VALUE: After Hours (S08 E05): Jay D. Hatfield, Portfolio Manager InfraCap Small Cap, Income, MLPs and REIT Preferreds

TRANSCRIPT’

[Tobias] And we’re live. We’re running a little bit late. Sorry, folks.

This is Value After Hours. I’m Tobias Carlisle, joined, as always, by my co-host, Jake Taylor. Our special guest today is Jay Hatfield from Infracap.

He’s going to tell us a little bit about… How are you, Jay?

[Jay] I’m doing well. Thanks for having me on, Tobias and Jake.

[Tobias] Pleasure. Tell us a little bit about Infracap.

[Jay] We are a $3.5 billion money management company. We have six ETFs, all focused on monthly income, three on the fixed income side, three on the equity income side. We also have a hedge fund.

And so we are committed to providing great total return, but also good income for investors who want to sleep at night and know that they have good, stable income coming from their portfolios.

[Tobias] What’s the attraction to income-orientated strategies?

Why Income Investing Matters: Dividend & Fixed-Income Strategies for Retirement Stability

[Jay] Well, it’s primarily helpful for people who… I would recommend having it even when you’re young, having some. But for older individuals who are looking forward to retirement or in retirement, it can give you a good base load for your portfolio whereby you know a good percentage of your expenses are being covered by the income coming from your portfolio.

And then you could have more growthy or riskier investments in the remainder of your portfolio. Because what you don’t want is like during… We haven’t had one since 22, but during major drawdowns, you don’t want to have to be selling securities and taking losses.

And so, nor do you want to be worried about that, even if it doesn’t happen. And so it can provide a lot of solace. If you have fixed income, that can be a lot less volatile than the rest of your portfolio.

So you can also use it for rebalancing. This is what major pension funds do. So every quarter, they say, oh, well, my fixed income, because equities are down a lot, it rose from 40 to 45.

So we’ll sell 5% fixed income and buy 5% equities. So it can be a great way to buy at the bottom and sell at the top. Force yourself to do that by setting an allocation of fixed income and then rebalancing.

Usually equity income is pretty correlated with the market. So it doesn’t help you that much on that, but true fixed income would.

[Tobias] What are your sources of income?

Preferred Stocks vs High-Yield Bonds: How Income ETFs Generate 8–9% Yield

[Jay] So on the fixed income side, it’s preferred stocks and high yield bonds. The great thing about both of those asset classes is they’re higher risk fixed income. So unlike like our biggest, or not biggest, but our high yield fund is BNDS.

There’s a fund BND that’s just investment grade bonds and we’re high yield bonds. So their fund yields four, our fund yields eight. So in the long run, you’ll get a lot higher returns from these higher risk bonds.

And our preferred fund yields nine, same situation where you get higher income. And what’s great about that is it’s really almost like a hybrid security. So it’s much lower risk than equities, but has equity like returns because eight or nine is pretty close to equities or 10 or 11.

And so we think that’s an attractive addition to almost all portfolios is BNDS or PFFA or similar funds where you get really good income. You have some correlation stock market, but low, much lower volatility and really good income.

[Tobias] What about on the equity side? Sorry, JT.

[Jay] Oh, on the equity side. So we have three equity income funds. ICAP is a large cap dividend fund.

SCAPs are small cap dividend fund and AMCAs are pipeline dividend fund. With all those funds, we do add income by writing cover calls. But importantly, there’s two things that are different from our funds relative to others, which is we write very short term calls, which is to do that yourself, I’d recommend shorter term, like one, two, three weeks for max.

And we get a lot of the dividends. So those funds yield eight, nine, 10. We get a lot of the income from actual dividends from high paying dividend paying stocks.

Shouldn’t try to generate too much of your income from writing calls because like 10, 11, 12, what ends up happening is that in up markets, your returns get capped because you’re writing too many calls and particularly if you’re writing them farther out. So the ideal strategy is to write very short term calls on just a portion of your portfolio. And we can do that because we are investing in real dividend stocks that pay substantial dividends.

So we don’t need to write the whole portfolio to generate high single digit income flows.

Covered Call ETFs Explained: How Short-Term Options Boost Dividend Income

[Jake] I was going to ask, I’ve read a lot about the perhaps loosening of covenants in a lot of debt these days. Have you noticed that or how has that factor into the underwriting in when you’re looking at how confident you can feel about the cashflow coming in?

