Navigating the Bond Market: What You Need to Know About Recent Trends ft. Stephen Miran

[00:00:07] Steve

There’s not really an alternative. Like, where else are they going to keep their money? The gold markets not big enough. And even the flows that we’ve seen so far have sent gold, you know, soaring.

There’s nothing that’s big and deep enough, you know, something like a lot of these crypto assets have deflation built into them where the supply declines over time. And so that’s not really suitable to something where you need an increasing supply to fund increasing transactions and savings the way the Treasury market increases over time.

So, without an alternative, they’re sort of stuck. They’d love nothing less than to stop using the dollar and the Treasury, but they’re stuck. They have no, no choice.

[00:00:46] Intro

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes and their failures. Imagine no more. Welcome to Top Traders Unplugged where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level.

Before we begin today’s conversation, remember to keep two things in mind all the discussion we’ll have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions. Here’s your host, veteran hedge fund manager Niels Kaastrup-Larsen.

[00:01:42] Niels

Welcome and welcome back to another conversation in our series of episodes that focuses on markets and investing from a global macro perspective. This is a series that I not only find incredibly interesting, as well as intellectually challenging, but also very important given where we are in the global economy and the geopolitical cycle.

We want to dig deep into the minds of some of the most prominent experts to help us better understand what this new global macro driven world may look like. We want to explore their perspectives on a host of game changing issues and hopefully dig out nuances in their work through meaningful conversations. Please enjoy today’s episode hosted by Alan Dunne.

[00:02:27] Alan

Thanks for the introduction, Niels. Today I’m delighted to be joined by Steve Miran. Steve is a fellow at the Manhattan Institute. He is also a Senior Strategist at Hudson Bay Capital.

Previously he was a Senior Advisor for Economic policy at the US Department of The Treasury. Prior to that he was a Portfolio Manager at Sovarnum Capital and previously worked at Fidelity.

This Year he came to prominence after writing a paper with Nouriel Roubini on activist treasury issuance and he’s also contributed to the Wall Street Journal, Barron’s and Bloomberg. So, Steve, great to have you with us today. How are you?

[00:03:02] Steve

Great, thank you so much for having me. It’s a real pleasure to be here.

[00:03:05] Alan

Well, great. Well, we like to just kick off by getting a sense of our guest’s journey to their current position. Obviously, you’ve got a background in academia and in the markets. What got you interested in economics and the markets in the first place?

[00:03:18] Steve

Sure, I’d love to discuss all that. Let me first start by just giving a really simple disclaimer that I only speak for myself. I don’t speak for the views of Hudson Bay Capital, I don’t speak for the views of the Manhattan Institute. Everything is just my opinion. But you know, that, that out of the way.

I guess I went to graduate school to get a PhD in economics because at 22, like I guess I had no idea what I wanted to do, and I couldn’t imagine getting a real job. And so, I said, hey, being a student is kind of fun. I’ll just keep being a student. And economics seemed both like interesting and potentially useful.

As I went along in the course of academia, you know, it sort of became obvious that being a professor wasn’t for me. And of the what, like 25, 20 students in my PhD class, I think I may have been the only one who went straight into the private sector. The overwhelming majority of them became professors at other institutions. So, this is graduates, you know, who became professors at other institutions. A handful of them went to the Fed or the IMF or something.

But you know, I said, hey, I’m going to go work in the real world. And I had a friend who was working at another hedge fund at the time and he knew someone who was trying to hire. At the time, I didn’t know what a hedge fund was. If you told me, hey, go work at a hedge fund, I would have said what do they do, invest in bushes or something? No idea. I was just this nerdy PhD student. But as it was described to me, it sounded like really, really cool and really interesting.

You know, one of the most fun things about being an economist, or someone who works in economics and in markets, and as an investment professional, is getting to deal with the top level, high order, most important issues of the day on a daily basis in terms of what’s driving markets, what really matters, what are the important economic changes and policy changes?

You know, if you’re an academic, it takes a long time until you get to the point at which you can actually really think about those things because you’re working in what’s a highly segmented and highly specialized universe as opposed to being a generalist and bouncing around to whatever the most important issue of the day is. You don’t get to be Paul Krugman until you’re Paul Krugman. Right? You don’t get to do that at 27 years old, straight out of grad school.

So, getting into markets that way was really fun for me. And yeah, as I learned more about it, it was just more and more interesting, exciting stuff.

[00:05:55] Alan

Good stuff. Well, it’s always great to speak to people who have that solid theoretical foundation and also are deep in markets. So, I think that’s a great combination.

And you wrote a very, I suppose, widely discussed and talked about paper this summer with Nouriel Roubini, called Activist Treasury Issuance and The Tug of War Over Monetary Policy. But as I say, it was quite a focus in markets and for fixed income markets in particular.

I think in that paper you put a lot of numbers around some of the talking points that had been relevant in markets, around were the treasury been tactical in their issuance? I mean, what was the background on writing that paper or the motivation? And, maybe what was the thesis you were trying to set out in the paper?

[00:06:49] Steve

Yeah, so, I guess the background question for the genesis of the paper is that if you had a time machine, and you went back in time to 2019, and you said to people, “Hey, the Fed is going to go from doing a huge amount of QE to doing QT and they’re going to hike the policy rate almost 5.5% in a relatively quick period of time.” I think most people would have predicted something like a financial apocalypse.

It would have been a really bad outcome for markets and for the economy and a really steep recession. And indeed, there are still people who are predicting that to this moment. And not only did that not happen so far, but growth has been really good and markets have been really phenomenal. And you know, inflation has remained stubbornly high for a long period of time. And it’s kind of come down in the last few months, but we’ve had periods like this before where it’s come down for a few months and it turns that underlying inflation is running somewhere between 2.5% and 3% rather than 2% or below.

The underlying question is really, why is this happening? Why does everything seem pretty much okay despite a really historic monetary shock? And then we’re sort of are looking around, trying to figure out, you know, okay, what are the things that can help explain that? And the explanation is, I’m sure, multicausal.

