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Podcast Radio News. Hello and welcome to another episode of the Odd Lots Podcast. I'm Tracy Oddaway. And I'm Joe Wiesenthal. Joe, we're back in New York.
Yeah. But the Jackson Hole episodes continue. Ha ha ha ha. That's true. You know what, by the way, oh my gosh.
The 30 year rate, by the way. Yeah. So it's just straight up the last few weeks. But it's right around as of the time that we're recording this. It's at 5.592.
And it's now hit the highest level since 2002. Wow. So a few weeks ago, we were looking at the yield curve and saying all these like, oh, now highest level since 2007. And then like it was 2004 was the other year and now we're getting highest since 2002. It really is both extraordinary speed and scale.
Yeah. And the other thing that happens since Jackson Hole is we had a fed rate. We had a fed rate. And yet yields continue to soar. And so there's an open question over whether or not that rate hike is having its intended effect in terms of dampening down financial conditions and things like that.
And another big thing in the background, I feel like I have to list all these mega trends. But the other big thing is there's been this ongoing debate over Fed's communication styles, new communication framework. What does credibility mean when a central bank is in an inflation fighting environment and things like that? We have to talk about all this. Yeah.
When you said another thing in the backdrop, which of these, I was like, which of the many things are you going to choose here because you could have said, oh, you know, this is against the backdrop of large deficits, against the backdrop of AI, spelling and the fact that big hyperscalers are spending it and borrowing at rates that are like the size of like pretty big nations. You could have said in the backdrop of longstanding questions about US global hegemony and the link between war and the dollar and so forth, etc. And so there are many backdrops. Yes. I've gone on for a while, but I chose not to know.
There's so much going on at the moment. They don't relate to rates. It all relates to rates and we do in fact have the perfect guess. Someone who can opine and share her research on many of these things. We're going to be speaking with Carolyn Fluger.
She is an associate professor at the University of Chicago Harris School of Public Policy as well as a visiting scholar over at the Chicago Fed. And she presented a very famous paper at Jackson Hole a couple years ago. We didn't get a chance to talk to her when we were in Jackson Hole, but we're going to make it up right now. So Carolyn, thank you so much for coming on all thoughts. Thank you for having me.
It's really great to be here. Why don't you give us the sort of 3,000 foot overview of your research? What's your specialty here? So most broadly, I'm interested in how the macro economy, monetary policy and inflation are reflected in bond markets and are in turn shaped by them. I think that's a pretty interesting topic because...
We did too. To me, the macro economy and inflation unemployment, those are the big questions. They're not easy to answer, but that makes it all the more intriguing to me. And of course, financial markets are unique in that they're sophisticated. They're forward looking, so a lot of these things get priced in and that's what I find very interesting.
You said that you think about the way various things get reflected in the bond market, but then also how the bond market then reflects back on to quote the real economy or the real world or whatever. That part doesn't get discussed as much as it seems. It seems like for the most part, people when they think about the link between the real economy and the bond market, it seems like they mostly make, you know, goes in one direction. So it's interesting to me that you said reflected back. Yes.
So that brings me to my research on the policy reaction function. Now, what is a policy reaction function just as a quick definition? Most simply, that's what markets or observers more broadly expect the Fed to do in response to economic conditions. So as a numerical example, if forecasters expect 2% inflation, they might forecast 4% policy rate. If they expect 4% inflation, they might expect a 6% policy rate.
So that would be a 1 for 1 adjustment, a perceived policy reaction coefficient of 1. And that will, that matters, this policy reaction function matters for at least two reasons. And one of them comes back to your question, this reflection back, which is that if the policy reaction function is well understood, then that means that as data comes out, unemployment, inflation and so on, the policy rates will move in the direction that the Fed intended and thereby help with monetary policy transmission or maybe even speed it up before the next FOMC meeting. So this is the market doing, quote, the Fed's work for it, apparently. Yes, but if the reaction function is understood.
Correct. That's why the understanding is important, right? So if there is whatever the intended policy reaction function is, if it's well understood, markets will adjust in response to inflation news coming out and unemployment news coming out and so on. How are you actually measuring how the market incorporates its future expectations of Fed policy? Because there are a number of ways that you could do it, some obvious ones, but what are you looking at specifically?
