Do you believe then that this is perhaps a buying opportunity in the bond market?
I do think it's a buying opportunity, but I think it's important to recognize that a buying opportunity in the process of a mechanical selloff, you can't know where this is going to stop. And so this can go quite a bit further if we continue to maintain our investment strategies in this manner. And if the central bankers don't wake up and recognize that hiking interest rates in no way will address fears of inflation around a war in the Middle East, in fact, it makes it harder for the investments that would ameliorate the conditions of that energy shortage and tightness. This is terrible policy. We are pursuing it without thought and we're reacting because we want people to like us.
Welcome to Prof G Markets. I'm Ed Elson. It is September 29th. Let's check in on yesterday's market vitals. The major indices declined as the US and Iran appeared deadlocked in negotiations. Brent crude climbed as high as $108 per barrel before settling around 105. The yield on 10-year treasuries hit another 52-week high. More on that later. And finally, the odds of a rate hike in October climbed to 70% on Kalshi.
Okay, what else is happening? The bond sell-off is deepening. After President Trump rejected Iran's proposal to reopen the strait over the weekend, Brent crude soared to $108 per barrel. US bonds then sold off and the 10-year yield climbed towards a 24-year high. Meanwhile, the 30-year yield is now at its highest levels since 2004. European bonds also sold off with French borrowing costs at their highest level since 2008 and stocks fell across the world as investors grapple with what persistently high yields might mean for the equity markets. Joining to discuss this, we are speaking with one of our favorite market commentators, Michael Green, CEO and CIO of Tier 1 Alpha Asset Management. Michael, great to have you back on the show. Let's start with yields here. The 10-year coming up close to 5.3, it's above 5.2%. 30-year yield above 5.5%.
I mean, this keeps on happening. This sell-off doesn't seem to end. What do you make of what the markets are telling us, what the bond markets are telling us, and what does it mean for stocks?
Well, unfortunately, I think what it is telling us is that the mechanical properties, as you've heard me emphasize in prior discussions around passive investing, are now playing out in the bond markets. And this is particularly problematic because the bond indices that passive vehicles reference was never designed as an investable product. It was not designed to represent a specific risk which would be appropriate for investment. Instead, it was designed to represent pure representation. What is the total quantity of bonds outstanding? That means unfortunately that there's very little thought that's actually going into this bond sell-off. There's lots of narratives that exist around it that the United States is running unsustainable deficits or that France is running unsustainable deficits or that debt to GDP is higher than it has been. And that somehow or another explains the sell-off that we're seeing.
Unfortunately, that isn't borne out by the facts. If we look at a country like Australia which has a low debt to GDP, it's experiencing the same sell-off. You look at countries like Switzerland which are also running deficits. They are experiencing very different behavior in their bonds as is China which is now part of western bond index markets. What we are really seeing unfortunately is the mechanical byproduct of an investment strategy that says a bond that is trading below par is significantly less attractive in terms of incremental capital allocation as a bond trading above par even if they're from the exact same issuer. And so there's no difference in credit risk or anything else. It's simply a function of how we've decided to build the indices that is creating most of the behavior that we are seeing at this point. It's analogous to the nonsense that occurred around the dotcom cycle when a similarly improperly constructed equity index brought to light the distortive impacts of passive investing at much lower levels of passive penetration than we are seeing now in the equity markets where my work is well known. In the bond markets, this is not an investment opportunity. This is a mechanical feature of how we've structured the markets and ultimately we will have to address it.
Do you disagree then that the bond markets are telling us something that is relevant about America's fiscal standing?
I do disagree with that. I think it is absolutely false that that's what it is telling us. If it were telling us that, we would expect to see credit spread widening in the form of CDS on US credit. That is not widening, that is actually tightening. Likewise, if it was a signal about inflation, we would expect to see that priced into inflation swaps. Once again, they are going the opposite direction, suggesting that inflation is less of an issue. The only thing that we are seeing is the price behavior of the bonds themselves and it's happening on a global basis. It is not US-specific. It is not inflation centered. It is a mechanical product and increasingly the administration is beginning to recognize this. This is what Scott Bessent is indicating when he says these do not reflect the fundamentals.