I don’t want to say that Activist Treasury Issuance, or ATI as we call it, I don’t want to say that’s the only explanation and that’s driving everything in the universe. It’s most surely not. But we sort of looked around at what are the other major policy changes that are happening through this. And obviously, fiscal impulses from the deficit remain, I would say, pretty well understood. There are lots of people who talk about that, and lots of people who look at the budget numbers. But outside of what is a pretty niche audience of fixed income traders, not that many people were talking about changes in the issuance profile of Treasury debt.

You know, it’s, it’s normally something that is pretty specialized. Like, okay, if you’re a Rates RV Trader, you’d be like, oh, I’m long twos and short threes because there’s going to be a few billion dollars more issuance here or there, or something about Fed policy, or whatever.

Look, you can make money doing fixed income RV, you can make lots of money doing fixed income RV, but it’s not very interesting to a broader audience, saying I’m long fives and short sevens or something is not very interesting to a broader audience.

So, Nouriel and I looked at what was going on with the issuance patterns, and we thought about sort of the narrative that sort of this had been an economic driver and had been out there in the markets. We weren’t the first people to air this by a long shot. People had been talking about this for a long time.

I’d been talking about it informally for a while also. I’d been writing on the subject for a good nine months or something before Nouriel and I published the more rigorous white paper. And we said, hey, you know, let’s take this idea seriously. And we were speaking about it with folks at Hudson Bay. And I mean, I think there was a lot of receptivity that this was a big change in policy and maybe it could be something that contributed to the resilience of the markets, which Hudson Bay had been emphasizing for a while.

And we said, hey, let’s take it seriously, and let’s try and incorporate this change into a more rigorous economic framework and fit it in with the rest of the literature about monetary policy and fiscal policy and try and put some numbers on it to say, hey, could this be something that’s significant?

[00:10:25] Alan

And I mean to summarize it at a very high level, I guess the argument is that the treasury has been tactical in their issuance, and they’ve been issuing more bills and less longer duration bonds in a bid not to, I suppose, not to put upward pressure on long-term yields. And you put some numbers around it suggesting, I think that it was the equivalent of a 1% cut in the Fed’s Funds Rate, I think, was the number you had. But maybe if you want to outline how you kind of saw what they were trying to achieve in the magnitude of what they were doing.

[00:11:03] Steve

Yeah, sure. So, I think you’re completely correct in your characterization of the economic channel. The economic channel is very, very similar to the Fed’s quantitative easing, or QE, or large scale asset purchase if you’re at the Fed, and the way that works in markets and the economy.

Basically, the way both QE and ETI work are by changing the distribution of debt held by the public from assets that bear interest rate risk to assets that do not bear interest rate risk. And so, Treasury bills are very similar to what economists consider money – bank reserves.

They, even before forever, bore very similar duration and credit profiles to bank reserves at the Fed. But now, in the post Basil world, they also bear similar regulatory and return profiles to reserves of the Fed because bank reserves are now remunerated interest and the interest in overnight reserves, and we’ve switched from a reserve requirement to a capital ratio bank regulatory system.

And so, the way QE works is the Fed goes out and buys interest rate risk bearing debt from the market and gives them bank reserves in exchange. So, it gives them money and it takes away risk.

The way ETI works is it limits the creation of interest rate risk bearing, duration bearing notes and bonds at the creation, at the source of treasury, and instead gives them more bills which, as we as I said a moment ago, are now very close substitutes for bank reserves in a way that was less true 20 or 30 years ago, but is very true now.

And so, in both cases you have a situation in which the public gets more money, or money like bills. So, money supply increases. There’s a very normal monetarist pathway that’s familiar to lots of people, and there’s a lower supply to the public of interest rate risk bearing notes and bonds – duration bearing Treasury debt securities.

And this is what economists, and the Fed, and everyone would call the Portfolio Balance Channel. Which means that there’s, basically, a fixed appetite for risk in the universe. And if you take out some of the interest rate risk, there’s more appetite for other forms of risk.

So, the people who owned a 10-year Treasury note that gets bought by the Fed will instead go out and buy corporate credit because that’s more attractive now that interest rates on US debt has gone down. And then the guy who owned corporate credit will sort of go out and buy, you know, stocks. And the guy who owns stocks will go out and lend to VC.

Obviously, this is not every single person in the universe, but enough people that prices move and money flows into more risk seeking activities relative to less risk seeking activities. And liquidity flows through the economy, and it’s stimulative to markets, and it’s stimulative to economic growth.

And this is the channel through which QE works. ATI mimics this, but instead of happening through a Fed operation, it happens at Treasury. And so, Treasury’s policy shift has really had a profound impact on markets and through markets on the economy.

And there are really two questions to what’s going on. One is, you know, what is the size of this effect? How important is it? How big is it in the scheme of things? And the other question is, you know, why are they doing it? Why has this policy change happened?

We provided like what we thought of as a reasonable range of estimates using every estimate in the literature we could find about the effects of QE and other types of programs on markets in the economy. And there was a range, but you know, a lot of them clustered around the middle. And that was basically about that it was, as you said, about a 1 point cut to the Fed Funds Rate in terms of its effect on the economy.

Like I said, at the beginning, look, a one point cut in the Fed Funds Rate is material. It’s not zero, but it’s also not enough to get you huge, huge, huge responses.

So, ATI has contributed to the buoyancy of the economy and the buoyancy of markets, but I wouldn’t claim it’s a sole explanation for the really phenomenal growth and sticky inflation we’ve seen.

[000:15:27] Alan

Yeah. So, this, I mean this whole idea really came to the markets, I would have said, kind of, maybe between August and October, last year, it kind of became a theme, I think. At Jackson Hole, last year, the whole theme of debt and deficits was on the agenda, and it suddenly became a talking point. And then 10-year yields started to rise, and as we went into October, I think, yields peaked. I think it was around, obviously, the October announcement where they shifted and that that put a bottom under bonds.