Yes, that's a great question. I mean, I think the main point is that a policy reaction function can and should be measured. And what my core is and I have done, I would think of is actually the most obvious way of doing it, which is, I think, always a good starting point. So this is joint work with my core is Michael Bauer, this is Francisco Fed and Adi Sonder, I'm at Harvard Business School. So we took two approaches.
The first one is based on forecasts. We didn't run our own surveys because we wanted to know, you know, how have these perceptions changed over time historically, over decades. And, you know, a policy reaction function is quite similar to a 1993 type Taylor rule, but there are important differences. The first difference is that it's forward looking. So it's about expectations.
The second difference is that it's a little bit shorter run. It's about the next couple of quarters, at most the next couple of years. And traditional monetary policy rules are used to describe historical data on a backward looking manner. What we said is, hang on, rather than using this historical data, let's just use forecasts, survey data, interest rate forecasts. And it turns out that every month, there is a lot of richness in terms of the forecasts that are being produced for the policy rate.
And so we use this data from the blue chip of financial forecasters, which asks, what is your forecast for the Fed funds rate? And what are the underlying assumptions that you use for inflation and output to come up with this policy rate forecast? So it's in a way, it's an ideal set up because it's asking, what is the rule for the Fed that you're plugging in? And so we just took this data that's forward looking, you know, 3250 forecasters, a couple of forecasters, up to six quarters out, and we ran the exact same regression that you would run for a monetary policy rule, but, you know, on this different data, forward looking data. So, yeah, if you basically treat this, we can't run experiments on the macro economy, but if you treat this data as the best approximation of an experiment on the macro economy, you know, we ran a regression of the forecasted Fed funds rate onto forecasted inflation and forecasted output relative to potential.
And so the coefficients there on inflation would tell us when forecasters are forecasting high inflation, how much higher is the expected Fed funds rate and vice versa, for example. So that's the first methodology. The second one is closer to what I said about the macroeconomic announcement dates and rates moving in response. That's a way you can use that also to obtain a market perceived rule, just to say if inflation comes out higher or lower than expected, let's say inflation comes out higher than expected and interest rates, say the two year rate goes up a lot, then, you know, that is also a regression that we run.
You need a couple of observations, of course, it's a rolling window, but you can run this regression of how much do yields change onto what's the inflation use on that day. And that gives another way of getting a perceived reaction function. It turns out that both of these methodologies often give very similar answers. And I love that because it makes me a lot more comfortable with either methodology. So one thing I'm curious about is, okay, you know, you look at market reactions and you get there's one number there, right?
There's a lot of different views of the market, but it's one number. Whereas if you're doing a survey, you're going to get, you can average them together, but you can see all the different views. Something I'm curious about with the surveys or anything is whether we see historical changes over time with respect to, I suppose, the spread or the dispersion of views. Are there times where people in the market have, you know, there's a clear consensus of what market participants or forecasters perceive the reaction function to be? And are there times that we could point to where there is a lot of ambiguity on the part of market participants?
Yes, that's interesting. So we have focused on the variation over time in the point estimate of the reaction function. There clearly is a lot of heterogeneity across forecasters. We've looked at that a little bit, but we've really focused on how does it vary over time? But you know, as one example, when there was a lot of agreement, you know, after late 2011 was when the Fed came out and gave very clear, date-based forward guidance, interest rates will be at zero and least until mid-2013.
At that point, all the Fed funds rate forecasts collapsed to zero and you'll see absolutely no dispersion. So that would be an example where the collapse. So what moves the needle when it comes to the markets policy reaction function? Is it, you know, the Fed actually doing something and raising or lowering rates? Or is it forward guidance?
Is it having a press conference where they answer a question particularly well or badly? What do you observe in terms of what actually moves the needle? Great question. And that's a question that my course has and I thought a lot about. I think, you know, just having measurement is extremely useful, whichever approach you choose, right?
So in order picking a framework or picking a communication strategy, evaluating it, I think is very important. So now what we looked at in terms of what moves the needle on the perceived reaction function, let me take you back to 2020. It was not a good time for any of us. But so that was the time of the pandemic initially. Inflation was extremely low and in 2021 inflation then picked up and there were some of these really big positive inflation surprises. That was also the time where there was the discussion of, you know, as inflation permanent,
as a transitory initially word. We need to get a transitory. Yeah, yeah, for a no. The Fed initially just kept interest rates at zero. It was also the time when there was this now old new framework of average inflation targeting in 2021.
