Hello my friends. Today is September 5th and this is Markets Weekly. All right, so last week was a pretty exciting week when it came to Fed policy. So today, first let's talk about how the doves are taking a stand as we heard from New York Fed President Williams as well as Governor Waller and got very hot non-farm payrolls print. And secondly, let's talk a little bit about the surge in global bond yields because it seems like it's reaching a fever pitch and there are many many explanations for what's happening. Let's go over some of them.

All right, starting with policy. So last week, as we discussed, it seemed to me that Chair Warsh all but promised a September hike at his Jackson Hole speech. But of course, he's not the only person on the FOMC. And as far as Fed chairs go, Chair Warsh is pretty weak. Other influential voices of course include former Chair Powell and of course Governor Waller who over the past few years has been pretty accurate in his assessment of the economy and therefore perceived to be someone who is an influential voice on the FOMC.

Now last week first we heard from New York Fed President John Williams. Now the position of New York Fed president is historically one of the most influential roles in the Federal Reserve system. But I'll note that Williams in particular is widely regarded as an idiot. So we have to temper down our expectations of his influence. Now in his interview with CNBC he basically sat down and he said that he thinks that inflation is coming down and it will get to around 2% in one or two years. Now, this is of course dovish because he's not advocating for rate hikes, although of course he would change his view should the data change. Now, also note though that Williams basically says the exact same thing every year. Every year he goes and he tells people that inflation is just one or two years away from going back to 2%. This is because Williams is a PhD economist and in the models that they teach you in economist school is that if you have an inflation targeting central bank, then eventually inflation goes to the central bank's target. So by construction his models always have inflation going to 2%. So he always says the same thing even though of course that has not been correct for many years. But in any case, he seems like again not advocating for rate hikes. Although I suspect that he's someone who would just go along with whatever the Fed chair decides.

Now what people really cared about though was of course what Governor Waller would say. He is someone who is actually perceived to be more influential than Warsh on the FOMC. Now, the last time we heard from Waller, he seemed pretty hawkish that he would basically hike if we had a hot CPI print. Now, his remarks were perceived to be much more dovish than expected. Of course, he explicitly told everyone that if CPI came in hot next week, he would be open to hiking in September. However, he also said things to the extent that inflation has been improving and he felt that we are kind of at a turning point. Now he thought that inflation in part has been driven by tariffs and that effect is fading, and focusing on core rather than headline. He felt that we are probably at a turning point. Now headline of course includes energy prices. Energy prices have been going higher. So he seems to be discounting that.

He also made a very interesting observation in that the government is going to change how it calculates PCE over the coming weeks. PCE is the Fed's target. Now, in PCE, there's a component there called portfolio management fees, which basically goes up when the stock market goes up. So, part of the reason that PCE inflation has been elevated is because the stock market has gone up and up and up. Now, of course, we don't really think of that as something we want to measure in inflation. So, they're going to change how they calculate it. Now, after this change, PCE is expected to decline by about 0.2%. So another reason why inflation is according to him about to come down, in his words he wants to give disinflation a chance. Let's listen to what he says:

"Yeah, that's what I mean. We're all anticipating that the revision is going to drop this down. So if that plus what's actually happened the data, you might see a significant drop in PCE core. So if it's 3.3, it'll drop to like 3.1. Then if you get some decent data, this thing goes under three on an annual basis and down to 0.3 a month, even lower, right? So that's what I'm willing to take the chance to see, you know, I'm going to paraphrase John Lennon here. Give disinflation a chance, okay? And let's we can wait one meeting. I just don't see why we have to do it. The mistake you run is if in fact we're at a turning point and disinflation starting to happen like we've long thought it was going to or I certainly long thought it would. You're raising rates into a disinflation. You're too far ahead of you're depending too much on the past. So that's why I'm saying look what's the cost of waiting one meeting? Hiking 25 basis points one meeting right now is not going to bring the CPI down to 2%. Sure. So let's just we I think this is risk management. You want to take a chance to see if disinflation continues but I'm not taking a big chance on it."

So again Waller is basically saying that he feels that things are turning around and he wants to just kind of wait. What's the cost in waiting? Of course. Now I actually perceive that to be a little bit disingenuous because many people think that the Fed can't hike right in front of a midterm. I actually think that September is still okay. You still have, say, six weeks between a theoretical September hike and the midterm. So, there's plenty of time for the market to digest. But if they were to not hike now and to hike in October, now that would be literally a few days before the midterm. And that I think is just too close to the midterms. Too much of a perception of political interference. So I don't actually think you can just maybe wait a meeting and hike. If you skipped September, I think you would have to be thinking of December as the next time that you could hike.

