Bonds Are Going Haywire Again — Howard Marks Explains Why

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1:20Money market matters. If money is evil, then that building is hell. The show goes on!

1:30Welcome to Prof G Markets. I'm Ed Elson. It is September 24th. Let's check in on yesterday's market vitals. The major indices declined as US Treasuries sold off. More on that in a second. Brent crude spiked above$103, adding pressure to the sell-off. And on Calci, the odds of another rate hike next month rose to 66%, and the odds of a third hike later in the year rose to 34%. Okay, what's happening? The bond market continues to flash bright red. Yesterday, the 10-year Treasury yield ripped above 5.1 % to a fresh 19-year high. The 30-year yield returned to levels not seen since 2004, and even the five-year yield breached 5%, the highest since before the financial crisis.

2:23That was despite the Treasury's attempt to bring yields down with a historic buyback program weeks ago. Treasury Secretary Scott Besant bought$6 billion worth of long-dated bonds, and still yields went up. And Besant's second buyback operation, Another$6 billion is set to happen today. Well, our guest today says that the rise in yields is no surprise. In his new memo, legendary investor Howard Marks argues that the Treasury's response was a cosmetic fix to America's economic problems. He says that buybacks will not solve a situation that is structurally unsound. He joins us today on Prof G Markets to explain why.

3:06Howard Marks, thank you so much for joining us. Looking at the yields, the 10-year is back at its highest levels in years, 30-year close to 5.4 % highest levels. In decades, the Treasury has tried multiple times to stop the bleeding here. It isn't working. What is going on? What is the bond market telling us right now? We never know exactly what the market is saying. The market doesn't tell you what it's saying. It only does something and you can infer from what's going on around you what the causes might be. When rates go up, other than when government puts them up, what it basically means is that people want more yield from a given investment.

3:54Now, why might they want more yield? The obvious reason is because if they think if they lend you$100 today, when you pay them back in 30 years, it'll buy less. And so they need a purchasing power protection or inflation premium in the yield to compensate for that. And that's common. The other reason that yields go up is because they think that the proposition has become riskier. So if they lend you$100 today, the probability that they get$100 back in 30 years, it may be a little less. So some risk. Another reason that yields go up is because there's a lot of demand for capital. And so a given use of capital has to compete with all the other uses to attract it.

4:47So yields on investment X go up to make sure that it goes to X rather than Y. So there are lots of different reasons. And as I said in the memo, I think the main reasons why rates are going up is because, number one, inflation is stubborn. and it has stubbornly been above the Fed's 2 % target for the last, well, five years. And while it has come down from nine and a half, it went down to like 2.7. The target is two. They could never get it to two. And now with the impact of the Ukraine war raising oil prices, it's up to 3.4 or something like that. So I think that's the main reason. people want inflation protection if they're going to lend you money for a long time.

5:43But there's also concern, you know, simultaneously, you know, the U.S. came out with a number of 40 trillion for its national debt. And there's concern about the impact, the meaning of that, I would say, profligacy. Why are we spending$2 trillion a year more than we're taking in in taxes? Why are we running a deficit that approaches$2 trillion? You know, if you had a brother-in-law who every year or every month spent more than his salary and put it on the credit card, you might look askance. Well, so that may be going on here. And then the third factor is that there's a very strong demand for capital at this time.

6:27And in addition to the U.S. financing the growth of the economy, which always takes place, it has to finance a deficit approaching$2 trillion. And that's at the same time that AI is drawing maybe hundreds of billions of dollars from investors in the debt market and competing with the Treasury to raise money. Just looking at the deficit as an example, which has been a problem for decades now, the U.S. debt, as long as I have been a conscious human being, has been an issue. It seems that something has changed this summer, really, at least in the bond markets. There has been a change in the tone of bond investors who seem to be a lot more worried about the U.S.

7:20deficit today than they were before, despite the fact that it has not been in great shape for a long time. I assume it might be because we're getting more and more indication that our leadership doesn't care about this at all. And you talk about this in your memo that the U.S. has this, quote, golden credit card. There's basically no talk of balancing the budget anymore. how big of an issue is this and what do you think is changing or what do you think has changed in the minds of bond investors not just in the U.S. but I guess around the world too? Ed, for historical reference, I think the last time we had a budget surplus was when Clinton left office.

