Former Goldman Sachs co-head: Fed rate cut may be a mistake if it comes too late

Original Author: Blockworks

Original text compilation: Peyton

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On July 2, 2024, Raoul Pal joined the show to discuss his theory of the ‘Index Age’. We delve into why Liquidity will surge again in the second half of 2024, why diversified investment is a thing of the past, financial repression, the fourth turning, and how these factors will affect the market.

Raoul Pal began his career at Goldman Sachs and later co-founded Global Macro Investor, focusing on providing comprehensive research on global economic trends for institutional investors. Pal’s expertise covers macroeconomic analysis, including currency, commodities, and emerging trends such as BTC and other digital assets. He is also a co-founder of the well-known financial media company Real Vision Group, which provides in-depth financial and economic interviews and analysis. He is one of the few investors who predicted the subprime mortgage crisis in 2008-2009.

The current Liquidity cycle

Felix: Let’s delve deeper. I’m very interested to know from your global macro perspective, which stage of the Liquidity cycle are we currently in?

Raoul: Of course we can. As I’ve been discussing for a long time, I believe we are transitioning from macro Cryptocurrency spring to macro Cryptocurrency summer. Typically, this transition occurs when the Deflationary forces are still present and the economy starts to rise.

Why is this important? Because it often prompts central banks and governments to increase Liquidity.

**1. The Federal Reserve mainly follows two factors: the unemployment rate and inflation. These two factors both lag behind the business cycle. For example, owner’s equivalent rent (OER), as an important component of the CPI, lags about 15 to 18 months. Because the two indicators of unemployment rate and inflation followed by the Federal Reserve have lagging characteristics, considering the signs of deflation that have already appeared, the Federal Reserve should cut interest rates.

Currently, the ISM (Institute for Supply Management) index remains below 50, indicating a weak economy. Even if the ISM bottoms out now, the Fed’s indicators will not reflect this until next year. When the unemployment rate rises slightly, for example, reaching 4.5% to 5%, even if the ISM index exceeds 50, the business cycle is strengthening, and this lagging indicator will still prompt the Fed to continue cutting interest rates. Because the Fed relies on lagging indicators, this situation occurs in every cycle.

The factors driving down CPI also lag behind the actual cycle. Currently, Truflation (a Decentralization platform that provides RWA index) estimates the actual inflation rate to be about 1.83%, and the core CPI is also sharply declining, but the Fed interest rate still remains at 5.5%. If the Fed does not take action, they may not be able to achieve their 2% inflation target.

2.This phase coincides with the election cycle. During this period, politicians often stimulate the economy to gain support and continue this stimulus into the next year. Since 2008, the presidential election cycle has shown a pattern: the market tends to decline in the summer, then accelerates sideways during the election period, and finally rebounds regardless of the election result. This cycle is evident in both the stock and cryptocurrency markets.

3. I believe that Japan will need to intervene with the support of the U.S. Federal Reserve System, which will be beneficial to the business cycles of various economies around the world. This is necessary because the U.S. dollar is currently too strong. Additionally, the rate cuts by the Federal Reserve will help with debt refinancing at low interest rates, as most of the debt is currently short-term. The lower interest rates will facilitate this refinancing.

Felix: It seems that we all agree that the Fed should cut interest rates now. Do you think they could make the mistake of cutting rates too late, or are they still on the right track?

Raoul: They could have acted earlier, as many leading indicators have shown Deflation for some time. However, we should not think that central banks are foolish. If the goal this year is to refinance $10 trillion of debt - plus similar actions in Europe, China, and Japan - it makes sense to refinance at the lowest possible Intrerest Rate. It appears that they have a deliberate strategy of aiming for inflation targets below their target. Observing the coordination between central banks and governments, it is clear that they are not independent, as evidenced by the actions of the US Treasury and the Federal Reserve, and this coordination is also evident in Japan, China, and Europe. Therefore, if they appear to be slow in taking action, it may be intentional in order to achieve the best refinancing results.

