Yesterday we talked about the Treasury’s move to support the long-end of the government bond market — providing “greater liquidity” in the 30-year bond market, pushing yields lower.

This is the Treasury taking over a function the Fed performed for the past eighteen years (managing liquidity and the level of bond yields).

This looks like the execution of a new 1951-like Treasury-Fed Accord.

Remember, we talked about this back in early February (here), just after Kevin Warsh was named Fed Chair.

As we discussed in that note, both Bessent (Treasury Secretary) and Warsh (new Fed Chair) worked for, and are very close with, legendary macro investor Stan Druckenmiller.

Druckenmiller is a mentor to both.  And few in the world understand global liquidity, sovereign debt supply, and how they affect capital flows, risk premiums and market psychology like Druckenmiller.

Fast forward six months, and his proteges are now managing the world’s most important liquidity spigots (one from the fiscal side, one from the monetary side).

On that note, in an FT article back in January, Druckenmiller had used the word “accord” to describe the relationship Warsh and Bessent would have between the Fed and Treasury.

That word “accord” is significant, because it’s in reference to the 1951 Treasury-Fed Accord that established the Fed as an independent central bank.

During World War Two, the Federal Reserve pegged yields on the government bond market. Bills were at three-eighths of one percent. Long bonds at two and a half. The Fed committed to buying whatever quantity was necessary to hold those levels, with newly created money, without limit.

It worked. It financed the war at cheap rates. But when the war ended the peg stayed, and by 1951 inflation was running hot and the Fed was still legally obliged to buy Treasury debt at prices the Treasury wanted.

The 1951 Treasury-Fed Accord ended it.

The Fed was freed from financing the government. It became an independent central bank. And managing the government bond market went back where it belonged, to the Treasury, through the supply of debt.

That arrangement held for roughly fifty-seven years.

It ended with the Global Financial Crisis.

The Fed became the largest buyer of Treasury debt in the world in response to the financial crisis. Through three rounds of quantitative easing, then a fourth in the pandemic, the central bank bought government bonds to hold long-term rates down.

The Fed financed the deficits. The deficits kept growing.

What the 1951 Accord was designed to separate was again entangled.

As we discussed back in February, it appeared that Warsh and Bessent were assembled to take them apart again.

End the Fed’s QE business. Stop the distortion. Give the responsibility back to the fiscal side.

Then yesterday, we saw what may be the execution of that arrangement — the Treasury stepped in to manage liquidity in the long end, taking back the job of managing the bond market through supply.

Is the 1951 Accord restored?

The dollar fell on the news. But that’s the opposite reaction of this policy move.

A central bank that monetizes deficits debases its currency. If the Fed is genuinely out of the deficit-financing business, and the Treasury has to manage the debt on its own balance sheet with real constraints, then the structural change toward fiscal discipline should shore up credibility in the dollar. 

This should be dollar-positive.

As we discussed back in February, if the U.S. chooses structural reform, those who don’t will get punished.

Which brings us to Europe.

The European Central Bank is running the opposite policy.

Its bond market is being held together by the credibility of ECB intervention, and by an instrument built in 2022 that has never actually been used.

This is policy divergence.

One central bank is withdrawing from managing its bond market, and its Treasury is picking up the job openly, with published operations and stated sizes. The other is holding its bond market together with the threat of intervention.

One is separating the fiscal and monetary functions. The other is fusing them tighter.

The currency market should figure it out.

 

On Monday, we talked about the rise in government bond yields and the related vulnerabilities in sovereign debt markets (most acute in Europe).

This morning, the U.S. Treasury addressed the U.S. government bond market, by saying it will “provide greater liquidity” to support the long end beginning next month.

The 30-year fell 10 basis points to 5.19%, and yields were down globally on the news.

Let’s talk about the significance of this move by the U.S. Treasury Secretary, Scott Bessent. 

