Contrarian Codex — Macro update: the Fed's fiscal backdrop

Why another macro update — and what it is not

• He opens wondering whether he has spent more time on macro this year than in all previous years combined, "because it certainly feels that way" — after covering the macro drivers and bond market in two separate updates and the previous newsletter, "there is still more to cover as Jackson Hole is underway."
• Deliberately not another "melatonin macro supplement": he skips re-explaining the workings of the UST market and global bond markets he has already covered and goes straight to what changed. Written across Wednesday and Thursday with Friday reserved for the Jackson Hole data, so "I might be a few basis points off here and there."

The long end: lower is lower, and that is all it is

• The 30-year has come down roughly 14bp since he last wrote about the bond market and trades near 5.17%, with the 10-year around 4.64% after tagging 4.75% late last week — its highest since early 2025.
• "Lower is lower, sure. The deficit did not improve though. No new buyer appeared for 30-year paper. Inflation did not roll over either folks." The rally is an announcement effect, not a change in the financing arithmetic.

The buyback: $4bn an operation against $2.1tn of financing

• A bit over a week ago Treasury said it would at least double its liquidity-support buybacks in the 10-to-20-year and 20-to-30-year sectors, taking the maximum from $2bn per operation to at least $4bn, effective early September and running through the current refunding quarter.
• The 10-year closed down almost 6bp on the news and the 30-year down 9 — "then it faded and inside of 2 sessions the 30-year was back above 5.27% and the whole move had been handed back, because $4 billion an operation against $2.1 trillion of deficit financing is a rounding error dressed up as a rescue."

The "Treasury Twist" — funded out of the General Account

• Then came the reporting that the purchases could be funded straight out of the General Account, the roughly $950bn of cash Treasury parks at the Fed.
• Bessent has taken to calling it a "Treasury Twist," which Mart concedes is "wonderful branding for something that historically required a central bank to execute."
• A footnote with a portfolio implication: Bessent "can bolster the TGA with higher gold prices as well and I think gold may be feeling that."

Swap spreads — a light backstop gets priced in

• Treasuries have outperformed equivalent-maturity swaps since the announcement and the 30-year gap between the two narrowed to its tightest since February. A swap spread is "a rough read on how willing investors are to hold actual government paper instead of a derivative carrying the same rate exposure," and years of ballooning supply had pushed Treasury yields well above swap rates.
• Hedge-fund positioning in that trade hit something like $305bn last year against under $50bn in 2022 — "so there is real money leaning on the answer."
• What the narrowing prices in: "some probability that the buybacks get raised again, and again, and again. A backstop, if you will, a light one, but a backstop."

The fear has inverted

• Calls on long bond futures have run up sharply against puts over the past week, while skews on shorter maturities have stayed near the neutral levels they have held for months.
• "A couple of weeks back it was yields grinding higher without end, and now it is being caught short into an intervention."

The crowded short — and why it settles nothing

• A trend-following simulation from one of the larger liquidity providers puts ultra-long-end fixed income at a z-score of −2.28, the most stretched short reading in a sample going back to the start of 2024. That same desk was warning about a cruel summer for bond investors a month ago and has flipped constructive, arguing further declines trigger only limited additional selling while a sustained rally forces the shorts to cover.
• Their cross-asset model finds 64 comparable episodes since 2003 where yields fell 71% of the time over the following 120 days, average decline 25 basis points.
• His conclusion: "meaningful, sure, but a crowded short describes who owns what today and says nothing about who funds $2.1 trillion next year. I would rather not be short duration into a squeeze. Basic English conclusion, the structural problem is untouched either way."

Corporate supply — the term premium's second engine

• Investment-grade issuance has run close to $1.5tn so far this year, up something like 36% year over year and on pace to eclipse the 2020 record. The biggest technology borrowers alone account for roughly $200bn of that — about 25% of Treasury's net note and bond issuance to private investors, and around 5x what the same group did last year.
• A single multi-tranche deal printed near $53bn. "Somebody sold a century bond. 100 years of duration, into this."
• Hyperscaler capex is projected near $800bn this year and above $1tn annually from 2027, with full-year AI-related issuance estimated somewhere between $300bn and $570bn. One estimate puts roughly 30bp of this year's move in the 10-year on corporate and mortgage supply combined — "so the term premium thesis picks up a second engine it would appear. Sovereign supply meeting a shrinking pool of price-insensitive buyers was always the core of it."

