What an end to the shutdown means for Fed rate cuts, why the bond market is worried about AI

Key Concepts

• Government Shutdown: A situation where non-essential government functions cease due to a failure to pass appropriations bills.
• AI Trade: Investment strategies focused on companies involved in Artificial Intelligence development and deployment.
• Stablecoin: A type of cryptocurrency designed to maintain a stable value relative to a specified asset or basket of assets, such as a fiat currency.
• Federal Reserve (The Fed): The central banking system of the United States, responsible for monetary policy.
• Dual Mandate: The Federal Reserve's objectives of achieving maximum employment and stable prices (low inflation).
• Interest Rates: The cost of borrowing money or the return on lending money.
• Credit Spreads: The difference in yield between a corporate bond and a comparable U.S. Treasury bond, reflecting the perceived credit risk.
• Buy vs. Rent Break-Even Point: The time it takes for the financial benefits of homeownership to outweigh the costs of renting.
• ETFs (Exchange-Traded Funds): Investment funds traded on stock exchanges, offering diversification and liquidity.
• Fixed Income: Investments that provide a fixed stream of income, such as bonds.

Market Catalysts and Economic Overview

The US trading day began with a mixed picture. While the Dow Jones Industrial Average was up approximately 450 points (about 1%), the S&P 500 saw a smaller gain of about a fifth of a percent. In contrast, the NASDAQ was trading lower by about a fifth of a percent, indicating a divergence from earlier futures market sentiment that favored the NASDAQ. Sector-wise, energy, real estate, and communication services were down, while financials and healthcare were leading the gains.

A significant market catalyst being watched was the potential end of the government shutdown. The House of Representatives was expected to vote on a funding bill to reopen the government, following a bipartisan deal that cleared the House Rules Committee. Washington correspondent Ben Worshkll reported that the House was scheduled to convene at 12 noon, with the final vote anticipated before 8:00 PM Eastern. House Speaker Mike Johnson expressed optimism about having the necessary votes. The deal would extend government funding until January 30th, with some agencies funded through the end of the fiscal year. President Trump was expected to support and sign the bill.

Data Lag and Federal Reserve Implications

The reopening of the government would also address the significant data lag caused by the shutdown.

• Inflation Data: October inflation data was unlikely to be released, as surveyors were unable to collect price information during the shutdown. The focus would shift to November data, but even that might be "tainted" due to the ongoing data collection challenges.
• Jobs Data: September jobs data was expected to be released relatively quickly as it was largely completed before the shutdown. However, October and November data were uncertain, depending on when workers returned and the availability of survey information. There might be possibilities to recreate some of this data.

This data uncertainty creates a "fog" for the Federal Reserve, particularly as they approach their December meeting. Senior advisor John Hilenrad Stone noted that the Fed has a dual mandate of stable prices and maximum employment, with inflation and unemployment rates being key data points. The tainted data for October and November for both inflation and unemployment means officials might be incentivized to wait until January, when the data picture is clearer, before making decisions on interest rates.

Federal Reserve Dynamics and Leadership Changes

The Federal Reserve is also experiencing shifts in its internal dynamics. The retirement of Raphael Bostic at the end of February 2025 was discussed. While Bostic is not a voting member in 2025 or 2026, his departure is seen as representative of growing discord within the central bank. The expectation is for more disagreement on interest rate policy in the coming years, potentially making the Fed's decision-making process more akin to the Supreme Court, with less unanimous outcomes. The influence of presidential appointments on the Fed board and their role in selecting regional bank presidents was also highlighted, suggesting a potential shift in the Fed's ideological leanings over time, though this is expected to be a slow process.

AI Infrastructure Buildout and Bond Market Concerns

A major theme driving market activity is the substantial investment in AI infrastructure. The total spending on construction of AI data centers is projected to reach $1 trillion by 2030. This "meteoric rise" in spending has generated angst, spilling over into the bond market.

Corporate Bond Market for AI Data Centers

Brian Whan, TCW Chief Investment Officer, discussed the bond market's perspective on this AI buildout. He noted that large AI data center deals are often coming from companies with "incredibly strong balance sheets," such as Meta and Oracle. These companies are issuing billions in transactions, but their net debt relative to their overall financial health remains sound.

However, concerns arise outside the corporate bond market, particularly in the asset-backed market involving smaller companies. The question is whether these smaller entities will be able to meet their debt obligations if the pace of AI development leads to overbuilding and subsequent market disruptions.

Credit Spreads and Investor Compensation

Whan pointed out that credit spreads across corporate bonds (both investment grade and high yield) are currently "very tight," meaning investors are receiving historically low additional yield for taking on credit risk. While AI-driven deals might offer a "healthy premium" or "a little bit of extra yield," this compensation is relatively modest compared to historical standards. Early investors in these deals may have received higher premiums, but a "bigger rush to the space" is now leading to a compression of these premiums.

