Bonds, inflation and the Fed. Plus, Nvidia in turmoil

0:00The stock market has all the fun sometimes and heaven knows the sprawling Nvidia spy scandal is the gift that keeps on giving. But while you're all rubbernecking at that, the bond market has been producing drama of its own. US inflation is proving very sticky indeed and suddenly the Federal Reserve, the biggest, baddest central bank of them all, has rediscovered a zeal for defeating inflation with hefty rises in interest rates. Bond prices have, yet again, taken a big hit in response. Today on the show, we've found someone who actually knows what he's talking about, obviously not Rob, to tell us what it all means.

0:39This is Unhedged, the markets and finance podcast for normies from the Financial Times. I'm Katie Martin, a markets columnist at the FT in a crisp and autumnal London. Lovely stuff. I'm joined, as usual, from New York by the big man, Rob Armstrong. Rob, say hello. Hello. How are you today? Good English accent. Keep it up for the whole podcast. But also in London, another big man, Greg Peters, who is co-chief investment officer at PGM Credit. He is a bonds guy, basically. Greg, thanks for coming on. Thanks for having me. Were you never tempted to do stocks instead? Like they're much easier, aren't they?

1:16They go up, they go down. Like why do you torture yourself with the bond market? I am glutton for punishment. Right. But that being said, it fits my lack of sunny dispositions. positions. I've been called Eeyore before. So bonds are more for me. Yeah, yeah. They do suit a certain sort of person. It is.

1:35Katie Martin: That's the cliche of bond people. A little bit dour, a little bit paranoid, and good at math. And then on the equity side, you have adrenaline-addled risk monkeys. Yes. Yeah. Because for bonds people, there's only so good it can get. It's only going to gets to the point where you get paid all of your money back. That's it. That's the grand prize. You get exactly what you're supposed to get. Yeah. But so the thing that bonds really hate is inflation. Why won't it go away? We had some more data this week. It came in, US inflation came in at 0.4 % month on month in October. So that's bad. It's better than September, which was 0.6, but it was expected to be a little bit lower.

2:26Greg, make it make sense. Why is the inflation hanging around? Well, so I think there's a few things going on. First and foremost is that the demand side is actually pretty strong. So there's this demand draw that continues to drive inflation higher. And then you're also seeing these series of supply shocks and disruptions. And you put it all together, the global system is just much less efficient. And inflation typically is a virus, let's call it, that once it's in the system, it's hard to get out. And, you know, quite candidly, investors have not had to contend or really have to understand inflation since the 80s, right?

3:07It's been one direction lower really for the better part of 30 years. And so I think this is just a re-reminder of how it works. And quite candidly, I've been surprised that people have been surprised that, you know, there's just this expectation. You still see it in the forward pricing that it's going to go back to normal. And I think that's just been a mistake and will continue to be a mistake.

3:30Katie Martin: I'm really struck by the forward expectations, Greg. Like the break-even inflation numbers are like at cycle lows here. I'm looking at five-year, five-year forward inflation expectation rate. So the expected rate of inflation in the five years, five years from now. And it's been dropping like a rock. It's down near 2%. So the market's telling you, we're going to beat this thing. But the thing is not being beat. What I mean, Greg, what's going on with that? There's a math problem there, which is to say there is no math to solve for. Right? So if you do forward interest rates, there's what we call bootstrapping.

4:15It prices the forwards a certain way in a linear fashion. There's no mechanical way to do that for inflation. And so consequently, what you see is just this centering bias. So investors are not really willing to go too far afield. And so there is some movement with current inflation that drives the back end, but not nearly enough. And I just think it's the byproduct of there's no real way to price it. And so investors just typically kind of hang around the center and the mean. So the Federal Reserve wants inflation to be about 2%. So we're going to say that it's going to end up at about 2%. It's remarkably unscientific when you really think about it.

4:57Yeah, I think it's a really big deal in the marketplace that's not fully understood. And I also think it drives a lot of the pricing and tips and other things that also kind of lack that proper mechanic. For the uninitiated, like inflation protected bonds. Yeah, but we're all circling around the same thing, which is we don't know how inflation works, actually, because we're just not used to it anymore. Coupled with the inability to price it. Yeah. So it's a twofold problem. And no one really wants to kind of stick out too far from 2 % because it's hard to justify.