I mean, one interpretation might be it was tactical, but it, maybe, stems from the Treasury, but it made sense given the kind of trend in yields at that point in time. Would that be normal for them to look at the trend in bond yields and say, actually, you know, yields are rising now. It might not be a good idea to be adding to the supply, and maybe we should tactically just tilt towards bills, or would that not be the normal kind of way they would operate?

[00:16:24] Steve

Yeah, that’s very much not the normal way they operate. In fact, they have a policy framework that has been the policy framework for a really long time. You know, it didn’t originate in the last few years, which is that Treasury is not a market timer. Treasury seeks to achieve the lowest cost to taxpayers, over the long term, and by that it means decades. It does not seek to time the short-term market. Part of the reason why is because they can get the cycle wrong.

If you’re trying to be a directional interest rate trader, unless you’re Stan Druckenmiller, George Soros or Scott Besson or something, it’s not an easy thing to sort of make macro directional calls. There are those of us that do it, but Treasury, properly, has the humility to know that they might get it wrong if they tried to do that. And indeed, if that had been the Argument for much of the last year and a half, they would have been getting it wrong.

People have persistently been expecting the Fed to cut far more than it actually did, and interest rates to go down much faster and much more steeply than they actually have. And until the Fed’s sort of sudden about face in September, those folks had been wrong for a really long time.

[00:17:41] Alan

And I mean, you talk about this possible size of the impact. I mean, it’s fair to say, is it not, that the size of the impact of QE is much disputed in the first place, and I think you allude to it in the paper. Some people say it’s the stock of the balance sheet, or some people say it’s the flow, and there’s a debate around that.

And then also, you know, there’s the issue of how much of an impact does QT have? Logic will dictate that it has an impact, you know, but the Fed seems to be of the view that it doesn’t have much impact. They kind of presented as a super policy that can work on one side but have no negative consequence on the other side.

I mean, what do you think of that? Do you think that’s reasonable or not?

[00:18:26] Steve

Yeah, so I think that’s a great question.

Let me say that I entirely agree that there should be a huge amount of uncertainty around any useful macroeconomic estimates in any field of macroeconomics. The efficacy of QE continues to be hotly debated and, you know, there are people who will spend entire careers estimating that. Our goal was to take a wide variety of estimates from the literature and, you know, run it through a lot of them.

Look, if you told me that the effect was 40% lower, or 40% greater, I would say, look, I’m not going to be able to reject that statistically, not going to be able to reject that. That’s outside of the confidence bands or something. I absolutely want to agree that we shouldn’t try and be overly precise, and we should accept that there’s uncertainty around estimates, and economics is not physics.

That said, you know, I do think that QE and ATI, because they’re so similar, they both have to work or neither one of them works. If you wanted to say that QE doesn’t work then neither does ATI. I don’t agree with that position, but it’s an internally consistent position. If you want to say that QE works, but ATI does not, I do not view that as an internally consistent position. That, that’s a contradictory position in my mind.

And the Fed’s insistence that QT is not policy has no effects, whereas QE does. I mean, that just strikes me as quite silly cognitive dissonance that they say it. I’m really not sure why they say it. Maybe for political reasons to try and retain as much autonomy over their policy deals as possible, or because they want balance sheet reductions to be so slow and gradual that they have to do them over a very long period of time and they want the flexibility to be easing the funds rate at the same time that they do that. They don’t want to look like they’re hitting the gas and the brake at the same time, even though they are. You know, I’m not quite sure exactly why they do that, but it has always struck me as quite silly.

And then if you remember in 2019 when they stopped doing QT and turned around and started buying assets again to create more reserves in the system, because it turned out that the Basil universe was thirsty for more reserves than they’d provided. They insisted that it was not QE. It was the exact same transactions as a QE program, but they insisted that it was not QE.

And so, they were insisting that ‘not QE’ QE had no economic effects, even though it was the exact same policy implementation as QE. So, you know, I prefer to sort of get at the underlying economic mechanisms and try and think about how important they are and not get lost in jargon from the Fed. I think every transaction has, has an effect of some sort.

[00:21:07] Alan

Fair enough. And one of the things, then, you point out in the paper; so you make the point, obviously, that there’s been less issuance of bonds and more of bills and that’s had, at the margin, the effect of yields being lower than they would have been. But obviously then the flip side of that is at some point these bills will be termed-out (as the expression you use). So, at some point they will move from issuing so many bills that they’ll move back towards the longer term average, and that by doing that you will see upward pressure on bond yields.

Now, obviously, in the context of what we’ve seen in markets (we’re recording on the 25th of October), over the last month, or so since the Fed cut, actually, 10-year yields have risen by about 60 basis points. Lots of discussion as to what’s behind that. Maybe the Fed has misjudged the cycle or maybe it’s deficit concerns.

Is there any sense, do you think, that the market is refocusing on this terming-out issue, or do you think it’s some of the other structural issues that bonds face in the background?

[00:22:10] Steve

Oh, totally. So, I very much think that term-out risks are significant, and a significant downside of engaging in ETI. You eventually have to undo it. And, and if you eventually undo it, then, you know, you’re going to be raising yields at a time that might be very inopportune.

In fact, I, you know, I think the IMF sort of flagged this risk in their recent financial stability report that came out a couple of days ago. They talked about Treasury short term issuance and said that it raises the risk of the Treasury’s, overextended reliance on short term issuance and so that it raises the risk of higher interest rates down the road. So that’s, I think, a huge downside and very much a real risk.

I don’t think that’s what’s driving the increase in yields that we’ve seen in the last month or so in large part because who knows when that’s going to happen and who knows what the policies are going to be. You know, Janet Yellen has indicated that she’s going to step down regardless of who wins the election.

So, regardless of who wins in a little bit more than a week, a week and a half, you know, President Trump or President Harris will appoint somebody else to be Treasury Secretary. And that person is likely to choose his or her own staff. And so, all the folks who are making the decisions are likely to overturn very soon. So, I don’t even know what people would do if they were there.