Remember, as we discussed in these daily notes, when Kevin Warsh was sworn in as the new Fed Chair back in May, the “Warsh doctrine” went into effect: a smaller balance sheet, less telegraphing, and structural reform to break the entanglement of the Fed with government financing.

And with that, under a Warsh-led Fed, the fiscal dominance funded by the Fed for eighteen years should give way to fiscal discipline, with crisis management given back to the Treasury.

We just saw it this morning.

The Treasury stepped in to support the long end of the bond market. That’s the job quantitative easing used to do. For fifteen years, when long-dated Treasuries needed a buyer, the Fed was that buyer.

Those days are over. Warsh has been explicit that the balance sheet borders on fiscal policy and that he wants the Fed out of that business.

So the backstop didn’t disappear. It moved to the Treasury.

And this is now the second time we seen evidence of the handoff.

Emergency dollar liquidity for foreign central banks used to run through Fed swap lines, extended automatically to allies. Three weeks ago the Treasury intervened to support the value of the yen and asked the Fed to expand a facility that lends dollars only against Treasuries already held.

And crisis management at the long end used to run through Fed asset purchases. Today it runs through Treasury buybacks.

So, the Fed and the Treasury are reorienting dollar policy.

On that note, one of the biggest movers on the day in global markets was gold.

Earlier this month we talked about the 4.1% jump in gold — the magnitude of which was matched or exceeded in only three episodes of the past 7 years.

And as we discussed, all three of the outsized rises in gold (going back seven years) had one thing in common: change in the architecture of global dollar liquidity (who supplies the dollars, and on what terms).

Today gold jumped 4.3% — another rise of rare magnitude.

Another big trading session, and again, it came with a change in the architecture of dollar liquidity. Not an inflation print, not a war headline, but the Treasury taking over a function the central bank used to perform.

Let’s talk about some spots in Europe that are flashing warning signals.

It’s all related to vulnerabilities in the European sovereign debt markets.

First, for comparison, the U.S. interest rate curve is steepening and the 30-year is at two-decade highs. But the 10-year sits at the high end of the same 75 basis point range it has held all year, still well below the significant 5% level. Long-end steepening with inflation expectations anchored is a term premium story. It is not a stress story.

Europe, on the other hand, is a stress story.

Italy’s 10-year is at 4.02%. France is at 4.08%, the highest since 2009. And Germany, the anchor for the entire system, is at 3.23%, a 15-year high.

Notice, France is now borrowing more expensively than Italy. The euro zone’s second largest economy, is paying more than the country everyone has spent a decade worrying about.

Is this periphery stress?  Or is this is the core repricing?

Look at Germany. It’s the safest credit in the euro zone, the benchmark every other European borrower is priced against. It’s now funding itself at a level it hasn’t paid since 2011.

Then there’s the UK, where the 10-year is back above 5%.

As you can see in the chart above, this 5% area for UK yields has been tested repeatedly over the past few months. It hasn’t sustained.

But look at the other spike in that same chart. The one that compelled the Bank of England to step in back in 2022, to resolve a liquidity crisis that was threatening to become a solvency crisis.

That spike revealed leverage in the financial system. As Warren Buffett says, when the tide goes out you see who’s swimming naked.

The tide went out, and the margin calls followed. Then forced liquidations, which drove yields higher, which brought more margin calls, and more forced liquidations.

It was a self-reinforcing debt spiral, and it happened fast. Major pension funds came within hours of insolvency. The Bank of England was forced into emergency bond buying to stop it, as the buyer of last resort.

It was never that 4% or 5% was a magic number.

It was a threshold that revealed the leverage already sitting in the system.

Now, what else happened in European bond markets in 2022?

The European Central Bank was forced back into the business of backstopping the weak spots of Europe. Italian 10-year yields crossed 4% that June, and that was enough to warrant an ECB response.

Italy is at 4.02% today. There is no response.

