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“The market prices over a 90% chance of hikes by year’s end.”
Join us to discuss the current global economic landscape, Fed policies, and market signals on Treasury buybacks, currency, gold, and commodities behind the AI expansion with Erik Norland, Chief Economist, CME Group.

Keywords

central banks, inflation, Fed rate hikes, treasury buybacks, currency, gold, AI impact, commodities, market signals, CME, futures

Chapters

00:00 Introduction and Erik Norland’s background
02:28 Current US stagflation and historical comparison
05:05 Fiscal deficits and inflation
07:00 Treasury operations and liquidity concerns
09:32 Currency and gold market outlook
10:25 Gold as an inflation hedge and current trends
11:32 AI expansion and commodity demand
13:05 Circular financing risks in AI chip supply chains
14:26 Market signals: oil, equities, and long-term yields
15:05 Summary and closing remarks

Transcript

S. Aneeqa Aqeel (00:00)
Welcome to the HFR Podcast. Today we’re delighted to welcome back Erik Norland, Managing Director and Chief Economist of the CME Group. Erik, welcome back!

Erik Norland (00:09)
Thank you for having me.

S. Aneeqa Aqeel (00:11)
So let’s start with the fact that the Fed initiated a new phase of raising the Fed Funds rate on September 16th. How does this sit in the context of other central bank policy rates around the world and how many more hikes is the fed funds futures market anticipating?

Erik Norland (00:27)
Yeah, so the Federal Reserve is not the first central bank to hike rates. Numerous central banks were already into their hiking cycles before the Federal Reserve decided to join them. Those include the European Central Bank, the Bank of Japan, as well as a number of smaller countries, you know, Reserve Bank of Australia, Norges Bank, for example, the South Korean Central Bank were all tightening policy ahead of the Fed.

When it comes to fed funds futures, they price generally quite a few rate hikes between now and the end of next year. The market seems to think after the PPI number, which just came out a few minutes ago before we recorded this, that there’s about a 50-50 chance that the Fed hikes at the end of October. This is a fast-moving target. A number of Fed officials have denied that they’re planning to hike at the end of October, but the market prices over a 90% chance that they will have hiked by the end of the year. and then looking ahead into next year the market prices perhaps anywhere from a total of two to perhaps five rate hikes between now and the end of 2027.

S. Aneeqa Aqeel (01:33)
Okay, so I guess on that basis, especially the remark you just made about Fed officials, do you think Kevin Warsh is going to take a hawkish tone in Thailand later this week?

Erik Norland (01:42)
Well, that’s a good question. I can’t really predict what sort of tone he might take. I think that in general, Fed officials tend to be pretty cautious ahead of the midterm elections. and Kevin Warsh is somebody who, at least given his public statements, doesn’t necessarily like to signal his intentions to the market. so I’m curious to see what he says in Thailand, but I don’t really have any insight as to what he might actually say.

S. Aneeqa Aqeel (02:07)
Right. So I want to zoom back and kind of think of past episodes of stagflationary pressure around the world and especially on the US economy. How does the current economic situation resemble past episodes? And what does this imply for how the Fed may respond, not just over the year, but over the course of the cycle?

Erik Norland (02:28)
Right. So the United States, I think, is in a sort of very mild stagflation. the economy is still growing. GDP is growing at around two percent per year in real terms, which isn’t too bad. and core inflation, as measured by the broadest measure, the core PCE, is running at around 3% year on year. So it’s running about 1% ahead of the Fed’s target.

This is a lot milder than stagflations that we had, say in the 1970s, where inflation would occasionally accelerate into double digits. We’re not seeing anything like that at the moment. But in the 1970s, the eventual solution was that the Federal Reserve chose to hike interest rates significantly above the rate of inflation and leave them there for a very, very long time, really throughout the entire decade of the 1980s and well into the 1990s.

And so, so far the Federal Reserve and other central banks seem reluctant to take the kind of really decisive action that might be necessary to bring inflation rates down. But I think there’s also one other key component to this, which is what is driving inflation. And this is a very controversial topic in economics. Sort of in general, economists I think generally believe that inflation is created by too much money in the system.

But the thing is, central banks hiked rates a lot in 2022 and 2023. They slowed the economy. They did lower rates, but not dramatically. Now they’re raising them again. I think it’s hard to argue that the reason for inflation is because central bank policy is too easy. And I would add to that that you had a lot of QE, a lot of quantitative easing on and off between 2009 and 2022.