So, you know, I don’t think that that’s what’s driving the increase in yields that we’ve seen very recently. I think it’s a combination of things. One, the Fed, as you said, overextended itself and, I think, has gotten the cycle wrong. I think that they’ve been misreading signs in the labor market as indicative of recessionary dynamics, or indicative of a significant decline in aggregate demand. Which I think is wrong. And we can talk about the labor market if you want to.

I also think it’s been sort of people doing the math and sort of increasing their expectations of deficits into the future, whether those expectations are right or wrong. I think those expectations have been moving a little bit higher recently. Those have both had the effect of increasing yields.

You know, the recession narrative was very strong a month ago, a month and a half ago. And I think a lot of the people who have embraced the recession narrative have, for the umpteenth time in this cycle, gotten a beating.

[00:24:39] Alan

We’ll talk about the labor market. Before we do that, in terms of the refunding, as I say, we’re recording towards the end of October, the next announcement is next week, is that right? So, the details will be out before this is released. But are you expecting anything dramatic? I know they’ve kind of been given guidance in the last few quarters, so presumably, should we not expect anything kind of out of the ordinary relative to that guidance? Is that your expectation?

[00:25:06] Steve

Yeah, exactly, that’s my expectation. You know, the refunding is next week and I don’t expect it to be an event in the way that a couple of refunding announcements were events. And the reason is because they’ve given that guidance.

So, Treasury has been saying… You know, the most shocking thing, to me, that they did in October of last year was to say that based on current funding projections, Treasury doesn’t anticipate having to increase nominal coupon options for at least the next several quarters. And they’ve reaffirmed that guidance in every QRA over the last year. So, you know, that basically de-dramatizes, through funding announcements, because they’ve just told you what they’re doing in several quarters into the future.

So, for them to sort of surprise about near-term issuance next week would require violating that guidance. And you know, they did give themselves an out because they did say ‘based on current funding projections’. So, they could say funding projections have materially increased and so therefore we need to increase the coupon issuance. I don’t think that they’re going to do that, although it’s always possible that they increase their options.

The other possibility is that they could change the guidance for the future. That is not credible because, as we said a moment ago, all the staff is going to turn over very soon.

So, if they’ve already bound themselves, for the next several quarters, not to increase coupon issuances, and they tell me, oh, well, a year from now we’re going to increase coupon sizes. Okay, I mean, what good is that guidance until we know who the Treasury Secretary is and what his or her views on the matter are?

So, you know, I don’t view this likely to be in an event. And I guess the way that I like to think about it is to think about it like QE. If we were in the 12th month of QE, it wouldn’t be a market event anymore.

It’s a market event when it stops; when you get some sort of indication that, hey, they’re going to taper QE, they’re going to end QE, they’re going to shift to QT, then it becomes a major market event for fixed income markets and therefore for other markets as well.

And I think the same is true of ATI. As long as they keep on giving the guidance that we’re good for the next few quarters, it’s happening in the background, so it’s having the persistent effect on yields, but it’s not going to have an event like ‘big trade’ come out of it until the guidance changes.

[00:27:27] Alan

So, you touched on the labor market and the view. Obviously, the view was that we’re seeing a notable deterioration, if we went back a couple of months or at least at the start of August. And now that’s kind of shifted with the most recent data, in terms of jobless claims, and the employment numbers from the employment report. So, looking at it in aggregate, the Fed likes to emphasize looking at all of the labor market data. I mean, what’s your take if you look across all of the labor market data in terms of the overall trend?

[00:27:56] Steve

Yeah, So, I mean, like, I think that the labor market remains in pretty healthy shape. You know, there’s no question that it has weakened from a year ago. But I don’t think that it’s weakened precipitously.

If you look at the increase in unemployment, in the first half of the year, it was overwhelmingly new entrants and reentrants to labor market. It was overwhelmingly concentrated in younger demographics, particularly the 16 to 19 age demographic, but also the 20 to 24 age demographic, who, of course, are likely to be first time or reentrants to the labor market.

I somewhat wonder if what happened was that folks in those age cohorts were exposed to their first jobs in what was really a ‘once in a generation’ or ‘once in a lifetime’ level labor market that we had in ‘20, ‘21, ‘22, where even people taking summer jobs got fabulous, amazing salaries. And then once the labor market normalized a little bit, those opportunities were no longer available. But that’s where they had benchmarked. That’s where they’d set their reservation wages. Those are also the demographics that are most likely to be competing with unskilled labor from migrants.

And so, we did see genuine weakness in those cohorts, but I think those cohorts are a little unusual for those two reasons. You know, in Q3, some of the weakness that we saw was in the temporary layoffs. Okay, that’s already mostly resolved itself. We had some really anomalous weather in California. We’ve had storms. We’ve had various striking. We’ve had auto retooling.

And so, I go through this, and I don’t see the type of breadth across the labor market geographically, that would sort of say to me that there’s some problem with aggregate demand. I do a lot of looking, you know, in terms of looking for breadth of labor market weakness or strength. And the weakness wasn’t really broad for me, either across demographic groups or across geographies, which I would want to see to say, hey, there’s something really going wrong here.

My view is that the labor market that we’ve been seeing has been a little bit more like the inventory supply chain bullwhip cycles that we saw on a lot of goods and commodities. In ‘21, ‘22, there was this surge of labor demand and everyone hired everyone they could. “I don’t know when I’m going to get to hire. When I’m going to have someone else to hire. If I can hire someone, I’m hiring him or her.” That’s it. You know, “Are you on the market? Mine! I’ll take anyone you have. All mine!”

So, they hired anyone they could. And then it turned out that the economy started to go from, whatever, 5% or 6% growth rate to a 3% or 4% growth rate. And maybe they had a little bit too much labor, but considering the economy wasn’t falling off a cliff, they said, okay, I’m just going to slow down my hiring and wait for my revenues, wait for my company to grow into my headcount. Rather than reducing headcount now because demand is not falling off a cliff, I’m just going to sort of hold tight for a bit and slow down hiring and wait for the company to grow into the headcount that we have.