[Jay] Well, one thing that is great about the securities that we invest in versus private credit or a lot of high yield bonds that are in the indices is that we’re dealing with public companies and they typically have pretty high target credit ratings. So they’re not looking to take money out and distribute it to their private equity holders or investors rather. And so the covenants become a little bit less critical.

We also have higher quality credits that also don’t really need those covenants as much. And so that’s the way we deal with that problem is focused on large public companies. And then they’re less likely to have this big incentive to take cash out of the business and distribute it to their LPs.

[Tobias] How do you define good income versus bad income? I mean, what’s sustainable yield versus a yield trap in the dividend companies?

Yield Trap Warning: How to Identify Safe Dividends vs Risky High Yield Stocks

[Jay] Well, first of all, it’s important for all ETFs to disclose something called SEC yield. And so that’s the cashflow coming into the fund. And so with our fixed income funds, the cashflow yield is essentially the distribution yield.

So we’re not returning capital. We might, from a tax perspective, return some capital, but that’s good because you don’t want to pay tax. But the cash coming in is very close to the cash going out.

And that’s published every month. And it’s very strict set of guidelines published by the SEC, hence 30-day SEC yield being the name. But you can also look that up for our equity income funds.

And then the reason that’s valuable, as you can see, like the distribution yield, the SEC yields usually like six or seven or eight. So that means we’re only getting 2% or 3% from ball routing. So having a substantial amount of real income is critical.

The other issue, some people, we have a European ETF, and I’m told that Europeans get really, really suspicious about any dividend yields much above three or four. And that’s a reasonable concern for common stock, but not preferreds. Preferreds, you get paid first.

That’s why it’s called preferred. And the yields are usually seven, eight, nine, sometimes six. So that’s not a sign of distress.

That’s just an indication that it’s more like that and less like common dividends. But so if a common stock has a dividend that starts approaching 10, a lot of time the management team will say, well, we’re not getting credit for the dividend and just cut it. So I would be concerned about trying to get super high yields from just common equities.

But it’s perfectly reasonable to get close to double digit yields from bonds and preferreds because that’s kind of their inherent return or yield rather. And it’s not a sign of necessarily distress. And also management teams, of course, with bonds, they have to pay them or else go bankrupt.

And then with preferreds that are loath to not pay them, and particularly all the ones that we invest in are public companies. So public companies want to have good credit. This is why they don’t need covenants as much.

Because their shareholders want them to have good credit. Their board wants them to have good credit, but most importantly, their counterparties. So the companies they do business with, pipelines being a good example.

If you’re transporting oil or natural gas, there’s credit risk on both sides. So it’s important for these companies to have good credit. So with better credits, you don’t have to worry as much about defaults.

And the sustainability of a dividend is quite high because the companies don’t want to suspend the dividends because then their rating agencies will downgrade them. Their counterparties will get concerned about their credit. So why are your dividends suspended on your…

Most of the time it’s cumulative, so you owe the dividends back if you start paying common dividends again. So I would say that’s a distinction to draw. Common stocks that pay super high dividends should be concerned about that.

Preferreds and high yield bonds, generally not.

[Tobias] Do you use leverage or how do you think about leverage as a tool?

ETF Leverage Strategy: Using Moderate Leverage to Increase Income Safely

[Jay] With some of our funds, we use really the lowest leverage you’ll find in the market. So closed-end funds use 40 to 45. In PFFA, we use 20.

BNDS, we don’t use any leverage. And then ICAP, SCAP, and AMCA, we run 15 to 20, so super low leverage. Just a little bit of enhancement of income.

Typically, we have preferred stocks, so they’re not very volatile, just to add a little bit of income. And we do constantly monitor the risk of the portfolio. So if the market becomes more risky during the pandemic or during the tariff tantrum, we’ll take that leverage down so we don’t just sit around with leverage without looking at the market.

So we think that’s one technique to add a little bit of alpha. As long as you’re actively managing it, we think that’s a great strategy and keep it very low. So leverage has kind of gotten a bad name because there’s triple-levered funds and nonsense like that.

And closed-end funds use what we think is too much leverage, like 40, 45% leverage. So we keep it really, really low and monitor it depending on market conditions.

[Jake] Is there ever any concern about, with an ETF structure, you have liquidity of coming in and out, but if the underlying securities are not as liquid, you can run into market dislocations then on the ETF wrapper versus what’s inside of it. How do you think about that?

[Jay] Well, we only trade in securities that are listed. So there’s more liquidity on the listed securities. Of course, with the equity funds, they’re kind of infinitely liquid.

