Danielle DiMartino Booth: "Recession Coming? The Fed’s Endgame" (Hedgeye Investing Summit)
What this covers
***This interview originally aired live on Hedgeye.com on April 15, 2020***
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This is an exclusive "Hedgeye Investing Summit" interview between Danielle DiMartino Booth, CEO of Quill Intelligence and Hedgeye CEO Keith McCullough.
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The Federal Reserve is using illegal off-balance-sheet mechanisms to rescue insolvent financial firms and manipulate markets, violating the Federal Reserve Act and enabling insider information trading that benefits Wall Street at the expense of Main Street, small businesses, and the broader economy.
- The Fed's special-purpose vehicles to purchase corporate bonds and fallen angels violate the 1913 Federal Reserve Act which restricts Fed purchases to Treasury-backed securities
- Fed announcements of market interventions leak to Wall Street before public knowledge, allowing institutional investors to front-run Fed actions while small businesses and workers are left behind
- The Fed is propping up insolvent zombie companies rather than allowing natural bankruptcy cycles, which perverts the capitalist system and prevents creative destruction
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A prolonged economic downturn and shift toward consumer frugality will change how Americans fundamentally perceive money itself, moving away from the consumption-dependent culture to one based on savings and cushions, with profound implications for a consumption-driven economy that are currently unappreciated by Wall Street and Washington.
“this downturn is going to be so protracted that the US consumer is going to change the way they perceive money itself but the slide you put up a few minutes ago about having no cushion I don't think we're going back there anytime soon and the implications the implications for a consumption-driven economy are simply unappreciated because they're they're a complete unknown we're not we're not used to Americans being frugal we're not used to having substantial cushions in savings it's it's just it's foreign to our culture”
Negative interest rates pose an existential threat to the banking system because they undermine the fundamental business model of banks, which depend on net interest margins; a functional banking system is critical to capitalism, and the US still has one of the last truly functional banking systems in the developed world.
“I think that negative interest rates pose an existential threat to the banking system and we have one of the last functional banking systems truly functional banking systems in the developed world”
The Federal Reserve is a full federal agency under the Treasury Department in Washington DC, not a private entity owned by banks, and the people working there are duty-bound to the people of the country, not to a small coterie of Wall Street hedge fund and private equity firms—therefore, the Fed's preferential treatment of these financial firms violates its public duty and represents a fundamental breach of fiduciary responsibility to the American people.
“the feds are private it's owned by the banks blah blah blah and I'm like it is not it is a full federal agency the Federal Reserve in Washington DC their email addresses end in dot govt and they are duty-bound the people of the country not a small coterie of Wall Street hedge fund private equity guys”
The Fed started rescuing triple-B credit in January 2019 (specifically January 6, 2019), not in response to COVID-19, meaning the current crisis is a continuation of pre-existing policy rather than an emergency response, and the virus provided only the trigger for an already-building collapse.
“he started writing to the rescue of a triple B credit on January the 6th 2019 he's just kept up ratcheting up his game that's it”
The United States is only partially locked down, with the Northeast corridor showing strict lockdowns but much of the rest of the country remaining open with significant mobility, meaning assertions that 'the whole of the United States is in lockdown' are inaccurate.
“the country's not closed in large parts I mean up up in the northeastern corridor certainly that is the case but if you look at much of the rest of the country it is open and people are mobile”
The Federal Reserve and Wall Street asset managers have coordinated to prop up asset prices and maintain the narrative that Fed intervention will create a V-shaped recovery, enabling these insiders to reposition their portfolios and talk their books while simultaneously the Fed enables this arrangement, creating a conflict of interest where the system is designed to benefit the top 1% and connected financial institutions.
“asset manager a calls asset manager B and we have a conference call and then we try to think about how we could reorder the deckchairs because currently we have a lot of asset management products that are god forbid susceptible to economic gravity that are going straight down so we need to fix that and then I'm gonna get on TV and tell you hey don't fight the Fed and isn't that a nice nice cycle doesn't that just give you the warm and fuzzies”
The communication speed and breadth via social media and online platforms means Fed actions can no longer be hidden from middle-class, educated investors who understand they are being disadvantaged, unlike the 2008 crisis where information spread more slowly, making this current situation different and less sustainable.