The dilemma of the Japanese forex market

Felix: You mentioned that the yen has risen above 161 and suggested that the Fed’s easing policy is the best way to solve this problem. However, they seem to be moving slowly in this regard. I am curious to know, when faced with this situation, which side would the central bank prioritize, domestic interests or international interests?

Raoul: I think they see it as equally important. Pay attention to Janet Yellen’s recent two visits to China. This is related to their debt refinancing cycle, as they need dollars; their real estate industry is borrowing in dollars. The global dollar shortage has already begun, spreading from Silicon Valley banks to major participants in the euro-dollar market, such as Credit Suisse. Japanese banks, as the center of the euro-dollar market, also urgently need dollars, leading to the depreciation of the yen. Yellen’s visit to China is part of planning for this situation.

This strategy appears to involve putting pressure on China through Japan. China does not want to devalue its currency, and Janet does not want to provide them with loans directly through the swap protocol. Instead, she may use Japanese banks for indirect intervention. At the same time, China may have agreed to buy US Treasury bonds, and Janet, as the world’s largest junk bond salesman, needs these bonds. This arrangement provides liquidity to the euro-dollar market and encourages China to increase its holdings of government bonds.

In addition, extensive efforts are needed to recalibrate the global trade landscape. United States cannot afford such a large deficit, and all countries need an economic rise. The depreciation of the dollar is critical to the global rise, benefiting emerging markets and boosting United States exports. At the bottom of the economic cycle, it looks like this “dance” will end with the Fed cutting interest rates to drop spreads and shock markets, possibly just as July.

Felix: I share the same view. It seems reasonable, but Powell’s speech today did not show any signs of immediate action.

Raoul: That’s true. However, the recurring theme is giving Japan an unlimited capacity to intervene. Every cycle, Japan intervenes in the currency market, causing a sharp depreciation of the US dollar and sparking a global rise. While the US benefits from a strong dollar, it also hampers exports and increases the deficit through inflation drop. Everyone understands what the necessary steps are, which is why Yellen’s visit to China is significant.

Diversified investment is a thing of the past.

Felix: How do you manage asset allocation in these dynamic environments? A few years ago, you were actively engaged in macro-specific trading, but now you have shifted towards index-style investing. How has this process evolved for you? Do you still participate in traditional macro trading?

Raoul: I no longer engage in macro trading. My personal investment portfolio is completely cryptocurrency. Among global macro investors, we have some technical bets and other investments, but these are all part of the same trade. Over time, I realized that everyone in the macro space is struggling because we haven’t focused on the right thing: the Liquidity cycle. Once you realize that everything is related to this cycle, the question becomes which assets perform best.

The central bank has effectively eliminated the left tail risk, that is, debt deflation - when the Collateral value drops too much, it will lead to a vicious cycle of selling. They did this in 2008 by devaluing the currency, causing asset prices to pump. They repeated this in 2012 and during the COVID-19 pandemic. Essentially, they will not allow debt deflation and will devalue the currency by 8% every year to prevent this from happening. It can be seen as a put option, costing 8% annually to ensure that the system does not collapse.

With the elimination of left-tail risk and everything linked to the debt refinancing cycle, in a scenario where currency is devaluing over time, this could be the best macro risk investment opportunity in history. As I analyze, only Nasdaq and Crypto have been pumping, with an average annual return rate of 177% for Nasdaq and 150% for BTC since 2011. Despite the volatility of BTC, its performance still outperforms all other assets.

Felix: The Sharpe Ratio of BTC is unbelievable.

Raoul: Indeed. In the long-term perspective, it is unparalleled. BTC is a unique asset class. I realized it too late, this is the only trade. People hate it because they want to go back to traditional trades like oil or USD/JPY. But if our goal as investors is to maximize profit, we must focus on the best trade, that is, diversification of Crypto has no more benefits.

Debt Era

Translator’s note: Debt monetization, also known as deficit monetization, or colloquially as “helicopter money”, is simply a way for the Central Bank to provide financing for government debt by printing money through issuance.