So they can be liquidated into an hour, really, particularly, well, really all the equity funds. And on the preferred side, well, first of all, we have inclined redemptions, which we barely have, but let’s say there was a market dislocation, we’re getting redemptions. We just delivered the securities.

So we don’t have to go sell any of our securities to meet redemptions. So the only issue is just if we wanted to take leverage down and we have hyper-liquid securities that are intraday-type liquidation securities, like intra-hour even, so we can get our leverage intraday down below one or to zero and start raising cash in extremely short order. But the real key to understand is that if we did have a lot of redemptions, we would just deliver all of our underlying securities to them.

So it’s not like we’d have to find $20 million we’d deliver. So in-kind creations and redemptions also lowers trading costs. With PFFA, I mean, it’s a $2.2 billion fund. So we really only have inflows, so it has great returns. But that lowers our trading costs because we don’t get a whole bunch of cash and then have to deploy it and pay the bid-ask spread. We just get it.

So that’s actually a great structure, is to have these in-kind creation redemptions.

[Tobias] Jay, across your front, this is two sides of the same coin, but where do you take risk? How do you generate the alpha? Is it security selection, structure, leverage, volatility, harvesting?

How do you think about the way that you’re generating risk and return?

How Income Funds Generate Alpha: Macro Investing, Covered Calls & Security Selection

[Jay] Well, on the fixed income side, it’s pretty straightforward. It’s like playing basketball or soccer with no opposing team because you have to manage the risks inherent in fixed income that don’t exist with equities. So that’s, in short, call risk, credit risk, interest rate risk.

And there’s also opportunities on the new issue side and arbitraging the index funds, particularly preferred because they’re pretty illiquid. So that’s pretty straightforward. And that’s why we’ve doubled the returns of the index with PFFA and BNDS has beaten it, not by as much, but it’s not as inefficient.

On the equity side, to your point, it can be more challenging to generate alpha with equities because for two reasons, passive funds are calculated, which can be a phenomenal strategy because in effect, you’re a momentum trader. And by the way, that’s a terrible thing to do with fixed income. Because it’s callable par.

So the higher it goes, the more you should sell it. But index funds do that. So that accounts for why we’re so confident about beating on the fixed income side.

On the equity side, there’s two dynamics that give an advantage to index funds, the momentum and also sometimes the dumbest securities go up the most. So meme stocks or I don’t believe that Tesla should trade at 220 times earnings, but maybe everybody else does. And so my analysis doesn’t really help.

It may hurt even. It’s better just to be like, oh, silver, it’s at 80. It’s probably going to go to 180 and just play the momentum.

But what’s in our favour is exactly what you mentioned. So we are, I would argue, really great at macro. You can access to our macro slides, our highly proprietary data that you won’t get anywhere else like the global monetary base, et cetera.

And so we have a macro view. And based on that view, that drives our stock selection. So for instance, about a year and a half ago, we were at Midtown Manhattan.

So that helps a little bit. And I used to be an investment banker, Ty. So it became obvious when the Trump administration came in that there was this huge pent up demand for M&A.

Rates are coming down, huge issuance on fixed income side, likely to be AI related IPOs. So we got really long, all the investment banks. And that works spectacularly well.

But it was driven by the macro, like rates are coming down a little bit by analysing the political situation. So you can use your macro skills to pick stocks. We use a GARP model, so growth at a reasonable price.

So that’s why we hate Tesla, because it’s really not growing and it trades at an unreasonable price. Which like I said, get outsmart yourself. I wouldn’t recommend shorting it.

But we’re okay missing out on the Tesla opportunities. But what you don’t want is to be like, it hasn’t happened yet, but it may be in pound tier at like a peg of eight. So the PE to growth ratio is like seven or eight times.

And then if they miss, it goes down 60%. So we want to avoid the down 60s. We’ll give up a few game stops.

I mean, actually Tesla’s underperformed over the last five years, but in the earlier years, we might’ve given that up. There might’ve been times where it was trading at reasonable pegs, but I mean, I would have to go back and look. But so we do think that being disciplined on the valuation side can add alpha, but more importantly, writing very short term covered calls on individual stocks, where you have a gain and where it’s close to your target based on GARP or peg type valuation metrics can be a phenomenal approach, particularly if I have a diversified portfolio, because what you also capture is overvaluation in certain sectors. Like over the last couple of weeks, for instance, I would argue that consumer staples got pretty fully valued. So like we’re in Coke and ICAP, and some of that was getting called away, but then it’s not like getting crushed, but it’s off a couple of bucks.