And so eventually, you know, the company will grow, revenues will grow, and, you know, the actual headcount will get back to the right amount and then they can start hiring like normal again. In this story, it’s very similar to what we went through with cars or semiconductors or something else where there’s this huge, sudden demand, and then stockpiling, and then too much of it, and then drawing down the stockpile, and then, okay, things can start growing healthily again.

In this telling, the reduced hiring rate, which don’t get me wrong, the reduced hiring rate is the number one concerning thing about the labor market. I agree with the doves and the bears about that. But in this telling, the reduced hiring rate is not indicative of a sharp decline in aggregate demand in the economy as a whole, as would normally be the case. You normally think a decline in the hiring rate says, uh-oh, demand is falling off a cliff, we’re about to go into a recession. Things are really not good.

If the reduced hiring rate is because of bullwhip inventory cycles in the labor market, in the same way that we had in cars and semiconductors or commodities or whatever, then there’s no big problem with aggregate demand in the background. That would sort of tell you, hey, there’s a real reason to get really concerned about the economy and you better start slamming on the gas right now.

If anything, GDP growth continues to be really good. We grew 3% in a year through June, maybe almost as much as 3.5%, or close to, in Q3. Although, you know, we’ll find out. Core PCE was 3.3% in the first half of the year, although, as we said, it has slowed down recently. I view there being a bizarre and anomalous disconnect between GDP Growth and the labor market that I suspect is driven by those dynamics.

[00:32:50] Alan

Okay. And I mean, it sounds like your read is that the economy is doing fine. Okay. Labor demand has slowed a bit, but aggregate good demand is doing fine. Does that suggest… I mean, I think you alluded to it earlier. Was the Fed too reactive? Did it make a mistake?

If we’d gone back to the start of August, the fact that it didn’t cut, whenever it was – at the end of July, initially looked like a mistake, and now people are saying would have been too reactive. Obviously, it’s difficult. I mean, what do you think? What’s your assessment on how they’ve handled it?

[00:33:26] Steve

Yeah, I think the economy has been going pretty well. And I think that the Fed sort of threw gas on the fire by blessing the easing of financial conditions, accelerating the easing of financial conditions that had happened sort of in the months into the Fed cut. And that what we’ve seen, since then, is partly an increase in nominal growth expectations as a result of this.

The financial conditions easing, that we’ve seen over the summer and the fall ought to really be a significant tailwind to growth in the third quarter and the rest of the third quarter and into the fourth quarter and the first quarter of next year. And markets respond to that. They see that coming. Regardless of what happens to the election, they see that coming.

So, I think that cutting was a mistake. I think that cutting 25 would have been less of a mistake than cutting 50, but I don’t think it was the right move.

[00:34:23] Alan

Okay. And I know in your paper you touched on the whole debate about neutral and where neutral is, and obviously that’s a whole debate in itself. But I mean, that’s a key, I suppose, framework for how the Fed is viewing policy at the moment. The view being that policy is quite a bit restrictive and well above neutral, so they can be reasonably aggressive.

But even now after one cut, you know, they are kind of sense checking that. I mean, what’s your sense? What’s a plausible range for the neutral rate at this point in time, do you think?

[00:34:57] Steve

Yeah, totally. That’s a great point. Nobody really knows where it is.

I’m willing to say with confidence that it’s above where the Fed thinks it is, and I’m confident about that because the Fed insists that policy is so restrictive and yet GDP growth still keeps printing closer to 3% than to 2%, let alone 1.5% or 1%.

So therefore, if as Powell says, you know it by its works, or something like that, it seems pretty obvious to me that it’s materially above where the Fed thinks it is. Where exactly is it? I would agree with the people that say it’s difficult to know. As I said before, I’m not a big fan of being overly precise when it comes to macroeconomics and I’m definitely not a fan of false precision.

The bond market? So, if you look at the 5-year TIPs, inflation protected Treasury interest rate, so, what’s the real interest rate? The 5-year average real interest rate is considered to be a longer-term average, five years forward. So, after all the short term business cycle is out of the way, the market will tell you that’s somewhere just below 2%.

It’s been a couple days since I looked at it, but I think it’s probably around 1.9% or something, 1.95%. You know, maybe it’s a little bit higher because fixed income has moved higher in last week. So, maybe it’s 2%, but let’s just say it’s around 2%.

So, if you think that the Fed’s going to achieve its 2% inflation target over the long term, you’d add two to that and you’d say, okay, the nominal neutral rate is going to be 4%. That doesn’t strike me as crazy. And so, if the nominal interest rate (just to sort of take what’s in the market, that strikes me as a reasonable guess) is 4%, and they just cut to what, like 490 or something, 480? Where’s effective Fed Funds, something like that, 480?

[00:36:44] Alan

Yeah, exactly, yeah.

[00:36:45] Steve

And then you believe me that ATI is worth 100 on top of that, then the real effective Fed Funds rate is now below neutral. I think on the flip side of that you have to sort of add a little bit more in for QT. But I forget what my number on that was off the top of my head. So, maybe we’ve gone from just above neutral to just below neutral. But in any event, we’re still within spitting distance of neutral.

[00:37:08] Alan

Okay. And I mean, do you think this whole framework is helpful or not? I mean what’s a central banker to do? On the one hand, you know, you could be guided by some kind of sense on where neutral is and steer that way. The alternative is, as the Fed is now doing, saying, well, let’s just wait and see, we’ll cut a little bit, see how the economy reacts.

But obviously you’ve got lags of monetary policy. You’ve got revisions to data, so you don’t even know. Getting a read on the economy in real time isn’t easy. You know, from an academic perspective or from any perspective, what’s the best way to run policy? Is there a better way, do you think?

