Summarize this content to 2000 words in 6 paragraphs in Arabic Good morning. The minutes from the Fed’s December meeting were released yesterday, and they gave more evidence that the Fed’s governors are jumpy about inflation (and Donald Trump’s tariff and immigration policies). The market barely responded. A cautious Fed seems to be priced in already. Email us: [email protected] and [email protected]’s writers thoroughly enjoy Martin Sandbu’s Free Lunch newsletter, which just added a Sunday edition, written by Tej Parikh. We think Unhedged’s readers will enjoy it, too. Sign up here. Quantitative tighteningTen-year Treasury yields, at almost 4.7 per cent, are at their highest level since last April. No one likes this. Treasury investors have lost money. Equity investors will see a threat to stocks’ high valuations. Homebuyers foresee more expensive mortgages. And for government officials, the bond market is signalling discontent with fiscal policy.The causes are mixed. The market seems to be absorbing recent strong economic news, which suggests that inflation might stay a bit high. Investors may be coming to terms with the possibility that full Republican control of the government might lead to bigger deficits. At the very least, the bond market is pricing in rising uncertainty. Structural changes in the Treasury market may have a role, too. The Treasury has been issuing a larger share of short-interest debt than in past years, which has made longer-duration Treasuries more scarce. This may have supported prices and driven down yields. Some observers have characterised this as a “secret” monetary policy tool — “quantitative easing by other means”. Treasury secretary Janet Yellen has denied this claim. Incoming Treasury secretary Scott Bessent is said to favour issuing more long-duration debt. It’s possible the market is anticipating Bessent’s approach and selling long bonds.The rise in yields may subside. But if it persists, adding to the stress in the financial system, what will happen to monetary policy? If inflation does indeed hang around, the Fed will have to keep rates higher for longer. But what of quantitative tightening, or the effort to shrink the bank’s balance sheet after the Covid-19 pandemic response bloated it? Might the Fed halt it to reduce stress on the financial system? Might they even reverse it, and start buying Treasuries — quantitative easing — again?Unhedged has not written about QT in a while for a simple reason: it’s been working. After QT contributed to 2019’s repo crisis, many feared that the newest QT cycle, started in 2022, may lead to similar panics. But things have been smooth, and there is good reason to think they will remain so.For starters, QT does not seem to have had a major impact on long yields, so ending it would not give the Treasury market much relief. By buying up Treasuries, the Fed raises the price of Treasuries and depresses yields during quantitative easing (though the size of the impact is debated). At the start of this cycle, many feared that QT would have the opposite effect. But the impact appears to have been more muted: a paper by Wenxin Du, Kristen Forbes and Matthew Luzzetti estimates that it has boosted yields by roughly 8 basis points. Next, the Fed would only end QT if faced by a major liquidity breakdown in capital markets, and a jump in Treasury yields does not a crisis make. From Darrell Duffie of Stanford University:The Fed only buys up securities when interest rates are 0 to stimulate the economy, or when the market for Treasuries gets clogged up. It’s not that rates are high or low, it’s that the market is not functional because there are too many investors selling Treasuries . . . [even] if Treasury yields get very high, the Fed won’t move unless there is market dysfunction. QT may be reaching its natural end soon, in any case. There is no “right place” to stop QT — the Fed is feeling its way, or “learning by doing”, in Ben Bernanke’s words. Ideally, QT stops at a point where banks reserves have normalised, but there is still enough liquidity in the system for markets to function smoothly. One approach to finding this level is looking at the sum of bank reserves held at the Fed and balances in the reverse repo window (RRW), or bank reserves plus “the excess reserves that banks can access if they are willing to pay market rates”, according to Joseph Wang of Monetary Macro. Together, the two represent the total amount of money available to the banks on short notice. When the repo crisis hit in 2019, that number was around 8 per cent of GDP. Getting close, but not too close to that number, is a reasonable goal. And we are probably not too far off: the sum of the RRW balance and reserves is around $3.4tn, and 8 per cent of Q3 GDP is $2.3tn. Most analysts we spoke with expect QT to end this year — but of natural causes, rather than market stress.(Reiter) More on Big Tech capexSeveral readers wrote in response to yesterday’s piece about capital spending and depreciation expense at the big US tech companies. The gist of their comments was that the market sees through accounting, and looks at cash flow. That GAAP profits of the Big Techs are not representative of how much they are spending doesn’t really matter.This is right, but only to an extent. Here is free cash flow (operating cash flow less capital expenditures) at the five companies we looked at yesterday:These companies (except for Tesla) still generate a boatload of free cash, even after shovelling billions at AI data centres. But notice that the trend in cash generation is flat to down. This is easier to see when you look at them in aggregate:Now, one might look at this and say, “cash flow is cyclical, and the industry has been through down cycles before, like in 2021-2022, no big deal”. And there is some truth to that. But it is worth remembering that during that part of the cash cycle, all these stocks underperformed the market (and except for Microsoft, the underperformance was significant). Of course, the important thing is what happens next — how long the wild AI spending continues. It’s hard to say. Meta, Amazon and Alphabet have all suggested that capex will be higher in 2025 than in 2024. We’ll find out more from fourth-quarter earnings reports. In terms of earnings per share — as opposed to cash flow — the future is doubly hard to see, because we don’t know how exactly these companies depreciate data centre assets.Ravi Gomatam of Zion Research Group, which specialises in accounting issues, emphasised to me that modelling future depreciation at big tech companies was highly complex. The companies provide only high-level information about their investments, and those high-level numbers can obscure a lot. Take data centre spending: what part is servers? The non-server infrastructure? The building? If treated individually, each of these would be depreciated at different rates; or they could be depreciated together. On top of that, there is the question of how depreciation rates might be changed, or writedowns taken, when computer equipment is made obsolete by innovation. A lot of assumptions and back testing is required to come up with a reliable projection.What we can say for sure is that investment, depreciation and cash, and not just AI hype, will matter for tech investors this year. One good readStuck in the middle.d template
