Everyone got used to no inflation. I think that's what created kind of the bond bubble. You have no inflation, you can spend more than you need and you can issue debt very cheaply. And now we are having to pay that bill. So the way that we deal with this is inflation. It's the most insidious tax on the global population that's ever been invented. And you can see it very slowly. And it's a regressive tax, Ed, so it taxes everyone.
Welcome to Prof G Markets. I'm Ed Elson. It is September 3rd. Let's check in on yesterday's market vitals. The major indices rose, halting a sell-off. Treasury yields remained at multi-year highs. More on that in just a moment. Brent crude rally slowed, but it did stay above $90 per barrel. And finally, Dell shares soared 16% after posting record revenue due to AI server demand. Okay, what else is happening?
Around the world, bond markets are having their worst stretch in years. Japan's 10-year yield hit 3% for the first time in three decades. Germany's is at its highest since 2011. France's is at its highest since 2008. British 30-year borrowing costs are back at levels last seen in the 1990s, and the US 30-year yields recently hit its highest level since before the financial crisis. This global sell-off reflects the countless worries that investors are now forced to reckon with, including climbing energy prices and hot inflation due to the war in Iran, unsustainable levels of government debt, hawkish sentiment from the Federal Reserve, and also the enormous amounts of debt that is now being issued to fund the AI buildout. As we discussed earlier this week, Secretary Scott Bessent tried to bring yields down and failed. And so the big question for investors is the following: What will happen if yields keep rising? Here to help answer this question, we are speaking with John Mowrey, chief investment officer at NFJ Investment Group. John, it's great to see you again. I'll just start with kind of a broad question, which is when you look at the bond markets right now, when you look at this sell-off, which has continued into the week, what do you think the bond market is really trying to tell us right now?
Ed, great to see you. So, I think there's really, you know, there's two scoreboards. There's the equity market and there's the bond market and they both have interactions. On the bond market side, there's clear concern about deficits and debt. But what I would say is that, you know, the deficits and debt levels were pretty high 15 years ago as well relative to nominal GDP across Switzerland, Japan, the US. I think the real difference today is there's been a regime shift because for so long investors thought inflation was dead and globalization really had kind of quenched that. And today we have a shift that's going on, Ed, and I think we've moved from the cheapest being the most important to the safest. And that's not that it's a binary situation, but there's a continuum. And I think that as that trickles into supply chains, you know, inflation is part of kind of the new normal a little bit because it's almost like we skipped the insurance premium for getting everything so cheap in years past.
To what extent does the war on Iran have a role to play in this new normal of higher elevated inflation? Is it that or is it multiple things at the same time?
Well, I think the war on Iran is one key component of it. But I mean, energy prices are definitely affecting so many components of the economy and it's something that touches the consumer very directly. But you know, the high oil prices is just one part of this. You know, again, I'd kind of go back to the reordering of supply chains, Ed. I mean, if you think about, you know, we used to rely heavily on China for cheap exports, cheap labor that was basically importing labor deflation to the US. So there's a lot of things that are pulling up inflation today. Oil is definitely part of that. I think the challenge for investors and for the Fed is raising rates won't necessarily fix the Strait of Hormuz. It doesn't necessarily fix the supply chains in China. So there's no doubt that what's going on in Iran is pushing inflation higher, but I think it's a bigger phenomenon that's going on when you look at bond yields across the globe.
When we look at the prediction markets, there's now a 77% chance of a rate hike this year. We're getting increasingly hawkish sentiment from Kevin Warsh and the Federal Reserve. Is your expectation that he's going to raise rates and is the plan to essentially try to get to 2%? It seems kind of crazy at this point. We've been so far from the target for so long, but are we actually going to continue to try to get to that Federal Reserve target?
You know, it's a great question. You know, the bond markets have done a lot of tightening for the Fed. I mean, you know, you had negative rates, right? Back in COVID, now you've got the highest rates going back to, in some cases like in Japan, since '96 as you cited. So, you know, what I would say about, you know, the Fed's decision coming up with the rates is yes, they are in a tough spot because the 2-year bond yield is roughly 60 basis points ahead of the Fed funds rate. So that's a signal for them, but I think they know the complication and that is that if they raise rates, that is going to definitely increase the cost of capital, but the cost of capital is already up. I mean, everyone knows what the mortgage rates are. Everyone knows what it costs to go, you know, buy a new car today. So you already have cost of capital higher. I think the real fascinating dynamic in the market is cost of capital is up and that's a headwind, but earnings resiliency and earnings growth is a tailwind. And right now the earnings growth is beating the headwind, if you will, from the cost of capital. So, you know, it's plausible for sure that they could raise rates, but my expectation would be that it's going to be a tough outcome for them because I don't think that's actually going to fix the problem. And maybe if I can share one other observation, you think back to where rates were, they were negative, and I just want to make kind of a valuation comment around this. I don't think people fully appreciated what they were paying. We just went through a bond bubble bursting. Okay. When you have the 10-year bond yield at 50 basis points, that's like paying 200 times cash flow for that asset. So people were paying enormous multiples for bonds. And so what we've really done is normalize the bond market. Everyone thought it was going to stay that way forever, but inflation has kind of woken up and it's really rerated bond yields back to levels that are really more normal if you look at history.
