The great rate debate

Episode notes

What's the trajectory for interest rates? It's complicated, and structural and cyclical dynamics may matter more than near-term policy decisions. Three of our experts, Amar Reganti, Mike Medeiros, and Brij Khurana, discuss their differing views on which forces bear watching when it comes to the direction of rates in coming years.

0:00 – Introduction to the Great Rate Debate

2:15 – The rate cycle: structural vs cyclical forces

5:15 – Labor markets, inflation, and fiscal backdrop

9:00 – Foreign flows and demand for US assets

12:20 – Implications of AI

17:00 – Which matters more: productivity boost or debt reduction?

20:20 – Investor takeaways and insights for allocators

Transcript

Amar Reganti: Inflation, weak labor markets, central bank independence, tariffs, and a housing market in flux. For fixed income practitioners here at Wellington, this conflicting and noisy data feeds into what we call the Great Rate Debate. Our aim is to understand the direction of US and global interest rates and what nuanced forces hold the most sway over them. 

Today, I’ll be talking with two fixed income portfolio managers about their thoughts and opinions on this multi-trillion-dollar question. And in doing so, we’ll see that the Great Rate Debate doesn’t only come down to whether investors think rates are going up or down, though that is an important consideration. We’re going to see that how they think about rates has as much to do with their views on time horizon, portfolio construction, and implementation. 

Mike Medeiros is a macro strategist on Wellington’s hedge fund platform. Mike has refined a view over the long term that dollar rates are likely to be structurally higher. But he also watches near-term cyclical dynamics and data, which can drive rate movements and positioning in the near term, versus his longer-term structural views. Brij Khurana runs an total return strategy that incorporates credit, rates, and currencies. While Brij believes that the US economy is slowing, and that should put downward pressure on rates in the near term, he also sees the potential for rates to settle into range where labor markets do not necessarily derail growth, and that bond regain their role as diversifiers. So, let’s get into the Great Rate Debate. How, when, and why will rates move, and how should investors start thinking about it in terms of their own asset allocation. Let's start with Mike Medeiros.

Mike Medeiros: Thanks, everyone. My name is Mike Medeiros. I’m a US macro strategists on our hedge fund and global fixed income team.

Amar Reganti: And Brij. 

Brij Khurana: Hi, I'm Brij Khurana. I'm a fixed income portfolio manager here in Wellington.

Amar Reganti: You both have been among the most vocal discussants of fixed income markets here at the firm. And to our listeners, I just want to highlight that Wellington does not have a chief investment officer. Instead, our culture and our investment processes encourage debate, discussion, collaboration across investors from a variety of different strategies and asset classes. We think it makes for a richer discussion about what's happening with capital markets and how we could think about asset allocation and investing. Mike, I want to start with you. I think it was Warren Buffett who said, and I think he was paraphrasing Benjamin Graham, that in the near term, the market is a voting machine. And in the long term, the market is a weighing machine. While they were speaking about stocks, I think there is some applicability to think about that in fixed income. That in the short term, it's a narrative that can dominate. But over the long term there's real structural dynamics that can drive where yields go. Could you lay out to me where do you think we are in the rate cycle now, and how we're aligned at current levels, and how does that align with prior cycles?

Mike Medeiros: Yeah, so it's a great question. And the way I would approach it is in terms of the cyclical, let's call that the next three to six months, and then the structural backdrop. And so, from a structural perspective, one of the big overarching questions is what level do bond yields, particularly long-end yields, need to get to be sufficiently restrictive for the economy. And I approach that by looking at kind of four different factors. One is trend growth in the economy, making some assumptions about productivity, which is improved in the labor force, which is slowing quite rapidly. That's number one. Number two is average inflation. And so, making some assumptions of where we think inflation is headed over the next, call it 12 to 24 months, or where the underlying inflation rate should be over that time. To me that's higher than prior cycles. Number three, some cyclical components from the labor market getting to the Fed's dual mandate. And then, number four is the fiscal backdrop and incorporating both deficits and levels of debts and trying to figure out what that means in terms of where long-end bond yields need to head to over the medium term.

And so, when I put all of those structural pieces together, it does not seem to me yet that we are at sufficiently restrictive levels. We've had multiple fits and starts from a cyclical perspective that I'll get to in a second, but financial conditions are fairly easy. The economy in the short term is responding to that. And inflation, we're going on almost half a decade of quote-unquote transitory, with inflation still above target. Now from a cyclical perspective, right, that structural view can be right. It can be wrong. But you can't ignore the short term. 

We run an analysis which helps us decompose what elements of the cycle are driving bond markets the most at the current moment. The sensitivity to growth and inflation is actually pretty close to zero right now. It is all about the labor market. And you can see that coming through in the Fed's reaction function and even in the data payrolls has have slowed. And that's typically consistent with the Fed cutting. And so, to me I think that's really important; and puts a much higher emphasis on the labor market going forward.