Felix: I want to have a deeper understanding of your specific theories on index assets and Cryptocurrency, but first, what will this refinancing cycle ultimately result in? Is it endless, or will it end when the debt-to-GDP ratio declines? Where is the turning point?

Raoul: Currently, we use all available domestic production to repay the debts of the private sector, which is about 100% of GDP. The average interest rate is about 2%, while the US GDP rise rate is about 1.75%. Basically, all economic rise is now used to repay debts. At the same time, government debt also accounts for 100% of GDP. Where will this trajectory lead? The answer is towards monetization.

With the aging population, sustained rise depends on population expansion, improved productivity, and continued accumulation of debt. However, since the 2008 financial crisis, debt rise has only been servicing existing liabilities. The population in the Western world is stagnant or even declining - the population challenge is imminent. Due to the aging workforce, productivity rise has been insufficient, forcing us to turn to technologies such as artificial intelligence and robots.

Taking Amazon as an example, it rapidly increased its robotic workforce from 250,000 to over 1 million within three years, surpassing the human employees. These technologies are expected to increase productivity by three to ten times, shaping an almost limitless potential for productivity through automation in the future. This evolution is changing the way economic calculations are made, moving towards a scenario of productivity expansion driven by artificial intelligence and robots. This shift relies on the expansion of power consumption and the improvement of computing efficiency, and significant progress is expected—investments in green energy in Europe and China suggest a 75% drop in electricity costs over the next decade.

Similar dynamics occurred after World War II, when yield curve control and productivity improvements drove the recovery of the baby boomer era. Now, with the potential of artificial intelligence and robotics to replicate 30% of the global population’s rise in productivity, we are following a similar script.

Felix: So, debt monetization seems to be a transitional strategy that maintains social stability while promoting necessary capital investment.

Raoul: Exactly. Also, as some people in the financial industry have suggested, allowing for systemic collapses is not realistic. The debt-to-GDP ratio of the global economy has reached 350%, and the consequences are dire - it could revert to pre-modern economic conditions or threaten global trade. Even at a cost of 8% to mitigate these risks, it seems more preferable. Strategic investments can effectively offset these costs.

Felix: I understand. As a 30-year-old, our generation is actively addressing the housing challenges. In Canada, especially, housing affordability has become an increasingly serious issue, similar to Ponzi Scheme. During this time, the prevalent high leverage phenomenon in home purchases still exists.

Raoul: In a devaluation cycle, assets with limited supply will appreciate due to currency depreciation, while variable income linked to GDP rise stagnates, leading to wider poverty. Countries like Australia and Canada, driven by capital-rich immigration and strong pension systems, have pumped up real estate values. However, widespread homeownership remains elusive. In the case of currency devaluation, price-earnings ratios continue to rise - a clear trend.

Felix: Does this background support your argument on Cryptocurrency and index assets?

Raoul: Exactly. In this environment, traditional assets have lost their appeal. Cryptocurrency and index assets, with their scarcity and technical support, have gained significant pump potential, making them an important part of modern investment strategies.

Banana Zone and Bubble

Felix: We have mentioned the “Banana Zone” several times. For those who may not be familiar, could you explain what it is and how it is related to the current price cycle?

Raoul: We use the term “Banana Zone” to describe periods of increased Liquidity and abnormally violent market Fluctuation, especially before elections or major events. We first mentioned this concept in the last quarter of last year, pointing out that Liquidity often drives the market into a “Banana Zone” where market prices show a vertical rise. This area is symbolized by a large yellow candle on the price chart, with a shape similar to a banana. This is an interesting term, but it indicates that during these periods, everything seems to be exceptionally crazy due to Liquidity and market cycles.

Banana Zone is also applicable to the fields of technology and artificial intelligence. We are in an unprecedented period of technological transformation. We are integrating advanced robotics, self-driving vehicles, gene editing, and other cutting-edge innovations into our daily lives. Despite this, some investors still prefer traditional assets because they appear relatively cheap. However, technology and cryptocurrency are where the exponential growth occurs.