So anyway, perceived to be dovish by the market. So at that point after Warsh's speech, market was pricing in a 60% chance of a hike in September. After the Waller speech it was back down to about 50/50.

Now both Warsh and Waller downplayed the importance of employment. They were talking about employment: "Yeah, we're basically meeting our full employment mandate. We're really just concerned about inflation." So all the focus was on next week's CPI. However, this week's non-farm payroll surprise was surprisingly strong. Now if it were weak, if it were lukewarm, I think the market would just ignore it. But the print was much higher than expected showing over 150,000 jobs created. Now if you look at the underlying aspects of the print you can notice that the unemployment rate remains really low at 4.1% and you even have some improvement in the labor force participation rate.

What you don't see though is an acceleration in wages. If you had a heating up labor market, you would expect wages to accelerate, but we don't really see that yet. Now, it could be lagging. Now, if you take a step back and you look at the time series for the unemployment rate, it's unmistakable that it's gradually trended lower. So, it is possible that in the coming weeks that maybe the labor market really is heating up and we'll have stronger wage growth. At that point though, you could actually have the Fed care more about the labor market potentially overheating and making it harder and harder for them to get inflation under control.

Now, the beat in the payrolls print was so large that of course the market again increased the odds of a September hike to a little bit below 60%. So basically after Warsh 60% September hike, after Waller down to about 50%, after non-farm payrolls print up to around 60% again. So it seems like a lot will be riding on what happens in next week's CPI print.

Now I will also note though that it seems like oil and energy prices continue to move higher and higher due to what's happening in the Middle East. And so if you're the Fed and you actually are forward-looking and just not completely discounting energy prices, I think there are serious upside risks to inflation especially if you say focusing on refined products like diesel which hit an all-time high in the US. So if and as we recording it seems like we have additional military conflict in the Middle East. So I think if you have a labor market that continues to surprise to the upside and inflation that due to energy prices at least on headline basis will trend higher. I think that really strengthens the argument for a September hike. So I guess the market will have more resolution on that after we get the CPI print.

All right. So the second thing I want to talk about is the surge in global bond yields. So we focus of course on the 10-year yield approaching 4.8%, 30-year bond yield seems to go up and up and up, but I think it's important to also note that this is a global phenomena. Now this is something that has honestly I think it's becoming more of a frenzy because I hear talked about in all sorts of media outlets even those for the broader public.

Now there are many stories people tell. Now of course first principles people buy and sell for different reasons. So understanding market movements is always understanding the stories that they tell each other, how they perceive the market. It's not some kind of equation, it's not physics, there are no natural laws that move prices, it's always about perception and of course constraints that investors have.

So let's talk about a popular story. Popular story of course is runaway deficits. Now no surprise the US is having a very large fiscal deficit about 6% and it looks like it's going to go on and on and on and so that is a story why yields keep going higher. Now of course notice that this is a global movement and so you can also make the argument that government deficits throughout the world are rising and so it makes sense for bond yields to rise and I think that that does make sense. Higher deficits on the one hand, higher supply of sovereign debt. On the other hand, obviously it increases economic activity, increases demand, so it should push yields higher.

Now, one thing I will push back against is any claims of this is a huge fiscal crisis in the United States and so forth. Now, in the US in particular, there are actually solutions to this and that is, you know, you just raise taxes, right? There's no need to go do some galaxy brain thing about oh nominal GDP yields and so forth like that. The government pays its debt based on tax revenues and it also can adjust the tax rate. What's special about the US is that compared to other Western countries taxes in the US are pretty low. On the federal level for example the top federal tax bracket is 37% and it only hits when you make say $650,000. Now, you also have to pay state taxes. In Florida, Nevada, Texas, there's no state income tax. So, the highest you'll ever pay is 37%. In some high tax jurisdictions like California, you probably have to pay about 10% on top of that depending on where your income is. So, again, it does vary, but compared to say Canada or the UK or Western Europe, in those countries, if you make $150,000 US, you're basically at the highest marginal tax rate and you're basically say have to pay close to half your income. So for them, I really do think that they have limited fiscal space. You really just can't raise taxes anymore because your tax rates are already so high. But if the US were to just marginally raise income taxes, they could easily raise a ton of revenue. And so the US has honestly a pretty good fiscal situation in the sense that you can easily raise taxes. And if you look at the politics, it's very clear that in Democrat-run jurisdictions, the trend is to raise taxes, to tax the rich. And eventually the pendulum will swing until the Democrats will be back in power. And so that's something that I think will be pretty easily solved. So not really worried about that as well. I think that's honestly kind of a silly reason in the US. Now for those other countries where you don't really have as much room to raise taxes if at all, I think it's more of a problem, especially say in France you even just by shifting the retirement age a little bit higher you get outright protests. So I think in those countries it's probably more of a challenge.