Why? In 2022, Italy at 4% meant a spread of roughly 240 basis points over German bunds, because Germany was yielding 1.6%.

Today Italy at 4% is only 79 basis points over Germany.

Same Italian yield. But a rising anchor. 

And this time around the ECB isn’t fighting the rise in yields, it’s contributing to it. The market is pricing in a 90% probability of an ECB rate hike on September 10, into an economy that is barely growing.

Why would they hike into that? Because of this chart.

This “gas ratio” shows the multiple Europeans pay for natural gas relative to Americans. It closed Friday at a new war high of 7.6 times, 145% above where it stood before the February strikes.

That feeds straight into European inflation. And a central bank’s response to inflation, even energy-driven inflation, is rate hikes. More upward pressure on yields.

And the energy shock is not letting up.

Scott Bessent said last week the campaign has moved from Epic Fury to Economic Fury, that the pressure has been raised again, and that Washington will apply (on Iran) measures of economic isolation unlike anything in the history, alongside a continued blockade of the Strait of Hormuz.

So Europe is refinancing debt at 15-year-high yields, with a central bank raising rates rather than supporting the market, and an energy shock that Washington intends to extend.

In 2022, the buyer of last resort arrived (to supress yields). Today the central bank is the one applying the pressure (upward pressure on yields).

All of this, while European equities sit at or near record highs.

So, the bond market is pricing the highest cost of government money in fifteen years across the three largest economies on the continent. The stock market is pricing the best conditions ever.

That’s dislocation.

Oil is back up. WTI traded back to $82 today, up 5%. That’s an $8 round-trip inside of a week. 

And it’s the sixth time the de-escalation campaign (orchestrated by the U.S. administration) has evaporated. 

Iran’s Revolutionary Guards said over the weekend that they will not reopen the Strait of Hormuz until the U.S. meets its list of demands. Iran wants to retain control of the waterway after the war, and it wants to charge tolls for passage.

That’s not going to happen.

As we’ve discussed for months, Venezuela is the model for how Trump will resolve the Iran war: eradicate the regime, take the oil, remove the leverage.

That said, Trump has made a series of starts and stops on Iran, to massage market sentiment. But the endgame is regime change and control, not a peace deal. Kharg Island, which handles 90% of Iran’s crude exports, has to come under American control.

So, clearly this does not resolve with a deal that leaves Iran charging a fee on a fifth of the world’s oil and gas. 

With that, the U.S. naval blockade remains, and the gas ratio (chart below) is pricing in risk of bigger, longer global energy supply disruption — more war. 

Remember, this gas ratio is the multiple that Europeans are paying for natural gas, relative to what Americans are paying. It just printed another new wartime high — trading above the prior highs marked in the early days of the war, and in late July.

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Gold closed up 4.1% today. And as you can see in the chart below of historical one-day price changes, we’ve only seen three episodes like this since 2019. 

Let’s talk about what was happening in these two other episodes. 

Gold closed up 4.1% on April 6th, 2020. 

What was happening? 

We were less than a month into the pandemic. Global central banks and governments had gone all-in, pumping stimulus to keep the economy alive. And there were signals from data in New York and Europe that infections and death rates might be slowing. And with that, the move in the gold market was the contemplation of the inflationary impact of the massive liquidity that was dumped onto the economy from the pandemic response. 

Episode number 2:  This was late January/early February of this year.  Gold swung sharply. Up 4.1% on January 28th. Down 12% over three days, and then a 5.9% bounce. 

What was going on? 

The Fed met and held rates steady that day, as expected. 

And remember, it was a month prior that the Fed started buying Treasuries again to address a liquidity problem that was bubbling up. 

Like 2019, it was “strains in the money markets” again, that prompted the return of Fed action. 

Not only did they start with $40 billion worth of short-term Treasuries (what Powell himself described as ‘big’), but he said the situation would require ongoing $20-$25 billion a month (a perpetual liquidity injection — up to $300 billion a year, indefinitely).

