AI’s CapEx Frenzy Hits Wall of Fed Hawkishness | Weekly Roundup

Key Concepts

AI Capex Ponzi: The idea that the current surge in Artificial Intelligence capital expenditures is unsustainable and resembles a Ponzi scheme.
Liquidity Suck: A situation where money is withdrawn from the financial system, making it harder to access capital.
Fed Forward Guidance: Statements made by the Federal Reserve about its future monetary policy intentions.
K-Shaped Economy: An economy where different sectors or groups of people experience vastly different outcomes, with some thriving and others struggling.
Crowding Out: When large entities (like big tech companies issuing bonds) absorb available capital, leaving less for smaller businesses.
Real Rates: The interest rate adjusted for inflation, indicating the true return on an investment.
SOMA Portfolio: The Federal Reserve's portfolio of securities.
Carry Trade: A strategy where an investor borrows in a currency with a low interest rate and invests in a currency with a high interest rate.
Stablecoins: Cryptocurrencies designed to maintain a stable value, often pegged to a fiat currency like the US dollar.
UBI (Universal Basic Income): A government program in which every citizen receives a set amount of money regularly.

Nvidia Earnings and AI Capex

The discussion begins with the immediate aftermath of Nvidia's earnings report, which exceeded analyst expectations for both earnings per share (EPS) and revenue. Adjusted EPS was $1.30 (vs. $1.25 estimate), and revenue reached $57 billion (vs. $55 billion estimate). Nvidia also provided strong guidance for the next quarter, projecting $65 billion in revenue (vs. $62 billion estimate) and a gross margin of 75% (vs. 74% estimate). This performance is framed as a continuation of the "AI Capex Ponzi," suggesting that the market's reliance on Nvidia's growth for AI infrastructure spending is a potentially unsustainable cycle. The market's reaction, with a 3.5% post-market rise against an implied 7% move, is seen as a relief, potentially rolling off event risk and protection bought for downside scenarios.

The Two Economies and Credit Market Dynamics

A key theme introduced is the concept of a "two economies" scenario. One part, centralized and heavily backed by government spending, remains healthy on the surface, particularly concerning the AI capital expenditure cycle. The other part of the economy is not performing as well.

The conversation then shifts to the increasing reliance of major tech companies on bond issuance to fund their AI capital expenditures. Bond issuance by these companies has surged, indicating a pivot from equity investors to credit investors as the primary drivers of sentiment and risk for these AI companies. Credit investors have a different risk profile, demanding tangible impacts sooner than equity investors who can bet on long-term visions.

Data Point: Forecasts show that starting next year, nearly 80% of these companies' free cash flow will be dedicated to AI capex, explaining the increased bond issuance.

Real-World Application: Examples of strong demand for corporate bonds are cited:

Meta's "Beignet" data center bonds saw demand so strong that Morgan Stanley structured a $27.3 billion offering to a select group of large investors, with the only "grumbling" coming from those who didn't get a piece.
Amazon sold $15 billion in bonds, upsized from $12 billion due to high demand.

This trend is seen as potentially negative for "middle America" and small businesses, as it represents a further "crowding out" of the debt markets. Large, AAA-rated companies with strong cash flow are "hoovered up" by institutional investors like pension funds and endowments, leaving less financing available for smaller entities. This exacerbates the "K-shaped economy" where the big get bigger.

Macroeconomic Indicators and Fed Policy

The discussion delves into macroeconomic charts, focusing on the relationship between nominal yields and inflation expectations.

Chart Analysis (Slide 51):

Two-Year Nominal Yield vs. Two-Year Break-Even Inflation: This chart, and its ratio showing real rates, indicates that as nominal yields rise and forward inflation rolls over, liquidity is being sucked out of the system. This is seen as a primary driver for the selling in riskier market segments, including growth stocks and crypto.
Real Rates: The rising real rates are identified as a significant factor impacting growth sectors and crypto.