Even though these assets have experienced bubble cycles and adjustments, the long-term trend is still upward, as technology is more long integrated into all aspects of our lives. If you choose to invest, it is crucial to focus on the best-performing assets, such as technology. Considering these assets as bubbles ignores the fact that “tomorrow will be more digital than today.”

Felix: People are often troubled by past bubble cycles, such as those in 2000, and are also cautious because of past failures like Cisco. But I think that despite people’s cautious attitudes, there is still a general belief in its potential.

Raoul: Caution is understandable, especially after experiencing past bubbles. But look at companies like Amazon, Google, and Facebook. Despite short-term fluctuations, they have demonstrated long-term resilience and growth. My view is simple: if the world is becoming increasingly digital, then technology stocks are likely to be a good investment choice. Even in the event of a bubble cycle, the overall trend will still favor technology.

Change your investment framework

Felix: How do you make yourself feel comfortable during the investment process? I have had the same experience, always worried about economic recession, but I eventually took a more detailed and optimistic approach. Do you have any suggestions on how to make this transition?

Raoul: Change your mindset - you should anticipate market sell-offs. See it as an opportunity to reinvest. For example, if the price of BTC pumps to $200,000 and then drops to $70,000, this is a reinvestment opportunity. This kind of cyclical nature can be seen as a gift. Someone on Twitter pointed out that every four years, BTC becomes the worst performing asset, but this provides another opportunity for substantial returns. Embrace the long-term view, just like managing your 401k retirement plan. Get excited about market downturns and be prepared to invest when prices are low.

Some people may suggest selling at market highs, but instead, you should buy when prices drop. This way, you avoid the pressure of timing the market perfectly. By facing and embracing your fears, they lose their power. This psychological approach is also widely applicable in life. Many people worry about their financial future, but long-term thinking and following investment risks can alleviate these concerns. Changing your mindset from fear to opportunity will completely transform your entire investment approach.

The Fourth Turning Point

Translator’s Note: “The Fourth Turning” is a book co-authored by William Strauss and Neil Howe, exploring a recurring cycle pattern in American history. In this theory, events unfold in a cyclical manner known as “saecula”, lasting approximately 80 to 100 years. These saecula are divided into four turnings, each of which impacts the attitudes and behaviors of a generation, influencing how society responds to challenges and shapes the future. This theory has significant influence in understanding long-term social patterns and predicting future trends.

Felix: We also want to discuss how this framework is affected by political uncertainty and the fourth turning. As observers outside the United States, we note that significant political interests may affect policies, including those related to cryptocurrency. How do you manage these uncertainties, especially given the accelerating pace of political change?

Raoul: This is interesting. I see the battle of regulating cryptocurrency as part of the inherent generational conflict in the fourth turning. Institutions struggle to keep up with technological advancements such as artificial intelligence, making it almost impossible to regulate these distributed systems. Neil Howe has talked about the need for new institutions and infrastructure, which is now becoming evident. The rise of populism stems from conflicts between different generations in terms of debt and economic opportunities. The older generation is blamed as the root cause of current problems, but the real issue is systemic.

This conflict will not be resolved until technology takes complete control. The fear of technology is immense, especially for innovations like blockchain and artificial intelligence. Society may split into two groups: those who accept technology and those who resist it. This division could lead to major social changes, similar to the split between Neanderthals and Homo sapiens. Felix: And there are also biological Hackers, etc.

Raoul: Yes, we are increasingly integrating with technology to enhance our cognitive, physical, and genetic abilities in a long way. There will be resistance to this change. This dichotomy may lead to a scenario where technologically advanced individuals coexist with those who reject these advancements. The pace of change is so rapid that harmony is difficult to achieve in a period of time. It is difficult for humans to cope with rapid changes, leading to social tension.

I choose to invest in these technological changes, rather than worry about them. I can retreat to my house in Little Cayman, where the impact of these changes may be smaller. This dual existence allows me to enjoy the benefits of technology and the tranquility of nature.

investment philosophy of encryption

Felix: This nicely brings up your argument for Cryptocurrency investments. How do you view the current state of Cryptocurrency investments? Could you please explain in detail your perspective on risk-return trades and your philosophical stance on various assets? I know you’ve gone through a journey from BTC to Ethereum, and now you’re involved in the Solana ecosystem through Depth.

