Long Rate, Yen Intervention, and Fed Independence | The Trade Off

Today on the Tradeoff, the price of money. With interest rates at rates we haven't seen since 2007 and US total debt exceeding $40 trillion, today we'll discuss the economic and strategic implications. It's been a busy summer and early fall for interest rates and and debt markets. We've had interventions in the yen market, unscheduled buybacks of bonds, and eventful speeches by the Fed board and others. So, to unpack all this, we have an excellent guest with us today. We have senior advisor and non-resident scholar for CSIS, former Deputy Assistant Secretary on international monetary and financial policy, Mark Sobel. Thanks so much for joining us. >> My pleasure. >> Excellent. Well, again, I'll say this to you and and to the audience in general, I am but a humble trade economist. So, this is really outside of my area of expertise, but we we've been seeing a lot of action, more than I can remember in a long time, in these markets. So, would love to have sort of your take on this. Before we get started in the nitty-gritty of the policy and and the broader perspectives, you know, long-term interest rates are quite high now, about 5 and 1/4, again, highest rates since 2007, if if my math is correct. What are your general thoughts about where we are, what has brought us here, and any broader implications you might see? >> Thank you for having me. First of all, nobody in the audience should buy this humility from Phil Luck. He knows his stuff across the board. >> All right, too kind. >> Okay. [laughter] So, now um longer-term rates, they've been rising. Um and I think in February the 10-year Treasury yield was around four. It's hovering today just below five. You mentioned 5 and 1/4, that's the 30-year yield. Um Now, should we be surprised by this? Um I would say on the whole, no. Now, there are those who are going to make the case to you with a positive spin that this is a a very positive real growth story for the United States. I don't buy that. Um I believe there's a confluence of factors. Uh first and foremost, I believe that uh the United States is pursuing damaging, reckless fiscal policies. Our fiscal deficits uh now are about 6% of GDP. If you look at uh CBO's work, they hover around 6% if not higher for the next decade. And then, they get worse. Um So, uh that's a lot of paper for the markets to um digest. Now, right now, we've all been reading in the newspapers about AI and hyperscalers and whatnot. So, I read something that suggested maybe hyperscaler demands, including broader uh chip entities and the like, AI entities. Um the demands are somewhere like 300 billion in the long-term markets, and and you think that's a big chunk of money relative to uh the Treasury. Um so, there could be some crowding out uh going on there. Now, um inflation persistence. So, we um The Federal Reserve has a 2% target, right? Well, they've missed that for the last 5 years, for whatever reasons, understandable or not. But, they've missed it. And the US economy seems continuously buffeted, expected or not, by supply shocks. So, um AI demands come in. Energy prices soar because of the uh war with uh Iran. Am I allowed to say war? >> Yes. >> Okay. And um um And then I think that uh in the transition to the new Federal Reserve chair, there's a degree of greater uncertainty about where the Fed is headed, what what their reaction function is. Um could there be diminished trust in the US playing a role? Could um some countries be less willing or eager buyers of uh Treasuries? Um I think that's a plausible interpretation. Um And in addition to which, if you go back to the early 2000s, remember China was accumulating reserves at the wazoo, as were all the other emerging markets, and a lot of that was being poured into Treasuries. Well, since China hit its hiccups in 2015-2016, um if you look at the aggregate size of global reserves, they've been they've trended up, but nothing major. So, that that's less of a foreign bid as well there. Um and then I'd say maybe that um the buyers of Treasuries are somewhat changing. It used to rely apart from the foreigners, there was a reliance on the prime brokers, the prime dealers to take up the market and hold on to it. Um that's less the case now. Hedge funds are playing a greater role, and but they're less sticky buyers. So, I think those are um a lot of the factors underpinning um the move up in rates. Um it's not necessarily a positive story. Um and and whatnot. So, let me I've spoken too long >> No, no, it's >> in response to your first question, so let me stop there. >> I want to pit pull on two threads there. One, um so let me just I'm going to say back to you a little bit of what you said, make sure I'm understanding this. So, I mean, this seems like a lot of different factors here. We're just we're issuing an amount of debt that requires a large market First and foremost, um there's competition for debt