“this is not this is not oh seven this is not oh oh the communication happens so rapidly yeah the word spreads so quickly and you're not talking about you know conspiracy theorists up in the middle the night you're talking about rational middle-class well-educated investors who are trying to go about it by the book and understand that they're being screwed to the wall again”
The Federal Reserve's current actions using special-purpose vehicles to purchase corporate bonds and fallen angels likely violate the Federal Reserve Act of 1913, which explicitly stipulates the Fed can only own paper backed by the full faith and credit of the US government, specifically Treasuries and mortgage-backed securities, and this legal question will eventually be resolved in the courts.
“the Federal Reserve Act of 1913 stipulates that the Fed can only own paper that is backed by The Full Faith and guarantee of the United States government so we're talking about Treasuries mortgage-backed securities end of story”
Information about Fed policy interventions (specifically the decision to purchase fallen angels and related details about grandfathering rules) leaks to Wall Street before official public announcement, enabling institutional investors and hedge funds to front-run the Fed's actions, as evidenced by trading activity in high-yield ETFs the day before official Fed announcements.
“I received an email from an individual at one of these great big firms the day before the Fed announced that it was going to be buying fallen angels asking if the Fed was going to be grandfathering in fallen angels downgraded after March 23rd the word was on the street before it happened”
Millennials entering the workforce during this crisis will face their first major job losses and have been living close to the financial edge with high lifestyle costs, are being fired for the first time, and lack financial cushions that prior generations had.
“millennials as a generation is being fired for the first time in their life they are and they've been living really close to the edge with their experience or lifestyle”
JPMorgan Chase took extremely low loan loss provisions relative to current economic reality and simultaneously provided Small Business Administration loans to publicly traded companies including Ruth's Chris Steakhouse, which are not small businesses but rather large public companies that happen to be JPMorgan clients, while actual small business owners in towns across America received minimal support.
“Jamie Dimon who's one of the world's greatest people calling by his first name they never have never even met the man but but here he is and all of his glory yesterday taking wicked low loan loss provisions relative to the economic reality we have talking up how good the quarter is that it but at the same time you know that JPMorgan was giving again SBA loans to pot-bellied Corp a great name for this by the way Ruth's Chris Steakhouse these are public it's not small company loans it's small cap stocks that are clients of JP Morgan”
One in six US companies today does not have sufficient cash flow to cover one month of lost earnings before interest and taxes, indicating a massive population of 'zombie' companies that would be insolvent without Fed intervention, and these companies will remain insolvent regardless of whether the Fed purchases them because insolvency is a structural problem not a liquidity problem.
“one in six US companies today does not have the cash flow to survive to cover one month of lost earnings before interest in taxes so the sheer population of zombies tells you that the Treasury might have to come in and recapitalize these special-purpose vehicles that are going to withstand losses because it if a firm is insolvent and has inadequate cash flows and goes out of business it doesn't matter if jpowel bought it or not it's still insolvent and gone”
Private equity firms including Apollo lobbied Congress to allow their portfolio companies with fewer than 500 employees to access the Paycheck Protection Program (PPP) despite having loaded them with excessive debt through leveraged buyouts, which is fraudulent misrepresentation of these companies as 'small businesses' eligible for the program.
“they're constantly on my Twitter feed but the feds are private it's owned by the banks blah blah blah and I'm like it is not it is a full federal agency the Federal Reserve in Washington DC their email addresses end in dot govt and they are duty-bound the people of the country not a small coterie of Wall Street hedge fund private equity guys who have the gall to lobby Congress which Apollo and others did but the gall to lobby Congress and say our companies in sight of our portfolios have fewer than 500 employees by the way look the other way we've loaded them up with debt to their eyeballs that's what we do were leveraged buyout Kings but we think that they should be eligible for the PPP program”
Interest rate volatility broke down in 2008, with rates stopping their decline in March and rising until October before declining again, indicating a period where the Fed temporarily lost control of the interest rate trajectory.
