Inside Trump's pick to replace Jerome Powell

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In May, the chair of the US Federal Reserve will change. For most of his term, Donald Trump has

thrown criticism at the outgoing chair, Jerome Powell. Trump has called Powell Mr. Too Late,

a stubborn moron, a dishonest guy, and said it was like talking to a chair. The Department of Justice

even launched a criminal investigation into Powell over the cost overruns in the renovation of

the Federal Reserve building. So, with this backdrop, how will the replacement Kevin Warsh

fare and will he tow the Trump line? Joining me to break this down is Chris Bernie, a portfolio

manager at Fixed Income Specialist cap stream. Not only is Chris a portfolio manager,

but he is also responsible for macroeconomic research, asset allocation and interest rate

and foreign exchange trading. Therefore, he keeps a close eye on the Federal Reserve.

Chris, the US Federal Reserve, a little bit going to be happening over there in May.

We've got Kevin Warsh coming in to replace Jerome Powell, whose Jerome Powell has been

under fire from Donald Trump, of course. A lot of accusations have been thrown around at him,

a lot of mud slung from Donald towards him. Why should Australian investors and Australian retirees

and accumulators actually care about this? Sure. Firstly, it's not for the mud slinging

element. The chair of the Federal Reserve actually has a huge influence on Australian investments,

whether it's equity markets. There's a global theme to risk sentiment, and when the US

sneezes, Australia catches a cold, as you might have heard, and equity markets are a great example

of that. Risk sentiment is a very global phenomenon, but it also has a direct impact on interest rates

here in Australia. The US really sets that global risk-free interest rate off, which all other

interest rates are based to some degree or another. It'll also have a pretty significant impact on

interest rates here locally. That relativity in interest rates is really clear when it comes down

to the currency. The Australian dollar will go up if Australian rates are higher than in the US,

and vice versa will go down if Australian interest rates are lower than the US. What the Federal Reserve

does in terms of official interest rates can impact everything from retirees, interest rates

that they're earning on their term deposits, to it might impact if your firm is an import or an

exporter, if they're going to be doing better or worse, and of course it can just affect the overall

level of the risk markets as well. Equities will decline significantly if the Federal Reserve keeps rates

high too long and puts a break on the economy. Let's talk about Kevin Warsh. What do we actually

know about Kevin coming into this? Well what I would say is that he's not the political or pointy

that some might have expected from Trump. He's not a Fox News host that's now been put into a

position of power. He is someone that I would classify as an insider. He's a former Fed governor. He

was a Fed governor from 2006 to 2011, and he was really the market facing person for the Fed

during the global financial crisis. So he's very well credentialed, very well respected in the space.

He's been successful both inside and outside the Federal Reserve. So what I would say it's not

really a question of competence or even experience. Both are very highly respected in the space.

What I would say is that there are some philosophical differences between the two.

Powell is a bit more flexible. He's a bit more about discretion when it comes to setting monetary

policies. He's a bit more about balancing inflation and trying to get full employment in the US

economy. A dual mandate as they call it. Really, Kevin Worsh is a much more focused on inflation.

He's not rules based, but he's a lot more about having a little less discretion, making sure

that inflation is low and that the Fed remains credible as an inflation fighter. Can you explain

when you say he's not rules based? What do you mean by that? Yeah, so there's some rules that

you could have as a central banker that you might be able to apply as a matter of hand and there

might not be any discretion at all. So there's one good example of that's the Taylor rule, which is

a very common, very well known rule in economics, which basically says that the level of interest rates

should be dialed up if inflation is above target and dialed up if unemployment is below the rate at

which wages tend to be around the same rate from year to year and vice versa in return. There's

a little rule that is very mathematical and prescribed. Now, discretion says that you don't follow

those rules, that you do something that's a bit more touchy-feely. If you think inflation's

going up, you start to hike rates or if you're worried about the labour market and the risks

around the outlook, even if they haven't materialised yet, you might actually look to cut rates.

So there's a bit more discretion in the process and you can oscillate between the two, but really

economics is an art. It's not a physical science. So no one really applies the logic that you should

just be following hard and fast rules. There's always that element of touchy-feeliness to it

in terms of how you can actually operate monetary policy for the best outcomes in the economy.

And what kind of political pressure will wash beyonder? I think you'll be under significant

pressure. We've already seen, as you said, there was some political pressure applied to put

it politely on power to try and get him to reduce interest rates. And I think you'll see the same.