Yeah. So the interest rates stayed at zero for quite a while, even though inflation was running at five, six percent. And the perceived reaction function that we saw at that time was extremely flat. So there was a perception that that the policy rate would stay at zero pretty much irrespective of economic conditions. And you saw that, for example, in May 2021, that was a particularly positive inflation surprise.
That was an inflation surprise of almost half a percent. So annualized the surprise component was six percent. That's huge. And the two-year rate didn't move, not at all. And you also saw that in the forecast, which were all very, very close to zero.
And that was true for the forecasters who had higher inflation expectations. That was true for the ones who had lower inflation expectations. So that's a little bit the nice thing about our data set because of course there was a very big good ship transitory as power quality at some point at the time. A lot of people thought inflation was transitory, but not everyone. And by looking at this set of different forecasters, we can also see the ones who thought that inflation would be higher.
And all of them expected zero interest rates. And that I think is quite telling about the response that was anticipated at the time. And so then, towards the end of 2021, the tone started to change and March 2022 was lifted off at first just 25 basis points. And then we saw these really, really big interest rate hikes repeatedly. And so after the Fed started to act, that's when our data, we see that the perceived inflation response really picks up.
It basically goes from zero to one between say early 2022 towards the end of 2023. So there was a very big increase in the perceived inflation response, but it occurred late and only after the Fed had started to act. So we call that the learning from actions channel. There are some market stories where we want every detail. Tracy and I have made quite a few podcasts on that basis.
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Ask radio to join the conversation right here on Bloomberg Radio. In a dream country that executes perfect monetary policy all the time. Reaction function in central bank. That's a good question. And that goes back to I think the difference between a monetary policy rule and a reaction function.
I don't think it has to be stable. It doesn't have to be perfectly stable over time. It also goes back to this much older discussion about rules versus discretion. Right. If it was just a mechanical rule then you know why I central banks needed at all.
So there is you know there are conditions change. I don't think it needs to be stable and you know the appropriate reaction may be different at different points in time. Actually what we see in our data we do a very simple exploration. We have an earlier paper in the quarterly journal of economics also with Michael and Ari. Where we look at a longer time series of the perceived reaction to output.
And we see that it varies over time and we try to systematize a little bit. When is this perceived reaction to output steep when is it flat. And what we find is that it tends to be steeper during tightening cycles. So that's when chairs Bernanke or Yellen would have said we're going to be quite data dependent. And you see that in the data in that there is a stronger perceived response to output.
Whereas easing is often sudden and then not much else is expected. So that tends to be a time when the perceived policy reaction becomes flatter. So if the markets perceived reaction function moves the most when a central bank is actually doing something. So they're taking an action rather than perhaps just talking about it. What happens if a central bank wants to be gradual in terms of raising rates.
Because we all remember 2022 the big lift off that was a pretty painful time for markets. Is there just an accepted trade off here where maybe you have to show the market that you're serious about inflation by actually doing something and that helps the market change its perceived policy function and then that helps with actually fighting inflation. But the offset or the trade off is that stocks are going to go down or there might be financial stability issues or something like that. Yes, that's very interesting. That gets me to a different branch of my research which is about the risks in treasury bond markets.
You know, I've worked on that for a long time going back and a fact that you may be aware of but many people aren't is that treasury bonds were not always safe historically. So there were periods especially during the 70s, 80s and 90s when treasury bonds were viewed as quite risky. That was the period of bond market vigilantes the inflation risk premium. And the way I measure that in the data is through the core movement between bonds and stocks. So pre 2000 treasury bonds were actually quite stock like if you will in their correlation with the bond market.
And that's a recent paper with John Campbell and Lucy Sarah at Harvard. Now post 2000 treasury bonds were safe in the sense that they had a negative correlation with the stock market. And then in the most recent period these types of bond risks have gone up again. There are many ways many reasons to care about this type of bond risk most simply if you're holding a portfolio that contains bond and stocks having a positive correlation means that there is nowhere to hide. Another reason why 2022 was so painful.
That's right. And I think that is connected to monetary policy. So in the research that I've done on that, you know, I've asked what has changed in these bond risks. Is it nominal? Is it real?
Why has it changed? Can we attribute it to deeper forces, the nature of shocks, lock versus policy? And what does it mean for yields going forward? Or not necessarily going forward but just what does it mean for yields? What I've found in this research is that inflation the inflation component and nominal bonds plays an important role.