So what it does is it forces you to rotate out of fully valued sectors like utilities. We’ve sold Southern Company is a 91, but we’ve sold calls at 98, a hundred and have some of that called away. So when you do it on individual stocks, you’re not taking losses, you’re taking gains and you’re forcing yourself to recycle into better valuations.

And you don’t do stupid things like during the tariff tantrum, we didn’t write any calls because we didn’t have gains and it wasn’t near our target. And so, whereas if you look at most of the call writing funds, they’re just mechanical. Like they always have calls written out two or three months and they redo them regardless of fundamentals.

So they’ll redo them when there’s a tariff tantrum or the market goes down irrationally, like it kind of did over the last three or four days. And so then, and if it’s an index call and it goes into money, they’re just taking a loss. It’s not like selling Southern at in the high nineties when you have like a 20% gain.

So that’s the, we think tremendous value added or alpha. And then opportunistically running a little bit of leverage when the market’s good can get you a little bit better returns. So short answer is if all we could do is pick stocks, we still could probably beat, but it would be harder if we can write bespoke short-term covered calls, little, I would argue heavily stock to deck in our favour.

And then a little bit of extra income from a little bit of leverage on preferreds in most markets while at alpha. So we’re kind of stacked, not super easy, just pure equities, but we stack the deck in our favour by having these kind of hedge fund light strategies, running a little leverage and writing covered calls.

[Jake] What makes that covered call market inefficient? Like where there is kind of a, sounds like a free lunch.

[Jay] Well, a lot of times my kids ask me like, who the heck is buying these call options?

[Jake] That’s a good way. That’s a better way of asking the question perhaps.

[Jay] And to some degree, it is what I would argue somewhat irrational retail investors. So like in our hedge fund, we don’t do this in our ETS, but we’ll write micro naked 1000 micro strategy calls. And I would argue that’s just pure irrationality on the part of retail investors.

But to some degree, it’s also just, and even when it’s a mechanically just being done by market makers, the volatility of micro strategy might be driven by retail investors, even though they may be the ones making markets like that. But where I would argue the alpha is coming from is not us analysing, oh, well, the volatility is 3% above or below where it should be, but overlaying fundamentals on what’s mostly a technical market and having a bias towards selling options. Like there are services that tell you, oh, it’s much more lucrative to buy options and you get a higher return, but they failed to recognise that the decay of options makes it like you’re going to casino and the casino is raking off 10%.

And so what we’re doing is the opposite of that. We’re selling risk to the street and sometimes directly to investors. But the fact that that risk we’re selling decays over time stacks it at odds in our favour.

And since we layer them one week at a time out, even when it looks like we take a loss, the stock gets called away and we replaced it with other stocks. So we maintain our exposure to the market. So it’s not so much that there’s just a bunch of idiots out there buying call options.

It’s more that we’re just taking advantage of the fact that the probabilities are stacked in your favour by having theta or decay in your portfolio, and then managing your exposure. This is really what the street does on the other side of the trades, managing your exposure to the market because they’re short a bunch of calls and they have to be long other securities. So if you constantly monitor your exposure to market, you’re really not taking that much risk.

So if you love, like right now, I guess, trying to pick a good example. So we love KKR. I think that everybody’s freaked out for no reason.

We might write a call. We’re actually not writing a lot of calls on that, but let’s say we did a 120 and it’s at 210 right now. I mean 220, it’s at 210.

Then if it ran to 220, we might just buy some stock and then let that get called away over the next week or two. So if you actively manage that selling of calls, then it can produce alpha. If you just sit around and go play golf during the day, then half the time you would be capped out on big returns and you would have a lower return on your overall portfolio.

It requires you to be a bad golfer. So you have to be looking at your screens all day or else, as you’re implying, the times when you get capped out on some stock would offset all the decay of the portfolio. So you have to manage your exposure to the market and your exposure to your ideas to make sure they don’t get called away and then you lose all the upside.

[Tobias] Tobias Carlisle Yeah. I’m just going to give a quick shout out to the folks at home. Jake’s got some vegetables, which is a little lesson for us.

And we’ll come back and talk about some of your macro views. London, UK, what’s up? Boise, Idaho, Philly, London, Toronto, ARAS, Saudi Arabia, what’s up?

Valparaiso, Tumble, Texas, Yorkshire, Pettitikva, Israel, Utah, Snohomish, Tallahassee, Kingwood, Texas, Temecula, what’s up? Wollongong, New South Wales, early start for you, Rochester, New York, Gerrard’s Cross on the main streets, Lausanne, Switzerland, Vienna, Austria, Tehran, Iran, really amazing. Good to see you got your internet back.

