00:00On the Treasury side, we had a little bit of what you might call intervention, and then obviously we've had
00:04a rate hike.
00:05The result is that yields at the front end are higher, back end lower. Is that the desirable outcome? Is
00:11everybody happy?
00:16Well, good question. Very difficult to answer. Of course, we never want this to go too far, because if the
00:21front end goes up and then the bottom end goes below the front end,
00:24then that's the yield curve inversion, which, of course, is the amber warning for a downturn in the U.S.
00:32I think I want to say yes, simply because near term there are some inflation risks that the U.S.
00:38has to deal with.
00:39And so ordinarily you would want markets to price in Fed tightening, which I think is true.
00:44And then at the long end, we've got the fiscal concerns, which I've written about at length.
00:48So the long end potentially suggests that there's a little easing of that.
00:52But for me, fundamentally, the U.S. is just borrowing way too much money.
00:58This is clearly the big risk to the global economy.
01:02While this works, everything's OK.
01:05But to get things back on track, at some point there's going to be a bitter adjustment period.
01:10And I think over the past few weeks, we've gone closer to the triggers that could lead that to unfold.
01:17Yeah. How do you read that move that we saw before the Treasury Secretary stepped in?
01:21It seemed like all of a sudden, you know, the debt was becoming a problem for the bond market and
01:25maybe even the vigilantes were stirring.
01:28But that hadn't been the case for a long time.
01:30And now they seem to have gone away again quite happily.
01:34So the way I framed the U.S. economy – and by the way, it's not to say that this
01:40is all bad.
01:41I mean, the U.S. has benefited enormously from this in three respects.
01:45First, it's helped drive this very helpful, given the headwinds facing the global economy and advanced economies, this AI innovation.
01:54Second, it's produced outsized growth in the U.S.
01:58And third, it's allowed the U.S. to outspend basically everyone on defense.
02:03But what's happening is at full employment, the U.S. is borrowing 6% of GDP.
02:10The federal borrowing is 6% of GDP.
02:12Every single major fiscal act since 2015 has expanded the deficit.
02:17So we have this enormous pro-cyclical expansion.
02:20This is a huge experiment.
02:22It's never happened in history.
02:23Just to give you an idea, the normal deficit in the U.S. is 2%.
02:26But this has helped driven the stock market to an all-time high, pushed household net worth to an all
02:32-time high.
02:33Households basically spend every dollar they earn.
02:35It generates the growth.
02:36And because this has gone on for so long, we feel like it's okay.
02:39But if we threaten the savings rate in the U.S., the valuations in markets, or if that share of
02:45borrowing has to go towards non-productive spending, suddenly this positive cycle can go into reverse.
02:51That's the thing that's making me nervous.
02:54Yeah.
02:54And then that catalyst, whatever it might turn out to be, Callum, what would it do to the –
02:59Well, inflation, you're saying that's what's going to be the catalyst?
03:03Yes.
03:03That's the risk here.
03:04What event do we see in the market at that point?
03:08So, this is where the Fed is, in my view, sort of doing the right thing.
03:13So, it's worth keeping in mind here, there are lots of conversations in markets that I just don't think merit
03:19any attention, such as structural dollar crisis, de-dollarization, major debt problem in the U.S.
03:27No, the U.S. is and can meet every single liability that it's issued in dollars, simply because it's at
03:34the Treasury's ability to just print those dollars.
03:37We aren't worried here about the U.S. not repaying its debt.
03:41What lenders to the U.S. and other countries, by the way, worry about is whether or not it will
03:45be worth what it is worth at issuance.
03:48And so, we factor in inflation.
03:50Bond deals are tracking inflation more than debt.
03:53And over the past three, four months, what we've seen is the risk of a short-term inflation spike coming
03:59from energy, coupled with more and more evidence that the U.S. economy is overheating.
04:03So, it's producing less real growth, more inflation, and of course, for a while, we were concerned about whether or
04:09not the Fed would react.
04:10It's sensible that the Fed reacts to dampen these inflation expectations.
04:15And note that the Treasury market has started to calm as the Fed has pivoted.
04:20So, for me, it's just another signal.
04:21If inflation is under control, the market will tolerate this borrowing.
04:25Once inflation gets out of control, then it's a completely different story.
04:28Callum, it is an extraordinarily difficult challenge that the Fed is being presented with, right?
04:34And there's so many moving parts and so many things they can't have much of a direct impact over and
04:39so on.
04:40But if you were suggesting growth is slowing and the Fed is suggesting it's not really slowing, in fact, growth
04:45is quite healthy and will stay healthy, is the Fed getting something wrong?
04:50So, the Fed still thinks that U.S. potential growth is a little bit below 2%.
04:56And recent data have been faster than 2%.
04:58And so, from the Fed's analysis and its output gap model, it will say, actually, growth is above potential, so
05:03we can keep policy tight if we need to.
05:08I worry a little bit about the following scenario playing out over the next few months.
05:13One, a re-escalation in the Middle East, which pushes up energy prices and expected inflation.
05:19Second, market downgrades to the CapEx cycle, especially in AI.
05:27And together, those things put pressure on the U.S. economy and we have a bad earnings quarter.
05:33We've had five quarters of good earnings, which have kept markets fairly relaxed.
05:38The Fed really should be hiking as earnings are good.
05:40What happens if you get bad earnings, Fed hikes on inflation risk, and then suddenly the market corrects?
05:47That, for me, is the danger to watch here.
05:49So, I think the Fed has got a window of opportunity to just tighten and send a credibility signal.
05:54If it goes too long, I think the three, four hikes priced in are much too much, by the way.
05:59I think we start to run into danger early next year.
06:01Yeah, I mean, you could see a scenario where all of that happens just at the wrong time and everything
06:06goes badly.
06:07But you think three might be too many hikes or four.
06:12But if you're worried about inflation getting out of control, then how many hikes would be enough, Callum?
06:18Well, look, it's a balancing act here because there's always a time inconsistency with monetary policy that central banks say
06:25that they're forward-looking,
06:26but often they're just reacting to the latest shock.
06:29And so, the danger is we get upside surprises in inflation that the Fed has to react to to maintain
06:35credibility.
06:36But if we were to just look forward 12 months, we would see that the trajectory for the economy is
06:41one where things are softening.
06:42And so, that short-term inflation effect, which must be reacted to, produces this unfortunate circumstance where the lagged impact
06:51of higher rates hits a weakening economy.
06:54This is often what happens with central banks.
06:56Just real quick, Callum, because we're out of time, but what do you think inflation could reach if it were
07:01to spike back up again?
07:03Well, north of 3%, perhaps towards 4%, I think, is the danger.
07:08But for me, financial conditions are reacting so quickly to inflation worries.
07:12The danger is that in the near term, we get an inflation spike in energy-oriented goods and in energy
07:19sectors.
07:19But we start to see very quickly in things like services, lots of price disinflation will be the signal that
07:25the underlying economy is weakening.
07:27This is what we see in Europe, for instance.
07:29It's not happening yet in the US, but I think that's the thing to watch out for.
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