I guess the question then would be why is it happening now? Because it does seem to be coinciding with something that you might expect where you might expect that bonds would be reflecting and pricing in more risk associated with higher inflation which we are seeing associated with what seems to be a less fiscally responsible government that is okay with printing trillions more dollars and it's happening now. I guess my question, if we don't think that it is that, then why is this occurring right now? Why are we seeing this sort of mechanical mistake in the bond market in your view currently?
Unfortunately, it's directly tied to the Federal Reserve not understanding what it is actually doing in a market that is dominated by these passive flows. Fed Chair Powell has very specifically said he is looking to the market for pricing signals and for information. Unfortunately, that leaves him completely exposed to the market not pricing fundamental information and instead reflecting the manner in which we choose to invest which is being done against an improperly constructed index. If it were any of the phenomenon that you were highlighting, if it was indeed fiscal profligacy, we would expect to see the dollar weakening, not strengthening. We would expect to see credit default swaps on the United States widening, not tightening. They are tightening and not widening. This is doing the opposite. The dollar is strengthening, not weakening. We are seeing the opposite of what that hypothesis would suggest. And unfortunately, people want to bury their narrative and maintain their morality where they're saying this is deserved. That's not correct. This is mathematical.
Do you believe then, if yields are mistakenly too high, do you believe then that this is perhaps a buying opportunity in the bond market?
I do think it's a buying opportunity, but I think it's important to recognize that a buying opportunity in the process of a mechanical sell-off, you can't know where this is going to stop. You have to ultimately identify the behaviors that will change around it. And again, this is the core problem with a passive investment strategy and a systematic rebalancing. It has no mechanism for those types of overrides. And so this can go quite a bit further if we continue to maintain our investment strategies in this manner. And if the central bankers don't wake up and recognize that hiking interest rates in no way will address fears of inflation around a war in the Middle East. In fact, it makes it harder for the investments that would ameliorate the conditions of that energy shortage and tightness. This is terrible policy. We are pursuing it without thought and we're reacting because we want people to like us. That is really what Kevin Warsh is doing. He's saying, I'm going to show that I'm tough and I'm credible and I want my colleagues to respect me even as he does exactly the wrong thing.
Is your view that the reason that it is pointless to be raising rates is because it wouldn't address the inflation problem which is largely a function of what is happening in the Middle East right now and that therefore it's useless?
I actually think it's not just useless. I think it's actually counterproductive. By increasing interest rates, you're actually increasing the fiscal transfers in the United States. More money is going to flow to those who are already resourced and have significant money market fund assets or bond assets, their bill assets, shorter-dated securities. They're benefiting from the increase in interest transfer from the US government. If you stop and recognize that the bond market is not a friend or partner of the US government but instead an opponent, much like you're an opponent when you walk into a grocery store of the actual grocery store itself, its objective is to sell you milk at the highest possible price. Your objective is to buy milk at the lowest possible price. If the grocery store were to turn to you and say, 'You know what? We're done setting prices. We're going to rely on you as the customer to set the price for us.' What would happen to the price of milk? It would fall. Right? Likewise, if you walked into the grocery store and said, 'You know what? I'm done negotiating prices. I'll take whatever price you want for milk.' What is going to happen? The price of milk is going to go up. That is what Kevin Warsh has told the bond market. Wherever you tell me prices should be, that's what I'll do. It's a terrible negotiating strategy. It's exactly what I would expect from somebody of Kevin Warsh's caliber, but unfortunately, it's being embraced because it largely plays to the morality that somehow or another we must be punished for the fiscal profligacy that's occurred before.
Would you admit though that inflation is still a problem and that it is rising and that if there's anything that we could do in our toolbox to address it, then something like this might help?