5:29Katie Martin: It's interesting how you fame it, Greg, as a problem of the market being able to price it, because the Fed will look at the forward rate expectations and say, what a wonderfully good job we're doing. You know, Kevin Warsh says, when you look at the market, you can see everyone believes me that I will get inflation under control. And what a generally wonderful Fed chair I turn out to be. But you seem to be suggesting that actually it's not so much Fed credibility, but market mechanics that keep forward indications of inflation under control. I think you said it well. I just wouldn't make it so kind of separated as two completely different ideas.

6:13But where it does intersect is if the markets do have a sense that the Federal Reserve or central banks are not vigilant, they're not worried about inflation, then that is a reason to untether from this 2 % measure to different levels, right? So that's how credibility manifests itself. It's OK. I guess I need to widen the distribution of outcomes on inflation because the Fed is clearly not vigilant around their core mandate here. So that's how it plays all together. But it's a little overplayed as well. So speaking of vigilance and credibility, so just a few hours before we had this inflation reading from the States on Tuesday, we had a Fed governor, Chris Waller, who at one point was punting for the top job at the Fed and was making lots of noises about how much he'd like to cut interest rates, which is something that Donald Trump would like to hear.

7:09Admittedly, this was in a slightly different macroeconomic environment. But nonetheless, he was squawking like a hawk when he spoke in London. He was basically saying, so as a reminder, the number came in on the month at 0.4%. And he was saying basically anything over 0.3. And we're going to have to start thinking about a really big rise in interest rates in December. We're going to have to really over deliver to send an even stronger message that we are not going to stand for higher inflation. And so all of a sudden, a half percentage point rise in interest rates in December is on the cards that wasn't there before.

7:47That's a big change in the weather, isn't it? It was definitely surprising to be so declarative and drawing a line in the sand, particularly, you know, in this environment where, quote unquote, forward guidance is being pulled back or frowned upon, however you want to think about it. So I think that was a surprising statement. It's important to remember, too, at the time leading up to it, when he made those comments, the number wasn't released yet. And the markets were in a lather about inflation being over, right? Markets were even expecting a softer inflation print. And so it came in complete opposite.

8:24So I don't know if he was playing the odds or probability that, you know, 0.4 wouldn't really be on the table. But I was surprised by it. But, you know, Waller knows better than anyone how difficult it is to forecast inflation. Yeah. There is a lot of noise in the inflation data on a month-over-month basis. I personally believe the markets get too worked up over a single inflation print. Well, this is what Rob always says. Omijom. Amen.

8:53Katie Martin: Omijom. One month is just one month. It hasn't caught on quite as well as Taco. I was going to say, that's a tongue quiz here, Rob. But, you know, you keep working on that one. Once again, I'm surprised that people are surprised. There is a leaning, a constant leaning for the markets and market participants to wish and will inflation lower. Yeah. And we have this kind of rule of three when we think about forecasting inflation because we're constantly being asked, oh, are you going to revise your number after a certain print? On the first month, the forecast misses what we thought. We just kind of put it to the side.

9:29The second month, if it misses again, we'll reconsider. And it's not until the third month. So three misses in a row, then we'll actually change the forecast. And I think having that vigilance around not just being a weather vane for month over month has been helpful in us pricing out inflation. The other reason I thought Waller was interesting this week is, so first of all, there's this big signal around December, which is we're going, potentially we're going to deliver a really big rise in interest rates to try and tamp this thing down. Secondly, and we just referred to this, like suddenly like forward guidance is back, right?

10:09So the message from the new-ish Fed chair Kevin Walsh has been, we're not going to spoon feed markets anymore. We're not going to tell them what we're going to do. This felt quite a lot like spoon feeding. Is that back? Are we back to the old Fed? It's unclear. I think the markets are confused by the signaling. Warsh is definitely of the mind and in the camp that forward guidance is something that was just too extreme. Right. At the same time, he's equally of the mind that Fed governors are allowed to have their own opinions and thoughts. And so I don't think he wants to tamp that down. So trying to reconcile those two often is a challenge.

10:52And we're seeing that in real time. But I think you're quite right. The markets are confused by it. It's akin to forward guidance. So where are we in the process? It's just injecting more confusion into the marketplace as far as where do they ultimately want to go?

11:08Katie Martin: I would have made the point more drastically. it's great if the fed chair doesn't want to talk but and doesn't want to spoon feed but if the rest of the committee grabs the spoon and feeds away what has the fed chair done but kind of decrease their influence relative to the rest of the committee you know what i mean he's he's giving himself the silent treatment and so he's essentially ceding power to other members of the committee which I don't think is what he planned to do here. Yeah, yeah. But either way, like it is a message that we're not going to let inflation just run away. You know, all things equal.