The yen operation — funded by selling euros

• Toward the end of last month Treasury bought yen alongside Japan's Ministry of Finance, the first joint operation of its type since 1998, and funded the purchase by selling euros rather than dollars — "sparing anyone from having to liquidate Treasuries into a market that was already choking."

FIMA — asking the Fed to resize its balance sheet for an allied government

• Days later Bessent publicly asked the Fed to upsize the FIMA repo facility, the $60bn-per-counterparty line that lets foreign official institutions pledge Treasuries for dollars instead of selling them. Japan holds around $1.1tn of Treasuries and its recent intervention is estimated at $60–80bn, "so the existing cap runs straight into the constraint."
• "Every element of that architecture is engineered around one objective, making sure nobody has to sell a Treasury."
• Expanding FIMA requires an FOMC vote, "which puts a Treasury Secretary in the position of publicly asking the central bank to resize its own balance sheet in service of an allied government's exchange rate policy, right into the new Chair's first Jackson Hole address. Does that sound like an independent central bank to you? That is fiscal dominance at work."

65 months above target

• Core PCE came in at 0.2% on the month and 3.3% on the year, in line; headline ran 0.2% and 3.7%, "a touch hot." That is the 65th consecutive month above the 2% target. "65 months. Remind me what the target is for again?"
• The policy rate has been parked at 3.50–3.75% for five meetings, three regional presidents dissented in favour of hiking in July, and futures have a September hike somewhere in the 36–40% range with a hike still live into year-end. "Cuts are not on the menu at all, which is a strange sentence to write given where the long end has been trading."
• The energy component of July PCE fell 1.5%, "so the crude move is not in this print just yet as it lands in the August and September data instead."

Canada — 50% tariffs in both directions

• 50% tariffs are now live on somewhere between $20bn and $28bn of Canadian goods depending on which report you trust, with Canada matching dollar for dollar from the second week of September "and Carney using the word war out loud." The relationship carries close to $900bn of two-way trade — roughly $426bn of US exports and $454bn of imports.
• How the framework died: metals producers ran a pressure campaign against the tariff relief, Commerce ran a parallel negotiating channel alongside the trade representative's office, and the auto concession narrowed from all vehicles to light vehicles only — putting a GM plant and a Ford plant in Ontario in the firing line — "and the Canadians walked." Buried in the wreckage is a package that reportedly covered critical minerals, aerospace and export controls.
• "I struggle to construct a path where you run 50% tariffs in both directions against your largest trading partner and get a disinflationary outcome out the other end, into a Fed that already has a hike priced and 65 months of above-target inflation on the board."

Iran sanctions run through Chinese banks

• Treasury promised an economic onslaught against Iran's financial connections, rolled out dozens of designations and then threatened secondary sanctions against anyone still trading with Tehran. China buys something like 90% of Iran's oil, "so any serious version of this runs through Chinese firms and eventually Chinese banks, weeks before Trump and Xi are supposed to meet next month."
• Beijing has already warned it will take all necessary measures. "The retaliation lever I would watch is a fresh round of critical minerals export restrictions, because that is the pressure point Beijing reaches for every time it gets squeezed and there is no reason to think it has found a better one."
• For now the market read the package as softer than feared and noted the trading partners were spared — "but if that changes and new sanctions arrive that can really mess with the market."

Hormuz — two corridors on the same map

• The IRGC says a revenue-sharing agreement has been reached with Oman covering each country's share of the strait's waters and the fees; both foreign ministries were "considerably more careful," describing an interim framework for resuming transits and declining to confirm anything about money.
• Iran has designated one corridor running through its own waters and the western naval coordination group another running south through Omani waters — "which is the whole dispute drawn on a map."
• Trump says the mines are gone, the strait is open and 10 million barrels made the passage in a single day; the head of the IMO said last week the strait is not open and there is no confirmation the mines were cleared; Tehran says only its own officials know where the explosives were placed. "Another case of mixed messaging olympics from everyone involved." The EIA does not expect Middle East production near pre-conflict levels until early 2027.

The deflated risk premium — optionality sold too cheaply

• Tehran still wants sanctions lifted, the blockade ended and its assets unfrozen, "none of which Washington has shown the slightest sign of conceding just yet."
• "So the risk premium has deflated on a framework nobody has signed, that would not reopen the waterway by itself, and that depends on concessions nobody has agreed to make. The way I see it that optionality is being sold far too cheaply here" — he wants more confirmation on shipping volumes and on diplomacy before taking further positioning action. (More on Hormuz traffic promised for the next newsletter, "as it may be very surprising to some.")