JT hit us with some veggies. Market folks, it’s 15 minutes past the hour. You can come back and find these later.

The Overton Window & Information ‘Resolution’: How Simple Messages Shape Public Thinking

[Jake] All right. So today we’re going to be talking about resolutions. And I’m curious, Toby, did you make any New Year’s resolutions?

[Tobias] The same one I make every year. A little bit of value performance. Let’s go.

[Jake] All right.

Well, actually, we’re not going to be talking about that type of resolution. It’s going to be a little bit different. So first of all, shout out to a friend of the show, Luke Delana, for inspiring today’s veggies.

And this comes from a book of his that’s this hidden little gem. When I asked him privately, like, what’s your best book you ever wrote? And he said this one.

It’s called The Control Heuristic. It’s quite good. So pick that up if you have a chance.

Anyway, on with the show. Imagine that you’re looking at a photo on your phone like one does. And at normal size, everything looks crisp and normal and clear.

But if you zoom in far enough, it starts to turn into little squares like pixels and compressed artefacts, weird jagged edges. And the photo didn’t change. We know that.

But the amount of detail that you demanded did. And you’re looking at the same thing, just at different resolutions. So that’s the kind of resolution we’re talking about today.

And in the brain, we might be able to say that resolution refers to the number of statements that are available to describe a concept. So for instance, let’s compare two statements here. And we’re going to try not to get political with this.

But okay, statement number one, vaccines are safe. Statement number two, most vaccines are safe, and nearly all are safer than unvaccinated exposure, but a few of them are dangerous and have extreme side effects for some people. Okay, obviously, like a big mouthful.

And we talk about truth in general, like that it’s this binary switch, like right or wrong, true or false. But that conflict is maybe not always what’s actually what we’re worried about. It’s actually more like what resolution are we allowed to speak in?

So, you know, as you saw with that example, like low resolution, vaccines are safe, is fast, portable, clear, easy to explain. High resolution is much higher fidelity, but a lot more conditional, heavier to carry and transmit. And that pressure of what’s available at a resolution also happens in political discourse.

And it even has a name. So care to give a guess as to what the name is of that? You’ll know the answer when I say it.

That’s the Overton window. This is the envelope of ideas that a public figure can say without getting treated as an outside the mainstream. And I think part of what people miss with that is that this window is also filtering resolution as much as it’s filtering ideology.

So too compressed feels like the slogan for idiots, basically, too detailed can feel like you’re over explaining the story, even when you’re just being more accurate. So this explains, I think, why politicians can often sound dumb, and still be quite effective. It’s they’re not broadcasting the full model all the time.

They’re shipping this low resolution packet that’s optimised for broad reach, less conditions, less exceptions, less ways to mishear what you’re saying. And in mass coordination, what they’re aiming for, that kind of bandwidth beats high fidelity. So a message that’s 60% accurate, and repeatable can dominate a message that’s 95% accurate, but kind of too heavy to carry around and share.

So quick sidebar on Joseph Overton was not a pundit. He was actually an electrical engineer and project manager at Dow. He later became a senior executive at the McInnes Centre for Public Policy in Michigan.

And in the 90s, he developed what he called a window of political possibility to describe this constraint that we’ve been talking about. And sadly, he died at 43 in 2003, in an ultralight aeroplane crash just a few months after his wedding. But after his death, his colleagues popularised this model, and it became known as the Overton window.

So the window of public discourse isn’t, it’s not just selecting for truth, it’s also selecting for transmittable truth. And so outside, nuance feels like you’re kind of this like mealy mouthed waffler, you’re over explaining everything. And in public arguments, they collapse often into slogans, not because everyone loves slogans, but because slogans fit through the Overton window.

So simple, true or false misses something important. A statement can be correct at one resolution, and then feel misleading at another, and no one’s actually being dishonest here. So I think an example from finance might also drive this home.

Low resolution statement, index funds are the best default. Higher resolution statement, for most long term know nothing investors, diversified low fee indexing beats most active options after tax and fees. The exceptions are real, but narrow and hard to identify in advance.

All right, the first isn’t a lie. It’s a simple compression of the truth. The second is probably much closer to kind of the full map, but like, who the hell has time to say all of that in a soundbite, right?

So we don’t get unlimited bandwidth when we’re talking with each other. There’s time limits, there’s attention limits, character limits, audience limits. If you’re speaking to a specialist, you can probably stay zoomed in and give the full picture.

