggregate, which is on all time tights. So I have this sort of spread arbitrage trade that I have on, and then, and then, I also have some idiosyncratic event driven bets that, you know, they theoretically, ultimately, they’re not reliant on the greater fool to take me out right, even though they every trade ultimately has hidden, hidden stock market data to it. But ultimately, this, this bet, is going to be dependent on some esoteric restructuring events in Puerto Rico to play out, for instance, but then, but then, that’s just like a relatively small even though that portfolio is very, very concentrated, the rest of my asset allocation is, you know, I’ve, I’ve invested across in a lot of different assets, asset classes From some interesting hedge funds that provide working capital financing on a secured basis, on a secured equity and debt basis. I have some other funds that are sort of multi sleeve funds that invest in anything from things like, you know, aging bourbon barrels, to, you know, to rural car washes. So, so I’m what I’m after is, I’m trying to build a a very diversified exposure to what I call orthogonal asset classes, asset classes that are just orthogonal to stock market, beta, right, uncorrelated assets. And I also like to have a I’ve been partial to assets that are that are current pay to generate passive, a large amount of passive income. So that’s, that’s how I’m positioning. So
Andrew Brill 53:45
if someone had a lot of cash, those are the places you would tell them to stick it right now.
Michael Kao 53:53
Again, it depends on, you know, what, what, what people are after. I don’t, I don’t like to have what I what is what, what is relatively absent in my overall asset allocation are what I call greater fool beta trades. If that makes any sense, I don’t like to have I don’t have any passive equity. I don’t have, you know, I tend to not follow the flavor du jour like, you know, when, when, yeah, exactly. I don’t, I don’t, I don’t, I’m, I’m, I’m old enough to know that the flavor du jour doesn’t necessarily pan out. I think, like you know, for over the last I’m in this investment group where we collectively vet deals together. And you know, for a while. All the deals that we were seeing were AI build out related, you know, venture type deals. And that’s, that’s not I’ve seen, I’ve seen that that play out before in in 2000 so not do
Andrew Brill 55:18
you get, do you get free samples on the age bourbon that you’ve invested in?
Unknown Speaker 55:23
I wish
Andrew Brill 55:27
Well, Michael, thank you so much for joining me. I really appreciate all the the great information and insights and tell us where we can read all the stuff that you write, because it’s, it’s not only is it great information, it’s fun to read, because I don’t always, you don’t always, you know, follow the the norm, and, you know, it’s a lot of fun to read.
Michael Kao 55:47
Well, I hope, I hope that I’m fairly irreverent, but thank you. On Twitter, I’m at Urban Cowboy with the Ko and then my sub stack is Urban cowboy.com and and my Chaos Theory podcast is part of that so
Andrew Brill 56:04
and we can find that all on your website. Yes, awesome, Michael, thank you so much. Really appreciate it. Yeah,
Unknown Speaker 56:10
thanks so much for having me. This was fun. Certainly. Thanks
Andrew Brill 56:13
so much for watching our discussion here on wealthion with Michael cow. Michael is certainly a little controversial, but as you can see, backs it all up with facts. If you need the facts on being financially resilient, please head over to wealthion.com hit the button in the top right corner that says, find an advisor and sign up for a free, no obligation portfolio review. And of course, if you could like and subscribe to the channel and turn on notifications so you know when we post new videos on the wealthion channel. And please do the social media thing with us all. The links are below in the description. And if you like this content and are looking for more ways to achieve long term wealth, watch this video next. Thanks again for watching until next time. Stay informed. Be empowered and may your investments flourish. You