Some other stories people tell of course is hyperscalers or tech firms crowding out the market. So what's been happening over the past few months is that as big tech companies have been trying to build data centers, they've spent all their free cash flow and now are out borrowing in the markets to try to get some extra cash to finance their AI buildout. Now, of course, supply and demand always matter, but I'm actually not persuaded that this is actually that meaningful. For sure they're increasing their issuance in debt, but I think it's quite difficult to crowd out treasuries because treasuries in particular you can easily get financing against it.

Now there's a mental model out there whereas an investor has say x amount of dollars, a billion dollars, and as they're allocating more to let's say hyperscaler debt maybe they have less left over to buy treasuries and so treasury yields have to go higher. Now that is an incorrect mental model because you don't actually have a fixed amount of cash to invest because you can actually get financing. You can lever up, so banks can lend you for example, and this is especially true for treasuries where it's very very easy to get financing against treasuries. You have the repo market. It's trillions of dollars in overnight size, super liquid. So if you wanted to buy a treasury you're never really constrained by the amount of cash you have. You can easily borrow and lever up. So, treasuries in particular, I think it's very very unlikely to be crowded out by these private sector issuance. Now, not to say that it doesn't matter. It does, but I don't rank it as a very high factor.

Oh, one other thing, one other possibility of course is that yields are high because of strong economic growth. We heard that from New York Fed President John Williams:

"The big story I think this morning and as of the past couple days has been the rise in bond yields. Does that create a headwind for the economy? Well, with anything with financial prices or financial market developments, you have to think about what's driving it. And I think what's driving it in large part is higher yields is really a strong US economy and a strong economic outlook fueled by big investments in AI and data centers and technology in general. So I see this as more of a reflection of the strength of the economy. We're not seeing it in terms of inflation compensation. We're seeing it mostly in real rates. So I think much of this is really about with a strong economy, the cost of funding this investment tends to go up. And so I see that mostly through that light. It's not really about financial conditions affecting the economy. It's more about the economy affecting financial conditions."

Now, I think this is actually a pretty silly explanation because again, first off, economic growth is not that strong. Most recently, it's at 1.5%. Before that, it was about 2%. You know, that's just normal. It's nothing particularly strong about that. And of course, note that yields are going up globally. And so, it just can't be a story about the US growth. It has to be a global story. So I think that is just not true.

Another common story is of course term premium. So term premium is basically the degree of uncertainty in expected path of central bank policy. So if you were in a world where the central bank is behaving in an erratic way or for example you're not really sure what inflation will be in the future, you will have more uncertainty in what the path of interest rates will be and so you want to be compensated by that and that's what people call term premium and I think that's actually a totally reasonable way of looking at it as well. We do have big changes in not just the global economic model but also domestic politics as well. So I do think it makes sense for investors to demand a little bit more term premium when they're trying to price in the future trajectory of interest rates.

Now what I find most persuasive though is when I look at this chart of the sudden surge in global bond yields is that this is really driven by energy prices. Right? So notice that the moment that the Iran war began, oil prices began to shoot higher and bond yields have been going higher as well. And if you spend your day staring at the market as I do, you'll notice that when we're war on, yields up, right? It's really that easy. War off, yields go down. So the yields are very sensitive to what's happening in the Middle East because that determines oil prices which in turn impacts inflation much more so for other countries than the United States.

Now think about for example in Europe. Now in Europe they depend a lot on natural gas and part of that is imported through the Middle East. In the US we're a lot less dependent upon that. So other countries are extremely sensitive to energy. The US as well but of course not as much. And so I think the biggest driver in the surge in global bond yields of course has been the Middle Eastern war. And I guess the way that we'll figure out if that theory is right is if we eventually have a resolution to that. I would expect bond yields to come down and come down quite a lot and so all these people who are talking about fiscal crisis or like hyperscaler debt I think that's going to be shown to be quite a trivial part of the recent rise in yields.

So when is the Iran war going to end? I actually have no idea and it seems like a lot of people in the political sphere are beginning to think that maybe this might go on even through midterms. Now, I'm actually a bit more positive to that. Looking at the polls, it really does seem like there is a growing chance that there could be an just total blowout in the midterms where the Democrat just sweeps both the House and takes the Senate. So, I think that would be a very dangerous outcome for the president. And so I'm thinking that he probably doesn't want that to happen and will probably have to do something maybe just basically buy the Iranians out to make sure that this problem goes away. At the moment it seems like that's not happening though. Things are still escalating. So let's see what happens. I think the president would really need to act fast if he wants to save the midterms because things are just not looking good for him.

All right, so that's all I prepared for today. Thanks so much for tuning in. Talk to you guys.