because there's a lot of corporate debt as well as you know, we're also seeing across the G7 quite a bit of debt. Um there is the again, we've hit missed inflation expect or inflation targets on the upside for years and years now for a confluence of reasons. And I had to that a new Fed chair who um you know, wants to give a little bit less forward guidance and and markets are a bit spooked by that or at least it looks to be at certain points. >> Or he's not making even if less forward guidance, what's the reaction function? I think the markets are not certain about that. And if he's not going to speak to the reaction function, the markets are going to look for it from somebody else. But that increases uncertainty and volatility in the market. >> Okay, that's a perfect. Thank you for that. Um one thing I'd love for you to pull on if you wouldn't mind is that your point about sort of the composition. So like the the increasing role of hedge funds. Um so we saw uh the Treasury Department and and Bentsen sort of um you know, uh engage in unscheduled buybacks of bonds. Um you know, my understanding of that was largely that he was, you know, arguing that the market was not the pricing on fundamentals. The first would be, do you agree with that or do you It sounds like you've given a lot of good fundamental reasons for what we have here. The second would be like, well, maybe there is that issue to your point, if we have sort of less sticky uh even potentially more leveraged uh parties playing a bigger role, um you know, is that something we should be worried about sort of just overall? >> Well, um first of all, it is fundamentals. I think Bentsen said it was a fever. Um I don't believe that the markets are being disorderly. Yeah. Again, I think they're responding to um fundamentals. Um I thought his So, he he's done several things. I mean, you mentioned the end of an era up front, and then there's the whole question of uh the tripling of buybacks. And he didn't announce that as part of the regular Treasury refunding announcement. He in the middle of it. Um And and then there are the And then there was this issue that he mentioned with regard to Japan. It's very technical and esoteric, but the FEMA the foreign and international monetary authorities uh repo facility. So, basically, you you uh How do you finance an intervention? Um Well, if you're trying to strengthen your currency like Japan was, you sell dollars, you buy your own currency, right? And in selling dollars, you got to pay for that. So, how do you do that? You you offload your Treasuries, but that puts upward pressure on rates. So, FEMA You give the dollars to the FEMA, and it's basically collateral against liquidity from the Fed, and you're not selling Treasuries. Um So, to me, what Bessant was showing or revealing with these maneuvers was uh concern about the rise in the longer-term rates and a desire to cap them. And longer-term rates are really what drive investment. Um They drive mortgage rates. And then there's this little thing happening in November called midterms. So, so I could imagine that is what motivated him. But again, in the face of these gale-force winds of the fundamentals, our fiscal and whatnot, I think that uh Bessant was uh deploying band-aids. >> Mhm. Um So, uh so I'm skeptical about the uh efficacy of these and I really wish more attention were being paid on getting our fiscal house in order, but of course neither party uh wants to deal with that. >> Yeah, absolutely. Um yeah, and to your point, I mean, you know, I think the best in recent has talked about, you know, our the need to sort of grow our way out of our debt. That that's a argument you can make sometimes, but not when the debt is growing faster than really any plausible, I would say, argument for a level of growth of a developed economy. >> I agree with that and I would also say that um so when you think of debt GDP, there's the debt in the denominator in the numerator, which you just mentioned, but on the denominator, you know, the forecast for potential growth in the US are two two and a quarter, let's just say. >> Yeah. >> You know, they they are telling a yarn about AI is going to cause a surge in productivity and growth and we'll just grow our way out of this and the deficits will be down to 3% of GDP. That ain't happening. >> Yeah, I would agree with that. Um but, you know, it is one of those things where every problem slightly easier if you're growing fast, but >> Or you have lots of inflation, we can inflate our way out of [laughter] the debt. >> Exactly. That's right. So, to the point about sort of this, you know, the the gale force uh the gale forces here, um let's talk a little bit more about the the intervention in the dollar-yen exchange rate. So, um for those who are tracking this a little bit less closely, I think uh end of July, um the bank the uh the Japan's Ministry of Finance, uh it joined the US in buying uh yen. Uh and this sort of