This pro-liquidity pivot was pro-asset prices.

And one of the clearest reactions was in gold:  it moved up 34% in the 35 days going into that January 28th meeting.

Two days later, Trump named Warsh as his guy for Fed Chair. And markets spent the day unwinding the ‘fiscal profligacy trade,’ and selling the ‘easy money trade.’  With that, the market narrative on Warsh painted him as an inflation hawk.

Spot gold collapsed 9.8% that day.

So, what is today’s outsized move in gold about?

Perhaps an acknowledgement of a new Fed/Treasury regime. A Fed Chair that promotes his committee’s dissents (three votes for rate hikes last week), while rejecting the dissenters “old Fed” mental model by publicly saying that pushing down demand (via higher policy rates) until it meets supply is “not my mental model” (at least in the current circumstance). 

Meanwhile, the Treasury Secretary spent this past week reorienting dollar policy.

On Friday the U.S. bought yen for the first time since 1998 — trading (selling) euros for yen.

And Bessent said Washington will do “whatever it takes” to support Japan, and asked the Fed to expand the facility that lets foreign central banks borrow dollars against their Treasuries instead of selling them.

With this event, the guaranteed dollar swap lines (dollar liquidity) managed by the old Fed, may now be conditional dollar liquidity dictated by the Treasury — conditional on alignment with the U.S. administration.

So, what do all three of the outsized gold days of the past seven years have in common.

Each was a moment when the architecture of dollar liquidity changed.

Who supplies the dollars, and on what terms.

 

Palantir reported after the close.

Revenue was up 93% from a year ago. Net income was up three-fold from a year ago ($1.07 billion, against $329 million).

Adjusted operating margin came in at 62%. So, add that to 93% growth and you get a Rule of 40 score of 155.

That said, this is a stock that was trading down 29% on the year into today’s close (35% below its all-time highs), just prior to the earnings release. 

And now we know the company grew faster in the recent quarter, became a more profitable business, and raised the outlook. 

The decline in the stock was not related to the business. It was about market positioning.

That has been the theme for AI stocks all summer. And it’s a gift.

Why? It’s in Elon’s post this morning. 

This chart describes the “singularity curve.” In singularity, AI capabilities broadly exceed human intelligence, and can rapidly self-improve.

Progress stops feeling linear and starts feeling vertical. So, the change is no longer a little better every year. More like: the world changes fast enough that the old way of thinking breaks.

Elon said months ago that we are there.

AI understands its own code and hardware. It begins rewriting its own software more efficiently. The progress accelerates because it can rewrite itself faster and more effectively than before. The cycle repeats exponentially, leading to a massive and accelerating leap in capability.

And the next phase, robots.

Models self-improving, leads to robots building robots (self-improving), which leads to machines doing physical work. And that will effectively create unlimited labor, and therefore, ultimately, a limitless-sized economy.

So, Wall Street has spent this summer debating whether the capex is too big. Debating whether the multiple is too high. Debating whether Alphabet should blow all of its free cash flow (and then some) to build more datacenters/buy more chips. 

Those are ripples on the surface. As Elon has said, if you knew a tsunami was coming, would you bother cleaning up the beach?

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The Fed held today. Three members dissented and wanted a hike, the biggest divide in 10 years.

In the press conference, for forty-five minutes the financial media expressed their displeasure with the decision. Inflation (PCE) is over 4%. Employment is full. Why aren’t you raising rates?

AI capex is running hot. Oil prices have had wild surges.

Raise rates, slow the economy, cool the prices.

Bring demand down to meet supply.  

That is the model the old Fed has run. Warsh says pushing demand down until it meets supply is “not my mental model.”

He is not starting from the assumption that demand has to come down.

He described a race between supply and demand, and he is giving supply a chance to show itself.

Unlike the old Fed, a good economy doesn’t have to be taken out back and shot. When demand outstrips supply, it should incentivize building — more productive capacity in the economy, more supply.

