Odd Lots - Why Treasuries Became Risky Again

Episode Date: October 5, 2026

We all know that US Treasury yields have been surging, alongside bond yields all around the world. So what explains the selloff and does this mean that bonds are becoming fundamentally riskier? What happens if investors can no longer hedge stocks with government debt? And how do expectations of the Federal Reserve's "reaction function" fit in? In this episode, we speak with Carolin Pflueger, associate professor at the University of Chicago and a resident scholar at the Chicago Fed Bank, about her work on the bond market and central banks. We discuss why bonds have become more stock-like, what that means for yields, and the role of the Fed's credibility in making bonds “bond-like” again. See Odd Lots Live in Chicago!See omnystudio.com/listener for privacy information.

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forward slash Oddlots. And of course, a special thank you to Barclays for supporting Odd Lots Live. So that's October 15th at City Winery in Chicago. Get your tickets now. Bloomberg Audio Studios. Podcasts Radio News. Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Allaway. And I'm Joe Wisenthall. Joe, we're back in New York. Yeah. But the Jackson Hole episodes continue. 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. It has now hit the highest level since 2002. Wow. So a few weeks ago, we were looking at the yield curve and saying all these things,

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 happened since Jackson Hole is we had a Fed rate hike. 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 style, it's a 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, I was like 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 spending 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 U.S. global hegemony and the link between war and the dollar and so forth, et cetera. And so there are many backdrops. They're infinite backdrops. I could have gone on for a while, but I chose not to. No, there's so much going on at the moment. But it all relates 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 Flueger. 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 macroeconomy, 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 do too. You know, to me, the macroeconomy, 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 onto, quote, the real economy or the real world or whatever. That part doesn't get discussed as much at saying. 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, it 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 a 4% policy rate, if they expect 4% inflation, they might expect a 6% policy rate. So that would be a one-for-one adjustment, a perceived policy reaction coefficient of one. And 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. Correct. Yes.

But if only if the reaction function is understood. Correct. That's why the understanding is important, right? So if there is, you know, whatever the intended policy reaction function is, you know, 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, you know, 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 co-authors 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 co-authors Michael Bauer at the San Francisco Fed and Adi Sundaram 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 in 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's 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 used for inflation and output to come up with this policy rate forecast? So it's, in a way, it's an ideal setup 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, 30 to 50 forecasters, a couple forecast horizons, 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 macroeconomy, but if you treat this data as the best approximation of an experiment on the macroeconomy, 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 in 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 what 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

news 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 in 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 a, you know, there's a clear consent? of what market participants or forecasters perceive the reaction function to be? And are there times that we can 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. Got it. 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. Got it. 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 know, you see absolutely no dispersion. So that would be an example where, where that collapsed. So what moves the needle when it comes to the market's 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 that's a question that my courthors 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 2020, 2021 inflation then picked up, and there were some of these really big, positive inflation surprises. And that was also the time where there was the discussion of, you know, is inflation permanent, is it transitory? The T word. We need to get a transitory clock.

Yeah, yeah, foreign. Yeah. 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. So the interest rates stayed at zero for

quite a while even though inflation was running at 5, 6%, and the perceived reaction function that we saw at that time was extremely flat. So there was a perception 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 6%. That's huge. And the two-year rate didn't move, not at all.

And you also saw that in the forecasts, 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 Powell called it 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, you know, the response that that was anticipated at the time. And so then, you know, towards the end of 2021, the tone started to change and March 2022 was lift 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 in 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

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Yeah, yeah. Just want to pause it. The Bloomberg this weekend podcast. Subscribe today on Apple, Spotify, or wherever you listen. In a dream country that actually, executes perfect monetary policy all the time. Does it have a perfectly stable 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 are central banks needed at all? So there is, you know, their 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 Addy, 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 easings are 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 market's 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 liftoff, 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, you know, 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. 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 co-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 Luis Vicerra 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 point of, 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, luck 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 in nominal bonds plays an important role. That's a very natural decomposition. So the U.S. 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. Right. 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-linked 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. But the difference is, A, it's not as big. 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 the inflation part. Why is that? Well, in the 1980s, stagflation was the thing that everyone was talking about. If you have a stackflation and you hold nominal bonds, that's terrible because they become worth less. 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 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 lucked? 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 punchline 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 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 the 1980s in the sense that the Fed has been able to move more gradually. So 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 rule.