11:49Donald Trump always errs on the side of cutting rates because, you know, this is just one of his longstanding beliefs that the rates should be lower. And so they are showing some spine. And I think that's important because a few months ago, how worried did you get, Greg, about Fed independence? I was definitely worried. Rob talked about, you know, Waller lobbying for the job and talking about interest rate cuts, what it seemed like there was a lot of that going on and you weren't really sure. That being said, I personally believe that Warsh has been misunderstood. I think he's the ultimate Fed institutionalist.

12:23I think he cares about the institution deeply. So I think that was somewhat of a market misread. I think post midterm elections, that's less of a risk as well. You know, the institution has been tested and it's held up. And I think that's the important thing here. Yeah, I feel like the Fed's getting its mojo back here. Yeah, so do I. But so when the Fed is looking across the global economy to try and figure out what to do next, one of the things that it looks at, obviously, is the oil price. Now, since the midterm election results, obviously, the Democrats did very well. There's this big effectively trade in the market that says, okay, the war in Iran is all over bar the shouting, and the price of oil has fallen really fast.

13:11Does this make sense to you? I think it's too much of a reaction. Not sure the oil markets or the markets generally have done a great job around these geopolitical issues. I'm not sure what kind of unique insights the oil market has around what the administration's intent is. That being said, if that risk does get dialed down, energy prices should be lower, all else equal. But I think we're missing the other part of the equation. And that's just the massive drawdown that we've seen on these reserves. And, you know, I think it's been the largest stockpile depletement on record. And, you know, the US, obviously, Japan, lots of places, and there's just going to be a steady stream of drawing on that inventory that I think will just keep prices is higher, not lower here.

14:12So I think there's a little too much optimism. I think there's a little too much optimism everywhere. And I know I'm the Bond guy and the tower one. But I struggle with some of the price action that I see. And particularly, I struggle with the initial price action that has a tendency of looking through a rose colored glass. Yeah. I mean, Rob, we've spoken about this before, right? The oil market has done a lousy job of reflecting reality ever since March, right?

14:42Katie Martin: We had a nice piece in the newsletter by Hack Young on this. I mean, if you talk to market people about the oil price, they'll tell you a nice story that's a bit rosy about how we're heading back down. If you talk to politics people, they're still scared to death. Yeah. Right. You know what I mean? And I think it's important as a check those of us who live in markets we're always talking to markets people sometimes you just got to call up somebody who's in a different who's like in the real world that's made of things and governments and people and check in on that side too and if you look from that side i think the oil picture is a lot less rude yeah um hyperscaler spending is a really important part of the US economy, maybe you can help solve an argument between me and Rob.

15:35So as we've discussed on this podcast before, the hyperscalers, the big sort of AI companies are like building these massive data centres, and they're borrowing lots and lots of money so that they can build these data centres. And there is a school of thought that says that the hyperscalers are borrowing so much money that through issuing their bonds, they are sucking demand away from government bonds just by the sheer scale of what they're doing. Now, Rob has always said, that's a load of rubbish. I've always said, this makes a certain amount of sense to me. You run bond funds. What do you think?

16:07Are the hyperscalers sapping demand away from government bonds? I think it's important to remember that we're still in the early stages. So I would say that you're both right.

16:18Katie Martin: Oh, come on. And I'm not just saying that because I'm an invited guest. That answer was like kissing your butt. But somebody has to win and somebody has to lose here. Over time, that is the story. So we are still in the very, very early stages of this build-out. The CapEx numbers keep increasing. It's just massive. So over the next two years, you have$3.2 trillion of financing hitting the market. Over the next five years, you have just called$6 trillion. So that's on the AI build-out side. But another point of context is that the chip financing is only just beginning. So chip financing so far this year is$20 billion.

17:01This is before the SpaceX is actually launched.

17:04Katie Martin: So just to clarify, chip financing is literally borrowing where the collateral is semiconductors. Correct. The chips themselves. Okay. So that goes from$20 billion to$350 billion. Yikes. Next year, year over year. So that's the AI ecosystem side. And the numbers are poised to move higher, not lower. On the government bond side, we've been in a period of low financing. So you look at U.S. Treasury as an example, right? You haven't seen the increase in net issuance the past few years. That is poised to increase in a pretty meaningful way at the back end of next year and into the following two years to the tune of another two and a half trillion.

