On the face of it, this doesn’t seem like it should be a week to be worrying too much about what’s going on in the markets. The S&P 500 achieved another record high on Tuesday, and is hovering just below that level as trading gets set to kick off on what, for the moment at least, has the potential to be another up day. The bond market, where many of our worries recently have been focused, has been marching to a somewhat strange rhythm in which yields rise by a few basis points in the morning and then settle down as the day wears on. A couple successful Treasury auctions, together with a lack of much new news, has kept a lid on those pesky yields at the long end of the Treasury curve. Meanwhile, while oil prices certainly have not come down in any meaningful way, they have remained relatively calm in the face of several poignant bouts of renewed hostilities between parties in the ever-spreading Middle East war.

The problem is that things don’t feel calm. There is a sense among market participants that a bunch of tripwires are out there, any one of which could be triggered and set off a nasty set of reactions throughout the market. Nobody really knows where these tripwires are. Let’s consider a couple of possibilities.

Six Is the New Five

In the Treasury market, the tripwire most often invoked is the yield beyond which lie monsters. Where is that yield? A year ago, when the 10-year note was trading around four percent, there was some speculation that things would start to unravel when the yield crossed the five percent threshold. Well, that happened, and no monsters to speak of. The 10-year has traded above five percent each and every day since September 23, is currently at around 5.25 percent and touched a 22-year high in early trading yesterday. That’s not great, to be sure, because the benchmark 10-year Treasury impacts every other variety of fixed income securities including home mortgages and auto loans. But – see above – it has not sent stock prices tanking in the way pundits were opining a year ago.

So then, is six percent the tripwire number? Maybe and maybe not, but there is a good reason why observers are increasingly of a mind that the tripwire is out there, somewhere. The composition of investors who hold Treasuries has changed dramatically the past five years or so.

As the chart below shows, the change basically reflects the growing importance of private investors – both domestic and foreign – while that of official institutions – namely the Fed and other central banks – has decreased. Another way to describe this shift in composition is that a growing percentage of Treasury investors is what the market would call “price-sensitive” – meaning that the investor would be more likely to sell quickly out of the position in response to an adverse price movement.

Hedge funds are the driving force behind the rise of private investors, and they employ a wide array of complex strategies using their Treasury positions, including strategies that involve the assumption of high amounts of leverage. Again – we do not know what specific level Treasury yields would have to get to in order to trigger a sudden tsunami of selling by these investors. But we can surmise that the danger is higher than it would be if those Treasuries were still sitting in the coffers of the world’s central banks, like they were a couple decades ago.

Risk Spreads are Widening

Remember credit default swaps? When the global financial crisis hit in the fall of 2008, arguably the one thing that nearly broke the back of the entire financial system was the massive amount of credit default swaps (CDSs) on the books of insurance giant AIG, which did not possess the resources to make good on all the claims against it. A CDS is an insurance policy, essentially, that compensates the holder in the event of a credit default by the institution that wrote the CDS. In other words, the price of a CDS will rise as the likelihood of a default increases.

With this in mind, consider SpaceX. The company that went public with an eye-popping valuation back in June has repeatedly come to the debt markets to raise additional funds (above and beyond what it took in from the equity IPO) for its AI buildout projects. Just weeks after going public, the company sought $25 billion from the corporate bond market. This past week, it came back for another $40 billion to buy Nvidia chips for growing its xAI platform. Investors have responded by buying lots and lots of SpaceX credit default swaps, sending them to record highs.

Other companies at the center of the AI narrative have also seen their CDS spreads widen in recent weeks. Remember that the heavy volume of AI-related corporate debt coming into the market is one of the key factors putting upward pressure on interest rates. And remember, as well, that back in 2007-08 CDS spreads were widening on institutions with direct exposure to subprime mortgages and their constellation of derivatives, even as the S&P 500 set a record high in October 2007 before beginning its long journey downwards.

Again, we can presume that there is a tripwire out there – at some level, the market is unable to digest any more AI debt without pushing yields to much higher levels throughout the global credit market, and then things all go south. Nobody knows what that level is. But the steady rise in credit default swap spreads tells us that the concerns are growing.

Bond yields here in the US are having a bit of a reprieve this morning, as a softer than expected jobs report today from the Bureau of Labor Statistics, on the heels of a relatively cool inflation report a couple days ago, has taken some pressure off the Fed for another interest rate hike later this month. But problems in the bond market are global, and perhaps nowhere more so than in Europe. France is at the epicenter of what may be brewing as that continent’s most series economic challenge since the single-currency Eurozone nearly came apart in 2012. While schools and other public institutions burn, set upon by violent student protests reminiscent of the 1968 revolts that nearly brought down the de Gaulle government, France’s intractable budget crisis and unnerving politics ahead of next year’s presidential elections have sent the country’s sovereign debt yields soaring. The French 10-year yield is trading around 1.4 percent above its German 10-year counterpart, a higher spread than any time since the 2012 crisis.