I don't think the US president is necessarily going to fully respect the independence of the

central bank at the way that they would like it. He will be trying to get interest rates as

low as possible for his political purposes. Now, the real question in my mind is actually what

actual outcomes that political pressure will deliver. Because Kevin Wash, when he does come into being

the Fed Chair in May of this year, he's just still going to be one vote or 12. Now, there is another

vote that's already in Trump's pocket, if you want to put it that way. Stephen Moran was appointed

a few months ago. And he was someone that was less experienced in monetary policy than

than Governor Wash is going to be, for example. But yeah, there's going to be two people there

that are more than likely going to be going for rate cuts when the US Federal Reserve Chair

changes in May. So it's going to be interesting. There will be a lot of pressure. But I don't think

it'll necessarily be the case that you're going to get a huge sway of rate cuts straight away.

It's going to take some time for the new Fed Chair to influence the other members in the in the

board. And what kind of, I was going to say then in that context, what kind of environment

is he inheriting from power? A very difficult one, I imagine, because he's going to be balancing

a few different things. So, for example, he's been quite outspoken on the fact that he doesn't want

the Fed's balance sheet to be as large as it is. Now, in plain English, what does that mean?

It's how many of the US government's bonds or debt, the actual federal reserve, the central bank

owns. He's been a bit more of a proponent of having that to be a lower number, whereas power's

been a bit more activist, as I said, a bit more pragmatic earlier. And he's the balance sheet

as shrunk, but not all the way to zero. I think wash will be a bit cleaner to try and reduce that.

Now, what does that matter? Why does that matter? Is that the interest rates at the back end of the

US yield curve, which are really relevant for the homeowners in the US. So unlike here in Australia,

where it's a shorter term interest rate that matters, it's like a 10-year interest rate that matters

for the US. That's actually going to push up those interest rates. So I dare say that what Kevin

Walsh's plan is at the moment, or at least this is what the market is thinking, is that he'll lower

official interest rates in terms of the federal reserve rate, and that will actually help to offset

this impact from reducing the amount of US government debt that the federal reserve owns.

And you reckon he's going to be taking a bit of red pen to the renovations?

I'm not a property developer, so perhaps I might steer clear of that one, but I'm sure he'll be

reviewing it, but I imagine that those processes are quite expensive. I've never been. I presume it's

a bit of a fixer opera. It sounds like it, and then some. Let's talk about the US and inflation

or stagflation. Has Trump put the US between a bit of a rock and a hard place?

I think he has economically. I won't talk about politically, and I won't talk about militarily,

but in terms of the economics and markets, it's really interesting that the goals that he set out

in terms of having low interest rates and low inflation and increased affordability

just haven't really been met by his policy. So tax cuts are great for the economy, but they add

to inflation. The recent impact of the military action in Iran has pushed up oil prices, and if

that's sustained, if the straits of a mood stay closed for an extended period, then that's going

to push up gasoline prices in the US, which is not only going to hurt him politically in terms of

the votes, but it's going to lead to higher interest rates and otherwise would be the case.

So I think he has put himself in a bit of a corner economically with some of the other things

that he's looking to pursue out of his presidency. And what impact does that have on the US consumer,

the everyday person in the US? It's very much, is it already at very much a two-speed economy

between the haves and the have-nots? Well, personal consumption in the US has been the main

stage of the global economy for many years now. I'll be the first to say that it is much stronger

than what you would have expected, given that interest rates went up by 5% in the United States.

Historically, that's almost always tended to lead to a recession. It hasn't yet. The US

consumer has been very strongly buoyed by fiscal policy in the tax cuts that I mentioned,

but there's a sticker shock that comes with petrol prices. Whenever you're out and about,

you see those gasoline prices, as they call them in the US. You see the higher gasoline prices,

it has a psychological impact, as well as the real impact on disposable incomes. It just eats

up money that you would like to spend elsewhere. That is going to significantly negatively impact

both the economy and add to inflation, leading to that nasty stagflation word that you introduced

earlier. And also, though, it's got such a flow on effect to other areas of the economy as well.

So, logistics, your goods just moving around the country, and that comes at the question of,

does that cost then just also get passed on to the end consumer? Absolutely. And that is what

the central bank is going to be worried about. So, when you have something like a big spike in all

prices, even if the higher level is sustained, central banks tend to look through those one-off

impacts. It's what they call second-round impacts that tend to worry about. So, if it does flow

on to other industries, packaging, or all these services economies, Uber Eats, you know, might

have an impact on Uber Eats, if you're getting your food delivered by car. All of that is going

to be impacted and you should see price increases that you wouldn't have otherwise seen. Also,

there's this other really significant second-round impact that economists tend to worry about, which

is that if people start to ask for higher wages to offset all those costs, then you can end up in

these wage-price spirals that do demand an official interest rate response in terms of higher rates.