joint action, my understanding is the first time since 2011, so it's quite a while. Um and um I think you called this sort of operation uh the most surprising aspect of the operation um uh you know, a very surprising sort of action. Um, and what was I guess first thing that why was it surprising? Why was this abnormal? What was the US trying to accomplish and what was Japan trying to accomplish? And and did it work? >> Okay, um So, um Japan has had in recent years what I would call an overly accommodative monetary policy. Uh, in addition to which um So, so as you know, they held rates at zero for a long time. Now, that was against background of years of low inflation deflation, understandable, but they've been very they were very hesitant to raise rates even as inflation climbed wondering whether the inflation was durably going to stay a sustainable 2% target area. Um, and in the process the Bank of Japan acquired over half of the JGBs, Japanese government bonds outstanding. Okay, on the fiscal side uh Japan has huge debt. Um Uh, I think at one point it was general government debt was something gross was somewhere around 250% of GDP. It's come down since then. Um, but uh the markets have their issues about Japanese fiscal sustainability fairly or not. And um when the new prime minister came to power, she uh advocated um for, you know, increased defense spending as everybody is doing these days, but and also for some consumption tax cuts on food. So, those were seen as fiscally expansionary measures um and given the high debt loads, I think it caused some concerns. Um Interest differentials against uh US Europe very wide. Yen weakens. So, for the last 2 years, um dollar-yen sometimes has gravitated towards 160, uh which I think the Ministry of Finance is responsible for FX matters in Japan. Um and I think they saw that as somewhat of a line in the sand because the Japanese public does not like the weak yen. They think it adds to inflation and erodes real incomes. Um but they're not going to change their fiscal policy, and they weren't at the time changing their monetary policy. So, you know, what do you do? If you're a policymaker, you got to do something. So, you know, you you you jawbone, um you rate check, and then you intervene. And when they intervened, it would basically take some of the short position out of the market, so the yen would rise, and then it would go back. So, I guess what I'm trying to say is the markets were not disorderly. Coming back to fever earlier, >> fever? >> No, they There was a misalignment in the yen, but the misalignment was reflecting the fundamentals that were there. So, um now you asked a bit about um why was all this surprising and whatnot. Um >> Or was it? I mean, feel free to challenge that premise. >> [laughter] >> So, uh as you said, um so, in this century, the US has intervened twice, or three times now. Uh 2000 in the euro, a collective G7 intervention. 2011, a yen intervention, a collective G7 intervention. Um as a general rule, policymakers believe that intervention can be perhaps effective only in the short-term for the for the major floating currencies when their markets are disorderly. >> Mhm. >> Again, not a fever, not disorderly. >> Yeah. >> So, so there. Was this a G7 operation? No. The Treasury and the Fed uh Look, the US has minuscule foreign exchange reserves, but half of them were held by the Treasury, half of them were held by the Fed. Equal. >> Mhm. >> Equally invested. To the penny. In this operation, it appears the Treasury went alone without the Fed. So, so again, not disorderly, not G7, not concerted, Fed and Treasury go their own ways. Even if over minuscule amounts. So, I find that um a bit surprising. And um Now, it's it seems that the Japanese may be shifting a bit in terms of their monetary policy outlook, that they may be looking a bit at a faster pace towards normalization. This has helped to strengthen the yen a little bit in the last few days. We'll see if it's sustained. Um a lot of expectation uh Bank of Japan will lift rates 25 basis points next week, whether that is going to be um followed up more quickly than might otherwise be expected uh will be a key issue for the yen uh going forward. Um I guess to the extent I guess you could say that maybe Best Buy this this yen intervention and Best Buy joining in it um was a reflection of concerns that instability in yen markets might uh transmit to Treasuries, um, and by participating, um, in this, he could, again, help steady the Treasury market. But, as I said, there are fundamental reasons why Treasury yields are rising. >> Yeah. So, to that last point, I mean, one thing that I I we've I've heard, uh, from commentators is, you know, Japan is one of the biggest holders of of Treasuries. Um, you know, if they were going to continue to try to defend this, uh, you would essentially you would sell dollars and and buy yen. Um, how much do you think the Treasury Department was