8:02So that was 2000. So 26 years of deficits. One thing that has changed is the size of the deficits as a percentage of GDP. And, you know, we ran a$2 trillion deficit, I think around 21 to provide COVID relief. You know, then people kind of got used to that level and they've continued it. And, you know, it's one thing to give, to run a big deficit when you're in a recession and the government is not producing, I mean, the economy isn't creating enough jobs. There's another thing to run a deficit when you have something like the pandemic and the world economy is frozen and you want to jumpstart it back into action.

8:52But running a$2 trillion deficit at a time of prosperity, when unemployment is quite low, near a record, You know, when there is no emergency to counter, that's something very different. So when you ask what's changed, I think one thing that changed is it does seem that nobody cares about the deficit. Nobody ever talks about a balanced budget anymore, which used to be a topic of conversation and so forth. And I do think that's a change. And I describe it as profligacy. And, you know, I go back to the analogy of your brother-in-law. And, you know, if your brother-in-law was given a golden credit card, we know he'd buy 10 Ferraris.

9:37But, you know, if you're a hard-working guy and you live within your means and you don't have a big balance continuously on your credit card, you may not think that's so great. And that may be how other countries are feeling about us. I guess part of the problem here is it's not clear, it's not immediately clear to everyday Americans and doesn't seem to be immediately clear to our leadership what the consequences of running such large fiscal deficits actually is. because so far things have been fine-ish. We don't really know when this thing implodes. I guess what I would ask you is, what could those consequences be?

10:23What would it look like? Is it possible maybe that the yields would be the thing that whips our leadership into shape in terms of being more fiscally responsible? First of all, nobody knows because there's no history on what it means for a power like us to run such a big deficit. But they've been running big debts in Japan without major consequences in the financial markets. But I said in the memo that acute results like a failed auction or something like that are unlikely. and so I think your scenario of continuous rising rates is probably the more likely one and people just say you know US we're not happy with the way you're running your business and so if we're going to buy your debts especially your long debts and be exposed to inflation and debasement of the currency that is declining purchasing power and declining value versus other currencies, we need risk compensation to do it.

11:34And that makes perfect sense. By the way, one thing I didn't mention, but I think it's very important to mention to put this all in perspective, what we're talking about, Ed, is people talk about how they're thinking about today's high interest rates. It's very important that everybody recognize that today's interest rates are not high. You know, a 5.3 or 4 % 30-year bond is very low relative to history. It's only high relative to recent history. And I argue strenuously that the recent history of interest rates is the aberration. And you know, the Fed funds rate, which is the benchmark for short-term rates, and it's the main lever that is thrown on rates.

12:23The Fed can actually, unlike the Treasury with long rates, the Fed can actually change short-term rates by changing the Fed funds rate, and it does it all the time. That Fed funds rate was zero most of the time from the beginning of 2009 to the end of 2021. That's the aberration. Today's interest rates, you know, I've been around this thing since the 60s, and today's interest rates look low to me, not high. Might that signal then that we might have a lot more room to run here with yields? I mean, if this is the aberration, if this is the anomaly, and yet when we look at the fundamentals that would result in higher yields, i.e.

13:07persistent inflation that does not seem to be coming down anytime soon, spiraling fiscal deficits that is just stacking up and seemingly becoming worse and worse. Might that not mean that we're going to see even higher yields? If this is kind of a low relative to the rest of history, would you expect that it would continue to go up? The great problem in the investing and financial world, and I'm going to get a little wonky for a minute here, and I hope that's okay. We have a qualitative description of what's going on, and then we have an interest rate. And there's no way to really tell whether the interest rate is appropriate for what's going on in the environment.

13:55So today we have the environment I described to you at the outset, and then we have, let's say, a Fed funds rate of three and three quarters and a long bond yield of 5.3 or so. Put it on the balance scale. Are those interest rates right for this environment? The answer is can't tell. So, you know, we usually don't talk about what interest rates should be. We talk about whether they'll probably go up or down. We still can't tell. I think the most important thing is that people have been counting on declining interest rates for a long time, and people look at declining interest rates as a real booster for the markets.