Yeah. I mean, you say that basically Kevin Warsh is trying to fix this, but he might not be able to fix it. There's not much that you can do at the Federal Reserve to fix what's happening in Iran. But Scott Bessent has tried to fix it and he tried to fix it with buybacks and it didn't really work or maybe it did for a couple of days and then it didn't. What do you make of the buyback strategy as a means to lower borrowing costs in America? Is it the right strategy? Is it the wrong strategy? What do you think of it?
Treasury's job is to finance America, but there's no rule book on where on the curve the Treasury can issue that debt. It's a really fascinating topic. How many 30-year bonds is the right number? How many 10-year? What the Treasury is effectively doing is they're saying, 'Okay, we would rather finance more of America's debt at the short end of the curve.' So it's basically like taking out an ARM on America's debt, an adjustable rate mortgage. So you have to refinance more versus the 30-year fixed. So it's their prerogative. They can do it. You know, I think that it's relatively small compared to what was Operation Twist back in 2011 when the Fed stepped in and said, 'Hey, we're going to buy bonds back on the long end and sell short-term.' So it's a relatively small move from 2 to 4 billion when you think about the total size of the balance sheet of the US government, but it's in his prerogative to do so. He's getting criticized for it. But I guess I would just kind of throw out again kind of the thought piece on what's the right number for 30-year bonds that the US government should hold. And whenever he decides he's going to go out and buy back those bonds, what he's effectively doing is he's buying those back and he is exchanging what was at a lower interest rate for something that's at a higher interest rate. So that could be good if rates fall, but it looks a little bit like active management to me, which is an interesting role for the Treasury to be in.
Yeah, you mentioned earlier that the debt situation in America and kind of across the rest of the advanced world isn't that much different compared to what it was on a nominal basis or compared to GDP at least. I wonder if perhaps part of the concern for investors right now is that it seems like the longer this drags on, the clearer it becomes that our government just doesn't really care about fiscal responsibility. Like if we get to the higher numbers we get to now, we're at $40 trillion in US national debt. The longer this goes on, the more we start to realize, okay, no one's going to fix this. This is never going to change. And perhaps that might be the concern that is being priced in. Is that a concern to you? Do you see our debt and our rising deficit under this administration after he said that this was an important thing to balance the budget, at least that was part of his platform? Is that a real concern for you?
Yeah, no doubt. I mean, look, the debt continues to expand, but if you think about how we deal with debt in kind of the modern economy, it's through inflation. I mean, the reality is that we repay our debt with many dollars because the dollar and all currencies continues to depreciate over time. And everyone understands this. Everyone knows what a cup of coffee cost 10 years ago, 20 years ago, 30 years ago. So the way that we deal with this is inflation. It's the most insidious tax on the global population that's ever been invented and you can see it very slowly and it's a regressive tax, Ed, so it taxes everyone. So are we going to be able to contain it? I mean, if you look at the CAGR of the national debt, it's about 7.6% and that CAGR is pretty consistent. So we like to spend money and unfortunately when you don't pull enough in taxes and you spend more than you bring in, you've got to issue debt and the markets tolerate it. And particularly in the USA, they tolerated it because we're the strongest, most liquid, deepest market in the world. But the way that it's paid for is through inflation. And I think that for years, Ed, it was masked by globalization. And now that that's being reordered, I think that it's revealing that, hey, maybe that was temporary. Maybe inflation is permanently in the system and it's a byproduct of what we've done fiscally and monetarily, but it's also the price that you should pay for convenience. I mean, if you look again going back to what you said about what's going on in Iran, yeah, the oil markets are probably going to price in a new risk premium because it's like, hey, if the Strait gets shut down, that's a big problem. And when you have a just-in-time supply chain where everyone was used to getting things just when they needed them for their distributors and for their production, everyone got used to no inflation. And I think that's what created kind of the bond bubble. You have no inflation, you can spend more than you need and you can issue debt very cheaply. And now we are having to pay that bill. And what's fascinating though is if you told me that rates on JGBs would go from negative to 3 over the course of 3 or 4 years, I would have thought the markets would have had a really tough time. The Nikkei is at all-time highs. The S&P is at all-time highs. Why is that? It's because earnings are overpowering what's going on with the cost of capital. And so I think the Fed needs to pay close attention to that because to the extent they raise rates and to the extent they slow down growth in the economy, it could be a much more challenging situation because it's ultimately the US companies that employ all the people.
Say yields continue to rise even higher. They've been rising all week, practically all month, say it continues. What does that mean for investors? And then what does it mean for everyday Americans?