[00:37:45] Steve

I think a sense of neutral is absolutely necessary for running policy because you need to know whether your policy is stimulative or restrictive. You can’t run policy without that. It’s just conceptually incoherent, in my opinion.

I do think we have to remain humble about whether we can know where neutral is and, if so, where it sits. But my broader prescription for policy would be to stop being such micromanagers and stop freaking out about small wiggles in the data.

I’ve written a lot about this. We’re really bad at measuring inflation. Inflation is a lot like R-star, right? I know what the price of a barrel of oil is. I know what a barrel of oil is. I don’t know what the general price level is, and I don’t know what changes in the general price level are.

The general price level has to be constructed. It has to be estimated like our, you know, like R-star. And every step along the way of that construction entails significant methodological choices, right? How do you adjust for housing? How do you adjust for technological improvements? How do you weight? What weighting scheme do you choose? Are you only looking at out-of-pocket expenditures, or are you looking at expenditures that households consume, regardless of whether they spend money on them.

Every single step in the construction of inflation is methodological choices. And there are reasons for preferring one choice or another. But, you know, Moses didn’t come down from Sinai telling you that PC construction is better than CPI construction. These are all, at the end of the day, very, very questionable choices. And there’s a wide variety of reasonable alternatives.

The measurement error in inflation, I think, is very significant and very often significantly dominates the actual misses that we see from the target. And so, everyone freaking out about inflation being 50 basis points below, or 25 basis points below the target in the pre-Covid period struck me as really, really silly because the measurement error in inflation was way, way, way, way, bigger than that. And so, to me, it strikes me as just really, really, really profoundly silly to have a very precise inflation target when we can’t measure inflation very precisely.

And so, my opinion is that, look, you absolutely need a sense of neutral to sort of know whether you’re stimulating or whether you’re hitting the gas or the brakes. You need a sense of neutral. Can you know exactly where it is? No. But can you guess? Yeah.

But that we should also stop freaking out about sort of small deviations and small wiggles and stop trying to micromanage. And in general, if things seem like they’re okay, we should probably just let things sit where they are.

And if it looks like inflation’s really heading out of control, you need an aggressive hiking cycle. If it looks like we’re heading, if like we’re really heading into a recession, you need an aggressive cutting cycle. But given the noise in the data, I think that we’re just too much into micromanagement.

[00:40:43] Alan

Fair enough. As you know, we’re at the end of October. The election is coming into pretty clear focus now. Obviously, it’s going to be significant from a market’s perspective, but presumably also from an economic perspective. I mean, different policy agendas, et cetera. Any thoughts, any strong views on who’s likely to win and then, obviously, the economic impact? And then we can talk about the possible market impact.

[00:41:09] Steve

Yeah. So, it’s probably a good idea for me to stick in my lane, which is to talk about economics and markets and not make a political prediction about who’s going to win. I’ll leave that to the people who are more qualified than me.

[00:41:20] Alan

And in terms of, we’ve had more of a, I suppose, Trump trade in the markets, I suppose in the last number of weeks. Which has been rising bond yields. Do you see it that way, that a Trump win would be more, I guess the view is tariffs, possibly a stronger economy, a more inflationary economy, possibly more business friendly? That’s probably the general narrative in the markets.

Whereas, I mean, Harris, is a possible continuation of high deficits. But maybe, obviously, we already have tariffs, but maybe not new tariffs. But, what would you see as the key differentiators between the two?

[00:42:04] Steve

Yeah, so I think, as you point out, tariffs are going to be a huge, huge differentiator. You know, I have a very different view from a lot of… I think that most, most economists, and policymakers, and talking heads are all sort of emphasizing how inflationary tariffs would be. But I don’t think that’s what we saw in 2018, 2019. In 2018, 2019, we saw a non-trivial increase in tariffs. And there was, as far as I can tell, zero discernible macroeconomic impact.

Inflation stayed around 2%, regardless of how you measured it. In fact, if you look at PCE inflation, you know, it went from slightly below the 2% target to even further below the 2% target. I think that there was very little discernible macroeconomic impact of the tariffs.

And I think the reason why is because they were offset by moves in the currency. And so, the effective tariff rate on Chinese imports went up by about 17 percentage points. You know, less than 25 because there were some exempted categories.

The move in Dollar/China, Dollar/China moved higher at the same time because growth prospects in China became worse, because growth prospects in America became higher, not because of changes to expected Fed policy. The spread between the US two-year yield and yields in the rest of the world were actually narrowing at the time the dollar was strengthening, as people expected. All those Fed hikes in 2018, 2019 didn’t materialize. And then, as we said before, the Fed turned around and started doing not QE, QE. And so, the move in Dollar/China was just a couple percentage points shy of that.

So, what that means is that after you adjust for the change in the currency, the after-tariff dollar import price arguably, in aggregate, didn’t really move that much. The increase in the cost of the product, because of the tariff, was offset by the strengthening of the dollar that led to very little inflationary consequence. So, I think that folks who are emphasizing that, “Oh, there’s going to be so much inflation because of tariffs”, I think that’s completely wrong and it’s completely inconsistent with the experience we had last time.

The other major difference that I think is going to be significant, between potential second Trump administration and the potential Harris administration, is policy for the supply side. I’m a big believer that regulatory policy matters enormously and that, in particular, lots of stuff around permitting, and climate, and land use restructurings, and licensing, and labor licensing, and stuff like that, that’s all very, very significant in terms of its effect on the economy.

Economists have a really tough time grappling with that because it’s tough to measure. Regulations are numerous, they’re heterogeneous, they affect different firms, differently in different sectors, but they’re profoundly important in economic decision making, but they’re more difficult to measure than a tax. So, economists have a hard time grappling with them. But I think that it’s very significant.