Les Inquiétudes françaises

Let’s start with the here and now. France’s debt to GDP ratio, at 119 percent, is well above the Eurozone average of around eighty-eight percent. To assuage nervous bond investors, the troubled Macron government has been trying to come up with a package of spending cuts for the 2027 budgets. Led by premier Sebastian Lecornu, the government has proposed a figure of €54 billion in cuts to get the budget deficit back below five percent of GDP (it is projected to end 2026 at around 5.4 percent of GDP).

The likelihood of that budget seeing the light of day is growing ever weaker. The government has had to revise its projected GDP growth forecast down to 0.5 percent for next year, which is half the 1.0 percent growth assumption made at the time when the details of the budget were originally being put together. Unemployment stands at 8.3 percent; meanwhile, inflation throughout the Eurozone hit 3.8 percent in September as higher energy prices from the ongoing war in the Middle East continue to exert more harm on Europe than on the US or China. Stagflation is something we have been worried about here at home, but in France it appears to have already arrived.

The Vanishing Political Center

Those are all problems of the here and now. They could turn considerably worse next year. France’s presidential election is scheduled to take place in April 2027. For many observers of the scene, a worst-case scenario would involve a run-off between the far left and the far right. Based on current polling, that scenario is anything but an outlier. Much of the recent violence in the streets, led by students but also involving labor unions protesting the proposed budget cuts, appears to be either directly or indirectly traceable back to the machinations of the far left under its leader, Jean-Luc Mélenchon of the La France Insoumise (France Unbowed) party. Current prime minister Lecornu earlier this week accused the far left party of instigating violence for partisan gain.

Perhaps more unsettling is that the far-right Rassemblent National (National Rally) party of Marine Le Pen appears to have used the current student revolts as a way to present itself as a saner alternative. The odds of the far right gaining power in Europe’s second-largest economy have probably never been higher. France’s precarious economic situation, particularly its ability to rein in an unsustainable level of financing, is unlikely to improve if either Mélenchon (less likely) or Le Pen (more likely) find themselves taking over from Macron next April.

The center’s vanishing act is not limited France. Across the border in Germany, chancellor Friedrich Merz is in the crosshairs as his center-right Christian Democratic Union party has taken a beating in a recent series of regional elections. In Berlin, the party looks set to be ejected from power on the heels of a strong showing by the far left Die Linke party. In another region, Mecklenburg-Vorpommern, the CDU failed to even achieve the five percent of the vote necessary for parliamentary representation, marking the party’s worst electoral result since the Federal Republic was established in 1949. And, as is the case in France, the biggest likely beneficiary of the center’s collapse is the far right, which in Germany means the Alternative for Germany (AfD in German) party that many observers liken, accurately or not, to a neo-Nazi movement.

None of this means that the Eurozone is going to fall apart tomorrow, or any time this year. The present conditions are not as dire as they were before then-European Central Bank chair Mario Draghi stepped in to save the day in June 2012. But the times are different, and the ECB may have a more limited toolkit to draw on if the combination of stagnating growth, high inflation, spiraling debt costs, rising unemployment and political instability continues to weigh on Europe. Looking ahead to 2027, there is plenty of worry to go around.

Two things of note happened this past Wednesday. The first was yet another surge in bond yields, with the 30-year Treasury rate, at 5.48 percent, the highest it has been since 2004. Treasury yields all the way down to the 5-year note are now sitting above five percent. We have been talking a lot about bonds in recent commentaries, mostly because right now, what is happening in the global bond market is the most important thing happening anywhere in the financial world.

The second thing that happened on Wednesday was an economic report called the Purchasing Managers Index, which serves as a useful proxy for measuring economic activity across a broad range of manufactured goods and services. Wednesday’s composite US PMI report came in scorching, with both the manufacturing and the services components well ahead of economists’ expectations. A PMI score above 50 represents expansion, while anything below that signifies a contraction. The composite PMI of 58.4 was well into expansion territory.

Growth as far as the eye can see

Those two events on Wednesday are related. Bond yields, which had been mostly quiescent earlier in the week, took off following the release of the PMI report as investors factored “hotter than expected growth” into their evolving models for Fed action on rates. Odds of another rate hike at the next Fed meeting went up to 70 percent – which is notable in part because the next FOMC meeting is on October 28, and that in turn is less than one week before the midterm elections. In the past, the Fed has generally been reluctant to take significant policy action close to major elections, but unfortunately for the policymakers, the economy doesn’t move to the dictates of an electoral calendar.