“but again that's that's the history I mean there certainly I would never say it's impossible so I use you know real-time market signals to make sure I'm not on the wrong side of that slide 90 though on what you addressed guys the what we call the you affectionately call the the government's anti economic gravity machine you had a good run Danielle you gotta you gotta you got to give it that but again eventually these two bedfellows meet in in bed so the unemployment rate hooks up alongside the deficit as a percentage of GDP”
Baby boomers who have experienced two major stock market crashes (2000s and 2008-9) will attempt to sell their homes as soon as the housing market reopens for showings and open houses, seeking to obtain 'first mover advantage' to liquidate home equity before prices decline significantly due to supply shocks and generational demand mismatches.
“I propose that the baby boomers who have seen their 401ks burned not once but twice now is a third time despite the rebound in the stock market I think that you're going to have once the housing market opens up once you can have open houses again I think the baby boomers are gonna try and be trying getting that first mover advantage and get their home listed on the market as soon as possible”
Global trade volume has been in the worst condition in a decade on a year-over-year basis before the virus hit, indicating that the preconditions for a severe downturn existed independently of COVID-19 and the virus simply provided the trigger for an already-building crisis.
“this is global trade volume on a year-over-year basis the worse it been in a decade pre virus okay pre virus so if that's your condition previous and this is something you said to me before we went live on the switch here Danielle you said hey you know it didn't have to be the virus the preconditions were there from a global perspective obviously everyone can see that unless again you didn't know the China started slowing in 2018 and Europe went into parts of Europe point into a recession now they're back in a recession again”
Free-market capitalism requires creative destruction—the bankruptcy process—to work properly, allowing new leaders and fresh capital to enter failing companies and improve them, but Fed interventions preventing bankruptcies destroy this mechanism and prevent the system from naturally clearing.
“I think we we agree on that on the cycle itself ok we have you know generally a cycle a work out period in a bankruptcy cycle of a full-blown credit cycle and employment cycle you know can take anywhere between 914 in the case of the Great Depression but this one's going to end in two months so I just want to make sure that you knew Danielle because unfortunately from the all-time stock market bubble hi we need to end it there or people are gonna actually the real job losses are gonna be on Wall Street isn't that the truth”
A recession was likely avoided in 2001 because global trade remained positive despite the dot-com bubble collapse, demonstrating that trade dynamics, not monetary policy or Fed actions, determine recession severity.
“in 2001 we had a shallow risk we had a South shallow recession because global trade was positive”
Corporate debt as a percentage of GDP has reached peak levels comparable to the end of previous economic cycles, triple-B bonds represent an increasing percentage of the credit market, and debt-to-EBITDA ratios for investment grade corporate debt have deteriorated significantly, indicating Powell knew about the over-indebtedness before the crisis.
“this is where corporate debt was as a percentage of GDP and by the way this is you know if I were to show this nominally as opposed to a percent of GDP ie the amount of nominal debt I mean it's it's it would blow your mind it would look like I'm trying to make it make the chart look worse but a hundred percent of the time this is what happens at the end of an economic cycle when Wall Street gets Piggy and levered long investors get way too long in the tooth everybody's getting paid way too much and the complacency peaks in kind the second thing to show is to slide 72 which is triple B's percentage of the market and then you know debt to EBIT that like you look at looking at IG in particular so he knows damn well what it is”
Millennials will not want to purchase suburban McMansions that baby boomers are trying to sell, as they prefer urban centers and cannot afford both the purchase price and rising property taxes, creating a supply-demand mismatch between generational cohorts that can only be resolved by significant home price declines.
“they want to stay in urban centers I mean I know that there's gonna be a shift in the way we perceive urban centers because of density and the risks that go you know on a health level there but they sure as hell don't want some McMansion in the suburbs and they can't afford it either and they certainly could never afford the property taxes that are going to be rising in coming years so the supply-demand mismatch that would be typical in a recession is going to be even more stretched that the divide between the two generational cohorts is going to be vast and the only thing that's going to resolve the disconnect the divide is for prices to come down more than people are anticipating”
Consumer price inflation (CPI) could turn negative due to multiple deflationary pressures including 50% declines in clothing sales, collapsing port traffic, the fact that the top 20% of earners drive 40% of consumption (which is being reduced), elimination of travel and tourism jobs (10% of jobs created in the past decade), and housing prices falling as the largest input into CPI.