So, there's definitely some risks out there that are worth monitoring. Well, that's also an

interesting area as well at the moment when we're actually starting to see redundancies take place

due to the progress of the two-letter word that seems to be coming up every single episode of AI.

It's funny, isn't it? I was thinking just today in preparation for this podcast, how often do I see

corporation X cutting Y-thousand jobs because of AI? And it's at least weekly and at least a few

times a week. It is becoming more prevalent. And we're at the start. And we're only at the start.

And it does come to my mind that these corporations, though, can't I don't think have

probably already made that progress? It might also be cutting some excess, trimming some excess fat.

I think there'd be a little bit of that as well. But what I would say is that there's been a few

anecdotes that have been floating around the financial markets, which have actually got quite a lot

of attention, by the way. They're not just off-hand anecdotes, but they're written by quite prominent

research analysts where they're talking about the job loss elements of AI. I'd caution a little

bit about that. History is littered with technological advancements. Everything from the industrial

revolution to the internet and what happened with the dot com bubble. For example, there is a

range of experiences that can be drawn on that. Yes, there are some industries and some particular

jobs that are going to be impacted. But what happens is that the income and the benefits that flow

from that very often lead to jobs somewhere else. So I'm not as negative on the overall impact of AI

on jobs, but yes, the impact of AI on, for example, people that code. That's where I think you're

actually seeing some of the more significant first round impacts. The AI is able now to do that

as proficiently as some people are at a lot less time and a lot less cost.

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Continuing to focus on the US. So housing affordability is quite a factor over there. It's quite

quite funny. We're sitting back here in Australia and thinking, well, they've just finally caught on.

We're very used to this. But housing affordability is also becoming an issue in the US.

And the consumer is becoming appearing to be more and more tapped out. So how does this impact

than credit quality? It does have a big impact. I mean, there is a cultural difference between

owning your own home here in Australia versus in the US. There is definitely some cultural differences

there. And it is starting to bite over there. And interest rates remaining high is particularly

that 10-year part of the curve is in debt that goes for 10 years, for example. That is actually

what drives the homeowners affordability much more so than here in Australia. We're a bit more

floating rate. There are a bit more longer term fixed rate in how they borrow for their housing.

So that's where you're getting the political pressure from President Trump and other to try and

really keep this lower, to try and help homeowners with their requirements in that regard.

It is going to be a significant test for the US consumer and the US economy. And then by

extension the global economy, how they manage things like higher oil and petrol prices, if they

are at that edge of affordability, it is going to sting a bit more. But as I said, if the US

consumer falls over, we are definitely going to know about it here in Australia. So it's something

to keep an eye out for. I think the risks are slightly overblown just at the moment, but it is

a significant downside risk that we are monitoring for sure. What does that look like in the Australian

context if the US consumer falls over? Sure. So consumption tends to be about two-thirds of the

economy both here and in Australia. So hopefully that puts it into perspective straight away. If you

have two-thirds of your economy not firing on all cylinders, it's very difficult for the other

one-third to make up the gap. So what that means is, well, Australia is seen as a small open

economy. Now what does that mean? It means that our traded sectors are larger portion of our

economy than what you might see overseas. So if the global economy slows, then there's less

demand for our exports. Think about the demand for all of our mining. There's going to be a lot

lower. You know what's going to need as much steel as much of our other things that we produce here

as well, our beef. There's going to be lots of things that we export that there'll be less demand

for. And our economy will slow down as a result. So which might be welcome given what's going on in

inflation, but genuinely speaking, obviously if the global economy slows because the U.S. economy

slows on the back of the consumer not having any money to spend, that could really have an impact

on equity prices in particular given how correlated our equity prices are with the U.S.

And this is the balancing act that wash will be facing. I don't envy his job in that respect.

It is going to be tough because he will be trying to balance inflation with what's going on

in terms of the labour market and everybody having a job and all the risks around that in both

directions. So it is going to be tough and there will be some pressure from the president no doubt

to push it in a particular direction. And that's where he's going to have to tread very carefully

to meet on. I don't know if commitment is the right word, but he would have definitely had to

have said I would have thought that he was going to cut official interest rates before getting the

job. He's going to have to balance that with the fact that inflation still being sticky, almost

no central bank or no economy around the world has seen inflation return all the way to their target.