The regulatory burden (I was just looking at a chart yesterday, I think from Piper Sandler), the regulatory burden imposed can be several percentage points of GDP, from administration to administration, and can swing in terms of the dollar value of the regulatory burden. That’s something that I think would be very, very different, and I think that’s very significant for potential growth. And I think that it’s very significant for its disinflationary effects, for allowing the supply side to more dynamically adjust to changes in demand and to respond to a changing economic environment and allow for non-inflationary economic growth.

And so, my opinion, again, this is just, you know, my own opinion for whatever it’s worth, is that was a major difference between the last two administrations, and a significant portion of why we were able to have a non-inflationary 3.5% unemployment rate in 2019, but then an extremely inflationary 3.5% unemployment rate in 2022, 2023.

[00:45:55] Alan

And I mean, practically, what are the examples of that? I mean, I know Trump talks about deregulation, supply side, business friendly. I mean, what kind of specific policies would that translate into, do you think, in terms of supply side freedom or deregulation?

[00:46:12] Steve

Yeah, It’s very diverse on an industry by industry, job by job basis. But broadly speaking, there are a few major categories: environmental stuff is a major, major one. And so, just off the top of my head, if you look at the Infrastructure Investment and jobs Act of 2022. That was sort of one of the major pieces of so called Bidenomics. That required requirements that cars come with equipment to automatically disable idling to reduce carbon emissions.

That’s the type of thing that, okay, it achieves a climate goal that the administration deems important, but it also is a checkbox that the auto manufacturers have to produce that make producing autos in America more expensive, increases the cost of production. There’s a whole compliance burden that goes with it because now firms have to make sure that they’re doing it in a way that actually complies with the laws written and with the regulations as written and enforced. And, you know, it’s just another step in the process.

And so, this is just an example of that you’re forcing to add something to the car that purchasers of the car may or may not want. Some people may want it. And if the auto producer finds it profitable to add, to offer that as an option because people want it, great. You know, that’s how a market should work. A market should get products people want to the people who want them. But by forcing it across all things, you’re sort of just raising the cost of making cars, which then makes the American auto industry less competitive. It raises prices. It drags on the economy. It’s inflationary, you know. But you can sort of go across the entire thing.

The EPA has set up an entirely separate regulatory apparatus for semiconductors, you know, not statutorily required, just entirely separate from the rest of the semiconductor industry just for, you know, making semiconductors. That’s an entirely additional set of regulatory loopholes to go through if you’re building a semiconductor plant.

At the same time that we are, you know, sort of funneling many billions of dollars into the semiconductor industry for what, in my opinion, are very sound national security grounds. You know, I think that’s a good policy. But we’re also making it more expensive to make semiconductors here by creating additional environmental loopholes that semiconductor manufacturers have to jump through that other manufacturers do not. An entirely additional set of monitoring, testing, you know, compliance, preparing for inspections, all this stuff.

And so, you’re slamming on the gas and, at the same time, you’re putting restraint restrictions on how it can happen. And of course, the natural consequences is lower potential growth and higher inflation.

[00:48:58] Alan

I mean, you mentioned Yellen plans to step down regardless. And there’s been a lot of speculation around future Treasury secretaries. The latest one, Scott Bessent has been the name that’s kind of been mentioned a lot. I read a couple of articles around his kind of policy suggestions and ideology, more around deficit cutting and being in favor of a relatively strong dollar, which is kind of different to what we’d heard from Trump kind of earlier in the campaign. Have you any insight as to who are the likely candidates or what the impact would be? Does it matter or do you think who the Treasury secretary will be?

[00:49:35] Steve

Oh, I think it absolutely matters because I think that it’s a very influential seat and whoever is in that seat is going to have a lot of influence with the President and in deciding the direction of economic policy. I think it sounds like Scott Bessent is enormously qualified based on his background and illustrious career in markets.

I don’t have an idea who it will ultimately be. I think folks on both sides are focused on winning the election, and that decisions like that won’t get made for a while.

[00:50:16] Alan

Just going back to then kind of linking this to what we talked about earlier with the bond market. Obviously, we also have the issue of the debt limit coming up again towards the end of the year.

So, I mean, obviously there’s so much uncertainty in terms of who’s the President, what’s the shape of the House and the Senate. But I mean, how do you see that? You know, basically the can got kicked down the road the last time. Do you think this is going to be a flashpoint in markets again or any thoughts on how it might play out?

[00:50:45] Steve

Like you said a moment ago of Mr. Bessent, I would expect that if President Trump wins the election, I would expect him to be more concerned with deficits because the amount of borrowing is pretty big right now. And I think that it is important to get the deficit back on a sustainable path.

And I think lots of folks are underappreciating the future dedication to that, should he win, because we’re on a fiscally unsustainable path and you’ve got to find ways to pay for the things that you want to accomplish. As you mentioned, the Fiscal Responsibility Act suspended the debt limit last year and that suspension expires at the end of this year. So, when Congress comes back on January 3rd or something, I think the debt limit binds again.

In the last refunding announcement, the Treasury indicated that it was going to end the year with I think, $700 billion in the general account. That means that we’ll start the year with about that in the balance. And then once the debt limit is reinstated, you then have that $700 billion to spend down until you reach what people call the X date, the date at which you run money for funding the government and paying interest in principal on the maturing debt.

There are some other sort of tricks the Treasury has that they can do that they call ‘extraordinary measures’, basically borrowing from various other government pots of money. The Treasury can basically write IOUs to extend things beyond the general account. But broadly speaking, this will push the key date out until probably the third quarter of next year sometime.

So even though the debt limit is reinstated on January 3, the do-or-die date isn’t probably until the third quarter or so because of the spending the general account and the extraordinary measures that Treasury can use. And I think it’ll be a priority next year, regardless of who wins the election, to start dealing with this right away.

[00:52:54] Alan

Okay. And I mean, you touched on that the Treasury general account, which is basically the Treasury’s kind of balance at the Fed. I mean, linking that to what we were talking about earlier, if they’re running that down, presumably that means they’re spending out of that account as opposed to issuing. Is that a potential positive from a liquidity perspective in this kind of the first half of the year?