That leads to cooler price pressures, and a bigger, more robust economy. 

And as we’ve said, the productivity gains from AI should be structurally disinflationary. 

We know this is the Warsh view. He called productivity strong. And it’s easy to see why he wants to give it more time, and it’s also easy to see why the old Fed regime that still sits in the room wants to aim and fire at the culprit of hot demand (AI infrastructure).

Warsh fought off the room full of financial journalists that wanted their rate hike with this: “nominal and real yields are materially higher across the Treasury curve” … “market participants are learning to play the ball, not the referee.”

So, he said rates are higher since the last time the Fed met. The market has tightened financial conditions in the past month, without the Fed’s steering, or outright policy rate change. 

That said, Warsh made this comment about the old Fed’s preferred inflation gauge, PCE (which we’ll get tomorrow, for the month of June) — he said, “I’m looking at a broader set of inflation data than PCE.”

Remember, earlier this month, in a report prepared for Warsh’s first Congressional testimony, he criticized the timeliness of the data the Fed depends on.

So, it’s fair to assume he’s looking at a mix of real-time data (private and public), as are the top companies in our economy. And with that, he reminded the room of journalists that inflation has been above the Fed’s 2% target for 63 months. But for the 64th (which will be the July number) he says “the final calculation might be a close one.” 

If he’s talking about core cpi, a negative 20 basis points for July would bring the year-over-year down to 2.0% — for the first time since March of 2021.  

We get the Fed tomorrow. It’s the second Fed meeting with Kevin Warsh at the helm. 

The market is pricing the odds of a rate hike at roughly 30%, and better than a coin flip on two (quarter point hikes) before year end.

The old Fed doesn’t like to disappoint markets — using forward guidance to steer expectations, then citing market pricing to justify their move.

With that, in his first press conference as Chairman (on June 17th), Warsh said this: “I’ve said for years, inflation is a choice.” Then he told the room the committee is unanimously determined to deliver on price stability. 

Wall Street heard a hawk.

The Fed’s preferred inflation gauge (PCE) days later printed 4.1%.

If inflation is a choice, and you’ve promised to fix it, you hike rates. Right?

Not so fast. The Warsh-led Fed, if we listen to his words, is not the old Fed.

The “Warsh doctrine” has been laid out for the better part of the past year, since Jerome Powell’s job was under threat, and Warsh became a short list candidate. He began to publicly sell his policy views. 

And if we listen to those views along the way, we know he sees inflation getting back to the Fed’s target by way of two drivers: 1) a smaller balance sheet, and 2) AI — “AI is going to make everything cost less.”

Those two do the work.

First, the balance sheet. Fifteen years of expansion, which we’ve long argued is what carried gold from under $1,000 to over $5,000, was a quantity-of-money story, not a rates story. 

And remember, the Powell Fed stopped and reversed on the balance sheet as Powell was walking out the door (stopped shrinking, started expanding again as of December). The Fed has added $212 billion to the balance sheet in seven months.  

The second piece, Warsh thinks artificial intelligence is a structural disinflationary force.

In his first press conference last month, he called it “American ingenuity.” He said strong, productivity-led growth is “not something that we fear, but something we embrace.”

So, the old Fed raises rates to slow the economy down.

The Warsh-led Fed thinks the economy running hot on productivity is the cure, not the disease.

You do not hike into your own cure.

We heard from Google on Q2 last week.

They spent $44.9 billion on capital projects in three months, produced negative free cash flow of $5.9 billion, and raised the 2026 spending plan to $195 to $205 billion.

This week we hear from Microsoft and Meta on Wednesday. Amazon and Apple on Thursday.

Together with Google, these four are on track to spend about $700 billion this year, against roughly $410 billion last year. Wall Street expects the number to approach a trillion dollars in 2027.

This shouldn’t be news to anyone who has been paying attention.