But if you’re speaking to millions of strangers, you usually can’t. And my hunch is that this explains a lot of the divisions that we feel. One person is speaking high resolution, the other is here, you know, and the other person then hears the actual guy on the internet.

One person speaking in low resolution, and the other person hears this like irresponsible simplicity, and they just aren’t sharing the same zoom level. So different domains, different error rates of this, you know, engineering and medicine, precision is super important. Mass politics, public coordination, the job’s really more about alignment and a perfectly nuanced message that nobody can carry around in their head is functionally useless.

So it’s kind of silly of us to expect political slogans to meet some academic standards, or to expect scientific caveats to function as rallying cries. They’re calling each other dishonest on both sides of this when these messages are just clashing. So maturity, I think, is not picking one zoom level to live in forever.

It’s having an adequate focus, knowing when a simple model is good enough and knowing when the edge cases are worth the effort of that more granularity. So next time you’re tempted to say, you know, this guy’s a lying idiot, maybe first ask yourself, what zoom level are they speaking at right now, most likely? And half the time, maybe it’s not dishonesty.

It’s just a different resolution.

[Tobias] Good stuff, JT. I wasn’t lying. I was compressing the truth, your honour.

[Jake] There you go.

[Tobias] When I wrote Acquirers Multiple, I wrote that to a fifth grade reading level. And it’s, it’s like 10 times the sales of any of my other books, which were, I wasn’t aware that there were reading levels before that. So that certainly works.

Very interesting. Good stuff from Luca too.

[Jake] Hemingway was wrote at fifth grade level, didn’t he?

[Tobias] It’s hard to read though.

[Jake] Is it? You think so?

[Tobias] I just think it’s boring. I just think it’s like getting rabbit punched all the time, getting jabbed. No, no, it doesn’t mix it up enough.

Jay, let’s talk about macro a little bit. What are the, what are the risks that people can’t see right now that you think you’re going to have the most influence over the next one, three, five years? Easy one to start off.

Inflation Data Problems, Fed Rate Cuts & Housing Risks — Macro Outlook Explained

[Jay] Yeah. Lay up. Great.

And that was a great dissertation because I’m constantly dealing with that problem. When you go on national television, they ask you these complicated questions. You’ve got to answer it in one sentence.

So you’re just as likely to mislead people as give them any insights. So we, I would argue have very unique macro research on our website. So this might, so we’re not really going to say things you’ve heard all the time.

Our biggest concern probably is this ongoing problem with the BLS reporting inflation data. Specifically the shelter component is buying a design six months delayed. So it’s sort of like we were doing this podcast and then you just wait six months to issue it.

That’s not a good policy, obviously, but then they use renewing rents and they also, which are, you know, if you’ve ever either rented or been a less or typically hold back on all the increases, so you don’t create turnover. So that delays it further. And then they use terrible seventies style data data collection, which they call people and do little panels.

And so for that reason, you can see this on our website. Inflation has been overstated PC core. If you use modern data collection, like the internet developed since the 1970s Zillow and apartment lists, you’ll see the target inflation’s already at two.

And so our fear is that BLS keeps blowing the reporting of, of inflation and we don’t get the three rate cuts we need. And that’s important. Nobody seems to focus on it, but we have a recession going on in residential housing and construction.

And that’s causing the labour markets slow. And people are confusing that with a whole bunch of other things, tariffs and other things that needs to get fixed to have good economic growth this year. And so that’s our big concern is that the data doesn’t reflect what’s already happened, which is relations well-contained and rates are way too high.

And you can see that by the way, money supply is shrinking, which is very dangerous. Typically you have a recession when the money supply is shrinking. So it’s really all around the fed.

We’re kind of okay with worse this year, even though he’s an ultra hawk because he must have promised the president he was going to cut rates. And maybe he understands this issue with the BLS. Longer term, we’re concerned about worse, but it’s probably not today’s or this year’s business.

[Jake] Jay, one thing I noticed, I saw a chart that showed the healthcare expenses and premiums. And apparently it was derived from some tautology of profit within healthcare company insurers and not from actually what the premiums I pay for my employees, which were definitely not down 20% over the last five years, if anything, doubled. So what’s going on there?

[Jay] Well, that’s a good example. It goes the other direction, but there is a lot of complete nonsense that’s put out by the BLS. And I agree that our company had a 20% increase in healthcare premiums.