But since then, all of the major central banks have drastically reduced the size of their balance sheets. So the Federal Reserve balance sheet and the ECB’s balance sheet, for example, are no bigger today as a percentage of GDP than they were before the pandemic. So then it’s still the question of well, if it’s not monetary policy that’s causing inflation, what is it? So some of it could be relocating supply chains, near shoring, onshoring, other kinds of disruptions to supply chains that could all be temporary, can’t really be dealt with by monetary policy.
But the last part of it, the last possible reason is budget deficits. We’re running a massive budget deficit in the US of six percent of GDP. And the US is pretty typical of the rest of the world. We have four percent of GDP in the United Kingdom, five and a half percent in France, 8.5% of GDP budget deficits in places like China and Brazil. So there’s just huge amounts of fiscal stimulus in the system. And this is problematic for central banks. If they raise short-term interest rates, they actually increase the government’s cost of funding, which in turn can create an even bigger budget deficit. And so raising interest rates can’t necessarily do anything about inflation that’s being caused by excessively easy or loose fiscal policy.

S. Aneeqa Aqeel (05:34)
Quite right. So actually that makes me think of the Treasury’s unprecedented magnitude of buybacks this last month. So from the perspective of a mandated clearing agency, which the CME is, are you able to cast light on whether the market perceived this buyback event and the subsequent Treasury auction differently? Especially in the context of the fiscal easing is this a confidence enhancer for the market? Or did it just fail to land and cause higher yields as we’re seeing? What’s your perspective on that?

Erik Norland (06:03)
Yeah, that’s a great question. And I think it’s a very, very complex question. So I’ll break it down into three parts. First, the market’s initial reaction when this was announced in August that they were going to double the size of weekly Treasury repurchases from two to perhaps four billion dollars per operation. So it can be more than two to four billion per week. So they could potentially do more than one operation per week.
Initially bond yields fell pretty much across the curve. But not for long, for about three days. And so basically what these operations do is you have you know the very liquid on-the-run bonds, like a newly issued 30-year tenure, begins to become an off-the-run bond when the next 30-year tenure bond comes out. And it’s usually liquidity problems or lesser liquidity as the bond moves to an off-the-run. And so what the Treasury traditionally does is they issue some T-bills and then buy back a portion of the previous issuance to keep the market liquid and to generate demand. So they basically doubled the size of those operations.
Then for about the next month, bond investors I think got worried about this. And they thought to themselves, okay, well, if the Treasury is increasing its purchases by issuing more T-bills, there’s two potential problems for this. You know, first of all, it may be that they know something we don’t know. So, you know, maybe they’re worried that interest rates are about to go way up, or I should say bond yields at the long end of the curve are going to go way up. And they’re trying to prevent it from happening, which makes us nervous that it is going to happen. And so bond yields started drifting higher in the US and all around the world. And then, you know, in addition to that, when the government issues T bills into the market, those are near monetary assets. A T bill can essentially be used as collateral with no haircut.
Whereas a long-term bond has a significant haircut of maybe three to six percent of its value when it’s used as a collateral owing to its duration risk. So there’s this kind of adjunct argument that by taking more long-term debt off the market and replacing it with T-bills, the Treasury is in fact expanding the money supply in a way that kind of goes around the back of the central bank.
You know, it kind of goes around the central bank as an obstacle. Central bank may be tightening short-term policy rates, but then by injecting more T-bills, it’s almost like the Treasury rather than the Fed is easing policy. And so all of sudden it got people a little bit nervous. And of course, it coincides with many, many other things, including huge amounts of debt issuance by the private sector to fund data center construction. And then the last portion of this you mentioned is bond auctions. Well, the bond auctions have actually gone pretty well.
And so I think that that’s actually sort of injected some confidence back into the market. You see, people are more confident about buying at the auction if they know they can get out of the bond when it goes off the run. And so doubling the size of these operations may make them more confident. So it seemed like in the end it kind of hurt bonds in the secondary market, but may have helped the primary market, which has a sort of feedback loop of helping the secondary market after a while. That’s my complex answer to your question.

S. Aneeqa Aqeel (09:07)
Excellent. Okay. So I will potentially come back to that later, but staying on the yields increasing and the 10-year Treasuries for a minute, that has coincided with the dollar strengthening as well recently and gold’s bullish trend has sort of plateaued. So especially the CME with currency and gold futures, what do you see signaled for the coming year? And do you expect precious metals to rebound?