Now that's a very natural decomposition. So the US Treasury issues regular nominal bonds which pay $100 10 years in the future. And then it also issues bonds that pay $100 increased by the inflation index 10 years in the future. And that means if you hold these inflation index bonds or tips, you don't really need to fear inflation. Whereas when you hold nominal bonds that's of course exposed.
And so if you look over time the bond risks were so positive in the pre 2000 period. And for that actually I need to go to UK data because they've had inflation link bonds for much longer. But in this UK data you see that a big chunk of these bond risks were on the inflation side. And then post 2000 the inflation component became much smaller and both the nominal and the real treasury bond risks were negative. And then most recently actually the increase in bond risks has some similarities and some differences compared to the 1980s.
The similarity is that bonds and stocks have moved together often when we see treasury bond yields going up the stock market. Tanks and about the difference is A it's not as big. We're not we're not back to the 1980s yet at least according to my data. The other difference is that a good chunk of it most recently has been in the index bonds. So it's not necessarily about the inflation component in the same way.
So I think to understand the change from the pre 2000 to post 2000 an important component is is the inflation part. Why is that? Well, in the 1980s stackflation was the thing that everyone was talking about. If you have a stackflation and you hold nominal bonds that's terrible because they become worthless. The recession is terrible for stocks. So then they move together and bonds are risky post 2000 recessions tended to be more of the demand variety.
Which means also that recessions tended to be lower inflation and so nominal bonds benefit from low inflation. And so then in some of my work with with John and Luis we have shown that this can explain why treasury bond risks changed around 2000. What the interesting question is that still remains is of course, you know, is it luck? You know, is this just if we experience supply shocks is everything going to go back to the 1980s or is there also a degree of policy to it? So I have then you know lots of models and so on.
But you know, the punch line is that it really requires a perfect storm to go back to the 1980s risky bond markets. It requires the inflationary shocks. Let's say supply shocks. The typical one would be oil price shocks or it could also be. Fiscal sort of lack of credibility inflation expectations that start moving.
So you need these type of inflationary shocks and you need a fed that's willing to willing or forced to accept the recession when these shocks happen. And I think that has been a little bit different in the past five years from from the 1980s. In the sense that the fed has been able to move more gradually. So that's the big that's really I think of it as two big differences that happened around 2000 one is the supply shocks change to demand shocks. But of course monetary policy also gained a lot of credibility and the way that shows up in my data is as a more gradual, inertial monetary policy will and that has the advantage that when supply shocks happen a gradual rule may be able to stick a soft landing.
And if that's getting priced in it means that stocks don't need to fall at the same time as as a bond. Let's talk about because you mentioned perfect storm. You mentioned oil price shocks. People look, you know, we said at the beginning there are so many backdrops to this conversation. When you look at the interest rates where the 30 year is right now, what do you like?
How do you decompose the factors just driving either in the last few years or even on the last few months or even weeks? Great. So let me let me take a slightly bigger perspective because as academics we have the we have the luxury of looking at longer data. But hopefully this is useful. So if I look at the past five years, what has changed I think is that treasury bonds have become a lot riskier.
That's the bond stock movement that I just talked about that has gone up a lot. And if you think about any sort of basic investment logic, if an asset is risky, investors should not be willing to pay as much for it or said differently, investors should require a higher return to compensate for holding this risk. And so because these risks have so gone up so much that should really drive up the yield or drive down the price on bonds because they move inversely. And so that's something that I have been working on with. Mateo and Brody from Boston College and Arir Sundaram from HBS.
We have asked, you know, are these changing bond risks? Are they priced in? Can they help us explain some of these big trends in bond yields? You know, the 10 year yield was at 11 and a half percent in the 80s. Hard to imagine.
And it came down a lot towards the 2010s and then we've seen this very substantial reversal recently. And what we find is that the expected return that's priced in bond markets actually moves quite closely with one stock cool movement. And so we're looking at the price in the data. Now you might think that's really simple. Like when we know that already.
And the tricky thing is that at the same time, of course, a lot of other things changed in the bond market. Inflation came down. And when studying bond markets, really we don't have that many, not as much of a cross-section. We don't have as many different assets as if we're, say, asking, you know, how is one stock price versus another. So that in this kind of these big time trends can lead to forecast errors and surprises.