And then we're already getting these other influences which are likely to add to inflation and

Australia is unfortunately leading the way in that regard. Chris, let's move on to AI infrastructure

and the debt part that's building up here with these mega caps who I've got, you know, did have cash

for days, but they're actually using debt now to build these infrastructure for AI. Can you tell us

a bit about a bit about that? Yeah, sure. So there's a lot of hype. I think it's very easily

described as can we meet the hype? There's a lot of hype about what AI is going to deliver.

And the companies are certainly buying into it literally. There's a huge amount of investment in

a whole range of things from hyperscale data centers as the buzz word is. It's basically just

areas, rooms or indeed whole buildings that are set up full of service to meet the requirements

of the AI. It's very processive intensive. So they have set up a whole range of these data

centers that are just there for the new processing power that's going to be required.

There's demand for microchips, a huge demand for microchips, including custom AI that are embedded

with the microchips. So there's investments in that as well. We've also got a huge demand now

for building their own little power grids. So not only do you need more power for the building,

but you need to upgrade the grid and a lot of the people, the companies are building their data

and having to build a power generation complex side by side at the same time so that it doesn't impact

on the rest of the economy's ability and access to electricity. So there's quite a huge range of

actual investments going on that are not related to the actual development of the software

and aren't related to actually making the AI better, which is what most people think the

investments actually on. But this year is actually going to be the first year where the investment

spending on those other items, on the data centers, on the power grids, on the chips is actually

going to be more than the expenditure and investment on the software development. So things are

definitely going at a pace there and there's a huge amount of investment going on.

From a capstream perspective, is it an area that is attractive to you or is it something that it's

just not in your wheelhouse? It's not necessarily in our wheelhouse. So capstreams are fixed income

investor. This is much more relevant for the equity side. The technology stocks are much bigger

increasing in a huge share of these equity indices these days. So it has an indirect impact in

that if those shares fall, global risk sentiment will fall and Australia is not going to be able

to avoid that if that's what happens. So we do look into it very closely. It's not something that

we're necessarily investing in directly. You can invest in data centers in the fixed income

space. It's not necessarily where we focus our energy. We do think that there are risks there,

but I have to say that the actual implementation of AI has been the bigger focus for us. It's definitely

something that now that I'm interacting with on a daily basis and it's actually really significantly

changing our day-to-day operations, which I appreciate is not what you're asking about.

That's a random case. That is really the main focus for us. This is not like the .com bubble.

This is something that's already dramatically changed how we're doing things on a daily basis.

From a fixed income side of things, how has that impact changed?

Sure. Your actual work then. The most obvious one is it's a more advanced

Google, but it's gone far beyond that now. So it is useful for looking up the difference between

Kevin Walsh and Governor Powell. You could do that and do it for that, for example. But it's changing

all the orminial tasks can now be automated farm. So is it getting into the research side of things

for your team? Yeah, absolutely. We use it for, you can use it for drafting comments. I don't

think it's at the stage yet, at least the versions that we have access to. It's an ever changing

space and at the very sharp end, I'm sure they're a lot better than what is publicly available.

But yeah, it can do anything from writing monthly communications pieces or at least the initial

draft to coming up with plans on, so you could ask it a question of, for example, when the US

and Israeli attack of around happened, you could ask it to list what happened historically when

there's been conflict in the Middle East in financial markets. So this is something that you can

use to much more efficiently answer particular questions. But as I said, it's not 100% reliable

as yet. It's an enhancement. It's something that you can use to make your life easier, but it's not

it's not the replacement for the human oversight just yet. Hasn't crept into that analytical side of

things? Not on our side. I'm sure it has in a number of industries from research consultants that

actually look at and rate different fund managers. It has impacted that space a little bit,

but not as directly as I think you're asking about. So Warsh also argues that AI productivity

is a secret weapon that can help kill that tame that inflation. Can you see these productivity

games coming quick enough to actually help him out there? I think they will come quite quickly.

As I said, if they're impacting my industry straight away already and already having a significant

impact, I think there will be some pretty big productivity gains. And at least theoretically,

that will look to lower inflation and might lower interest rates. There's another theoretical

discussion around whether or not the huge amount of investment that's going on might raise interest

rates. Obviously, if you need to borrow a lot of capital to invest in AI, that's a demand on funds,

which tends to pull up the interest rate or the natural rate of interest if you want to think about

it as a in a long run average sense. But if it lowers inflation, it might actually help lower interest

rates in the shorter term. I don't think the full impact is going to be here for some time though.