essentially motivated by their extreme interest in not having that happen. >> Um, well, I think to the extent that you saw Bessant make this call for expanded use, uh, country limits for the female account, I guess you could say that, um, it was a factor of a or possibility that was on his brain. >> Okay. And And another question, so you mentioned the it was not a G7 operation. Uh, I I would say even more than that, it sounds so the US also, I think, did the somewhat a irregular thing of of selling euros to buy yen. So, not selling So, uh, in doing so, as far as the reporting is, uh, or everything reporting I've seen, without even informing the the the Europeans of that fact. Um, again, what If that's true, how irregular would that be? >> So, um, as I said, we we'd only intervene twice in the last century. And those were And they're G7 These were coordinated G7 operations, you know, not only did the technical people coordinate on, like, how much you're going to intervene, more or less, and where and what times or what time is the BOJ going to operate? What time is the going to operate? What time is the Fed uh, on behalf of the Treasury and whatever the US going to operate? So, in addition to to all that, we agreed on statements. So, we put out a G statement. So, there was plenty of coordination and cooperation in those cases. >> Okay. Yeah, so but a little bit less this time it seems like. >> [laughter] >> Um so, uh one of the thing I'd love to talk about so there's obviously the you know, there's a discussion around potential um fiscal dominance, right? So, there's always this you know, Treasury and Treasury and the Fed they sort of play uh you know, they they can sort of play in each other's sandboxes a little bit and um and Treasury can sort of take over some of these things. Um we we mentioned so uh war shoes the new um chairman of the Fed. Um he uh in his speech at at Jackson Hole, which is a large um a big speech on the on the calendar yearly. He recommitted to the 2% um target, which again I think we've missed for about 65 months straight now, which is you know, starting to feel like a trend. Um you know, how do you um what do you how how is his job harder now uh because of all of this? Um do you think that um what would you be looking for going forward of course we have the FOMC meetings uh next week I think. Um are you looking for anything in particular beyond just the announcements of of rates um from those meetings? Um should be a fairly interesting um uh I mean, obviously the rate outlook is going to hinge on inflation prospects. I mean, I I should say one could imagine a path back to 2% um PCE target in 2027 if the supply shocks abate, the energy prices fall sharply, maybe some of the AI abates. Um I don't frankly see that happen um given the latest CPI numbers yesterday on PPI and today, um, I think it would be really hard for the Fed not to hike given that the market probabilities are 90%. Um, and as you said at Jackson Hole, he was re-committed himself to price stability and the 2%. Um, and he said that financial conditions were not restrictive. Um, and he kind of said the labor market's fine. So, that was interpreted hawkishly. Um, he left his options open, of course. Um, but I I think it's really going to be would be hard for him not to go along with a rate hike and I think it would be very bad for his credibility if he didn't, though it may cause him some troubles with certain people at Pennsylvania Avenue, 1600. Now, um, what I find, um, interesting, um, so, I mentioned FEMA. Well, I mentioned, um, buybacks. >> Yeah. >> Th- those have implications for the Fed's balance sheet. Um, now, my sense, so Trump and Bessen want lower interest rates, short and long end. >> Mhm. >> Warsh kind of has basically said uh, he'd like the long end by spoon-feeding the markets less. He'd like the long the markets to figure out where the long-term rate should be. Um, but but if Trump and Bessen want to use want to see the Fed support lower interest rates to reduce the government's interest bill or to keep um, the rise in debt below the increase in nominal GDP. That that would be symptomatic of fiscal dominance and financial repression, which is what you raised in your question. That would fly in the face of Fed independence, I would think. Um that would fly in the face of trying get back to the 2% um target. Um so I see some definite uh potential for different perspectives coming from the Treasury and the Fed. And um uh depending on how this shakes out, Mr. Warsh may have a shorter honeymoon than he might have expected when he was confirmed. >> Uh yeah, so I mean yeah, I mean to your point, you sort of talking about Warsh's speech, you sort of you mentioned in in in writing that this he sort of avoided the elephant in the room, which of course is that fiscal dominance issue. >> elephant in the room. >> Um so I it might be helpful to step back just for a second. I mean so obviously look, you know, the