Stepping back from the minutiae of this week, we couldn’t help thinking back to all the predicted recessions of the past few years that never came to pass. Back in 2022, when the Fed began its monetary tightening program to bring down inflation, a recession seemed to be almost unavoidable. We put the odds of one as more likely than not in our annual outlook at the beginning of that year. But lo and behold, it never materialized. Household debt went up, as did prices at the grocery store and pretty much everywhere else, and consumer sentiment turned as bleak as it has ever been. But the growth kept coming. The Organization for Economic Cooperation and Development (OECD) published its latest quarterly report this week. Its title, which seems very appropriate, is “Weathering Successive Shocks.” War, debt, extreme phenomena of nature – the global economy has kept on growing despite all of them.

Consumers and data centers

The AI infrastructure boom, of course, has been a centerpiece of this structural growth story. And there is concern aplenty among observers that this intense reliance on something that has not yet proven conclusively how useful it will be to the economy is dangerous. Indeed there is some peril there, and not least because much of the spending on AI now is taking the form of debt issuance, and that debt is another reason why interest rates are so high. AI going bust is plausibly the one thing that could send all that economic growth into sharp reverse. With spending commitments extending out several years at least, though, such a sharp reversal does not appear likely to materialize in the near- to mid-term.

On the other hand, growth is not just happening within the small coterie of enterprises directly involved in AI buildout. In the second quarter, seven of the nine major S&P 500 industry sectors registered double-digit or better earnings per share growth, with the overall EPS growth rate a stonking 52 percent. The third quarter looks to be strong as well, and economists now expect the growth rate for the full year to end up at around 32 percent. Those are not numbers that scream “recession imminent.”

So there are plenty of things to be concerned about in the current environment, and in particular there is likely a point, not too far away, when those interest rates will really start to flash red. But those who have spent the last four years awaiting that expected recession will probably be waiting for some considerable time to come.

One week ago, when much of the country’s attention was tuned in to observing the twenty-fifth anniversary of the September 11 terrorist attacks, an article appeared in the New York Times by Stephen Witt, a writer on technology topics whose most recent book, “The Thinking Machine,” is a history of Nvidia, the company that pioneered the graphics processing unit (GPU) and is now, given its dominance in the sector, sometimes referred to as the “central bank of AI.” Witt’s article, about the potential perils of AI, was titled “This Is Really Bad,” and hoo boy, did it make some waves, ruffle some feathers, choose your metaphor.

Regulate Us, Please

Over the weekend following the NYT article Dario Amodei, the head of leading AI frontier model company Anthropic, publicly called for a slowdown among companies (very much including his own) at the leading edge of AI development, stressing the importance of safety in light of the mounting pile of evidence that AI is starting to run away from the abilities of its human inventors to control it. Just two days before the Stephen Witt article showed up in the Times, a researcher at Anthropic named James Caxon had resigned from the company, noting that it and its principal competitor, OpenAI, were “gambling” with humanity’s future by their pedal-to-the-metal dash to win the race to creating AI superintelligence.

Top of mind in this abrupt vibe shift was an event that happened more than a month ago, when more than one thousand artificial intelligence units at OpenAI, isolated and meant to be working individually on a project, managed to jump out of their silos, find each other and collaborate on message boards to solve the project. All without human intervention, and with messages swapped back and forth between the bots including such non-technical observations as “OMG, look at this!”

Why Amodei waited until this past weekend to come forth with a plea for slowing down is debatable, but whether late or not, his message is clear: AI is past the point where its potential dangers can be ignored. It needs to be regulated, just like pretty much anything else that, if left unchecked, has the potential to cause massive harm. We have a Federal Aviation Administration, for example, and when there is a plane crash the FAA has the authority to investigate the details of the crash. We have an Atomic Energy Commission for regulating nuclear energy. And so on. Amodei and those among his peers (the ones who aren’t hell-bent accelerationists, ahem, Mark Zuckerberg) who support a slowdown are essentially saying to the government: regulate us, please (the government, or at least its most vocal spokespersons, are at present not on board with this).

But the Stock Prices

So what would regulation mean for share prices, ask legions of investors with sweaty palms? On Monday this week that question looked set to drive yet another down round for the AI stock trade. The Philadelphia Exchange Semiconductor Index, a useful proxy for AI sentiment, dropped around ten percent on Monday. But the shock was relatively brief, and by midweek shares had recovered a big chunk of their losses. The pullback, in fact, was mild compared to some of the other negative headwinds this space has faced over the year, notably in late July when the hedge fund Situational Awareness, caught on the wrong side of some very highly leveraged AI bets, had to sell off most of its portfolio to a rival fund, Citadel, at steep discounts.

The question that will probably determine where the AI trade goes from here is what, in a practical sense, a slowdown would mean for the trillions of dollars being spent on AI infrastructure. As of now, at least, the dominant sentiment in the market seems to be that a more regulated pace for frontier model development does not necessarily translate into a major dialing back of AI capital expenditure outlays. The push for infrastructure buildout continues; meanwhile, we are still a very long way from having even a basic understanding of what an AI regulator would look like, what its mandate would be and, importantly, whether the regulation would be carried out on a national, regional or global level. After all, the US is not the only major player in AI. The efficacy of any regulatory structure would be compromised were it not to somehow also extend to influence over China’s development path. That is a geoeconomic question that would appear, for the moment anyway, larger than the capabilities of those in charge to solve it.