The market's current state is described as "purgatory," heavily dependent on Fed forward guidance. The speaker likens the situation to a "Wimar Ponzi scheme," emphasizing the potential for rapid reversals once the Federal Reserve withdraws liquidity.

Fed Communication Criticism: The Fed's communication style is criticized for being "insane." Despite stating in their last meeting that they saw no case for a December cut, it took until recently for the market to price that out. This led to a "whipsaw effect" with no government data, only Fed officials signaling a hawkish stance. The minutes from the last meeting revealed this hawkish pivot was already in the works, but it wasn't publicly communicated until later.

Credit Market Stress and Data Delays

Concerns are raised about stress in credit markets, with mentions of "thericolor stuff" and subprime auto loans.

Case Study: Blue Owl Private Credit Fund:

A private credit fund allowing 5% quarterly redemptions experienced 6% redemption requests in Q3.
The fund announced a freeze on redemptions and a merger with a publicly traded business development company (BDC).
Unit holders were to receive BDC shares at Net Asset Value (NAV), but the BDC stock immediately traded 20% below NAV, resulting in an instant haircut.
The merger was subsequently canceled, and redemptions remain frozen, highlighting issues in providing exit liquidity for private debt.

Economic Data Delays: The Bureau of Labor Statistics (BLS) announced it would not publish the full October employment report, only the establishment survey with the November release on December 5th. The November jobs report will be published on December 16th, after the final FOMC meeting of the year.

Impact on Fed Cut Odds: This absence of crucial jobs data for the December meeting significantly reduced the odds of a Fed rate cut. The probability of a cut in December dropped to approximately 29%. This lack of data leaves participants "in the dark," and even popular indicators like the Atlanta Fed GDP Nowcast are considered "broken" due to reliance on incomplete data.

Political and Fiscal Policy Implications

The discussion explores the potential political motivations behind the data delays and Fed policy.

Deflating the Bubble: It's suggested that the data delays might be a "concerted effort to deflate the bubble a little bit," implying human choices behind the government's actions.

Blame Game and 2026 Strategy:

The current situation could allow a potential Trump administration to blame Powell and the Fed if markets decline due to no December cuts.
The strategy might be to "save more juice for next year" (2026), which is seen as better for markets and crucial for election cycles.
The upcoming midterms are framed as an "uphill battle" for Republicans, suggesting a need to extend stimulus and support for the economy.

Tariff Policy: The possibility of a $2,000 tariff on goods is discussed as a potent fiscal tool, potentially pushed to a House vote. The narrative is that this tariff revenue would be perceived as "free money" for constituents, especially during an affordability crisis, making it politically advantageous for incumbents. This is seen as more impactful than quantitative easing (QE).

Government Spending and Financing: While spending is acknowledged as important, its financing is a critical issue, especially with existing liquidity concerns. The potential for a "real rate scare" prior to Fed balance sheet expansion is noted.

Trump's Influence: Trump's direct calls to lower rates are mentioned, highlighting a potential shift in Fed appointments and policy under a future administration.

Bessant's Role: The focus on "Main Street" by Treasury Secretary Bessant is questioned, with a lack of tangible results on the ground, such as the declining middle-income basket. The need for significant rate cuts, offset by a hawkish balance sheet, is proposed.

Federal Reserve Balance Sheet and Yield Curve Management

A detailed analysis of the Federal Reserve's balance sheet and its implications for the yield curve is presented.

Dovish Fed Funds, Hawkish Balance Sheet: A contrast is drawn between the dovish stance on Fed Funds (interest rates) and a hawkish approach to the balance sheet by key Fed officials (Bowman, Waller, and Moran), who are seen as aligning with Bessant and Trump's thinking.

SOMA Portfolio Composition: The Fed minutes indicate a deliberation on aligning the long-run composition of the SOMA portfolio with the composition of outstanding Treasury securities.