administration wants to to they have a lot of you know, important priorities. Everything from, you know, national defense to data center build out and all sorts of things, right? So it makes sense that they want to borrow cheaply. Um could you help um our viewers think a little bit about like why um why would Treasury and the White House care about long-term rates uh specifically in terms of the US economy? I mean they obviously don't well, shouldn't say obviously. They don't seem to care an enormous amount about the overall debt burden. >> Nope. >> Um so what is it about long-term rates that that um that would be um you know, important to this to this administration? How does it What are the economic impacts of that? >> Uh investment keys off of longer-term interest rates. Mortgages key off of longer-term interest rates. The housing market is not doing well in the United States right right now. The government's interest bill is over 3% of GDP. Government's spending more on interest than it is on defense. Um so uh rising interest rates will can tank an economy. Um if the markets get the jitters and um start dumping US paper, that will further ratchet up interest rates. So, how are we going to deal with the unsustainability of debt? Um maybe the chickens aren't going to come home to roost tomorrow, but um you know, it's with these massive deficits, social security financing problems looming around 2032, the trust fund goes bust. There there's some huge challenges there. We as a society need to deal with them. Um but again, the politics of our country suggests that nobody is willing to tackle um this fundamental issue. I fear that uh it's going to take an extreme market events to uh force us to uh grapple with it. >> Yeah. Uh I I totally agree, um unfortunately. Um Well, I'd love to let's pick up on that last piece, which is like um you know, extreme market events or things like that. I'm not asking you to predict how this is all going to unfold, but you know, you you've written a lot about dollar dominance and the so the role of the dollar in the US and in the global system. Um you've argued that, you know, the dedollarization is probably overblown in terms of, you know, the you know, the the the the risk of some, you know, a wholly new regime. So, what what will this look like, right? I mean again, if you if if we're both kind of correct that like politicians are not going to take this seriously until something fairly dramatic happens. Uh what would that be? How would how would I guess I'm asking you to to predict more than I said I was going to, but like what what should we be looking for? What is this going to look like going forward? >> For dollar dominance? yeah. Yeah. So, this is a great question. I think it's a important issue. Um So, why is the dollar dominant? You know, there were some policy things that have happened that buttresses. But, basically, why is the dollar dominant? It's features endogenous to the United States are properties. So, for example, we're huge economy. We've had we've been a we've tended to run good decent enough macro policies. We've got the deepest, most liquid capital markets in the world. We we can offer a scale of investable assets that no nobody else can. We've been a trusted ally. And I think there was a Fed study that showed that 75% of Treasuries were held by countries with some kind of military tie with the US. Uh we've good property rights, good rule of law, Fed independence. So, um what's happening? Um uh A former colleague of mine, Steve Kamin, who was head of the International Division of the Fed, and I have written about termites feasting away on dollar the foundations of dollar dominance. Okay. Big economy, yes. Trusted ally, uh not so hot these days. Um We're attacking Fed independence. Um our ma- macro you know, inflation has been not too great. So, um you could see that basically the termites reflect an erosion of the foundations. Um Now, does that mean dollar dominance is going to go away? No, as you suggested, um, partly because who else can match us on investable assets or the size of our economy. Um, and in addition to which, when you think about Europe, it has its warts. Um, China, RMB has lots of warts. Um, digital currencies, we'll we'll see about that. I think that's overhyped and and and whatnot. So, so what what I've said and what Steve and I have said is that the greatest challenge to dollar dominance is not the euro, it's not the RMB, it is not stable coins, it is American dysfunction. >> Mhm. >> Now, I don't think, again, we'll see maybe some more RMB, some more higher share for the euro, >> [snorts] >> more gold, more alternative this and that. But basically, the dollar, um, should remain preeminent. But as we always like to say, you know, if the dollar's role in the global economy diminished because everybody was performing wonderfully and optimally and [snorts] running sound policy, who'd care, right? But if it's if it's