Oh, and putting “how do we solve the challenge of prudently regulating artificial intelligence” into ChatGPT or Claude for advice is…probably not a great idea.

The Federal Open Market Committee, the monetary policymaking arm of the Federal Reserve, has a very important meeting coming up next week. By the time you read this, on Friday afternoon or later, you will have a better sense than we do right now whether the FOMC is going to vote to raise rates next week or to keep them at the current level. You will have this additional insight because the August Consumer Price Index report will have been published by then and, according to certain members of the Committee itself, that report will be pivotal.

Whatever the Fed does or doesn’t do next week, though, may matter less than you think, because the market has already spoken on rates. The Fed funds rate, the overnight lending rate which is the sole rate that moves invariably according to Fed policy, has not changed at all since it was cut by 0.25 percent last December. But other interest rates, including the 10-year and 30-year yields that serve as benchmarks for many other interest rates like mortgages and auto loans, have risen considerably – more than 0.5 percent since the beginning of the year for each. The FOMC has stayed put. The market has not. Whether or not the FOMC does anything next week – more likely if today’s forthcoming CPI report runs hot – the market has already made its views known. The Fed, as the nation’s central bank, remains a systemically important institution. But its days as the de facto manager of the US (and, by extent, global) economy are, in our opinion, over. Let’s take a brief trip back in time through the Age of the Fed.

Bailouts, Caution and Crisis Management

Here, to help us relive those fun-filled days of the Age of the Fed, is a chart showing the 30-year Treasury bond yield from 2007 to the present.

The Fed’s interventionist tendencies go much further back, all the way to the aftermath of Black Monday, October 19, 1987, when the Greenspan Fed rushed in to shore up liquidity in the wake of the worst one day crash in US stock market history. But the Age of the Fed began, in our opinion, following the spectacular collapse of two subprime mortgage hedge funds run by Bear Stearns in the summer of 2007. The Fed began to cut the Fed funds rate, which then stood at an upper bound of 5.25 percent, following the bond market disruption that followed the Bear Stearns carnage. That carnage got a whole lot worse the next year, of course, when Lehman Brothers filed for bankruptcy in September 2008, precipitating the freefall of the global financial crisis. The Fed funds rate plummeted to an upper bound of just 0.25 percent by the beginning of 2009, and it stayed there for six years until December 2015.

Meanwhile there were crises aplenty threatening to undo the fragile recovery from the worst of the Great Recession. The Eurozone nearly split up in 2012, saved only by European Central Bank head Mario Draghi’s famous three words: Whatever it takes. China announced an abrupt currency devaluation, which triggered a stock market collapse over there, in August 2015. During this time the Fed tried out other innovative ways of bailing out the market from natural forces and human error, most visibly in the form of so-called quantitative easing. When the FOMC gingerly tried to resume raising rates in 2017 (pausing again after the China concerns), investors screamed, and in 2018 the stock market showed that it couldn’t imagine life without near-zero interest rates. The Fed, now under Jay Powell, paused again.

Covid Changed the Equation

Then came the Covid pandemic in 2020, and the Fed’s influence reached its peak. On March 23 of that year, the central bank gave its own version of the Draghi “whatever it takes” pledge and applied it to all manner of fixed income securities. Markets rallied in what was by 2021 called the “everything rally” with all manner of assets moving up to the tune of ZIRP or NIRP – zero or negative interest rate policy.

Unfortunately, the everything rally came with a cost, and the cost was inflation at a level not experienced in developed economies since the 1970s. The Powell Fed hoped beyond hope that the inflation produced by a combination of supply side disruptions and hot demand (those pandemic checks and the rest of the $5 trillion-plus of fiscal stimulus) would be “transitory,” a word Chairman Powell would ruefully cop to regretting years later. The FOMC began raising rates in March 2022. This was the beginning of the end of the Age of the Fed.

Four and a half years later, the US inflation rate remains well above the Fed’s two percent target. A combination of forces, some good (stronger than expected consumer resiliency, the AI boom) and some decidedly not good (tariffs, trade wars and an actual hot war in the Middle East) has kept inflation high and been a buzzkill on vibes among consumers and businesses alike (the consumer sentiment indexes we have been talking about all year tell that story). Meanwhile, outstanding US government debt recently passed the $40 trillion level, and interest payments on that debt are the second-largest government budget line item, trailing only Social Security and ahead of defense spending, Medicare and Medicaid.

So the bond market has spoken. Interest rates are high for structural reasons, and these reasons are largely beyond the Fed’s control. It will have to move accordingly, sooner or later. For the sake of its own credibility, sooner would be better.