Erik Norland (09:32)
Yeah, that’s a good question. So let’s start with the dollar. The dollar had generally been weakening when other central banks were raising rates and the Fed was not. So you know, when you had the ECB and the BOJ, along with you know Korea and Norway and all these other countries raising rates and the Fed wasn’t doing anything, the dollar was weakening and those currencies were rising. but as soon as the Fed got into the rate hiking cycle, that has drawn capital back into the US dollar. It’s strengthened versus almost every currency.
The only two currencies I can think of that are exceptions would be the Brazilian Real, where they’re having an election that the market is sort of optimistic about, and and the Chinese renminbi, which of course is a heavily managed currency. But pretty much every other currency is weakened versus the dollar. Now gold has had a rough time of it. Gold, I think, is a phenomenal hedge against inflation, but before inflation actually happens. And so gold prices typically have huge, huge run-ups before you have a surge in inflation. But then once the inflation actually arrives and central banks start hiking rates, it usually turns out to be bad news for the gold market. So I see gold as kind of in a tug of war here. On the one hand, higher short-term rates in the United States are not good news for gold. On the other hand, geopolitical instability, the conflict in the Middle East, the conflict between Russia and Ukraine, the presence of gigantic budget deficits.
I think we’ll keep somewhat of a bid in gold. So gold’s had this brutal correction since Kevin Warsh’s nomination was announced in January. but I wonder, and I don’t know, but I wonder if maybe it’s starting to hit bottom and have gotten to some sort of a support level that will be difficult for it to crack through. We’ll have to see. I don’t know, but I that’s kind of how I’m looking at it.

S. Aneeqa Aqeel (11:14)
Right. And certainly all the central banks around the world have already done their hoarding of gold. Erik, last question for you. Nouriel Rubini recently made the point that the global economy as a whole, not just US and China, are being bolstered by the positive supply shock of the AI expansion.
And so looking at ancillary commodities and utilities, what are the notable trends you see connected to the AI trade, especially in the context of concern rising over circular financing risk for the AI build-out as well?

Erik Norland (11:46)
Yes, I guess like three major trends. So the the the positive trends I think are first of all for copper. All of these data centers have to be wired up to the grid. And so the combination of the data centers along with surging demand for electric vehicles is creating a lot of demand for copper at a time when there’s almost no supply growth.
Secondly, natural gas. These data centers use huge amounts of electricity, it has to be generated from somewhere. The primary source of generation in the United States now is natural gas. You know, China, other countries can also use natural gas to some extent. But I would also point out this can impact other electric adjacent markets, including anything that has to do with solar panels, including batteries. So it could create a lot of demand for lithium and cobalt and other kinds of materials, maybe for aluminum. Silver is also used in solar panels.
And then the third thing, to your point about circular financing, there’s a lot of concern here that these chipmakers are lending money to the companies that buy their chips. And I think that the way to think about this as an investor or a trader would be to look at credit products. So one thing we’ve been seeing on our credit futures on the various Bloomberg credit indices is that you’ve started to see a widening of spreads versus US Treasuries. And this is very, very new.
Really, only in the last couple of weeks since SpaceX announced this $40 billion bond to buy NVIDIA chips. And this is kind of the cherry on a very large cake. You know, the $40 billion comes on top of half a trillion dollars of debt issuance so far this year just to fund data centers alone. And of that half trillion dollars, about 100 billion is at the extreme long end of the curve, around 20, 30, 40 year maturities.
And so this is having the effect of pushing up long-term rates. But I think credit analysts are now starting to ask questions about the circular nature of some of this financing and whether or not some of these bonds deserve to have higher spreads versus Treasuries.

S. Aneeqa Aqeel (13:49)
Awesome. Okay, lightning round, final, final question for you. Ahead of the midterms, which are coming up very quickly. What are you watching? What are you keeping an eye on in the markets?

Erik Norland (13:59)
Right. So I think that there’s so many things going on. I’m keeping a close eye on oil prices, for example. Oil prices continue to drift higher at the back end of the curve. I think this is very interesting. You know, when we look at oil prices, we tend to look at what we call the front month contract, which it now would be the contract for December delivery that expires at the end of November. But if you look at further out, if you look, for example, at the June contract or the December contract for 2027.
Those are inching up higher almost every single day. And so what that tells me is the market is preparing itself for a conflict that perhaps lasts longer than people had initially believed. Also, you know, the various equity sectors are looking very interesting right now as well. The NASDAQ and the S&P continue to trade near record highs, relatively unperturbed by the fact of higher long-term interest rates. But when you look at the Russell 2000 and you look at most of the sectors of the S&P with the exceptions of information technology and energy, most of them are sinking in value because most of them are hurt by the reality of higher long-term bond yields.

S. Aneeqa Aqeel (15:05)
All right. Erik, thank you again for your time. It’s always wonderful to have you on. I appreciate it.

Erik Norland (15:11)
Thank you for having me.

 

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