So that realized returns can sometimes look very different from expected returns. We take advantage of similar forecast data to what I talked about earlier. And we just say, well, what's the return that you would expect on, say, 10 year treasury bond if the yield next year turns out to hit exactly what informed forecasters were expecting it to be. And once you do that, so you take out some of this forecast error component, the relationship with one stock cool movements is really striking. It's there for the US.
It's across bond maturities. You can even see it across different developed markets, which had pretty different experiences sometimes. So there's really a, there's a pretty clear evidence that markets require a higher return when bonds are risky. And so we, once we quantify that a little bit, and I'll call it a back of the envelope calculation, what we find is that roughly maybe a quarter of the decline between the mid 80s and 2010s in the 10 year yield was due to treasury bonds becoming better hedges, the other part being, among other things, inflation expectations went down. But over the past five years, or let's call it 2020 through 2025, the increase in the 10 year yield was really the majority was you can explain with changes in bonds becoming more stock like.
And, you know, of course, inflation expectations over the past five, six, seven years have been quite stable. We experienced high inflation, but if you look at long term inflation expectations, they're quite stable. And I think that's the other side of the coin that bond yields going up, then reflect increasing risks and increasing required compensation for risks. And the chaos. Now you can see it.
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Because, you know, if you think that what's driving yields is just investors asking for more compensation because the debt is perceived to be riskier than it has been previously. It feels like we need to return to a state where bonds could serve that hedging role or at least not be perceived to be as volatile or stock like as you described. I'd like to decompose that into luck versus policy. If you remember in the 1990s during the great moderation people were discussing economists were discussing was this luck or was this policy. And I think one can similarly think about that here.
There is certainly an element of luck here the nature of the shocks hitting the economy. You know that changes. And then there is the element of monetary policy which as I mentioned before having a more gradual approach to monetary policy priced in helps in keeping the bonds bond like now what is needed in the background for this gradual approach is probably something that one would call central bank credibility. If the if the if the trust is there that eventually the central bank will do what is needed then that's something that would you know in my models is something that can keep the bonds bond like.
So this is interesting because you mentioned at least market based measures of inflation expectations or break even they have been pretty stable. Yeah. So two things that calls to mind first of all I'm curious to have a theory for why because if you have a central bank that's now missed its inflation target for five years more or less at this point is it surprising that. That the market has not said you know what over the next 10 years I do not feel as confident that the fed will hit its inflation target as I used to because I've already seen the go five years and it's not there and then be like to my mind. If it is like doesn't that imply that actually the fed has is still seen as quite credible for all of their misses like if they're already the market is pricing and stable inflation not very high above target then why shouldn't we just remind that okay the fed is perceived as quite credible.
Yes that's interesting so I'm I'm not an expert on how inflation expectations are for him okay my colleague at Chicago Stefanie go has some really interesting work on that he has really interesting things work work on that. Now what I think we do see is that the point estimate the level of the long term inflation expectations has remained relatively stable yeah but at the same time we have seen more volatility and we have seen a delinking between the nominal and the real bonds so before 2000 if you were looking at nominal tenure treasuries versus the inflation expons.
The correlation was very high because no one was really thinking about inflation but that correlation when has changed so even though on average I think the inflation. The average inflation that's priced in looks looks very stable you know we have seen changes that are probably related to one certainty and that's that's something that also in my 1980s paper for example I asked you know what's the counterfactual. That explains best the bond markets the bond risks in 2021 2022 and the answer was a combination of 1980s supplies style shocks combined with a more inertial monetary policy like in the 2000s.
And so that that's something that generates more more inflationary shocks but the response of real rates and nominal rates is different because. The monetary policy that's priced in is a little more initial I don't know if you've done any specific research on this per se but we started out talking about. Various mega trends which there are many and maybe one of them we didn't mention is that the holders of us debt has changed very dramatically in recent years so for instance you have a lot more hedge funds present in the market do you notice anything or do you think about the changing I guess buyer base for us treasuries at all and how it might relate to some of your work. That is so that the buyer base is certainly interesting it's not really what my my research is about what I you know what I what I can say is that if you think about changing bond yields right so you there has been.
That was a long time there was a discussion is it a decline in the natural rate which would be productive growth is it a change in the demand for scarce safe assets or is it a demand is it a change in. The safety of treasuries themselves what I can say is that the change in the safety of treasuries themselves is a substantial component that doesn't mean that the other. Aspects don't matter but there's certainly something to the changing riskiness of treasury bonds so one of the things that people talk about a lot is just like okay let's say. We perceive the central bank to be still fairly still credible inflation is going to come back down at some point maybe more volatile than we look.