And that has the advantage that when supply shocks happen, a more 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 the bond market. 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, how do you decompose the factors?

Just driving either in the last few years or even in the last few months or even weeks. Great. So let me take a slightly bigger perspective because as academics, 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 who 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 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 Matea Ombroni from Boston College and Adi 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 11.5% in the 80s. Hard to imagine now. 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 bond stock co-movements in the data. Now, you might think that's really simple, you know, why wouldn't 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. Anyway, so if 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, a 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 bond stock who movements is really striking. It's there for the U.S., 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 pretty clear evidence that markets require a higher return when bonds are risky.

And so 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 20s, 2010's 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, you know, bond yields going up then reflect increasing risks and increasing required compensation for risks. Canadian women are looking for more. More out of themselves, their businesses, their elected leaders, and the world are out of them. And that's why we're thrilled to introduce the Honest Talk podcast. I'm Jennifer Stewart.

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Submit questions for experts and guests you hear on air. Visit Bloomberg.com slash ask radio to send questions to our hosts. You may just hear them asked on the air. Exclusively for Bloomberg.com subscribers. Get answers on today's headline, breaking earnings news, and big market moves. Visit Bloomberg.com slash ask radio to join the conversation right here on Bloomberg Radio. How do we make bonds more bond-like again? 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've liked 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 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 that's interesting because you mentioned at least market-based measures of inflation expectations or break-evens. They have been pretty stable. Yeah. So two things that call us to mind.

First of all, I'm curious you 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, point, is it surprising 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 that you could go five years and it's not there. And then B, 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 already, the market is pricing and stable inflation, not very high above target, then why shouldn't we just surmise that, okay, the Fed is perceived as quite credible?

Yes, that's interesting. So I'm not an expert on how inflation expectations are formed. Okay. My colleague at Chicago, Stefan Nagle, has some really interesting work on that. He has really interesting things 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. 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 10-year treasuries versus the inflation index bonds, the correlation was very high because no one was really thinking about inflation.

But that correlation has changed. So even though on average, I think the inflation, the average long-term inflation that's priced in looks very stable, you know, we have seen changes that are probably related to more uncertainty. And 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, 2021. And the answer was a combination of 1980s supply style shocks combined with a more inertial monetary policy like in the 2000s.

And so that's something that generates more inflationary shocks, but the response of real rates and nominal rates is different because the, the monetary policy that's priced in is a little more inertial. I don't know if you've done any specific research on this per se, but we started out talking about various megatrends, of which there are many. And maybe one of them we didn't mention is that the holders of U.S. 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 U.S. Treasuries at all and how it might relate to some of your work?

So the buyer base is certainly interesting. It's not really what my research is about. What I can say is that if you think about changing bond yields, right, so there has been, there was, for a long time there was a discussion. Is it a decline in the natural rate, which would be, you know, productive growth? it a change in the demand for scarce safe assets or 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 credible. Inflation is going to come back down at some point maybe a little more volatile than we look. There are many aspects of the U.S. policymaking apparatus that I would say we could neutrally describe as 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 Iran 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 U.S. even has a powerful enough military to win a war if it wanted and actually recapture the straight. And so then you start talking about like, well, you know, dollar hegemony and the U.S. is the superpower and that has the effect. And it's like, wait, is the U.S. the superpower that we thought it was? Does this say anything? Is all of these questions whether this sort of, just the sort of the physical strength of the U.S. as a power and the domestic policy volatility? How much is that part of the story here? Great question. Yes. So, yeah. I have done a little bit of work thinking about the interlink between geopolitics and the safety in bond markets.