Duration Mismatch:

Fed Balance Sheet Weighted Average Maturity: 8.96 years.
Treasury Debt Weighted Average Maturity: 5.86 years.

The Treasury is issuing more short-duration bills, while the Fed holds longer-duration assets. The Fed has been the "net absorber of duration." The stated goal is to match these durations, implying the open market will need to digest approximately $1.4 trillion of duration over several years.

Implications:

Recession/Crisis Flip: Any recession or crisis could quickly reverse this plan.
Directional Goal: The Fed aims to reduce the duration of its balance sheet.
Yield Curve Steepening: The intention is to steepen the yield curve, making long-end debt (used by mega-caps) more expensive, while making short-end debt cheaper for small businesses. This is seen as a deliberate policy to benefit smaller businesses.

QE vs. Balance Sheet Adjustment: The current approach is not seen as traditional QE but rather a deliberate adjustment to rebalance the market and steepen the yield curve. The timeline for this balance sheet adjustment is estimated to be 4-14 years, depending on the pace of reduction.

Currency Markets and Geopolitical Shifts

The discussion moves to currency markets, highlighting volatility and potential geopolitical shifts.

China Trade Balance and Tariffs: Tariffs are impacting China's trade balance, leading to less capital flowing into US Treasuries. This disruption in trade balance can cause "wonky FX stuff."

Japanese Yen (JPY) Weakness:

Japanese government bond (JGB) yields are breaking out.
The Yen is weakening significantly against the Chinese Yuan (CNY), reaching levels not seen in 20 years. This puts China in a precarious position.
The weakening Yen is attributed to the new dovish Prime Minister's fiscal spending plans amidst inflation above target.

US Dollar (USD) Strength and Volatility: The dollar has risen against expectations of bearish sentiment, causing cross-currency volatility.

Yen Carry Trade: The Yen weakening is contrasted with the typical understanding of a Yen carry trade unwind. The current situation is more about the Yen weakening due to dovish policy, potentially leading to interventions if it breaks the 160 level against the dollar. This is termed a "widowmaker trade" due to the risk of the Ministry of Finance intervening.

Controlled Burn: Japan's situation is described as a "controlled burn" with no easy solution, likely involving a long period of destroying real returns for investors. The 140-160 range for USD/JPY is identified as a "cabal range" where interventions are likely.

Gold and Other Currencies: Gold's performance is highlighted as a strong chart, potentially indicating a shift away from centralized banking.

Latin American (LatAm) Currencies:

A carry trade strategy is described as long six Latin American currencies (Argentinian Peso, Brazilian Real, Chilean Peso, Colombian Peso, Mexican Peso, Peruvian Sol) funded by short positions on the US Dollar.
This indicates capital flowing out of the US into these emerging markets, potentially linked to geopolitical shifts and the need for resource access as relationships with China change.

Global Macro Shifts: The focus is on these FX pairs and geopolitical shifts as having a greater impact on macroeconomics than the Treasury General Account (TGA) or Fed balance sheet discussions. The world is seen as fragmenting, with a new world order emerging.

Crypto Market Analysis

The state of the crypto market is analyzed through various metrics.

Bitcoin (BTC) Drawdown: Despite market carnage, Bitcoin is outperforming when beta goes down. The current drawdown is around 30%, which is within the normal range for this cycle, though not necessarily indicating a bottom.

Net Unrealized Profit/Loss (NUPL): Bitcoin's NUPL is at its lowest since late 2023, indicating less unrealized profit among holders, a factor of both whale and near-term holder selling.

Short-Term Holder Capitulation: The rolling 7-day moving average of short-term holder realized losses is at levels last seen during the FTX crash, indicating extreme capitulation and a lack of profits for this cohort.

Long-Term Holder Spending: While short-term holders are capitulating, long-term holders have shown high and consistent selling over the last six months, even into periods of not-great price action. This behavior is unusual and could be attributed to the four-year cycle belief, quantum risk fears, or other factors.