There are many aspects of the US policy making apparatus that I would say we could neutrally describe is volatile right so we obviously have a very volatile tariff schedule that has changed a lot over the last year and a half. There are two wars going on and particularly the war in around specifically. There's at least a few different there's all the spending associated with it there's the shock to the price of oil and then there's the question of whether the US is even has a powerful enough military to win a war if it wanted actually recapture the straight and so then you start talking about like well you know dollar hegemony and the US is the superpower and that has the effect that's like late is the US the superpower that we thought it was does this say anything.
Is all of these questions whether the sort of just the sort of the physical strength of the US as a power and the domestic policy volatility how much is that part of the story. Great question yes so yeah I have done a little bit of work thinking about the interlink between geopolitics and the safety and bond markets I'll say that you know I find that is even a little bit broader and a longer horizon than what I usually study. But if you go back very far to the development of bond markets they were pretty closely linked to winning wars and financing wars. Yeah Hamilton recognized this in his in his address about the public debt in 1790 where he said look most countries that are involved in a war need bond markets and the US credit is an quote here is the price of our liberty.
So he was very aware of that a famous example or maybe the most famous example of this would also be the UK the UK had a functioning deep bond market with low borrowing rates prior to the Napoleonic Wars and that helped it a lot. And that in turn winning these wars made it the undisputed military and financial power for several decades to come so you see that during this time UK. Government borrowing rates were really low and stable and then of course the US in the second half of the 20th century has held a similar position with being the military strongest country having no borrowing rates and so on.
So there's reason to think that these two advantages military and financial they're interlinked. And so what we what I've thought about with my core area read from Columbia is in a model where financial markets can become deeper and financial the capacity to borrow can take different levels. How does this shape this interaction between financial markets and the military equilibrium. And so the basic idea is that if bond markets are really minuscule they don't matter right whoever has an exogenous advantage if it's a natural moat or a mountaintop or whatever it is that country is going to be the safest.
It's going to be able to borrow at the lowest rate and end of story. If financial capacity is a little bit higher something different can happen. The country that maybe starts with an exogenous advantage may be able to save its way little by little into having a financial and military advantage. And in our model there's something like a tipping point if the system starts out on the one side one hand and one keeps getting stronger and stronger if the system starts out on the other side you get convergence to the other. And then if borrowing capacity is very high debt to GDP ratios are very high.
The causality if you will can flow in the other direction with financial market expectations becoming self fulfilling so financial markets. Expect that one country is safer they offer law financing rates and that allows for this investment to happen and which makes the expectations justified. Now this last case we think of more as my core there and I think more is a hypothetical it's not necessarily what has happened but it's kind of an interesting thing to think about that there could be a hegemonic transition that doesn't. Even involve war it's just financial markets deciding and pricing in their expectations. Who is the best AI agent.
Have you seen the yield on what do you think the yield on the Chinese actually the Chinese third year bond is. Tell me 2%. Wow. So again you know not putting words in the guest mouth. You know like talking about people are talking about hegemonic transformation without a war so we're at like 5.6 by the way we're recording this September 29th who knows what it's going to be by the time we're listening.
We have the yield of the Chinese third year bond 2% right now. That's crazy. Yeah. I remember there was a moment a few years ago where a bunch of people got really into Chinese bonds I guess because they added to the index so that would be an obvious catalyst. I want to go back to the perceived policy reaction function for a second and maybe talk about some of the recent things that Kevin Walsh has said.
So he talked about wanting you know markets to be the ball I guess but he has also emphasized financial conditions which are market driven and there seems to be a little bit of circularity there. I guess where the Fed you know maybe is reacting to market driven financial conditions but then markets are reacting to still to what they think the Fed will do is is there any way of disaggregating those two or like how you get away from that reflexivity. So yeah I can't really talk about what Walsh would say you'd need to you'd really need to ask him yourselves. What we did try in our estimation of the perceived reaction functions is we we tried to include something about financial conditions.
We included forecasts of the BAA triple A spread which which get reported in the same data set. If I remember correctly there was a little bit of a coefficient on that but it didn't really change any of the other responses. So yeah certainly discussion whether the Fed responds to financial conditions because they reflect the macro economy or whether there's something separate. But we found that kind of in terms of the response to the macro economy that it didn't really didn't really change that all that much. What's your view on supply as a factor in bond yields.
