Episode Transcript
The Finance Ghost: Welcome to episode 279 of Magic Markets, just after Father's Day. To all the dads out there, hope you had a fantastic day celebrating. Moe and I certainly did. We were swapping notes before the show on how cute our kids are.
But far more serious chats need to happen on this podcast, of course. And this week we are going to be talking all about the Fed.
And just to give you an idea of what is coming your way in this podcast, we'll be talking about how the Fed essentially sets the price of the dollar, and how this anchors the global financial system, which is why this conversation is relevant to literally everyone.
We'll be talking about the importance of the Fed Chair, but how it's not necessarily a one-man show. And we'll also be talking, of course, about the latest from the FOMC (rate cuts and just how we are going to see this interest rate cycle going forward).
So, Moe, thank you for doing this. You're going to be doing most of the talking on this one. We're going back to the good old days where I practically interviewed you every week, and we did a lot of these macro shows.
Looking forward to learning from you on this one. Welcome.
Mohammed Nalla: Yeah, Ghost, always a pleasure doing this with you.
In terms of timing, I think it's really relevant simply because we've had the first FOMC meeting where Kevin Warsh has chaired that meeting, Jerome Powell has moved on.
But also, on the day we're recording this, we've just gotten news that former Fed chair Alan Greenspan has just passed away, at the age of 100. And so, this is a bit of a homage to Alan Greenspan there.
But there's a lot to unpack, because quite often audiences aren't familiar with just how relevant these macro discussions are to their own wealth. And when they're watching markets, what does that actually mean? And so that's what I really want to land on with this week's podcast.
The Finance Ghost: Yeah, absolutely. The macro stuff is really important, which is why we spend a lot of time on it.
So, let's jump into the first question then, Moe, and I think we need to set the scene on why the Fed matters for everyone, literally everyone. Why is that policy so important for every other market in the world, including South Africa?
Mohammed Nalla: The Fed's effectively out there setting the global price for the US dollar. And when I say this, I don't mean the currency, per se. If you're out there and you're borrowing dollars, or if you're a lender and you're lending dollars, the Fed effectively sets the price of that, and it becomes the de facto global risk-free rate.
Now again, that's debatable. The US carries a lower credit ranking or credit rating than some other sovereigns that are out there, maybe even some corporates. But the fact of the matter is that you're not going to get away from the fact that the yield on the US Treasury is your global risk-free rate.
Now, this ties in because the dollar is actually the global funding currency. If you look at everything, commodities are priced in dollars; a lot of global debt is priced in US dollars. And so that is why that's the kind of transmission mechanism into a global financial architecture.
Now I want to unpack this because there are actually three channels. And the first is - we've spoken about this on several shows, but I want to reiterate it - the valuation channel. Because when you're valuing any asset out there, your equities, or whatever it might be, you bake in that risk-free rate.
And so, if yields go up, then the hurdle rate for effectively every other asset class out there will rise as well.
This factors into equities, it goes into property, private equity deals, emerging markets, you name it. The US dollar and the price of that US dollar (US interest rates effectively) is what sets the price and the discount factor.
The second one I've mentioned, it's the currency channel. And how does this translate? Well, if you go through an era where the Fed's going to be a lot more hawkish, that's usually supportive of the US dollar. And I know there are other issues at play, there's fiscal risks and so forth. But let's just focus on the Fed for now.
That more hawkish Fed, if you want to call it that, means that dollars, people who invest in U.S. Treasuries, will earn more at the risk-free rate. And so, it generally tends to support the dollar as the de facto global safe haven.
Now if we bring that back to South Africa, it's important because a stronger dollar often will translate into a weaker rand. The rand is a high-beta emerging-market currency. And that weaker rand then filters through into inflation: food, fuel, your imports, the whole lot.
And so, it very directly sets what the risk-free rate, in terms of where the US yields are, also sets what South African rates could be through that inflation channel that comes through because of the currency effect.
Then the last one is the capital flow channel. Effectively, if investors can invest anywhere in the world and they're getting higher yields on US Treasuries (effectively risk free) that actually starts to adjust where investors allocate capital to.