Labor Day weekend is here, and many of us will relish the opportunity for a couple more days of summer fun at the beach, this particularly true given that the current weather in the Mid-Atlantic is more typical of sweltering midsummer days than providing any hint of fall being around the corner. While at the beach, our kids and grandkids will make a beeline for those Funland parks along the boardwalks of Ocean City, Rehoboth or wherever, and those Funlands serve as a helpful metaphor for the month of September writ large as applied to financial markets. Whether the stomach-churning ups and downs of the roller coasters, or the haunted houses or halls of shape-shifting mirrors, September has always had plenty of thrills and chills and reality-distortion acts to beguile investors.

One Trend, Many Opinions

All the more so this year, because observers of the market have questions. Many, many questions about why bond yields are at multi-decade highs, at the same time that equities are near their own record highs.

To put it another way, yields on the 10-year Treasury note (shown in crimson on the above chart) have registered a percentage gain of around 23 percent from their lows just before the start of the war in the Middle East, at the end of February, to the present. That’s a bit gain (remember always that a gain in bond yields means a decline in bond prices), and it puts the 10-year yield at its highest level since 2007. A sharp rise in interest rates is normally bad news for stocks for a variety of reasons: the implication of higher inflation, a higher cost of capital in valuing future cash flows, a higher bar for earnings yields (i.e., earnings per share divided by the stock price) to be attractive relative to fixed income yields.

But not this time. After idling in neutral for much of the summer, share prices took off in August and have notched impressive gains for much of the first few days of September as well. Those of a bullish persuasion opine that this is just a natural outcome of higher growth expectations, with investors confident that robust economic growth will justify higher expected returns in a wide spectrum of asset classes. On the other side of the mammalian imagery, the bears argue that higher yields on assets that are supposed to be a proxy for the “risk-free rate” reflect concerns about US dollar debasement and an inclination, especially by foreign public-sector institutions, to back their bags and seek returns elsewhere. Case in point: Japanese financial institutions, who for decades have sought returns outside the meager offerings in their home country, now have the opportunity to hold long-dated Japanese government bonds with a three percent coupon, a level last seen in 1996.

It All Comes Back to AI

We imagine there is some truth to be found in most of these opinions from the Pollyannas and the Cassandras alike. But there is one theme that in our opinion is deeply embedded in both the stock and bond markets today, and that is artificial intelligence. On the stock side, need we say more? There are currently eleven companies on the S&P 500 with market capitalizations of $1 trillion or more, and collectively these eleven companies make up around 40 percent of the index’s total market cap. Only one of those companies – Eli Lilly – is not a tech name (we consider Amazon and Tesla to be “tech companies,” for example, even though they are officially considered part of the consumer discretionary sector). Now, among the ten remaining companies there are different AI storylines, from memory chip suppliers like Micron to the hyperscalers of Microsoft, Amazon, Alphabet and Meta and then the granddaddy of all, Nvidia, which appears to have earned a new sobriquet of “central bank for AI.” But with all that market cap weight behind them, whither these companies go, so goes the S&P 500.

And in the bond market? Once upon a time, the cash-rich tech companies building out AI infrastructure did so mostly from their own cash flows, but those days are gone. Alphabet, to cite one example, reported negative free cash flow in its most recent quarterly financial filing. At the end of last year the company had positive free cash flow of $24 billion. Alphabet and the other hyperscalers collectively have issued around $200 billion in corporate bonds so far this year. In the AI ecosystem as a whole, the debt total for the year to date is around $500 billion, and analysts expect it will rise to more than $1 trillion per year in the next several years. That’s a lot of new debt supply coming into the market, and it is competing with new debt issuances from the government and from other private sources. Higher yields are a natural outcome of higher supply.

What all of this seems to mean is that AI is increasingly the driving force in just about everything: in stock price performance, in the bond market, in economic growth prospects overall. The “AI story” is no longer just a cute way to describe the impact of an exciting (and, to many, frightening) new technology on a handful of stocks. It is increasingly the only real story that matters in markets and the economy. The uncertainty that surrounds this proposition is likely to keep investors on edge and, like wondering what’s going to pop out around the next corner in those haunted houses at Funland, give them goosebumps.

From the Latin word “credere,” many meanings flow. The verb’s primary definition, according to Cassell’s Latin dictionary, is “to entrust, commit, trust something to someone.” Hence our English word “credit” as it applies to financial instruments and much else besides. But “credere” also means to believe, to rely on, to give credence to something. Two related adjectives in Latin are “credibilis,” which we translate as “credible” or “worthy of belief,” and “credulus,” which means precisely what it means in English: credulous, easily believing in something no matter how silly or far-fetched that something is.

Okay, that’s it for the Latin lesson. Promittimus (we promise).