Raoul: My views on Cryptocurrency have undergone a significant evolution. When I talk about Cryptocurrency, especially when it comes to young people, I describe it as a global utility similar to the internet. The key difference here is that blockchain technology is tokenization, providing a behavioral incentive system for the rise of the network. Essentially, the more people join and use this network, the more valuable it becomes. This creates a unique opportunity for investment because it’s not just about the technology - it’s about the rise of the network and its applications.

Our current Crypto Market Cap is 25 trillion dollars, and if the current rise trend continues, it could reach 100 trillion dollars by 2032. This represents an unparalleled wealth generation opportunity. The challenge is to navigate this field effectively and avoid being distracted by various factors. While BTC still plays a key role, a broader space including Ethereum and Solana also offers various opportunities.

Felix: This is an interesting perspective. It seems that the main focus should be on capturing the overall rise, rather than getting stuck in specific assets. Can you talk about how you manage investment horizons and position sizes in this situation?

Raoul: Managing investment horizon and position size is crucial. What I emphasize is not to maximize Position or take extreme risks. The idea is to capture most of the rise while managing risks. If Crypto rises from $2.5 trillion to $100 trillion, you don’t need to take on maximum risk to profit. Instead, you can take a more cautious approach to capture major pump opportunities while controlling risk.

Felix: It seems that many people often have a lot of skepticism about Cryptocurrency, especially when the price fluctuates drastically. **How do you view this kind of skepticism, and how does it affect your investment strategy?

Raoul: I understand this kind of skepticism, because the field of encryption is easily driven by emotions and narratives. People want to see results immediately, and it is often difficult to think long-term. I want to make it clear that although I have allocated a significant portion of my liquid asset net worth to Solana, I have also made long-term investments. I am not holding too much BTC now, because I think other assets offer better potential returns. The BTC I currently hold is not long, because I believe other assets offer better potential returns. This does not mean I have given up on BTC; it’s just that my focus has changed based on current opportunities.

The challenge is to avoid being manipulated and influenced by speculation and fear. For example, during a market downturn, people panic and miss buying opportunities. Instead of trying to perfectly time the market, it is better to buy and hold during sell-offs and ride out the adjustment period. The key is to stick to long-term investment principles and not let short-term fluctuations affect your strategy.

Felix: The concepts of investment horizon and volatility management are crucial. Do you think exchange-traded funds (ETFs) and other investment vehicles affect market volatility and provide stability?

Raoul: Yes, ETFs and other investment vehicles play a role in reducing fluctuations. Especially in the United States, tools like 401(k) accounts are used for regular and fixed investments, which helps stabilize the market. In addition, the introduction of options and other financial instruments can also reduce fluctuations. As the encryption market matures, with increased institutional participation and a deeper understanding of the network, the market may experience fewer extreme fluctuations.

Felix: It’s interesting to see how market sentiment and market cycles affect perceptions of technology. Given the skepticism surrounding some technological narratives, do you think time is the primary factor in changing market sentiment?

Raoul: Time is an important factor in changing market sentiment. Doubt about technology, especially after experiencing hype and disappointment cycles, is natural. People expect to see results immediately, often overlooking the gradual development of technology. For example, the adoption of blockchain is gradual, usually being experimented with in edge fields before reaching the exponential rise stage. The key is to understand that technological progress takes time to fully realize.

**Felix: Regarding BTC, do you still consider it an important asset? Despite its potential not being as explosive as other assets, do you still see value in it?

Raoul: Yes, BTC is still an important asset. It serves as a primary Collateral and a tool to prevent currency depreciation. Although it may not be the best-performing asset in terms of rise, it still holds significant value, particularly as a hedge against currency depreciation. Its means as a store of value and widespread adoption ensure that it maintains its correlation, even as its dominance in the Cryptocurrency field may weaken over time.

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