So, in short, I think that's the real reason why it's important to global systems, it's important to South Africa.
And I'll go out and I'll say: the SARB doesn't copy the Fed, right? But they can't ignore the Fed because they exist in this global architecture. If the Fed moves, quite often emerging-market central banks have to move in tandem with that. Maybe not in every single move, but effectively that overarching trend sets the tone for where global capital markets are going.
The Finance Ghost: And of course, that's exactly why we are talking about it, because it is just so important and it really is the reference point for the pricing of so many assets.
And behind all of this, we find the Fed, right? And you've got the chair. And a change in chair is always a big piece of news. There's lots to talk about there.
But to what extent is that really the deciding factor behind monetary policy in the US versus making decisions by committee?
Mohammed Nalla: That's a great question, because there's this misnomer out there that the Fed chair is all-powerful. The most powerful person in the world a while ago, Janet Yellen, Fed chair at the time.
I think it's a misnomer because it is actually a committee.
The chair is still very powerful. So, let's unpack a little bit of how it works, because the FOMC has 12 voting members, and this is made up of an assortment of your Fed board governors from various regions.
You've got the New York Fed president that sits on that. You've also got your other regional Fed presidents that sit on that committee, effectively on a rotating basis. And they all participate in the discussions around policy, even when they don't vote.
And so, in that context, the Fed chair is effectively steering those discussions. But it's still a committee decision.
Now, if you're sitting in that chair role, it's very important because you get to set the communication tone. Markets don't just react to the decision saying, hey, guess what? Rates were on hold. Good example: last week's FOMC meeting.
The markets are reacting to, “What is the Fed saying that’s important?” They react to the press conference that comes after the decision. They react to the formal statement that's published. There's something called a dot plot, which is effectively each of those Fed committee members putting where they think rates will be over various time buckets. And all of that then frames the narrative that is out there now.
That's one part of the job. The other part of the job is that the chair also works at building consensus, because if you have a committee that's effectively completely split, in that instance, the chair has to work quite hard to find the consensus, so that it becomes an FOMC decision rather than just the chair's decision.
And then the third issue is effectively, I guess, the reaction function. Because right now, what's the most important thing on the Fed's mandate? Is it inflation? Is it the jobs market? And that changes from Fed chair to Fed chair.
It's important to note that the Fed chair is important, and very similar. I mean, they’re analogues to South Africa. Because at the SARB, you've got an MPC, and that's also a committee. It's chaired by the governor.
And when we're discussing the SARB, you know, the MPC can have up to seven members. At the moment, I think there are six there. You've got three deputy governors and then selected officials that sit on that MPC.
But even when it comes to a SARB decision (and the latest decision there was to hike by 25 basis points), you can actually see how this works, because four of the members on that committee supported the hike, two preferred no change. In that instance, it's pretty clear, you know, there's a majority.
But when there's some sort of divergence in a view, building that consensus and then communicating that to the market is very important.
So, in a nutshell, the chair is not the be-all and end-all. It's not a dictator that sits out there and says, hey, rates are going up, rates are going down, but they are the person that controls the narrative.
And very importantly, in markets, we know a lot of what happens out there is based on perception of what's going to happen going forward, as well as what the narrative is saying at any point in time.
The Finance Ghost: Interesting, Moe. So it is very much a committee, but also, as you say, the person in charge does make a difference and obviously has a significant influence, as one would expect.
Speaking of influence and political influence, maybe it’s worth touching on the extent to which the president of the United States has influence. At any point in time, but particularly at the moment (given Trump's approach to life), what sort of influence does he really have on the Fed?
And then maybe just again, the analogue of South Africa, what sort of influence does the ruling party at any point in time in South Africa have on the SARB?
Mohammed Nalla: [Laughs]. Ghost, I liked your last question. I don't like this one that much because, quite frankly, who knows, given today, then tomorrow, what the president does in the US?
In short, I would like to say that the president has influence, but not direct control.
And what I mean is that the formal appointment comes from the president. The president nominates the Fed chair and the governors, and then over time, those appointments will shape the committee, the direction they go. So, if they rotate out of their seats, for example, Jerome Powell is no longer the chair, but he still sits on that committee.