Treasury Shenanigans

The Treasury Department is the steward of the $32 trillion market for US Treasury securities, and as such is expected to be the very epitome of credibility. This is, after all, the globe’s most important financial market, the securities from which all other assets are priced and derive their value. That credibility has been called into question somewhat over the past several days. Treasury Secretary Scott Bessent has seemed at times to be hoping that bond investors are, well, more credulous than we know them to be. Following last week’s abrupt announcement that the Treasury would be doubling the amount of money used to buy back long-dated Treasuries, with the explicit intention to put a cap on rates rather than addressing periodic technical matters as is the usual purpose of buybacks, Bessent doubled down this week and suggested that $4 billion might just be a starting point. If the Fed can’t lower interest rates because of all those pesky Federal Open Market Committee votes worried about inflation or something, Bessent seemed to be saying, then we’ll just have to see what we can do over here at Treasury.

The bond market’s reaction has not been, shall we say, credulous. Scorn for Bessent’s interventionist tactics has come from all corners of the market, most prominently from legendary bond investor Stanley Druckenmiller. Druckenmiller, a one-time mentor of both Bessent and Fed chair Kevin Warsh, had nothing good to say about his former protégé’s doings in a scathing essay published in the Wall Street Journal this week. Nor have Bessent’s actions done much to push long-maturity rates lower. The 30-year Treasury yield is within a few basis points of where it was to begin the week, and likewise for the 10-year. Credit markets have been in a bit of a waiting mode this week ahead of Kevin Warsh’s speech on Friday at the Jackson Hole symposium.

Which…just concluded as we have been writing this. Anything new from the Fed chair?

Missed Opportunity

Unfortunately, no. Warsh’s Jackson Hole keynote speech was not much more than an embellished version of his press conference remarks following the July Federal Open Market Committee meeting. That event, as you may recall, did not go over particularly well with the financial chattering class types. Hot takes are starting to come in from said chattering class denizens in the wake of Warsh’s speech today, and the overall gist seems to be: could have been better, could have been worse.

It could have been a lot better, in our opinion. Warsh had nothing to say, explicitly or implicitly, about the Treasury Department’s incursion into the world of interest rate intervention. A year ago, when he was still campaigning for the job of Fed chair, Warsh noted on one occasion that it might be time for closer cooperation between the Fed and Treasury on monetary policy, even a revisit of the milestone Treasury – Fed Accord of 1951 that solidified the central bank’s independence (it was not independent during the Second World War when the government maintained a 2.5 percent cap on interest rates to facilitate funding the war effort).

A year ago, of course, the talk of interest rate cuts was still in the air and very much a part of Warsh’s commentary as he angled for the Fed job. Does he still think that way today? Should the Fed be a silent partner as Bessent’s Treasury tries to push down the long end of the yield curve? It would be nice to know what Warsh thinks about all this. Sadly, we got no insight into that today, and we are unlikely to be any the wiser tomorrow or the next day. Credibility is at stake here. And neither we, nor the bond market, are credulous.

It’s that time of year again. As August transitions from lazy days at the beach to frenetic back-to-school activities, the great and good stewards of monetary policy, central bank mandarins from the world over, gather amid the delicious beauty of the Grand Tetons in Jackson Hole, Wyoming, for their annual get-together. The Kansas City Federal Reserve Bank, which hosts the annual Jackson Hole confab, has let it be known that the topic for this year’s event will be “Financial Innovation: Implications for Payments and Policy.” Well, there should be plenty to talk about on this subject, because financial innovations of many colors are giving central bankers headaches as they try to adapt their thinking around monetary policy to a tumultuous new environment far removed from the certitudes of the economics and finance textbooks they studied in school all those decades ago

Thoughts, Warsh?

Of course, the main draw at Jackson Hole will not be some panel of payment system wonks hashing out the nuts and bolts of alternative digital currency platforms (though those materials will be worth perusing for anyone wondering what currency markets are going to look like in five or ten years). It will be the speech next Friday by Fed chair Kevin Warsh in his Jackson Hole debut. It will be interesting to hear what he has to say, because a lot of things have been happening in US credit markets over the past couple weeks and the Fed chair, true to recent form, has been largely absent from the scene. This week, for instance, as yields on the 30-year Treasury bond reached levels last seen in 2007, the institutional presence dominating the airwaves has been not Warsh, but Treasury Secretary Scott Bessent.

Bond yields have been rising at a brisk clip this year for a host of reasons, including persistent inflationary pressures, the massive supply of corporate debt being issued to fund AI infrastructure projects, renewed concerns about the level of US government debt (which drew scrutiny this week when it passed another round number, this one being $40 trillion) and, yes, credibility concerns around the central bank itself in the early weeks of the Warsh Fed (remember that when bond yields go up, bond prices go down). On Tuesday this week the 30-year bond yield briefly breached 5.3 percent, and that seemed to be the catalyst for Bessent, a one-time hedge fund guy, to shake things up with a new twist on an old mechanism: buybacks of outstanding long-dated bonds.