ETF Flows:

IBIT (iShares Bitcoin Trust): Net outflows on a 10-day and 5-day moving average have surpassed the Q1 sell-off, indicating significant capitulatory levels from ETF holders.
ETH (Ethereum): Drastic net outflows are observed, the largest in its existence.

Implied Volatility and Skew:

Bitcoin Volatility: Implied volatility seems to have bottomed out in the 30-40% range, similar to 2023, and is currently elevated due to the sell-off.
Skew: Put skew is very elevated, favoring downside protection, which is typically seen around bottoms but has persisted for some time.

Dominance and Liquidations: Bitcoin dominance is very elevated, indicating concentration. Allcoin liquidations over the last two years are substantial.

Four-Year Cycle vs. Current Cycle: The current cycle is not trading like traditional crypto cycles, leading to questions about the validity of the four-year cycle belief. This is linked to managed liquidity and Fed facilities.

Idiosyncratic Factors: The market is influenced by idiosyncratic factors like the DATs (Decentralized Autonomous Organizations) overhang and the potential for quantum risk.

Stablecoins and Global Reserve Collateral:

Stablecoins as a "Vampire Attack": Stablecoins are seen as a mechanism to extract capital from foreign currencies, offering an alternative to citizens of countries with slow growth or unfavorable policies.
Dollar Dominance: Stablecoins are facilitating the global proliferation of the US dollar, which is seen as a national security advantage.
Capital Controls: Countries are reacting by implementing capital controls on stablecoins (e.g., Bank of England's $20,000 limit), fearing a loss of monetary policy control.
Shift from Fiat: The trend suggests a move from fiat currencies to stablecoins and potentially Bitcoin as global reserve collateral, threatening existing political and economic structures.

Geopolitical Angle: The potential for state actors to target treasury companies, especially if Bitcoin becomes global reserve collateral, is considered. China's move towards a gold-backed yuan is cited as an example of this shift.

Political and Social Commentary

The discussion touches upon political trends and societal issues.

Populism and Generational Shifts: Populist movements and generational shifts are seen as slow but inevitable forces shaping political and economic landscapes. Younger demographics entering the voting bloc will eventually displace older generations.

"New Deal" Type Situations: The idea of a "New Deal" type situation, rewriting the social contract for labor, is discussed in the context of political figures like Mandani. However, concerns are raised about the feasibility of such policies in already struggling urban infrastructures.

Texas vs. New York/San Francisco: A contrast is drawn between Texas's low-tax, pro-capitalism environment with high population growth and cities like New York and San Francisco, which are perceived as having decaying infrastructure and high taxes.

Socialism and Communism: The historical track record of socialism and communism is viewed with skepticism, suggesting a slippery slope.

Destructive Mentality: A prevailing sentiment is a "destructive mentality" where individuals are upset with the status quo and latch onto any worldview that offers an alternative, even if concrete solutions are lacking. This leads to a fracturing and fragmentation of the world.

Generational Grievances: The frustration of younger generations regarding affordability (rent, groceries) and the perceived inaction of older generations (boomers) who benefited from past economic conditions is highlighted.

Policy Recommendations: Suggestions for bipartisan solutions include reducing red tape, incentivizing having children, and reforming corporate America's social contract to avoid excessive CEO bonuses and promote broader economic growth. The need to break up overly large corporations and create rules to foster competition is also mentioned.

Student Loans and Homeownership: Policies to address student loan debt and incentivize homeownership are proposed as ways to maintain capitalism and prevent societal devolution.

The "Cabal Range" and Gold/Yen: The 140-160 range for USD/JPY is referred to as the "cabal range" due to likely interventions. The correlation between gold and Yen is also noted as an interesting chart, with potential implications for currency restrictions.

Conclusion: The overarching sentiment is that the world is in a period of significant transition, marked by geopolitical shifts, evolving economic structures, and a search for new forms of value and stability. Navigating this complex landscape requires understanding these interconnected macro trends.