I'll say that, you know, I find that it's 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 address about the public debt in 1790, where he said, look, most countries that are involved in a war need bond markets, and the U.S. credit is, and I'll 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 U.K.

the UK had a functioning deep bond market with low borrowing rates prior to the Napoleonic wars, and that helped it a lot. And then 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 U.S. in the second half of the 20th century has held a similar position with being the militarily strongest country, having low borrowing rates, and so on. So there's reason to think that these two advantages, military and financial, they're interlinked. And so what I've thought about with my co-author Pierre I read from Colombia 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. 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 hegemon keeps getting stronger and stronger. If the system starts out on the other side, you get convergence to the other hegemon. 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 if financial markets expect that one country is safer, they offer lower financing rates, and that allows for this investment to happen, which makes the expectations justified. Now, this last case, we think of more as my co-author and I think more of as 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? What do you think the yield on the Chinese? Actually, the Chinese third year bond is. Tell me. 2%. Wow. So again, you know, I'm not putting words in the guest's mouth, but, you know, you're like talking about people are talking about a hegemonic transformation without a war. So we're at like 5.6. By the way, we're recording the September 29th. Who knows what it's going to be by the time we're listening. But yeah, the yield of the Chinese 30-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 had added to the index, so that would be an obvious catalyst. I wanted to go back to the perceived policy reaction function for a second

and maybe talk about some of the recent things that Kevin Warsh has said. So he talked about wanting 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 there any way of disaggregating those two? Or like, how do you get away from that reflexivity? So, yeah, I can't really talk about what Warsh would say you'd need to, you'd really need to, you'd really need to. to ask him yourselves. What we did try in our estimation of the perceived reaction functions is we tried to include

something about financial conditions. We included forecasts of the BAA AAA, AAA spread, 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, it's certainly a discussion whether the Fed responds to financial conditions because they reflect the macroeconomy or whether there's something separate. But we found that kind of in terms of the response to the macroeconomy that it 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 are going on well, their bond yields are 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 very simple in the sense that, you know, in the end, the exposure, we're all taxpayers and to the extent that we're also holding bonds. It's just, you know, going from one pocket to the other. 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 are bond stock co-movements price. 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. You know, it's all about, you know, it's all about a type of investor who's holding too many bonds and thereby if bonds become more 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 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 end up 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 are like, oh, where's the money going to come from? And that whole time I was just thinking, well, he just passed a tax cut. We know where the money

it's 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 stockholder will buy some treasuries. Like, you do, it is, it does seem as though, like, you know, when, 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 in economics, that's called recovery.

carding 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 in very, it works in theory and it has robust explanatory power. No, I've always found that to be very compiled. Perfect for podcasts and posting online. All right, Carolyn, thank you so much for coming on odd lots really appreciate it. Thank you.

My pleasure. So Joe, that was fascinating. Yeah, yeah. Truly the perfect guest for this particular moment in time. My big takeaway, Bon'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 U.S. tenure.

Yeah. Because not only is it dramatic, it. It, I mean, it just flipped during COVID. Like that, like the, the U.S. was yielding much less than, U.S. 10 year 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 a 300, over 350 basis point 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 like 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 shapers of global hegemonys. Either way, I like the idea of, I mean, it's really powerful idea that it's like, can you have like a handing off of the hegemon? Can you have a classic. Can you have a handle from the Hedgeamon 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 it's like, you can see how these things compound and snowball over decades. And, okay, so the U.S. now wants to embark on this big effort of industrialization. We had that conversation with Chris Power of Hadrian in L.A. talking about the ship gap or the robotics gap, et cetera. Well, we might do that. We might. But it's going to cost us a lot more just from a sort of dollar standpoint or resource standpoint than 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 guy and convince investors. That's right. Shall we leave it there? Let's leave it there.

This has been another episode of the All Thoughts. podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway. And I'm Joe Wisenthal. You can follow me at the stalwart. Follow our producers, Carmen Rodriguez, at Carmen Armand, Dashobennett, at Dashbot. Kale Brooks at Kail Brooks and Kevin Lazzano at Kevin Lloyd Lazzano. And for more oddlots content, go to Bloomberg.com slash oddlots or the daily newsletter in all of our episodes. And you can chat about all of these topics 24-7 in our Discord. Discord.g.g. slash oddlaws. And if you enjoyed this conversation, if you like it when we talk about the on market, then please leave us a positive review on your favorite podcast platform. And remember,

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