Warsh at Jackson Hole — hawkish, and deliberately empty

• "Warsh gave no timetable, no forward guidance and no reaction function, which will have surprised nobody who has watched him operate since May."
• The Fed will "have work to do" if it cannot be confident inflation is heading to 2% clearly and at sufficient speed, and price stability is the "predominant focus" right now. He called the 2% target firm and fixed, said the summer inflation data came in better than expected while the underlying trend has not meaningfully improved, and put progress over the past two years at modest.
• The 2-year sold off 7–9bp to around 4.30%, its highest in a month. September hike odds went from about 35% before he opened his mouth to 46%, then above 50% inside the hour.

The price action — and the part that didn't move

• The dollar index added roughly 0.55% to just under 99.7. Equities barely moved, the Dow up a couple of tenths and the Nasdaq flipping either side of flat all morning. Gold slipped toward $4,500 going in, stayed heavy on the way out and "is still weak as I am writing this."
• "Look at what did not move though": the 30-year finished roughly flat near 5.16%, the 10-year barely budged around 4.67%, "and the entire repricing happened inside 2 years."
• "A hawkish Chair delivered a hawkish speech, mentioning the word 'hike' like 5 times in the first 10 minutes, and the long end shrugged at him. The market has fully separated the policy rate from the term premium, which is the argument I have been making a lot over the past year" — and Warsh confirmed the separation himself.

What he refused to acknowledge

• Short-term interest rates remain the Fed's main policy tool; the task force recommendations will have no bearing on current policy decisions; market signals should stay "as unfiltered as possible."
• "Not one word about the buybacks, not one word about FIMA, not one word about the long end. Asked implicitly whether the Fed intends to participate in the Treasury's operation, he answered by declining to acknowledge that the operation exists."
• "So he is neither joining it nor standing in front of it and Bessent gets to keep running the long end by himself with a $4 billion hose and a checking account."

Both arms of policy pulling opposite ways

• Worth noting: Warsh said financial conditions are hard to describe as restrictive, credit and loan markets show few signs of policy restraint, business investment is rising rapidly and the economy appears to strengthen — "set that against a Treasury that has spent the past 2 weeks deliberately easing financial conditions at the long end."
• "Both arms of policy pulling in opposite directions with the Chair pointing it out and declining to name the culprit. It may just be me, but that doesn't strike me as a stable arrangement for very long."
• He also argued the potential for substantially higher growth is on the rise because of AI — "that is the grow-our-way-out-of-it argument, the same one Bessent and Trump have been running on the debt, now coming out of the Fed." A Chair reaching for productivity optimism to square a 3.7% headline print against an economy he describes as strong "ends up mattering for the fiscal side whether he intends to or not."

The issuer who needs him not to move

• Bessent has skewed issuance hard toward bills and the front end, "which I flagged for you when the refunding math first turned." If Warsh hikes in September, the government's own funding cost rises immediately across the largest and fastest-repricing part of the stack — "tightening the short rate is mechanically expensive for a Treasury that has parked itself there on purpose."
• Layer on 50% tariffs running in both directions with Canada and an energy component that has not passed through yet "and the hike gets uncomfortable real quick." Warsh is right that inflation expectations "tend to look durable until they don't" — but "he is also boxed in by an issuer who needs him not to move."
• "Warsh told us he will manage the short rate and let the long end fend for itself, which leaves the release valve precisely where it has been all along with USD written all over it… The market wanted Warsh to say who controls the long end. He told it nobody at the Fed does."

Positioning — the 10–20% cash stands, reassess in three weeks

• The next three weeks hand over a rate decision close to a coin flip (52% for September and 56% for October as he writes), 50% tariffs running in both directions with Canada, a Hormuz framework nobody has signed, and a Treasury managing the long end on its own. "Any one of those can produce a violent 2 or 3 day move in either direction and I have no interest in pretending I know which one goes first."
• "So the 10% to 20% cash position still makes sense to me here." In a regime this uncertain, cash "is optionality on somebody else's forced selling, and forced selling turns up in our sectors with some regularity" — visible that very day across the commodities space as the dollar strengthened.
• It also lets the gold asset core stay untouched when the front end reprices and the metals go heavy for a week, "which tends to be the exact moment people sell the thing they should be adding to."
• "The right number is not the same for everyone though. Remember your sleeping level." If 20% is what stops you checking prices at midnight, hold 20%; if 10% keeps you calm and fully engaged, hold 10%. "That 10-20% range at this time is a healthy one and we can reassess in 3 weeks."