Bond Selloff Fades as Oil Cools; Trump-Xi Takeaways

SPEAKER_1 (0:02)

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Tom Keene (0:27)

This is our interview of the day for Global Wall Street. I don't know what else to say about it. Michael Gapen brings prodigious academics and abilities across market economics, now Chief US Economist at Morgan Stanley, with a couple brilliant notes.

What I would really, it's Indiana University, Paul.

Paul Sweeney (0:45)

Love it.

Tom Keene (0:45)

It's like grounded.

Paul Sweeney (0:47)

They're solid.

SPEAKER_1 (0:48)

They're solid. Big time.

Tom Keene (0:49)

It's like serious, serious economics. Good morning, Mr. Bullard, as well as St. Louis Fed. Michael, buried in one of your notes is the heart of the matter, which no one's talking about. And this goes back to Friedrich Bastiat, 1850, which is second in the third round effects.

And that everybody's looking at the immediate oil bonds and that. But what we need to consider are the second round and third round effects of what we're living right now.

Can you see out into 2027? What are the second and third round effects of all this inflation, these yields in the central bank policy?

Michael Gapen (1:31)

Well, in one direction, well, first of all, good morning, Paul. Good morning, Tom. Thank you for that introduction. The second round effects on inflation are related to, as you've been discussing, gas, diesel. Normally, oil shocks are relatively short-lived, oil goes up, oil comes down, and we don't expect second round effects. But we're six months in, and as anybody's guess when this might end. Airfares, for example, are up about 24% year-on-year.

It's increasingly likely we're going to get second round effects that mean inflation, affordability, the cost of living remains a concern in 2027 Now, the Fed cannot directly control oil prices and diesel prices, but it does have the ability to lean against those second round effects. The question is exactly what is the Fed responding to here. But it's clear higher energy prices, they're not looking through this. The standard playbook is look through it, ignore it, but they can't anymore. Warsh made that clear, even Powell made that clear.

The Fed's now in motion, they are responding to it. The question is, how far will they go? Other second round effects that I'll mention that we're keeping an eye on, obviously the AI spending story is important, but somewhere in here in 2027, 2028, the growth rate of that spending will be slowing. So what's more important, the level of spending or the growth rate? So somewhere in here, there could be an inflection, we think it'll be coming in 2027, where some of the edge comes off of the narrative.

Tom Keene (3:10)

I mean, Paul, it's like your kid's spending in college.

SPEAKER_1 (3:13)

Sure. Is it the level of the growth rate?

Paul Sweeney (3:14)

Exactly. So Michael, given that inflation backdrop, how do you view the yield environment out there? A lot of folks are saying it's not so much where the absolute yields are today, but maybe it's just the velocity with which yields have pushed higher here. How do you think about that?

Michael Gapen (3:31)

Well, I think it's clearly a perfect storm in the rates markets.

Fundamentals, technicals, a whole bunch of reasons have pushed rates higher. So the magnitude of the move has been quite strong. We're up about roughly 150 basis points, and almost the entirety of that move has come in real yields. So the market is clearly saying, whatever's happening out there, monetary policy is going to respond to it. Markets are pricing in three to four additional hikes. And what it will do is, it'll kind of, we think it will perpetuate this K-shaped narrative. It's very unlikely higher yields will slow down the rate of hyperscaler spending and borrowing. The AI story we think is immune to a lot of this. So the Fed will be forced to essentially slow down the parts of the economy that are already slow in order to help bring inflation down. But the Fed has to respond with the economy it has, maybe not the one it wants.

Tom Keene (4:31)

Does that sound like a gilded H?

Paul Sweeney (4:33)

It does a little bit. Well, that kind of takes us to the next question there, Michael. I mean, despite some of the inflation headwinds, despite maybe some of the uncertainties out there, whether it's geopolitics or whatever, the consumer here for the US consumer, pretty aren't solid here. What do you make of the US consumer?