Despite the issuance volume, the bond market is expected to absorb it due to significant cash on the sidelines and continued investor attraction to fixed income. The primary concern for the bond market is the potential for a "disruption or a hiccup" in the demand for data centers over the next 12 to 24 months, driven by rapid technological changes and the risk of overbuilding. This could lead to "winners and losers" and potential pain for bond investors who have moved too quickly into this area.

Underappreciated Areas in Fixed Income

Whan suggested that while the market is focused on AI, there are "big other parts of the fixed income market that are kind of being forgotten about." These include parts of the securitized market and high-quality assets like agency mortgages. He advised retail investors to look beyond the popular AI-driven investments and consider these overlooked areas for value.

For retail investors, the advice is to remember that bonds are essentially loans with limited upside (returning par). The focus should be on making "really good sound investments" to generate income and total return. Expressing euphoric views might be better suited for equity portfolios, while bond portfolios should aim for stability, income, and liquidity, akin to a "four iron on the golf course."

Circle's Financial Performance and Stablecoin Outlook

Shares of Circle, the stablecoin issuer, were falling despite a strong earnings report. The company reported robust results for its second quarter as a public company, exceeding Wall Street expectations.

Strong Quarterly Performance

• USDC in Circulation: Grew by 108% in the quarter, reaching $75 billion.
• USDC Usage: Increased by 580%, with on-chain transactions reaching $9.6 trillion.
• Platform Expansion: Launched its Layer 1 blockchain, Arc, in testnet and saw continued growth in the Circle Payments Network.
• Financial Results: Revenue and reserve income increased by 66% to $740 million, and net income rose by 202% to $214 million. Adjusted EBITDA was up 78%.

Circle's CFO, Jeremy Foxkin, characterized the quarter as "terrific" and emphasized that the company is in the "early days of what can best be characterized as a mega trend, the building and the growth of the internet financial system."

Investor Concerns: Falling Interest Rates

The primary concern weighing on Circle's shares is the impact of falling interest rates on its revenue. The majority of Circle's revenue currently comes from "reserve income," which is earned on the assets backing its stablecoins, primarily U.S. Treasuries. As interest rates decline, the yield on these Treasuries decreases, impacting this revenue stream.

Foxkin acknowledged that the company is in a rate-cutting cycle but highlighted that Circle has experienced "tremendous growth in circulation" and "tremendous growth in our revenues and reserve income" even during this period. He argued that falling rates are "good for our business in the near term" as they lead to greater economic activity, risk-taking, and investment, accelerating the path towards the future of the internet financial system.

Long-Term Vision and Diversification

Circle is building for the future, investing in its distribution and product platform. The company is focused on bringing the world's economic activity on-chain through its platform, which is designed to be market-neutral infrastructure.

• Arc Blockchain: Described as a "fourth generation blockchain," optimized for economic activity with native privacy and the ability to pay transaction fees in USDC (money) rather than native tokens. Over 100 leading companies are building on its testnet.
• Native Token Exploration: Circle announced it is exploring issuing a native token on Arc, potentially for distributing governance over the technology.

Foxkin stressed that focusing on short-term fluctuations in revenue metrics misses the larger "forest for the trees" of the long-term growth trend. He believes that as other revenue streams ramp up, the business will become more diversified.

Analyst Calls and Trending Tickers

The market also saw notable analyst calls and trending tickers:

Analyst Calls

• AMD: Shares moved higher after AMD outlined a path to deliver over $20 in earnings per share with an annual revenue growth rate exceeding 35%. Wells Fargo raised its price target to $345.
• Oaklo: Shares saw a pop after B Riley Securities and Cantor Fitzgerald raised their price targets. This optimism stems from the nuclear tech company's nuclear safety design agreement approval from the U.S. Department of Energy, despite missing quarterly expectations.
• Carvana: Shares received a boost as Barclays initiated coverage with an "overweight" rating and a $390 price target, believing the company is well-positioned to gain share in the fragmented used vehicle market.

Trending Tickers

• Anthropic: The AI startup announced plans to spend $50 billion on U.S. AI infrastructure, including custom data centers in New York and Texas, in partnership with Fluid Stack. This project aims to support its growth and research agenda, creating jobs and with initial sites expected in 2026.
• Synopsis: The company will lay off approximately 10% of its workforce (around 2,000 employees) as part of a restructuring following its $35 billion acquisition of Ansys. The move is intended to redirect investment toward growth opportunities.
• Clearwater Analytics: The company is reportedly considering a potential sale after receiving takeover interest. Clearwater provides software to financial services companies and had a recent $1.5 billion acquisition of Infusion. Its stock has lost about 33% of its value this year.