“when you see negative eight point seven on retail sales when you see that clothing sales have fallen by fifty percent when you see port traffic collapsing when you know that this is a global phenomenon when you know that that 40% of consumption in the United States is is taken care of by the top 20% of earners you can just kiss the entire luxury sector goodbye when you know that one out of every ten jobs created in the past decade was in travel and tourism yep there are simply going to be too many different distinct gravitational poles on prices initially outside of that gallon of milk we go through one a day in my house they're gonna be to many different distinct housing is the largest one it's the largest input into the CPI”
Wall Street's current arrogance—claiming they are so skilled at investing that this time is different and they can lever anything up infinitely—reveals their consistent inability to predict cycle turns, requiring the Fed to 'reorder the deckchairs' every time the cycle turns, contradicting their claims of superior forecasting ability.
“you can parade yourself around as one of the richest people that you've ever fathom to be and you're so good you're so good at investing you understand the cycle so beautifully and perfectly that it's different this time you can lever anything up as far as the eye can see buy back as much stock as you want you get the executive paid on earnings for sharing a lower share account ha ha you know but you just can't quite get it at the cycle turns so every time the cycle turns we have to reorder the deckchairs”
Unemployment and deficit spending as a percentage of GDP historically track together ('meet in bed'), and there is a chart showing this historical relationship, indicating that eventually the Fed's anti-economic-gravity efforts must yield to reality.
“slide 90 though on what you addressed guys the what we call the you affectionately call the the government's anti economic gravity machine you had a good run Danielle you gotta you gotta you got to give it that but again eventually these two bedfellows meet in in bed so the unemployment rate hooks up alongside the deficit as a percentage of GDP so that's that's where we're going that's that's that's pretty clear”
The Supreme Court, as the third branch of government, should be called upon to enforce Constitutional checks and balances that have been destroyed by the Fed's accumulation of power under the guise of urgency, and the Court has a duty to reassert its role as a check on executive power.
“I think that this is something that needs to go to the Supreme Court checks-and-balances has been destroyed under the auspices of there being the need for urgency funding you don't nationalize the financial markets quietly and it's certainly not a situation that should be able to be sustained and I do think that when checks and balances is it's called into question that that is something that one of the two branches as Congress is sitting by watching this happening the administration is sitting by watching while they're happily sitting by watching this happen with minuchin at the drivers at the wheel there is a third branch and the third branch is the Supreme Court of the United States and I think it will be their duty to call this into question in future generations”
The US dollar will remain strong against other currencies in the interim because global debt buildup in frontier markets, emerging markets, Asia, and Europe is so enormous that these regions are experiencing recession (India first recession in 40 years, Australia first in 30 years) and as long as US Treasury yields remain positive, the dollar will be perceived as a safe haven.
“because it is such a [ __ ] show in most of the rest of the world that we're still the most attractive force in the glue factory you have to keep in mind that that frontier market emerging markets Asia Europe the debt buildup in the rest of the world is so enormous that wow this is what most on Wall Street prefer to say this is this is not a regular recession is this is a virus recession you have to look at it that way but the deck build-up in the rest of the world is so immense that it is taking down economies that haven't been taken down in decades India looks like it's going to hit its first recession in 40 years in the emerging markets complex Australia develop market first a recession in 30 years”
Italian government bond yields are rising while the euro is falling, indicating that the eurozone is experiencing a sovereign debt crisis even as the Fed is supporting dollar assets, suggesting future systemic risk in Europe.
“Italian bond yields are going up now the euros going down now”
50% of small businesses in the US cannot survive a shutdown lasting more than 1–3 months, making them critically dependent on rapid reopening, but the virus and public health response are unpredictable; second waves are occurring even in countries that shut down completely, and the US is only partially shut down with continuing mobility, increasing the risk of prolonged viral circulation.
“guys on slide 79 in the current macro deck just so that people have the data associated with what with with what Daniel is talking about how long can a small business survive a shutdown 1 to 3 months that's 50 34 %”
The US is currently spending stimulus as a percentage of GDP at levels higher than any other nation on Earth, approaching full socialist spending levels, which could create a scenario where unemployment continues rising but prices decline, causing a 'mutiny' at Treasury options and preventing the Fed from controlling interest rate volatility.