[00:53:14] Steve

Oh, absolutely. That is a huge liquidity injection into financial markets if they spend in the general account. And the reason is because, you know, first of all, they stop issuing new debt. And so, the Treasury is not injecting additional interest rate risk into the markets. And then they also are injecting liquidity by converting what are essentially public savings that you could think of as being stuffed into a mattress. And taking that and injecting it into the private sector by spending that down into expenditures into the private sector. And so, it’s a huge liquidity injection.

[00:53:51] Alan

Okay. I mean, putting all that together from a fixed income perspective, it sounds like that’s a possible positive in the markets. But at the same time, you’ve got this kind of terming out of the T bills that we’ve talked about earlier. And obviously we have high deficits concerns. I mean, on a medium-term basis, what’s your outlook on fixed income and 10-year yields given all of that?

[00:54:15] Steve

Yeah, I think that unless we start to address the deficits, I’m worried about the bond market on a medium-term basis. I think that addressing the deficits is absolutely key because that’s the fundamental driver of the high bond supply, and that’s the fundamental driver of, I think, what will be weighing on bonds over the medium term.

The term out is going to be significant if and when it happens like we were talking about before. I don’t know when it’s going to happen, if it’s going to happen. For all we know, they’re never going to term it out, and they’re just going to sort of permanently accommodate higher bills in the market. There’s no legal requirement for them to term it out. It’s just a matter of best practice and sticking to democratic norms. So, for all I know, it’ll be like that forever. That’s sort of a secondary issue.

It’s the deficits, which ultimately matter, both for supply of bonds (over the medium term to long term), but also for perceptions about the soundness of the Treasury market, and the soundness of government finances. We’re staring down the barrel of accelerating concern over US fiscal solvency.

The Social Security trust fund is going to expire in 2033. And, sorry, the Medicare Hospital Insurance Fund in 2034, at which point you’re going to have to make decisions about how to move forward because the government will not be able to meet all of its obligations purely with its current expected revenue intake. So, you need to start thinking about how you’re going to be addressing those.

You don’t have to do it today or tomorrow. The longer you wait, the worse it’s going to be. But, you know, you’re not staring down the barrel of the gun that’s not going to fire on you today. But, you know, it’s coming into sight over the course of the next decade.

[00:56:08] Alan

And in terms of the kind of the composition of the buyers of Treasuries, I mean, a lot has been talked about and written, you know, obviously with geopolitical concerns with China, that may be less of a source of demand. I mean, is that a concern in terms of the geopolitical dimension? Unless maybe the dollar standing being somewhat diminished because of geopolitical risk? Do you see that as a significant risk within that whole discussion?

[00:56:36] Steve

I don’t at the present moment, in large part because there’s not really a good alternative. You know, the US Treasury and the US dollar are liquid, reliable, deep markets that can absorb transactions, that can absorb savings, that can absorb assets being parked there and that unless you go in and invade a neighbor, you know that you’re going to get your money back. There’s not really an alternative. Like, where else are they going to keep their money? The gold markets not big enough. And even the flows that we’ve seen so far have sent gold, you know, soaring.

There’s nothing that’s big and deep enough, you know, something like a lot of these crypto assets have deflation built into them where the supply declines over time. And so that’s not really suitable to something where you need an increasing supply to fund increasing transactions and savings the way the Treasury market increases over time.

So, without an alternative, they’re sort of stuck. They’d love nothing less than to stop using the dollar and the Treasury, but they’re stuck. They have no choice.

[00:57:38] Alan

Good stuff. We’re coming up on the hour, just being conscious of time. We always like to just wrap up by getting our guest’s insights on any advice they would have for people who are interested in their chosen field. So, I guess you studied economics and macroeconomics.

Anything through your career that you’ve read or done that has been very influential, or any advice you have for people who want to get deeper into macro analysis.

[00:58:06] Steve

Sure, I guess one really interesting thing about the way that macro is done in the financial industry is that look, central banks are important. The central bank chooses an interest rate, and that moves fixed income markets, and then lots of other markets trade off of fixed income markets.

So, you need to study central banks. That’s absolutely critical.

But I think there’s lots of folks who only study central banks and look at all of markets through a central bank’s lens. So, they’ll tend to sort of focus on, oh, inflation is here, and employment is there, and that’s all that matters. But I don’t think that that’s all that matters. I think that lots of other policies matter too.

Taxes matter not just because they affect a demand impulse. Like when you move a tax rate, you know, people have more or less money in their pocket and therefore they go out and spend that. And that’s a demand impulse that a central bank might be concerned about. But they also affect the long-term growth path of the economy.

Like, people decide what fields to enter, where to live, the form of compensation, how much education or training to accomplish, what education and training to accomplish. You know, there’s how to organize their businesses, how to incorporate, where to do so, where to trade, trading internationally versus at home.

There’s all sorts of stuff that matters as a result of what are fundamentally supply side policies that affect economic growth and the economy over the long term. And I think that investors tend to have too much focus… Look, central banks are important, demand management is important, but the supply side matters too. And government policies, that affect the supply side of the economy, matter enormously for how decisions get made, and how GDP growth evolves, and how the economy evolves, and decisions that wind up getting taken.

We just lived through a period in which everyone was shouting supply side, supply side, supply side at each other for like years. And so, my advice would be, yeah, okay, central banks matter. You have to learn about central banks, but you should also go out of your way to learn about how the supply side of the economy works, and what types of government policies on that side do, and the effects that they’ll have.

[01:00:19] Alan

Interesting. Yeah, you’re right. I mean, for a long time it was central banks are the only game in town. But you’re right. I mean, it’s not so long ago that supply side economics was very much to the fore. So, that’s been fascinating to get your thoughts. I very much appreciate you coming on today.

So please stay tuned and follow Steve’s work as you can hear from today’s conversation, it’s an influential and very important time in policy and macroeconomics, so stay tuned to Top Traders Unplugged. We’ll be back soon with more content.

[01:00:50] Ending

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