Housing Market: Rent vs. Buy Calculus

The decision to rent or buy a home has become more complex, with the buy-rent break-even point significantly lengthening.

The Lengthening Break-Even Horizon

According to Zillow Group home trends expert Amanda Pendleton, it now takes the average homeowner 7 to 9 years for owning to make more financial sense than renting. This calculation considers:

• Mortgage Interest Rates: The portion of monthly payments going towards interest versus principal.
• Home Value Appreciation: Current flat home values and projected low growth (less than 2% year-over-year).
• Rent Price Growth: The rate at which rents are increasing.
• Opportunity Cost: Potential appreciation of a down payment if invested elsewhere.

Prior to the pandemic, the break-even point was typically 2 to 3 years nationwide, making buying a clear financial slam dunk.

Regional Disparities

Significant regional differences exist:

• Expensive Metros (New York, San Francisco): Break-even can take 15 to 20 years.
• Affordable Metros (Memphis, St. Louis): Break-even can be as low as 3 to 4 years.

The Rise of the "Lifestyle Renter"

Pendleton highlighted the emergence of "lifestyle renters" – individuals who can afford to buy but choose to rent for flexibility, freedom, and ease. The decision to rent or buy is increasingly personal, influenced by lifestyle choices (e.g., valuing flexibility over yard work) and the planned duration of stay.

Advice for Aspiring Homeowners

For those whose dream is still homeownership, Pendleton advised:

1. Financial Preparation: Improve credit score, debt-to-income ratio, and boost savings to secure better interest rates.
2. Affordability Assessment: Utilize tools like Zillow's "Buyability" to understand monthly affordability and only view suitable homes.
3. Team of Experts: Assemble a strong team including a real estate agent and loan officer.

Future Outlook for Housing

Pendleton anticipates that any cuts in mortgage rates will improve affordability, bring more buyers to the market, and shrink the buy-rent break-even horizon. However, a significant portion of renters (nearly 60%) plan to continue renting, with only 37% indicating they would buy even if mortgage rates dropped dramatically, underscoring the persistent influence of lifestyle factors.

ETF Strategies in an Uncertain Environment

In an environment of economic uncertainty and a divided Federal Reserve, ETFs can help investors navigate the market.

Fixed Income as an Opportunity

Steve Lely, BlackRock Global Co-Head of Bond ETFs, views the current environment as a "tremendous environment to invest in fixed income." The Fed's hesitation on rate cuts presents an opportunity to "lock in these yields" before they potentially resume cutting. The market is still pricing in three to four cuts over the next year.

Shifting from Money Markets to Longer Maturities

While money market funds have been attractive due to meaningful yields and liquidity, investors are encouraged to shift towards longer maturities to capture better income.

• Short Duration: ETFs like SGOV (0-3 month T-fund) offer yields close to 4%.
• Near-Term Duration: ETFs like NEAR extend duration out a couple of years.
• Income-Focused: Actively managed ETFs like BINC (CIO Rick Rieder's fund) monitor duration and credit risk.

As the labor market shows signs of slowing, longer maturities on the curve (e.g., IEF, TLT) may become more attractive.

Balancing Equity and Fixed Income Holdings

The debate continues on whether the equity market is topping out. Historically, fixed income has not always offset equity moves. However, with a potential sharp slowdown in the labor market, longer-dated bonds could fall. Investors are advised to "spread your bets a little bit."

Underinvestment in Fixed Income

Lely believes investors are still "underinvested in fixed income." With significant amounts in money market funds, a more balanced portfolio with increased income is recommended. Options like I-bonds offer a way to lock in yields with a maturing fund. Globally, fixed income has seen substantial inflows, but investors remain underallocated relative to the opportunity.

Synthesis/Conclusion

The market is navigating a complex landscape shaped by the resolution of the government shutdown, the ongoing AI infrastructure boom, and the Federal Reserve's monetary policy decisions. While the immediate concerns of a government shutdown are being addressed, the long-term implications of data lags on economic indicators and Fed policy remain. The AI buildout is a significant growth driver, but it also introduces potential risks in the bond market related to overbuilding and debt obligations of smaller entities. Circle's strong financial performance is tempered by investor concerns about falling interest rates impacting its stablecoin reserve income, though the company remains optimistic about its long-term vision. The housing market presents a challenging buy-vs-rent calculus, with lifestyle factors increasingly influencing renter decisions. Finally, in this uncertain economic environment, fixed income, particularly through ETFs, offers opportunities to lock in yields and balance portfolios, with a call for investors to consider underappreciated areas beyond the dominant AI narrative.