So there are these strange methodologies that are used. I mentioned shelter for financial services. So our business, if the stock market goes up, that’s treated as inflation because people are paying higher fees because the AUM goes up.

Healthcare is the opposite. And maybe we’re fortunate, at least if you want lower rates, that that doesn’t get properly reported. But I also give that as an example of why I fear Warsh, because he is probably the biggest proponent of this completely made up 2% inflation target.

So for instance, we could have pretty modest real inflation, which comes from the expansion of money supply, but maybe a little tick up because Medicare or medical inflation is surging. And so he overreacts to that and raises rates dramatically like he did in the 2000s, which precipitated great financial crisis. If you really think about it, raising rates is not going to lower our insurance premiums.

It’s a true supply shock or it’s just, it’s maybe not even a supply shock. It’s just that in the US we have the best healthcare in the world, worst way of paying for it, but the best actual healthcare. And it keeps expanding.

So we’re probably not picking up the quality factors either, but it certainly doesn’t- There’s lots of hedonic adjustments, right? But who knows what the hell direction- So that’s a good example, one where it goes the wrong way. I agree with you.

When I look at medical inflation and it’s like 0.1 or something, I’m like, I don’t know how you’re calculating that. But most of the other ones are overstated. But my real issue with Warsh is we’ve had very strong prosperity since World War II.

So outside the 60s, 70s, and 80s, which were damaged by oil price increases, when inflation, so outside that period, inflation averaged 2.7%. So not 2, but 2.7. So why don’t we care? Why don’t we have a target that’s 2 to 3%? The pushback is that, oh, inflationary expectations will become unanchored.

That’s the most ridiculous theory of inflation ever created, yet gets repeated constantly. So it’s an urban myth. In our models, inflationary expectations are deflationary because the only real place it gets reflected is in bond prices.

So yields rise, bond prices drop, and that tightens up the mortgage market, which tightens up the housing market. The notion that individuals can have high expectations and get higher wages is ridiculous. If you look back over the last couple of years, for Democrats, the Michigan survey, they thought inflation was going to expand at 10% and Republicans at 1%.

Sort of like asking whether you like the bad bunny or not. It’s like, oh, 90% of Democrats do and 90% of Republicans don’t. But believe me.

So the notion is, oh, if you have high expectations, you’re going to get high wage increases. The Democrats didn’t get 10% increases and the Republicans won. Nobody got any increases.

There’s no market power left in the US economy. So this whole expectation series is completely bogus. And therefore, it would not be an issue if we loosened up that target.

And then we could have certain sectors like medical care rise, but not try to precipitate a recession to deal with that. So that’s my fear with Warsh longer term. I think he’s going to be okay in the short run.

But this notion that we can precisely calculate inflation is ridiculous. So that’s why we need a band so we don’t have the volatility that we had. So keep in mind that inflation was barely above two, like basically two.

And the Fed raised rates 17 meetings in a row. We cannot have that. We should all be on the warpath to try to educate Congress, the Senate, and eventually the Fed, that that is a horrible, horrible target and needs to go away.

[Tobias] Jay, what do you think about the idea that the yield on the two-year is a pretty good proxy for the federal fund’s effective rate? And we should be guiding towards that because I track those two and I think it’s been a pretty good… I think it’s led the federal fund’s effective rate pretty effectively for as far back as I can go on the data.

That’s an idea from Tom McClellan, McClellan and Oscillator. I don’t think I’ve seen it from anybody else.

[Jay] Well, I always use interviews and questions and comments to learn. So I should look at the two-year more, but I’ll give you the real key to trading bonds is look at the Fed fund’s terminal rate, which right now I just looked it up on Bloomberg. It’s 3.17. So you can be a perfect 10-year bond trader. If you just know that number, then you add 110 base points, then you’ll know exactly where the 10-year is going to trade. So I think the two-year obsession is a little bit probably misleading, but to be honest with you, you need to track it a little bit more carefully. But we have a chart on our website, and like I said, you can get tremendous data you won’t get anywhere else in the world.

And so right now, my rule would turn you into a perfect bond trader. And by the way, when the yield curve is not inverted and the Fed’s not tight, it’s not the terminal rate of Fed funds, it’s the actual rate of Fed funds. I mean, there’s the same, but you can see both of those calculations that normally the 10-year trades 100 over Fed funds.

Fed funds trades 75 over the inflation rate. So it’s normally right around 275. So I’ll study a little bit more, but I would say you’re going to have far more clarity if you just focus on those two elements.