“we are a socialist nation right now there is no other nation on planet earth right now that is throwing as much stimulus as a percentage of GDP and its economy as the United States you could have a situation where where unemployment is is is still falling or low excuse me unemployment is still rising and high and you could have a situation where prices are declining and yet there is some kind of mutiny at a Treasury option”
Enron's off-balance-sheet accounting worked for a long time until it didn't, and the same pattern applies to the Fed's current off-balance-sheet activities—they will work until the insolvency builds up to a breaking point and the entire structure collapses.
“well I mean think about Enron they got away with off-balance-sheet accounting for a long time mm-hm until it didn't work anymore until the insolvency is built up to such an extent that it blew up so think about that the same way right now what the Fed is doing is off balance sheet”
A full-blown credit cycle and employment cycle typically takes 9–14 years to fully work out, as seen in the Great Depression, but the current consensus on Wall Street is that this downturn will end in two months, which is delusional and reflects the desire of speculators to avoid bearing losses and resume trading long assets.
“we have you know generally a cycle a work out period in a bankruptcy cycle of a full-blown credit cycle and employment cycle you know can take anywhere between 914 in the case of the Great Depression guys on slide on slide 49 you can see all the draw downs and the lengths of periods of depressions recessions etc you know but this one's going to end in two months”
Hedge funds will tell you there will be no protracted economic downturn because the Fed will make the recovery 'V-shaped,' but this consensus is motivated by self-interest and contradicted by history, consumer behavior data, and structural factors like generational wealth dynamics and savings behavior that make rapid recovery implausible.
“if you ask any of them this is going to be v-shaped because the Fed is going to make it v-shaped I just don't see it”
Bond markets are correctly betting on deflation by holding long Treasuries; investors should hold US dollars, US Treasuries, and gold, because betting on deflation and slower growth is not fighting the Fed but rather betting on economic gravity—the natural trajectory of a contracting economy.
“in the body the bond market by the way for those of you that aren't up first of all your net well should be up here today because your top three Holdings should be US dollars US Treasuries again betting on Treasuries is betting on deflation which is what Daniel just just addressed so again if you're betting on slower growth again you're not fighting the Fed you're actually betting on economic gravity”
Global fragility is extraordinarily high because frontier markets, emerging markets, and Asia all have massive debt buildup relative to their historical patterns, meaning the global slowdown is taking down economies simultaneously rather than sequentially, compounding the aggregate downturn.
“the debt buildup in the rest of the world is so enormous that wow this is what most on Wall Street prefer to say this is this is not a regular recession is this is a virus recession you have to look at it that way but the deck build-up in the rest of the world is so immense that it is taking down economies that haven't been taken down in decades”
The Treasury volatility index (MOVE index) is a leading indicator of potential Fed loss of control over interest rate stability; when MOVE starts moving upward, it signals the Fed is losing control of treasury volatility, which is why the Fed deployed 75 billion per day before seeing MOVE spike too high.
“the leading indicator for that is the the the the move index or the Treasury bond vol in X and that's started to move and then that's when the Fed jumped in because if you can't control the volatility of interest rates you've lost the whole thing completely”
The Fed's rescue system is not preventing economic downturn; it is delaying the mechanism of asset repricing and creating false hope that the economy can avoid contraction, which prolongs the psychological and behavioral adjustment, making the eventual contraction larger and more painful.
“I think there's going to be a reset there is going to be a revisiting of frugality that we've not seen since the generation that lived through the Great Depression and you don't get that by listening to bubble vision because of the people who have benefited from it”
If CPI goes negative while the Fed is above the zero lower bound, real interest rates will go positive because real rates equal the benchmark rate minus CPI, which mathematically creates a situation where monetary stimulus paradoxically becomes contractionary.
“if CPI goes negative and the Fed is above the zero bound real rates go positive because real rates equal the benchmark - CPI can that actually happen I don't know if you followed everything that I just said in the question but yes yes it actually can mathematically happen it's perfectly conceivable”
The National Association of Homebuilders sentiment index fell 42 points from 72 to 30, representing the largest single decline in homebuilder sentiment ever recorded, indicating severe deterioration in housing market conditions and future construction activity.