And unless Trump goes out there and fires him, which he thus far has threatened but hasn't managed to pull off, thankfully, that suggests a degree of independence at the Fed.
And that's what you want to see, is you want to see central bank independence. Because if you don't have that, you very quickly go down this rabbit hole of effectively political pressure to monetise your debt. You get some of that at the fringes.
But in fact, with the current appointment of Kevin Warsh, if you look at that, he's a Trump appointee. A lot of the early perception was that Warsh would be a lot more dovish, because Trump wants lower rates, he wants them to cut rates today.
In fact, you got the total opposite of that. Warsh came in, he sounded a lot more hawkish than the markets unpacked (we'll go into that a little bit later on in the discussion). But, the long and short of it is that the president can't just order the Fed to cut. He can't say, “I want lower rates. You're going to deliver that”.
If you see that central bank independence, which is a key institutional factor that you look at when you're an investor, that goes out of the window. And that would be a lot more damaging for the US.
And if we bring that back into South Africa, I would say, South Africa is probably one of the most credible central banks out there, not just in emerging markets, but globally.
It's why I have a lot of respect for the SARB; they get a lot of pressure. They get social pressure to cut rates, they get political pressure to cut rates. And the SARB is very clear in terms of our mandate from National Treasury (yes, that is politically directed, but our mandate from National Treasury) says inflation targeting. That's what we're going to do. We're going to stick to our knitting and we're going to deliver the tough medicine.
And in fact, it's one of the reasons why we haven't seen the same kind of blowouts in South Africa as we saw in other emerging markets. So, I think political pressure is always going to be there. But it's not as easy for a president to just come in and say, “Hey, this is what you're going to do, you're going to set rates”.
You want to see how that goes? Go and look at Turkey.
The Turkish leader appointed his son-in-law as the central bank governor at one point in time, directed interest rates, and the market's reaction was absolutely savage. Anyone who's thinking about doing that should go and look at some of those case studies. It doesn't end well.
The Finance Ghost: No, it doesn't end well. Capital is going to flow to where it is most welcome and where people feel safe sending it. And if you're going to behave like that, then unfortunately the capital is not going to come your way.
South Africa, for all its faults over the past, 10, 15, 20 years, perhaps even, has at least managed to keep some of these institutions on the straight and narrow. And I think that has really helped to save us during some of the tougher times that we've been through as an economy.
So, I think to bring the conversation home, Moe, having given us so much good insight into how this stuff actually works in the real world, let's just talk about that latest FOMC.
The world would love to see… well, maybe not the world would love to see rate cuts. Certainly some politicians would like to see rate cuts, and many investors would like to see rate cuts. Because all you have to do is go look during COVID to see what happens to equities when interest rates disappear.
Maybe that's not going to be so easy anymore, unfortunately. Although again, it's a moving target, right? It's inflation, it's oil, it's how this filters through, what that means for rates. It's not an easy thing to try and estimate, otherwise everyone would be rich.
Mohammed Nalla: Yeah, absolutely. Last week we saw a couple of things. Because the Fed has to be data-dependent. This issue in the Middle East, the war effectively, is on one day, off the next day, and it's very hard to set policy for the longer term in that kind of backdrop.
And so, Kevin Warsh is coming into the role with that as the data backdrop, the economic backdrop. But he also comes into it with a need to revise the strategic direction that the Fed is potentially taking.
And I want to try and unpack that, because the key message from last week is that rate cuts are not automatic. The Fed may be on hold, but that doesn't mean it's dovish. It doesn't mean we're going to price in rate cuts and the Fed put that we got so used to in financial markets is going to remain a feature.
In fact, the key takeaway was that we might actually see rate hikes in the US. If you look at some of the big banks, I think it was Bank of America came out with an expectation of three rate hikes this year, which is definitely on the much more hawkish end of the spectrum.
But I think that's what's changed is that the market was pricing in cuts. Now they're saying “Hmmm, they're not automatic. Maybe we actually get hikes if the current situation remains what it is”. And so that old story of, “Hey, you can just count on a Fed put”, I think has a question mark over it. And this is why it's so important.