declining because we're being dysfunctional and we're upsetting global markets, that's going to be a bad thing. And and the last point I'll make is as an American, dollar dominance shouldn't be seen as an end in of itself. If we're losing dollar dominance because we're messing up the US economy, dollar dominance will be the least of our worries. >> Mhm. Yeah, couldn't agree more. Um, and it you know, it also beyond giving us a sort of tool of statecraft, it it also confers enormous benefits of, you know, exorbitant privilege and all that. >> Since you mentioned Well, I I don't believe the privilege is that extraordinary. >> Okay. >> we we gain on some seniorage. We have reduced effects risk. And maybe interest rates are a little bit lower, but real interest rates are pretty similar in the major countries. But as you said uh >> Yeah. >> You mentioned economic statecraft, and I hadn't included that. It shows my old-style thinking about economics. >> Well, in the new world order. >> [laughter] >> Um So, um my feeling about that is um you are right. Um we 25 years ago we wouldn't have even thought about it. But after 9/11, uh we began to um think about it. Um and of course, you know, if you you have a carrot called diplomacy and a stick called war, that's you don't want to go to war all the time. So, sanctions um become a a tool. Uh my view of sanctions was if they were multilateral um and framed around a strategy, a coherent degree target, and you know, they weren't used willy-nilly or you know, like kids in a candy shop, it would be okay. You know, I That isn't to say one could preclude use of them bilaterally, but but basically to be responsible. I think we've overdone it um and um I think that that contains therefore the seeds of its own erosion in terms of its efficacy going forward. And I do worry that that is another factor that will uh weaken the dollar's role. That isn't to say that I I I totally support what uh was done with the Russian >> Yeah. >> um assets, um but but I I think there's a balance there and I think policy makers need to think more about how to strike that balance. >> Couldn't agree more. I mean, you know, uh as as an economist it's in my obligation to always say there's no free lunch, right? Like these are not costless tools. I have a colleague who's a great uh former Treasury official from uh France who describes it as sanctions is like antibiotics, right? It's like Look, just because they have, you know, they build resistance, right? Doesn't mean you shouldn't use them, but you need to think about that sort of that side effect in your sort of calibration of it. And I think that's one thing that it's hard for policy makers cuz you're always you're faced with a problem and you want to solve it and it's a it's a it's a hammer and the problem is a nail. Um well, great. Well, Mark, I before we wrap up, um I just want to ask you sort of two questions. We sort of touched on this, so so feel free to be brief on this. Um as I mentioned, we have the FO FOMC meetings next week. Um we also have the Bank of Japan uh meetings coming up next week as well. Um is there anything particular you're looking for those there? Um anything our audience should be watching for? Uh and then, if you're willing to, uh you know, uh we already sort of talked a little bit about the dollar erosion, so I I'd love to ask you a kind of a loaded question, which is if you could talk to uh the secretary, uh Secretary Yellen, um for 15 minutes, anything particular in addition to or on top of whatever you've said today that you might want to uh pearls of wisdom you might want to share with them. >> FOMC, BOJ, I'm expecting 25 basis point hikes out of both of them next week. Um I think the maybe even potentially more interesting question than the hike per se is how they articulate and frame the hike, particularly with respect to what might happen subsequently. >> Okay. >> I could see the Fed more seeking to treat it as a one-off thing and they'll worry about Yeah. Manana later. Although, we'll have to see what the dots show. And uh the BOJ, I think that's a very real question for the BOJ um given the weakness of the yen and the s- somewhat seeming change in attitudes in Japan. Uh what could I uh I'm not sure what I could possibly say to Mr. Bessant. Um You know, I I would hope that um You know, I I think this administration could be could do a much better job about thinking about we need some real fiscal restraint. Um and we need to do a better job in working with our traditional allies and I think doing that would um help them cope much better with China and uh reinforce the Western economies. >> Yeah, our our network of partners is one of the biggest advantages we have against so many of our sort of competitors with different systems. Totally agree. Well, Mark, thank you so much for for joining today on the Trade Off. Really appreciate it and hope to have you back again soon. >> Great fun. Thank you. >> [music]