17:49And that's the same story elsewhere in developed markets. So the reason why I said you're both right is because you haven't seen it quite yet on Moss, but you're seeing it within the AI ecosystem and you're seeing it kind of within credit markets. But the story has yet to unfold. So patience is how I'd say it. Speaking of things unfolding, it would be remiss of us not to discuss NVIDIA in somewhat more detail. So we're going to be back in just one sec with Longshore.

18:28Cash Now, More Later from Opendoor gives you cash up front for your home, plus all the profit later. That's no chaos now, no cash left behind later. Skip the showings now. Pocket extra profit later. This is so simple now. This is so awesome later. Or sell fast now and pop the champagne later. Cash now more later. Now available nationwide.

18:50Katie Martin: Start your offer at opendoor.com slash ACAST. Profits calculated after fees and costs, eligibility and offer price may vary. This message is brought to you by today's sponsor, Walden University. Set a course for change. Now is the time to make a real change in your life, career, and community. At Walden University, we give you the support and flexibility to get the W. Walden's online programs are designed for working professionals like you. You'll gain hands-on skills to take on real-world challenges and succeed. Your future is waiting, and Walden is here to help you achieve it. Take the first step to make your impact.

19:27Katie Martin: Visit waldenu.edu. Walden University. Set a course for change. Certified to operate by Shev.

19:38Okie doke, we are back with Long Short, that part of the show where we go long a thing we love or short a thing we hate. Rob Armstrong, what are you saying?

19:47Katie Martin: I'm going to go long NVIDIA here. And this is not, first of all, it's not investing advice. Second of all, it's not a particularly rational stock call. I'm just looking at this stock chart. And this was earlier in October. This was a$240 stock. Now it's$160. So, you know, you've taken a third off the price. No one person, even a person as wonderful and cuddly and good looking as Yenson Wang, is worth a third, you know, a trillion dollars. How good a CEO can he be? If the price was anywhere near right a month ago, it's very attractive now. So you're saying it's quite literally cheap as chips. So, yeah, just before we came to record this, the news broke that Jensen Wang had resigned after reports of an extramarital affair.

20:41First of all, with a woman who the U.S. intelligence thinks is an asset of the Chinese government. And then with another woman who is a colleague. And that seems to have been the straw that broke the camel's back. And the stock was very unhappy when we came to record this. It was falling really hard. But at a certain point, it's got to get cheap enough.

20:57Katie Martin: I think the second affair had nothing to do with the whole thing. If you have an affair with a Chinese national that the U.S. government thinks is a spy, you've taken the camel out and you've shot it in the head. There is no straw involved. It's over when that happens. Greg? But I think the NVIDIA news is important, and you mentioned it, because their tentacles are everywhere around this AI infrastructure. Yeah. And I don't think there's a full appreciation of how large those tentacles are. So I think there's a lot more to come as far as this repricing of the AI ecosystem. That's number one. Number two, I think it's a reminder once again of the importance of corporate governance.

21:43Heck yeah. If you look at a lot of these larger hyperscaler type of entities, they don't have the same type of corporate governance as other large firms necessarily. And then equally, the key person risk in a lot of these companies are quite substantial. I think it's a cautionary tale. And investors should think more critically in assessing the various corporate governance structures in place and protections around kind of key person risk. So that would be my comment. I'm going to take it from my long to the NVIDIA drama. I just love it. It's like proper like box office stuff. You absolutely could not make it up.

22:30You don't know what's going to happen next. I love the key man risk. I love that we've now got a new chief executive or interim who I've never previously heard of, which is probably my bad. Her name is Colette Kress. Yeah. Keep your eyes on FT.com for all the ins and outs of this. We are going to have to wrap it up there. Greg Peters, thank you so much for coming on. Rob, we will be back on Tuesday, unless I'm mistaken. So, listeners, listen up then.

23:17We'll see you next time.

23:34the credit economy, like 5 million more mortgage-eligible people. Banks win and francs win, lenders win, and so do lenders. When you build credit scores the right way, everybody wins. Get started at VantageScore.com. Cash Now, More Later from Opendoor gives you cash up front for your home, plus all the profit later. That's no chaos now, no cash left behind later. Skip the Showings now. Pocket extra profit later. This is so simple now. This is so awesome later. Or sell fast now and pop the champagne later. Cash now more later. Now available nationwide.

24:11Katie Martin: Start your offer at opendoor.com slash ACAST. Profits calculated after fees and costs, eligibility, and offer price may vary.