Wall Street Dialogues: Long Rates Challenge Scott Bessent and Trigger Global Alert, What Will the Fed Do?

The rise in long-term rates is once again making headlines worldwide. Is a formidable crisis looming? Did Treasury Secretary Scott Bessent's intervention fail? What role does Kevin Warsh's Fed play? What can we expect, Gekko?{#p-1788306947985-76441}

Journalist: Rates are rising and anxiety is growing. Is this a public debt crisis? Another one? Or is this the crisis that will force limits on the excesses of fiscal policy? Rates are rising globally...{#p-1788306947985-60819}

Gordon Gekko: Except for China.{#p-1788306947985-66281}

Q: Let's say, globally, where capital accounts remain open.{#p-1788306947985-17883}

G.G.: That's right.{#p-1788306947985-93468}

Q: Do you think it's time to address the underlying problem and cut the deficit and debt accumulation? Or do you think governments will continue to manage the issue and dress up a solution? In other words, did Treasury Secretary Scott Bessent fail in his attempt to fix the situation and calm long-term rates merely with a threat of intervention?{#p-1788306947985-36607}

G.G.: We are in a booming economic expansion cycle driven by a very strong promise: the bonanza of artificial intelligence (AI). We closed our last crisis - the pandemic - five years ago. That is, the time to address fiscal disorder did not arrive five minutes ago.{#p-1788306947985-48245}

Q: It is clear that there is no will.{#p-1788306947985-50522}

G.G.: None. Previously, Republican governments lowered taxes and Democrats raised them. Biden promised this during his campaign. But he did not fulfill it. He couldn't. Congress was against it. And Trump lowered them in his first term and also in the current one. When one asks: what changed that now rates are so skittish? The answer is not the deficit or debt accumulation. Bessent was able to lower long-term rates from when he took office until March. After that, he could not. What changed the landscape is the war in Iran, the rising cost of energy, and the investment boom brought by AI.{#p-1788306947985-62926}

Q: Everyone equally?{#p-1788306947985-68129}

G.G.: Not at all. Here we face two overlapping shocks. The war that was supposed to be brief and is prolonged. And the AI that does not falter and we do not know how long it will last. The closure of Hormuz produced the largest energy market disruption in history, according to the International Energy Agency. However, in terms of oil prices, it caused a smaller jump than the Ukraine war in 2022. And its peak level dates back to May. It is not from now.{#p-1788306947985-40858}

Q: Inflation has increased. It was a second shock after the one triggered by tariffs last year. But the inflation expectations implied in bond prices have remained stable in the medium term.{#p-1788306947985-45930}

G.G.: Correct.{#p-1788306947985-71122}

Q: One would think that if the AI boom and the enormous expansion of debt issuance by hyperscalers were not present, the situation would be more relaxed. Or am I wrong?{#p-1788306947985-41721}

G.G.: The AI leap is the main driver behind the increase in real interest rates, which is the distinguishing element of the current process. Over ten years, nominal rates have risen 75 basis points since March, and real rates explain 70.{#p-1788306947985-81463}

Q: The problem is not fiscal; it is the enormous investment in data centers and digital infrastructure?{#p-1788306947985-69360}

G.G.: The problem is accommodating both at the same time. Because the economy is growing and the deficit is not decreasing. Interest rates are rising and primary public spending is not responsive. It does not shrink. And interest spending is increasing, albeit with a lag. Bessent is juggling. He shortens the duration of public debt issuances. But corporate issuances replace it. And the pool of available savings is one and pushes rates up. Despite a visible crowding out phenomenon in the hardships of the real estate market, which is indeed affected by high interest rates.{#p-1788306947985-4563}

P.: Do you think Bessent failed in his attempt to silence the process? Long rates have challenged him again.{#p-1788306947985-1653}

G.G.: Do you see him very nervous? He made Stanley Druckenmiller, his former boss, lose money, and he seems to enjoy it.{#p-1788306947985-41891}

P.: But the fact is that the saga continues. And so does the upward pressure.{#p-1788306947985-39914}

G.G.: Sure. But the saga didn’t start when Bessent announced the buyback either. He intervened earlier by announcing an agreement with Iran "in a day or two." And thus he refinanced the long debt a couple of weeks ago. He placed 42 billion dollars for 10 years at 4.68%, with the oil price stabilized. Today it is 10 basis points higher. He issued 25 billion dollars for 30 years at 5.22%. Today the yield is at 5.25%. But it was at 5.34% before Bessent announced the buyback. Hedge funds are not pushing him. They are taking it slow.{#p-1788306947985-56967}

P.: But a showdown is looming.{#p-1788306947985-68231}

G.G.: It is inevitable given Trump’s decision to escalate his standoff in the Persian Gulf. We talked about it last week. Bessent’s priority is not the bonds; it is the Iranian operation. Even so, if you observe today the behavior of the bond curve, the increase in rates is general, not led by the long end. And the least that rises is the 30-year rate.{#p-1788306947985-45107}

P.: Let’s repeat the question then: Can Bessent tame the bonds while suffocating Iran?{#p-1788306947985-41969}

G.G.: We are in an escalation. What happens if the price of oil skyrockets to 100 dollars? Tehran knows that this is the Achilles' heel of its enemy. If they successfully attack it, they will strike there. To deal with that eventual scenario, Bessent has made it known that he is sitting on a trillion dollars deposited at the Fed. Prevention is better than cure. But if violence erupts, there will also be a need for healing.

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Kevin Warsh, President of the Fed.{#p-1788307316702-54281}

P.: And how does the Fed play into this mess?{#p-1788306947985-23164}

G.G.: Warsh failed in the second meeting he chaired at the end of July. The press conference was terrible. He could not explain the decision not to raise rates. Nor what his method was. And the three dissenters justified their proposal very well. It is better to adjust rates moderately and without haste than to have to do it abruptly when it is too late. Warsh dented the long end of the curve with his gaffe. And what Bessent did with the announcement of the buyback was to anticipate a tantrum from the bonds that had been waiting around the corner since that moment. A small rate increase in July would have relieved our headache. But Warsh did not dare. The stock market would have gone through turmoil with a sudden tantrum from the bonds. This way it erodes slowly, without shocks. Despite the news coming from Ormuz.{#p-1788306947985-89396}

P.: Bessent spoke extensively yesterday about monetary policy. Of course, he did not say what Warsh should do...{#p-1788306947985-18010}

G.G.: That would already be grotesque. Besides being counterproductive.{#p-1788306947985-97139}

P.: But he pointed out that it was not usual for the Fed to raise rates as a consequence of a supply shock. And he did not avoid saying that both he and Warsh are "on the same page."{#p-1788306947985-66575}

G.G.: Economic activity has not been affected. The unemployment rate is at 4.1%. Full employment. The adverse energy shock has indeed led to more inflation. And the other shock, that of AI, which he also mentions, but as a disinflationary force, is today quite the opposite. AI provides a formidable boost to investment demand. It demands real resources and financing that, as is evident, are scarce today. The idea of raising rates in that context is very reasonable. Of course, it is not the only path. A credible arrangement with Iran could help to decompress the situation and also start to reduce the deficit if it brought an end to the war. And it would give Warsh the perfect excuse to extend the wait. But that is also not accepted. And holding everything together is to expect the impossible. It cannot be done without forceps.

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