I want to be very clear. I don't think that inflation at 3.5% in the middle of a war in the Middle East that's driven oil prices to extraordinarily high levels should be particularly surprising or problematic to anyone. In fact, it'd be among the lowest inflationary experiences under those conditions we've ever seen in history. What I think is a real problem is the price level. And that's what we've talked about in terms of the $140,000 poverty line and the experience that many of your peers are having in which life appears unaffordable. It's not the rate of change of those prices. It's the level of those prices relative to your incomes. And the policy that is being pursued by the Federal Reserve, all else equal, will lower the quantity of jobs and job opportunities available to your generation while increasing the income that is flowing to the older generation that already has the assets and will no longer need to sell them because they are receiving an increase in income that you are not benefiting from. So this is unfortunately going to exacerbate and worsen conditions for the younger generation at the expense of the older generation. The exact opposite of what needs to be done.
What do you think will happen with rates going forward? We had Howard Marks on the show who believes that yields will likely continue to rise and therefore rates will continue to rise. We've seen this in mortgage rates which climbed to 7% for the first time in over a year. Do you think that yields will come down if they're priced incorrectly in your view or will they keep going up? I mean, what is your expectation for yields and rates going forward?
Well, at the end of the day, rates themselves have to be a non-arbitrage condition around the expectations of future Federal Reserve policy. The Federal Reserve controls the front of the curve. If it takes interest rates to 100%, we are absolutely going to see long-term interest rates much higher than they are currently. Likewise, if the Federal Reserve were to cut interest rates to 0% again, we would expect to see lower interest rates because the forward path would almost certainly reflect a lower interest rate environment. They are not predicting prices in the classic sense, nor are they establishing them. That's part of the point that I'm making that this is increasingly mechanical in its implementation. The vast majority of people who will tell you that the US government has issued far too much debt will simultaneously defend the hedge fund basis trade which is functionally a synthetic increase in the quantity of debt that is outstanding in order to arbitrage some of the pricing differentials that are being created by the inefficiencies that now exist in the bond market. So unfortunately most people will tell you a narrative that reflects their morality and their sense that the US government and other governments have behaved in a profligate manner that has almost nothing to do with the phenomenon that we're observing. These same individuals would have made the exact same forecasts 20 years ago and 10 years ago and in fact did make those forecasts. Almost nobody predicted the much lower interest rates that occurred over that time period and by and large assigned it to quote unquote manipulation even as most of the manipulation was actually designed to slightly increase interest rates over that time period through things like quantitative easing etc. That's trying to drive an increase in economic activity. It's not trying to quote unquote suppress interest rates in the way that most people think about it.
What do you think investors should do if an investor agrees with you that this is what's happening, that it is a mechanical phenomenon that we're seeing in the market due to passive investing and how entrenched passive investing has become to markets? What is one to do about that? Is there a trade? Is there an investing strategy that you think makes sense based on that thesis?
Well, I think the most important thing to understand is that what we're identifying is that there is a neglected asset. Low price, long duration bonds trading below 50s are something that is by and large ignored by the passive bid. Yes, that means that's an asset that ultimately is almost certainly underpriced. It's just a question of how quickly that will be realized. If the Federal Reserve continues to pursue the policies of chasing inflation or chasing a two-year where they've asked the bond market, hey, what interest rate would you like us to pay you? Much like that supermarket example I gave you, the bond market's response will always be, yeah, we'd like more interest. And so this cycle can continue. Eventually, the Federal Reserve will figure this out. The Treasury has already figured this out and is trying to take steps in the right direction. This is part of the reason why you see Scott Bessent increasingly trying to make Warsh aware of this phenomenon. But candidly, I just don't think Warsh is prepared to do that yet. And certainly the other members of the Federal Reserve Board, many of whom are political appointees, are very enthusiastic about the idea that they are going to somehow or another show how tough they are by fighting inflation with a tool that is totally inappropriate for it.
All right, Michael Green is CEO and CIO of Tier 1 Alpha Asset Management. Michael, we really appreciate your time and always appreciate your... I think this is, I would say it's a hot take, but it's a very interesting one and one that we will look into. Would you agree with that? That it's a hot take?
I think it's an accurate take. I think unfortunately that feels like a hot take in a world in which the vast majority of people are operating under a moralistic framework.