So yes, productivity gains are already coming through. I don't think the full extent will be felt

for some time. And I think the more important question from my point of view in trying to assess

where monetary policy is going to go is is it going to be the dominant influence? So the use of

technology in the 2000s was and globalisation more generally was the dominant influence which

saw inflation remain below central bank targets for most of the 2000s. I'm not sure it's going to be

the dominant influence just yet and particularly not here in Australia at the moment. In Australia,

we've actually got a proper demand supply and balance. The economy is too hot for our ability to

produce goods and services and inflation's gone up and that's why the reserve bank of Australia's

been hiking rates. So I think AI will have use having and will have an influence. But I'm

remain to be convinced that it's going to be the dominant influence in terms of trying to

forecast central bank movements. If you had to have a guess at some of the things that could also

be, if it's not going to be AI, some of those things that could have be that dominant influence,

what would be there? So things like the spike in oil prices if it's sustained and starts feeding

into those secondary and impacts that I mentioned earlier, that's going to be one of the more

dominant influences in the near term. Events can change quite quickly in that front. But more

broadly, what I would say is there's still that stickiness in inflation. As I said, we had that

big rise in inflation post the pandemic. Monetary policy and fiscal policy was so supportive,

a bit too successful is a way of saying that we saw a significant amount of inflation and it just

hasn't returned to target yet. And then in Australia, we're actually leading the world in a way.

We've actually had the re-emergence of inflation. So elsewhere inflation's just not continued

to go down towards the inflation target. But in Australia, it's gone back up. So it's about

is fiscal policy and monetary policy together leading to demand that's too hot for the economy

to be able to provide. And that I think is actually the dominant influence and will be for the next

six to 12 months. Interesting then, how are you positioning your portfolios inside of this?

Yeah, absolutely. So there are two key levers that we pull in fixed income. There's credit

spread duration and rates duration. So can you explain duration and credit spread?

Absolutely. So basically the credit spread duration and rates duration, I just tend to say

when you're thinking about the will you hear the word duration and a fixed income market context,

just replace it with the word sensitivity. So when you're talking about credit spread duration,

it's how sensitive is it to credit spread movements, which is highly correlated with equities if

you'd prefer to think about it that way. And then obviously the interest rate duration is just

the sensitivity to interest rate movements and bond yields. So you can dial that up or down

in a fixed income portfolio. And there's actually a few things that we've been thinking about

in terms of how we positioned. And the first one is that equities are up at record highs.

Credit spreads have been down near their record lows. So we've actually, we've been wanting to

have a low to moderate credit spread sensitivity duration because we're concerned that credit spreads

can really only go one way over a medium term context. When they're at their lows, it's not really

like equities. There's a big difference between equities can just kind of keep grinding higher.

It's very difficult for credit spreads to continue making their new lows because they can't go

through zero and into negative territory for an honest sustained basis. So we just wanted to be

a bit more defensively positioned in the credit space. In the rate space we've been quite neutral,

which is to say that we can see that some economies are going to see higher interest rates

like here in Australia. And prior to the recent military conflict, we'd been long regions

like US and UK where we had been expecting rate cuts partly reflecting that we've got a new

Fed governor coming in to be chair that is likely to push rates a little bit lower than otherwise

would be the case. So we were a bit neutral overall on the rate side, but we were somewhat short

here in Australia, which is code for we were positioned because we thought the RBA would hike

rates because of this idiosyncratic or individual inflation problem that we have here in Australia.

It was clear that the RBA was going to be hiking rates and we'll continue to do so.

Just quickly round off, I know capstream's got a couple of listed products here on the ASX

can tell us about those. Yeah, so we've got XCAP, which is basically an ETF for our main income

product. So capstream is a very conservative investor. So we'd really try and deliver on that

coupon income without having too much of that sensitivity. We're a very low duration or sensitivity

fund relative to some of our peers. So that is something that people can look at if they're looking

to get involved in the ETF space. And that comes fits into that fixed income sleeve in the portfolio.

Predominally, would you say predominantly used by retirees in the Australian market?

retirees would be someone that would be reasonably well suited to this because it is about

trying to consistently deliver coupon income rather than it's rather than it's meant to be a big

diversifier against the equities part of your portfolio. Obviously, everyone should seek their own

financial advice to make sure that it's appropriate for them, but that's really what we're trying

to deliver on is a steady source of income and deliver returns in excess of the cash rate

on the back of that. Fantastic. Well, we look forward to seeing what I'll make, Kevin.

Again, I get up to over in the US Fed and I really appreciate you coming into just to talk us

through that and explain what we're most likely to see going forward. That's great. Thank you for

having me. It's been a really good time. Thank you very much.