“we saw just today that the National Association of Homebuilders fell by 42 points to 30 I mean from 70 to 230”
Contractors represent the largest initial recipients of small business loans, but this is problematic because contractors need bridge financing and will be fine, whereas housing will suffer severe, prolonged decline due to demand collapse and other structural factors.
“the vast majority of the initial recipients of these small business loans are contractors I mean you're talking about companies that need to come that need bridge financing effectively that come out of this just fine sorry but housings gonna be in the in the pisser for a very long time”
Second waves of COVID-19 will occur in countries that totally shut down (like Australia) not in countries that stayed partially open like the United States, suggesting that the actual virus containment strategy had little effect on wave patterns.
“we do know that second waves will occur and that's in countries that totally shut down not in countries that stayed half open like the United States is”
Powell cannot explain why the Fed is rescuing insolvent, overly-indebted companies that bear responsibility for their own overleveraging, whereas in 2008 one could walk into a bar and explain the financial crisis in simple terms, but now the Fed's logic is inexplicable.
“I don't want to be him I don't want to be the private equity guy who's bailing out private equity and for him to come in and be able to explain what's happening and they he is frightening Lee enough he has the same line that Wall Street hats and that is that this virus was no fault of insolvent overly indebted wait he doesn't use those words but this this crisis was not the fault of these companies and therefore they should be made whole why is my question to him”
Small and medium-sized enterprises are solvent but illiquid and should be the priority for emergency lending, but the Fed's structure has made them the last priority while making wealthy financial asset holders the first priority through immediate announcement effects.
“the people who are not immediate beneficiaries even though the announcement has been made or small and medium enterprises in this country and that is it's a huge chunk of the economy and it is what can go wrong because of the massive delay and lag”
Powell has become a massive proponent of Modern Monetary Theory through his actions, despite having stated he is not going to pursue negative interest rates, as evidenced by his unprecedented fiscal and monetary stimulus programs.
“he certainly become a massive proponent just by actions of MMT”
A leader from outside the traditional left-right political spectrum is needed to stand up for ordinary Americans and address the Fed's violations of law and equity, as the existing political structure is complicit in or indifferent to these violations.
“and that's why I think that this will eventually come up in the aftermath because hopefully some leader maybe not from the left maybe not from the right [ __ ] from in-between where it doesn't exist maybe somebody's finally gonna stand up for Americans because it's about time”
Millennials are asking why the Fed and the government won't let insolvent companies fail so that they can finally purchase assets at prices their parents paid—a generational re-evaluation of whether Fed rescue policy is actually beneficial or whether it prices them out of wealth accumulation indefinitely.
“eventually get to the place which hey why don't they let it fail so that I can finally buy some of the things that my parents did and there's a lot of that and you know to have a generation that is fairly entitled get slapped in the face is again the effects are going to be profound”
The U.S. country is still a functioning free-market democracy where Americans 'should be proud' and must maintain faith, despite the current corrupt financial system and government actions, because the constitutional and legal systems still exist to eventually correct abuses.
“but I do believe that that when the rubber meets the road Americans aren't going to roll over and maybe this channel you know this communication channel that we have this conversation right now is a big part of it”
Danielle believes Americans will ultimately reject the current system and demand accountability, not through political ideology (left or right) but through fundamental patriotic principles of capitalism and free markets that transcend partisan lines.
“I do believe that that when the rubber meets the road Americans aren't going to roll over and maybe this channel you know this communication channel that we have this conversation right now is a big part of it you know you and I have a lot of followers you can't just ignore us anymore”
The COVID-19 virus was documented in mid-November in Wuhan, and the US intelligence community knew about it in mid-November, providing five months of data before current assessments, yet there is still no certainty about when the crisis will end, indicating complexity that cannot be predicted despite ample data.
“if they knew about it in mid-november in Wuhan and that's that that's actually documented data and and our intelligence community do knew about it in mid-november but take that and say you've got five whole months of data about one of the most one of the most contagious viruses ever to hit the planet there's no way of knowing with any certainty when this is going to end”