Remember, last October, the man who supplies the most advanced AI chips in the world said he could see half a trillion dollars of demand on the books through 2026.

By March he had doubled it. At least a trillion dollars through 2027.

And he went further, saying he was certain computing demand would run higher than that. His words on supply were plainer still: “we are going to be short.”

Then in the May earnings call the Nvidia CFO projected three to four trillion dollars a year in AI infrastructure spending by the end of this decade.

The numbers from the companies selling access to that compute keep backing it up. Google reported extraordinary demand last week. Cloud revenue grew 82%. Contracted backlog reached $514 billion.

So why is Wall Street wringing its hands about capital spending?

Keep in mind, these are companies producing tens of billions of dollars in operating cash flow, quarter after quarter, and putting that cash into capacity that is already sold.

But what about the debt raises?  Not only are they spending their operating cash flow, now they’re borrowing. 

When demand is growing faster than you can fill it, and the operating profit on that capacity covers the debt service roughly nine times over, levering the balance sheet is exactly what a shareholder should want.

And that kind of operating leverage is normally rewarded.

But Wall Street seems worried about the spending. Worried about the borrowing.

The only reason to worry about either is if you are worried about demand.

But they don’t seem to be worried about that.

Why?

Because agentic AI means model usage is multiplying by the day, and has been since February, when the agentic moment arrived.

Now add the proliferation of open source models, now at or near the level of the best in the world — and demand for compute goes up, not down.

More models, running in more places, doing more work. That is the justification for more capacity, arriving just as the companies best equipped to build and supply it are spending more and planning to spend more — as they should be.

The ECB met today. Remember, in Europe, before the Iran war, the market was pricing rate cuts/easier money to stimulate weak economic activity. 

But soon after the first strikes on Iran, and the related energy shock that followed, the interest rate market started pricing in as many as three rate HIKES to counter the expected energy-induced price pressures.

So, what happened today? 

They held rates steady.

And Lagarde acknowledged that the risk to growth is to the downside, while the risks to inflation are to the upside. 

So, growth is weakening while inflation pressure builds.

That’s the trap for the ECB. Respond to one side, exacerbate the other. The culprit is the energy shock (drives prices higher, while simultaneously dragging the economy lower).

And as we discussed earlier this week, this is the chart (below) that explains the economic squeeze in Europe. It’s the premium Europeans are paying for energy (Dutch TTF Natural Gas) relative to Americans (Henry Hub Natural Gas) — and it has been ramping aggressively higher all week. 

The multiple hit 7.1x today, a new high for the war, above the March peak.

Now, let’s revisit this next chart we looked at back in March…

This chart above represents the risk premium in Europe.  

Both the red and the blue lines show the key spread between Italian yields (Europe’s most fiscally fragile major bond market) and German yields (the anchor). 

The red line is the 2022 period surrounding Russia’s invasion of Ukraine.  The blue line is the current period (101 trading days into the war).  Everything to the right of the black vertical line is the market reaction to the war catalyst.

Now, the obvious observation is that the blue line is much lower than the red line. The current spread between German and Italian yields is much tighter in this U.S./Iran War (and related energy shock). 

Is that because the risk to Europe is significantly less?

Well the Italian yields component is signaling a similar degree of risk as it was in 2022 — trading over 4%, which is a level back in 2022 that European sovereign debt (generally) started showing stress, which compelled the ECB to act. The ECB restarted QE (QE by a new name, the “Transmission Protection Instrument”) to stabilize bond markets of the weak euro zone countries.

So, this time, Italian yields are back above 4% (up more than 50 bps this month alone). But the spread remains tight relative to the 2022 market stress.  Why? Because German yields (the historic low borrowing-cost anchor of Europe) are now more than two times higher than in 2022. 

The fiscal rock of Europe isn’t what it was just four years ago.

So, the tighter spread isn’t telling us Europe is safe. It’s telling us the anchor has moved.