14:37And I think the most important thing, and I think the thing we can say with more confidence than almost anything else, but I don't believe in confidence in opinions, is that interest rates probably will not be going down much, if at all, in the coming year or two, let's say. Yes, which spells implications for equity investors. I think there is an open question as to should people be selling? I mean, if we know that higher interest rates generally is not a good thing for stocks, that seems to be a question. You wrote about this in your memo. you say, no, don't sell. What is your view on this question?

15:19That was really not in reference to the high rates. That was in reference to the debt and deficit problem of the United States. So I think that as you and I said, the most likely implication of a possible implication of what's going on with the debt deficit is a demand for higher interest rates because of U.S. fiscal behavior. And maybe the right response for that is to reduce your holdings, not of stocks, because this isn't a stock market problem, not of investments in U.S. companies. This is not a company problem. You're holding of dollar-denominated assets. You know, that makes some sense. If the dollar is going to deteriorate because the government wants to debase the currency.

16:13Maybe you want to hold less dollar-denominated assets. The problem with that, as I laid out in the memo, is that there are very good reasons to be in dollar-denominated assets. We are still, I think, the best-functioning developed world economy. And so if you trade out of U.S. assets into other countries, companies or something like that, you have to face the possibility that your fundamental company level possibilities get worse. It's not an easy decision. And given that the U.S. continues to be, I think, the best functioning developed world economy, if you were going to do any, I wouldn't do very much.

16:55Part of the question here seems to be, when will our luck run out? and this is, I mean, you point out Warren Buffett has made this point, like we don't know if this is going to, if the reckoning is going to come in two years or if it's going to come in 20 years. I'm not sure if there's any way to know that, but that seems to be a pretty significant point for investors to grapple with. Do you land anywhere on that spectrum? Do you have any thoughts on how to even address that question? No, there's nothing intelligent to be said about that question. And, you know, usually in the, especially in the investment world, where in the investment world, we're not talking about fundamentals.

17:39Mostly, we're mostly talking about how people feel about fundamentals. And in the investment world, what I say is we sometimes have an idea what's going to happen, but we absolutely never know when. And I wanted to say earlier in reference to, you know, you said that maybe it seemed this summer like something switched. You know, people seem worried about it all of a sudden. There's a great saying in the investment world that things take longer to happen than we thought they would, but then they happen faster than we thought they could. And that's very true. So, you know, some people like me have been complaining about U.S.

18:22fiscal behavior for years and years. Why are people exercised about it now? And again, it has to do with human psychology. You know, cognitive dissonance says we can reject information which is at odds with our basic understanding for a long time. maybe at some point in time a critical mass is reached where you can't resist your lying eyes anymore and you say well i guess that's i guess that's the way it is maybe that was reached and you know a lot of people said to me this summer my god 40 trillion that's a lot of money for the national debt nobody ever said to me oh my god 39 trillion is a lot or 37 trillion is a lot now maybe it's the roundness of the number 40 or the the fact that we that you change that first digit But, you know, I do think that I've had more questions about the national debt since it turned 40 than I did when it was 39.

19:20It seems as good a reason as any to care about it. Exactly. Well, that's the point. The point, you don't need a very good reason for things to happen. Yes. Just before we let you go here, Treasury Secretary Scott Besson says that the yields do not reflect the fundamentals of the U.S. economy. He says that basically the bond markets are wrong or maybe that they're lying. They've got something off about what's happening in America. What do you make of that claim? Are the bond markets at the very least reflecting something that is actually true about our situation? Well, you know, there's a joke or is it a song?

20:01I forget, which says, who are you going to believe me or your lying eyes? Basically, what he's saying is that it's all in response to the inflation, and the problem with the inflation is all about the war. And I haven't seen anybody agree with that. Maybe there are people who agree with it that I haven't read it, but it just doesn't seem right to me. But as I said, nobody can tell you exactly why the market does what it does. He seems pretty confident for the first time that markets are getting it totally wrong. I'm not sure he has a choice but to say something like that. Howard Marks is co-founder and co-chairman of Oaktree Capital Management.

