Commenting on perhaps two of today’s driving narratives is difficult; monetary policy/tariffs and AI spending. How are they interconnected?
The markets are suggesting an 80% chance of an interest rate cut next week. One of the largest questions that cannot be answered but is a primary determinant of longer-term Treasury yields, what is the neutral rate or the interest rate that neither stimulates nor squeezes the economy.
The members of the FOMC have strongly different views. In September, the last time the data was published, 19 officials came up with 11 different estimates ranging from 2.6% to 3.9%, the latter number being roughly where rates are now.
This is the greatest divergence since at least 2012 when the Federal Reserve started publishing their individual estimates.
And then there are tariffs. It is generally accepted the yield curve will steepen considerably if the Supreme Cout overturns the tariffs given concerns that the lost trade revenue may further exacerbate fiscal issues.
Any action to restore tariff flows is likely to take time. Meanwhile Treasuries will be caught between the flood of debt sales needed to finance the federal deficit. Stronger conviction of rate cuts for 2026—given the reduction of inflation risks from lower tariffs—should keep a lid on front end yields.
And then there is AI spending. GOOG, AMZN, META and MSFT have committed more than $380 billion to AI spending in their current fiscal years. This is more than a 1,300% jump a decade ago. And they have pledged to spend significantly more in the year after that,
MSFT capex is now 25% of its revenue, more than three time what it was 10 years ago according to Bloomberg,
The key metric of spending to sales ratio of these companies is around the 20%,, well above companies in traditionally capital intensive industries like oil and gas exploration and telecommunications as per Bloomberg.
A lot of this capex is being funded by debt, debt that can crowd out the unsatiable demand for monies by the Federal government.
The yield curve started to steepen dramatically about 6 weeks ago following third quarter earnings announcements with GOOG, et. al announcing AI capital spending plans, the Administration was also dealt a major setback on tariffs during a Supreme Cour hearing, and the incessant demand by the Administration [and acceptance of by the market] for lower short term interest rates.
It is often written that the most obvious conclusions are those that are ignored. Over the last five years monetary policy has not unfolded as the Federal Reserve had forecasted. The markets have also consistently misjudged economic activity [and monetary policy].
Assumptions based on long standard precedence have not produced the expected outcomes.
Is this about to change?
Last night the foreign markets were mixed. London was down 0.19%, Paris down 0.07%, and Frankfurt up 0.17%. China was down 0.51%, Japan up 1.14% and Hang Seng down 1.28%.
Futures are relatively quiet on expectations of an interest rate cut next week and the appointment of a dovish Fed chairman. Bitcoin is staging a modest rebound. The 10-year is up 7/32 to yield 4.06%.