Well, I think that if you look at the continual rise in the cost of capital, there's no question that that is again a regressive tax, if you will, because that's affecting everyone up and down the economic scale. In terms of how it affects the market though, Ed, it's really going to come down to when does the cost of capital start to pull away the earnings resilience. And the reason that the market has tolerated higher rates is because we're probably sitting inside the biggest capex cycle in history. And so that's trickling to so many areas of the economy. And it's absolutely tied to the AI buildout. And so that has allowed the economy to tolerate higher rates. So no one knows exactly what that number will be when that starts to kind of erode the durability of earnings. But as long as we continue in this capex cycle, then that's going to allow earnings to be resilient and that's going to allow the markets to be resilient. And so that's really the tug-of-war right now between cost of capital and earnings resiliency. And to be honest, you know, the way you deal with it is you invest because you want to be on the side of the companies that can pass through that inflation. That's really the best gift that Americans have. We have a very open and liberalized market and anybody can do it. My kids can do it. You can open an account, you can stick in $500. Once you get that saved up, you can start it. And I've done that with my kids. I've started investment accounts and I've shown them when it's up and down. So I think that that is how Americans should try to tackle. Again, going back to the most insidious tax ever put on the global economy, which is inflation. You need to be an investor and get on the right side of the equation.
John Mowrey is chief investment officer at NFJ Investment Group. John, it's always good to see you. Thank you for your time.
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We're back with Prof G Markets. OpenAI has had a tumultuous few weeks. As we discussed a couple of days ago, roughly 700 rogue OpenAI agents hacked the machine learning platform Hugging Face in July and reportedly OpenAI didn't know about it until later. Meanwhile, the company is facing multiple legal battles. On Monday, Apple escalated its trade secrets lawsuit against the company, telling a federal judge that OpenAI is actively destroying evidence. Meanwhile, 30 new lawsuits were filed this week over a school shooting in British Columbia, which killed eight people. The suits alleged that OpenAI could have helped to prevent this as the suspected shooter had heavily interacted with ChatGPT. This all comes amid the anticipated release of OpenAI's newest model, Astra, which is reportedly the first to have critical cyber abilities. So, to get into all of this OpenAI news, we are speaking with Alex Heath, who just sat down for multiple one-on-one interviews with the CEO of OpenAI, Sam Altman. He also spoke to more than 20 people at the company for a cover story he just wrote for Time magazine. Few people know more about what's going on at OpenAI than Alex. Alex is the author of the Sources newsletter and he just launched the new Sources podcast. Alex, thank you for joining us. Good to see you. Let's just start with your interview with Sam, which was just released this week. I watched the interview. Fascinating on many levels. We'll get into it, but what were your top takeaways?
Oh man, thank you, Ed. I appreciate that. Yeah, I've been spending a lot of time at OpenAI and with Sam and we covered a lot of ground in the conversation. A couple things stood out. They are really slowing down frontier research in a way that is unprecedented in the industry. Speaks to the capabilities they're seeing that have not yet been released. They have Astra, their next family of models coming, which I've gotten to see as part of my reporting process for the Time cover story you were talking about. But no one externally has used yet. And what they saw, and I was actually in the office as this was happening, was even further frontier training runs that they have after Astra were showing, as Sam put it to me, various degrees of misalignment, which is AI speak for the AI is not doing what it's supposed to. And you see that with Hugging Face, right? The hack on Hugging Face that everyone knows about. But I think it speaks to as these models become more agentic, doing things in browsers, taking over computers, the security risks go way up. And OpenAI's research team decided, which that company is still very much a research culture-led company even with all the commercial stuff that we'll get into, that team has pushed them to slow down and they are. That said, they're also in this fierce model race. They want to get Astra out the door as soon as possible. I think it's going to be any day now. It's going to be a very powerful, capable model. And then we touched on a bunch of stuff. We touched on recent leadership departures. We touched on the IPO, Anthropic competition, the device work with Jony Ive. He told me they're going to make a humanoid robot. There's a lot to go over.
You asked him about the Hugging Face incident and the extent to which it was a security breach, an accident. Here's what he had to say in response. One of your unreleased models accidentally hacked a company. You didn't know about it for a while, right? I mean, that sounds like a safety failure.
It's a safety failure for sure. There's a question of how much you're supposed to understand that as a security issue or alignment issue. I think it's mostly been reported on as a security issue. I think I understand it personally more as an alignment issue. But in any case, yes, that was a bad thing. And I don't want us to make excuses for that because I don't believe that's how we fix it. The more we're like, 'Oh, our nice little model, he would never do anything bad,' like, you know, it was just a little eval harness misconfiguration, no problem, nice little model, that would be a very... if I said something like that, then I think you should be like, whoa, this is really bad.
It seemed as though his view is we're recognizing the problem, we've admitted the problem, so it's not that much of a problem. What did you make of his comments?