And we even trade Fed fund futures. We’re actually making pretty good money. Well, sort of irrelevant amount of money, but we’re long the December contract because people just got way too bearish about cuts.

So right now, going back to that same screen, like now we’re up to 55 base points of cuts this year. We think we’re going to get to 75 by the end of the year. When Warsh was nominated, it was at 45, but that’s really what’s driving the 10-year.

So I wouldn’t focus much on the two-year, but I’ll go and look at those correlations. But I always find like when I go on TV or radio, everybody’s like, oh, well, the yield curve steepened. And I go like, no, it hasn’t.

It’s still 100 over the Fed funds rate. So it hasn’t steepened. Like I guess the 30-year steepened, but the 30-year is really irrelevant.

Nobody prices anything off the 30-year. Like mortgages, I focus the one financial condition that matters is the 30-year mortgage because that drives housing. Housing usually causes recessions.

We have that data also on our website. Didn’t this time because it was offset by AI building boom, not just the technology, but also the chip plants and other infrastructure. Well, although investment’s zero, it’s actually not, the two are netting to zero.

So it’s not helping growth, but it’s not causing recession. But if you watch the money supply housing, you’ll call at most every market turn. And so if you watch Fed funds in the 10-year, 30-year mortgages priced off the 10-year, you got 90% of the battle.

And I think people are just confusing themselves by looking to the two-year. It’s not what the Fed controls, and it’s not the most critical element, which is Fed funds.

Yield Curve Signals: What Bond Markets & Fed Policy Say About the Economy

[Tobias] What do you think about the inversion? You touched on it very briefly, but we’ve been inverted. We had been inverted for since 22, was the longest and deepest in the limited data that we have.

And now we’ve been uninverted, very chopping around for six months there. And now we’re at 53 basis points of two to three to three months. That’s the old Cam Harvey version. Do you have any views on whether-Inversion is simply an indicator that the Fed is way too tight.

[Jay] To invert the yield curve, they need to severely restrict the growth of the money supply, or even right now it’s negative. So it’s an indicator that the Fed has its boot on the threat of the economy and is likely to cause a recession.

And I’m sorry to be repetitive, you can also get this data on our website. You can see that there are two sectors of investment that I already mentioned that are clearly in recession. They have negative year-over-year growth, almost 1%.

So the Fed is choking the economy. It just got lucky for two reasons. One, we already mentioned tech boom is more physical than it normally is.

The internet just had software engineers and some laptops. So much more physical, but also the great financial crisis made the housing sector less cyclical. So when I was a kid in the late 70s, we were building 2.5 million homes and there was a big housing speculation boom. And in the latest cycle, since the great financial crisis, we’ve never gotten over 1.7 million homes and normals like 1.5. So when there’s no boom, there’s less of a bust. So even though we have something that we’re tongue in cheek, we call the Hatfield rule. So when housing starts go below 1.1 million, you have a recession. Well, you might not get one in this case because we never have the boom, so you’re still going to have the bust. But the Fed is completely out to lunch, completely incompetent and should have cut rates over a year ago when real-time inflation went pretty close to their target of 2%. And you can see that.

We calculate CPI-R and PC-R published on our website. You can replicate it. Just look at Zillow apartment list.

So really, it’s an indicator of a terrible Fed. ECB is actually a great central bank, so that’s Europe’s only advantage over the US.

[Tobias] Jay, we’re coming up on time. If folks want to follow along with what you’re doing or get in contact with you, what’s the best way of doing that?

[Jay] Our website’s infracapfunds.com. And we do have a monthly webinar where we take questions just like we are now about our ETS. But I really love macros.

We do talk a lot about macro. But it is relevant, like I mentioned in the beginning of the programme. If you don’t get the macro right, you’re not going to get the stock picking right.

You’re not going to get the asset allocation right. And so it is worthy of obsession. And even if you don’t agree with us, we give you the data so you can come to your own conclusions.

But I would argue our data is highly proprietary, unique, and should stimulate more insights, even if you don’t fully agree with our views.

[Tobias] JT, any final words?

[Jake] No, we’re good.

[Tobias] Check out Journalytic, folks. Jay Hatfield, Infracap, thank you so much for spending time with us. We’ll look forward to seeing you again sometime.

[Jay] Thank you. Great questions and great education. You can send me a bill.

[Tobias] We’ll be back next week. Same time.

VALUE: After Hours (S08 E05): Jay D. Hatfield, Portfolio Manager InfraCap Small Cap, Income, MLPs and REIT Preferreds

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