We're paying homage to Alan Greenspan. Let's have a look at the history of the Fed chairs. Back in the day when we had an inflation scare, the oil crisis in the US, you had Volcker (Paul A. Volcker, ex-Fed chair).
And Volcker was known to be a very tough Fed chair and would do whatever it takes to restore inflation credibility. Hike rates very, very aggressively. And I'm certainly not suggesting that's what the US needs right now.
But the reason I put Volcker in there is because what came after, was such a massive contrast. Because initially after Volcker, you had Greenspan, probably famous for being one of the most powerful Fed chairs in recent history. And Greenspan was not just powerful, but he was very sensitised to “What are the markets doing?”.
He was suitably opaque. As a policymaker, you want to be opaque. You're an economist, so you want to balance all of your optionality, leave it out there in the market. And Greenspan was a master at doing that. They were trying to decode the Fed back in the Greenspan era, the early days.
After Greenspan, though (and it kind of started out as the Greenspan approach on markets, lower rates). You then had Ben Bernanke, who was more of an academic. And with Ben Bernanke, you got Quantitative easing (QE), and you had emergency liquidity. A lot more explicit communication. I think it was in the Bernanke era when you first got the Fed dot plot, and lots of communication.
Janet Yellen brought an extension of that approach, and then Jerome Powell, who effectively will be known as “The Pandemic Chair”, if you want to call it that, again, brought massive stimulus to the economy.
So, the current Fed has to move away from that, into the more standard playbook of what policy should be doing. You're not going to just hold the market's hand and say, “Hey, here's easy rates” every time it gets difficult out there.
The market wants some sort of credibility from a policy perspective, and I think that's what you're going to start seeing from Kevin Warsh. Be a little bit more opaque. Maybe that's less communication. They might even do away with the dot plot. Does that bring more uncertainty into the market? Yes, maybe.
But I think it does something more important. And that is it preserves the Fed optionality to move in either direction as the data warrants and not have this Sword of Damocles over their head to say, “You've got to keep cutting rates”.
And again, I want to bring this back to South Africa because if you have a Fed that's maybe more, let's call it tighter for longer (they're not as dovish as they were in the past), that could come through with a resumption of some rand weakness.
I'm not calling it right now because the rand's done really well, but it's done well because the Fed's been too easy. The US dollar has come under pressure.
If we see a structural shift there, it might reverse what we've seen over the last two years or so. That's what I would be paying attention to, Ghost.
The Finance Ghost: Thanks, Moe. Plenty of insights. Then I'll hit you with another bit of correlation-causation, not sure - but Alan Greenspan made it all the way to 100 years old, which is a pretty serious innings. So, RIP to him.
Charlie Munger, as you'll recall, passed away just before his 100th birthday. Warren Buffett at 95 and going strong. So perhaps the lesson here is if you want to live a very long, healthy life in the finance sphere, you either need to be a very long-term investor, which tracks, or you need to be the Fed chair.
That's my key takeout from today, Moe.
Mohammed Nalla: Yeah, maybe long-term investor. I don't know if I'd want to be the Fed chair. That’s a terrible, terrible job out there. Certainly, with the political pressure, a lot rests on the Fed chair's shoulders.
Ghost, I think that's a nice place to wrap the show. We’ve touched on all the key points we set out to touch on: the Fed setting the global price of the dollar and dollars in general, how the Fed chair is an important role but not the be-all and end-all in terms of the decision.
Where political pressure kind of comes through when you're a policymaker at a central bank, and then the practical point, which is to say don't just expect a “Fed put” to come out there and effectively solve your problems if markets get mispriced, whatever that looks like.
Things change. There are structural changes underway. Let's pay close attention.
I don't think this is the last time we're going to be discussing the Fed, or the market reaction function to it, but I certainly hope that our listeners have enjoyed this week's show.
Let us know what you thought of it. Hit us up on social media. It’s @MagicMarketsPod, @FinanceGhost and @MohammedNalla, all on X. Or you can find us on LinkedIn. Pop us a note on there.
Until next week, same time, same place. Thanks, and cheers.
The Finance Ghost: Ciao.