20:46Howard, we always appreciate your time. I recommend everyone go check out the memo that you wrote. Thank you so much for joining us. Thank you, Ed. We'll be right back. And by the way, tune in on Friday, September 25th at 11 a.m. for my first ever Founder Series live stream. I'll be speaking with Bending Spoon CEO and co-founder Luca Ferrari. You can subscribe to access that conversation and many others at profgmedia.com slash subscribe.

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23:25We're back with Prof G Markets. In a speech at the United Nations General Assembly on Tuesday, President Trump said that he could, quote, annihilate Iran. Iran's President Masoud Pazeshkin took to the same podium yesterday. He said, quote, we will never bow our head or bend at the knee. Despite these clashing speeches, U.S. officials held talks with Iran's delegation earlier this week. Trump now says he expects a deal with Iran after the midterm elections, but Iran is still keeping the Strait of Hormuz closed, and the United States continues to blockade Iranian ports. Brent crude now sits above$103 per barrel, up more than 40 % since the beginning of the war.

24:10So here to break down where we are actually at in this potential deal with Iran, we're speaking with Dan Baer, the former US ambassador to the Organization for Security and Cooperation in Europe. He is also the interim president of the Carnegie Endowment for International Peace. Dan, thank you for joining us on Prof G Markets. We are getting very mixed signals from Iran, from Trump, from the government on where we are actually, what our talks with Iran actually look like right now. What is your view on where we are? I think you laid it out quite well. I think one of the more surprising parts to me was the way that the president telegraphed that he didn't expect a deal until after the midterm elections.

24:57It may be his private expectation, but the way he telegraphed it, it's hard to discern what the rationale was to kind of expose that vulnerability. Obviously, the Iranians are well aware that the president is underwater politically in part because of the war, in large part because of the war and the knock-on effects on prices here at home. And so it seems strange to acknowledge that vulnerability publicly. I also remember that there have been multiple times where the president has come out either with very strong words or has said that they're working on diplomacy and has said one thing and gone another way.

25:33So it wouldn't surprise me if those talks that were happening, even as these tempestuous speeches were being given, if those talks did eventually, before the election, the elections even bear some fruit in terms of progress towards a progressive reopening of the straits. J.P. Morgan put out a research note recently saying that they basically cannot predict what's going to happen here. Their job is to predict and create a base case scenario. And they have said uncle and they're throwing in the towel and they're not going to do it. We spoke with oil experts on this show who agree there's no way to know what's going to happen here.

26:12Do you have any sense? Would you be able to make sense of what might happen or at least what is most likely to happen going forward? Trying to make predictions about when and what the terms of a deal would be is very difficult. And I understand why others who spend their whole time looking at things like this with enormous amounts of money on the line have thrown up their hands. I do think there are some things that we know, which aren't really predictions. But, you know, we know that even if there were a deal that, quote unquote, fully reopened the Strait of Hormuz, it would take some time both to work through the backlog and also for there to be enough trust that the Strait is actually safe for shipping.

26:56There will be added insurance costs. We can make some assumption that there's going to be some kind of added cost either in much more insurance or in some kind of tolling mechanism. And so I think we can make the prediction that the energy prices are unlikely, that the price of crude is unlikely, all other things equal, to come back down to those pre-war levels. We are going to see a medium-term at least increase in cost, and that's going to ripple through the various knock-on effects. not only obviously in fuel, but also fertilizer and other derivative products. What have been some of your other takeaways from this United Nations General Assembly, either about Trump or about Iran or about anything else?

27:39And I ask that knowing that you literally just met with President Zelensky of Ukraine. What are some of your other takeaways? Well, in terms of what the world should be focused on, I really do think we should be focused on what seems to me to be a double whammy for many of the most vulnerable people on Earth. The first being the effects of the Iran war and the way that that has driven up prices, including the price of diesel, which obviously is used to transport food, among other things, around the world. And the second of which is the wheat export, which should be starting in the coming month or so from both Russia and Ukraine.