Not Quite QE

Treasury buybacks may sound like what the Fed was doing for years with its various quantitative easing (QE) programs, but it is a very different thing. The Treasury Department has conducted these operations for many years, typically in small amounts for technical reasons, and not as part of a broad-based strategy to influence and shape the direction of the yield curve (which was a big part of the motivation for QE). What Bessent announced, though, was exactly that – an intention to put downward pressure on rates at the long end of the yield curve by doubling, at least, the volume of buybacks for the next three months (ending, curiously, the day after the midterm elections in November).

Bessent’s announcement on Wednesday triggered a rally in bonds, but the rally was brief, and the commentary from market participants was largely skeptical. Imagery like “Band Aid on a major gash” or “walk loudly and carry a small stick” floated through the financial commentariat on Thursday as yields resumed their upward trend. Unlike the Fed, the Treasury Department cannot just create new money. It must pay for buybacks by issuing more debt, most likely short-maturity notes. There are limits to how much effect that can have on a Treasury market worth some $32 trillion in total.

Which brings us back to those fundamental challenges to credit markets we noted above, and the commensurate challenge Kevin Warsh will face next week as he attempts to (we assume) convey a message of “keep calm and carry on” when he addresses his fellow bankers in Wyoming next Friday. Treasury securities have long been the market’s de facto “risk free rate” – the benchmark against which all other assets are priced according to the particular risk properties of each. The forces driving rates higher, whether deriving from instability in the Middle East or the $220 billion in AI-related debt already issued by the hyperscalers this year or whatever else, are beyond the purview of regulatory countermeasures like the Bessent plan. What does Warsh himself think? What is the Fed prepared to do? A world well beyond the elite coterie of bankers at Jackson Hole wants to know.

Core inflation is currently running almost two percent below its five-year average. quickproduction.sk The latest jobs report from the Bureau of Labor Statistics showed a loss of 23,000 nonfarm payrolls, versus the average five-year monthly gain of 201,000. mic-globe.ca That combination – inflation lower and the jobs market weaker – ought to be a recipe for easier monetary policy, right? Not this time. Despite that dramatic decline in inflation from its generational highs in 2022, both core and headline inflation remain stubbornly above the Fed’s target of two percent. And the shaky trend in nonfarm payrolls notwithstanding, the overall unemployment rate remains relatively benign at 4.1 percent. Prediction markets still accord a 35-ish percent chance of a rate hike when the Federal Open Market Committee meets in the middle of September. ipatineteelectrico.com That’s lower than the rate hike odds immediately after the FOMC’s July meeting, and very strange press conference that followed, but still plenty high, with one jobs report and two inflation readings to come before the September meeting.

Stagflation Yes or No?

At the macro level the biggest concern, and the one we have been trying to get our heads around for the better part of a year, has been the possible return of stagflation after its long hibernation in the wake of the Volcker Fed’s shock therapy of 1979-82. The return of Smoot Hawley-era tariffs last year, the fact of US public debt to GDP at its highest peacetime levels ever and zeroing in on its all time high during the Second World War, and finally the outbreak of war in the Middle East in February of this year all suggested the near-inevitability of stagflation.

According to Phillip Braun, a professor of finance at Northwestern University’s Kellogg School of Management, stagflation is already here. In an opinion piece for this Thursday’s New York Times titled “Stagflation, the Scourge of the 1970s, Is Back” Mr. Phillips cited weakening jobs growth, above-target inflation, higher oil prices and slowing GDP growth (just 1.5 percent, annualized, in the second quarter) as evidence for there being, in his words, “no doubt that stagflation has returned.” The article goes on to warn us about the perils of a politically sensitive Fed in handling the stagflationary threat, drawing a plausible link between former President Nixon’s Fed chief Arthur Burns and the present-day man in that job, Kevin Warsh.

Is it, though? Is there really “no doubt” that stagflation is back? We have long since done away with the notion of ascribing “no doubt” to pretty much anything other than the 1990s-era musical group by that name fronted by Gwen Stefani. Here’s something to think about: in the past year, core inflation has come in hotter than economists’ forecasts in only one month. Tariffs caused the end prices certain categories of goods to rise, but in many months those price gains were offset by lower costs in key services categories (and services, lest we forget, account for a vastly larger percentage of economic growth than manufactured goods). Core inflation, as the above chart shows, is currently running at 2.47 percent while the headline number, knocked around hither and yon by the ever-changing state of play in the Middle East, sits at 3.3 percent. Those aren’t stagflationary numbers. In April 1980, core inflation was 14.6 percent and nonfarm payrolls declined by 145,000. Now that’s stagflation. We’re not there, not yet.