This is a big question people. Well they're good while you're going up straightforwardly because they're issuing so many of them. How does supply fit into your framework? Yeah supply is interesting and my framework supply is is very simple in the sense that in the end the exposure we're all taxpayers and to the extent that we're also holding bonds. It's just going from one pocket to another.
Now of course the real world is a lot more complicated. There are people who are long bonds. There are people who are short bonds in the paper with where we look at how our bonds stock co-movements priced. I think that's the closest that I can come to saying how this is priced. So you might have the idea that well bond markets are totally separate from the stock market.
It's all about a type of investor who's holding too many bonds and thereby if bonds become volatile or this investor has to hold even more bonds. That's when they're not going to be willing to pay as much for bonds. That's when the prices fall and the yields go up. What is interesting I think what we find is that there is actually something about the co-movement with the stock market which would suggest that these bond risks are at least to a first order priced against the stock market. That doesn't mean that additional additional specific bond market exposure for these investors doesn't matter.
It's probably there also. But I think it's just kind of interesting that there is exposure to the stock market that matters for whether investors hold and not holding too much risk or not. I remember during the first Trump administration when he passed the tax cuts and they knew it was going to widen the deficit and people were like, Oh, where's the money going to come from? And that whole time I was just thinking, well, he just passed the tax cut. We know where the money is going to come from.
A bunch more people have dollars in their accounts and maybe they're not going to go out and buy treasuries necessary with it. But maybe they'll go out and buy a boat and then the boat owner will buy some stock and then the stock holder will buy some treasuries. Like you do it is it does seem as though like, you know, when you see these fiscal events, they're often corresponding with some other part of the ledger having more cash in the pocket. That's right. Yeah. So that's an economics that's called regarding equivalence.
I think it's just a powerful argument, right? You always need to think about where does the money come from? Where does it go? And of course in reality all of this is violated. But as a first approximation, I think it's still useful to think about.
It doesn't work in reality, but it works very well. It has robust explanatory power. No, I've always found that to be very compelling. Perfect for podcasting, posting online. All right, Carolyn, thank you so much for coming on all bots.
Really appreciate it. Thank you. My pleasure. So Joe, that was fascinating. Yeah.
Really the perfect gust for this particular moment in time. My big takeaway, Bond's got to be more Bond-like. Bond's got to be more Bond-like. By the way, I think maybe I'll make this a chart of the day or something in the newsletter. You should just look at the spread between the generic Chinese tenure and the US tenure.
Yeah. Because not only is it dramatic, it just flipped during COVID. Like the US was yielding much less than US tenure yields were yielding much less than their Chinese counterparts up until late 2020. And since then it's been a rocket. And now there's over 350 basis points spread between the two of them.
It's pretty striking. That's on the spread. I would just argue that the longer term downward trend in Chinese bonds looks like it started in late 2018, 2019 when they were added to the indices. So there's an argument to be made that the benchmark index providers are the future shakers of global hegemony. Either way, I like the idea of, I mean, that's a really powerful idea that it's like, can you have like a handing off of the hedgeomon?
Can you have a classic? Can you have a handle from the hedgeomon in the financial markets alone? Yeah. But it's really interesting thinking about the way this compounds, right? Because if you have the financial advantage, if you could borrow money more cheaply, then you can reinvest that money into economic productivity, military and so forth.
And then you're just like, you can see how these things compound and snowball over decades. And okay, so the US now wants to embark on this big effort of industrialization. We had that conversation with Chris Power of Hadrian in LA talking about the ship gap and the robotics gap, et cetera. Well, we might do that. We might, but like it's going to cost us a lot more.
Yeah. Just from a sort of dollar standpoint or resource standpoint, then it would have been say 10 or 15 years ago. You can meme, invest your way to military superiority. You just have to come up with a better story than the other guys. That's right.
Vince investors. That's right. Shall we leave it there? Let's leave it there. This has been another episode of the All-Bots podcast.
I'm Tracy All-Away. You can follow me at Tracy All-Away. And I'm Joe Wiesontall. You can follow me at the stalwart. Follow our producers, Kerman Rodriguez, at Carmen Armond Dash, O'Bennett, at Dashpot, Kilbrooks, at Kilbrooks, and Kevin Lozano, at Kevin Lloyd Lozano.
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