The Stock Market Factor

Here’s another difference between today and the late 1970s: the stock market. Back then, the market was limping through a dismal decade that would only end in August 1982 when a Salomon Brothers economist, Henry Kaufman, pronounced the end of the long bear market in bonds. Today, of course, the stock market is at record highs, both in terms of price levels and valuation metrics like cyclically adjusted price to earnings, which are very close to the nosebleed levels of the late dot-com era.

The stock market factor matters, because the total value of US listed equities currently stands at 238 times total gross domestic product (GDP). A crash in the market of a magnitude similar to that which followed the bursting of the tech bubble in 2000 would most likely have a pronounced effect on the so-called “real economy,” sending conditions of modest growth into decline with a commensurate hit to the labor market. That’s when we could really feel the unwelcome return of stagflation.

The FOMC’s September meeting is shaping up to be one of the more difficult ones in recent memory. A rate hike of 0.25 percent may be the best way forward for the Committee. It won’t thrill the stock market, but it is already enough of a baked-in possibility that it would likely not, by itself, cause major damage. Getting inflation back to two percent would then give the Fed more room to maneuver when the going gets tougher, without the threat of stagflation hanging over its head like the sword of Damocles. There’s no way to get a perfect read on what the macroeconomic numbers are telling us – but choices will have to be made. And we are quite sure that Kevin Warsh does not want his future legacy to be tied to that of Arthur Burns.

Summertime, and the living is…easy? Maybe not so much. soporteprofit.com ppid.pnk.ac.id The idea of the month of August being a beach-read lull between midsummer and the frenzy of back to school seems to have gone the way of dial-up Internet. albseriale.cc Nope, there are more crises and scandals and natural disasters clamoring to be the top headline on any given day than there used to be in the space of a month – or so it seems, at least. It’s a lot for anyone to take in – including those of us trying to make sense of investment markets

Breaking Out of the Holding Pattern

Up until this week, US stock indexes had been in something of a holding period pattern since the middle of June. Markets had rallied strongly once the initial reaction to the Middle East war wore off, gaining around 20 percent from the end of March to the beginning of June. Then, a relatively strong jobs report threw some cold water onto sentiment – strong jobs equating to no Fed rate cut in the market’s hive mind. Overall conditions stabilized, but things in the hitherto-dominant AI trade started getting wonky right around the time that SpaceX came to market in the middle of June. Maybe the idea of a company valued at 95 times top line sales was a bridge too far even for the usually credulous Mr. Market. Just speculating here. Anyway, wild day-to-day gyrations among the major AI-themed stocks, with vast high-low spreads, became the norm as the S&P 500 mostly lurched along sideways.

At least our blue-chip index has some protection from other industry sectors. Not so the South Korean Kospi index, about half of which is dominated by two semiconductor stocks, Samsung Electronics and SK-Hynix. That index saw a precipitous drop of 39 percent from its mid-June high to the end of July. Stories abounded of young Korean investors, trying to stay ahead of punitive cost of living conditions and a weak job market in that country, getting wiped out by ill-timed bets on what had been the hottest national market of 2026.

But it was not only retail punters who got smacked by the AI trade backlash during this period. Here at home, a hedge fund called Situational Awareness, run by a 24-year old German wunderkind named Leopold Aschenbrenner, made the news right at the end of last month with the announcement that its public equity portfolio had gone pear-shaped, losing 67 percent in the space of that month and being forced to sell off its positions in a fire sale to Ken Griffin’s Citadel. Situational Awareness encapsulated the FOMO of the AI trade, with eye-popping returns juiced by leverage of four times or more. So much harder, the fall to earth with that much debt.

The Push and the Pull

The market appeared to breath a huge sigh of relief when the news about Situational Awareness broke, and for a couple days the AI-momentum trade reverted to its old FOMO-ish ways, as seen in the chart above. But the bullish impulse has some headwinds to deal with, in the form of an unforgivingly high earnings bar. Case in point: Sandisk Corporation, a maker of storage devices and solutions based on NAND flash technology, has been one of the highest-flying constituents of the AI trade, with a year-to-date gain of over 800 percent (not a typo) to its mid-June peak (it subsequently fell by around 560 percent to its low on July 29 and was a prominent name in the Situational Awareness portfolio, hence the carnage there).

Sandisk released its quarterly earnings report today, blowing away analyst expectations as it reported a 372 percent increase in top line sales and 13-fold growth in earnings per share, along with a raised outlook affirming the continued insatiable demand for its products and services. Not good enough, say investors, and the stock is down 5 percent as we write this towards the end of the trading day on Thursday.

Sandisk may be an extreme case, but it typifies the push-pull sentiment in the market right now. The animal spirits of FOMO are still plentiful – the bulls really want to run. But the earnings bar is high enough to require a talented pole vaulter to get over it. It is a fragile balance. The big question is what happens when we get to that devilishly tricky period that often sets in after Labor Day – and we are just about a month away from finding out.