I've argued internally that monetary, fiscal, regulatory, and trade policy uncertainty coming down with some of the deals that are in the cut are pretty stimulative for the economy. So the question is, since the labor markets are lagging variable, will the labor market trough over that time period? I think it's still probably a little bit early. If the economy is growing above trend, then we should start to see an inflection in, call it, later in the year into the first half of next year. And that would obviously be very important given how stretched bond yields look to me versus cyclical risk assets or some of our nominal cyclical leading indicators.

Amar Reganti: Before I get to Brij, I just want to comment on two things that you said. One is that you seem to think that at least in the near term, bond yields have sort of come close to hitting their lows. The second is, you use a quantitative lens on almost a qualitative decision. Is it that the bond market cares about the labor market because the Fed cares about the labor market and is just reacting to that?

Mike Medeiros: I think it's both. The labor market has been slowing for a few years as growth isn't slowing relative to trend. But then in Q2, we obviously got hit by a pretty big shock from tariffs and immigration restrictions are ongoing. And so, the combination of those two has led to a more material decline in payroll growth and a gradual increase in the unemployment rate. To me, though, what that reflects is less those exogenous shocks and more just growth in the first half of the year was below trend. And typically when that happens, payrolls slow. 

Amar Reganti: All right. Brij, you heard what Mike said. Where do your views overlap with what he said?  I'd love to kind of hear your take on both the short and long term.

Brij Khurana: I think the concerns that Mike raises are very valid. And we debate this a lot amongst each other. And I would say that a large part of that, in my view, is already in the price in bonds. And so, the way I look at it is you can look at forward yields, which is basically the market telling you where they think yields are going to be in the future. And if you look at what the market's pricing for the 10-year Treasury yield 10 years from now, it's getting close to five and a half percent, which is really the highest it's been since pre-global financial crisis days. So before 2008, we're looking at that type of level of attractiveness of bond yields. And so, then I think about the three things that Mike talked about it.

Let’s start with inflation. I do think that inflation is a longer-term concern. But it's actually not a concern in the bond market. The market's actually saying that over the next 30 years, inflation expectations in the U.S. are going to be around 2.25%, which is quite low and actually not that different than it was before 2018. I think the supply is another issue that that bond markets certainly worry about. But then once again, we can look at that … what's priced into the bond market versus what's priced into the Fed. And that gap is actually narrowing, which means that as much as there were some worries about supply earlier in the year, the market is actually saying supply is not a real reason for bond yields to be as high as they are, either. And then I think the third reason could be foreign selling. And we are in this world where historically you've had this, what people call a savings glut, where people in, investors in China and Europe, they basically plowed a lot of their US savings into bonds. And there was worries in April that once, the trade talks were going poorly, that they would start selling these. Well, it's almost the opposite. We've seen an accumulation of US assets in the last six months. And so, I think the three main reasons that people have for bond yields in my view are actually really, really high. At least they're not concerns or they're not priced into the market right now. And so to me, why are bond yields as high as they are right now? To me it's largely this this AI theme, and the disinflationary growth that is currently priced into the bond market.

Amar Reganti: I want to push on two things you said. Would you think that longer-term low inflation expectations just sort of builds in that there'll be a recession in the next 30 years? 

Brij Khurana: It's interesting. I think you could have made that argument a few years ago because a few years ago, let's call it 2021, 2022, the market was pricing in a lot of near-term inflation but lower, longer-term inflation expectations because the idea being that, yes, Covid was a one-off shock, prices are going to increase and people were worried about them increase even further.But at the end of the day, the Fed will do what it takes to get inflation back to target. What's interesting right now is actually short-dated inflation expectations aren't that high or different than you see in terms of long-term inflation expectations. Now it's like the inflation expectations curve is relatively flat. And I guess the way I would put it is, well, if you take that as the reason for low inflation expectations that the market's pricing in some view of a recession, that's certainly not in the price of bonds either, because bond yields are still very high. And if there's a recession bond yields should fall a lot more.

Amar Reganti: And this last point on foreign purchases and selling, we have had a record number of conversations this year about one, just sort of diversification among client assets in fixed income markets. And too, obviously other countries now have higher interest rates than we saw just several years ago. Germany, Japan both come to mind. Are you surprised at sort of the consistent bid for both, let’s say US assets but in this case, Treasuries or corporate bonds, and so on? 

Mike Medeiros: I would say you have to break it into the public sector and the private sector. In the first half of the year there were a lot of calls for capital flight out of the US because of the shift in trade policy, even immigration restrictions, and let's just call them institutional risks. I think those were all valid. And I think everyone is somewhat surprised that things have been so robust with an effective tariff rate that's at the highest level in 90 years. But at the same time, from a private-sector perspective, the US is still the hub of the world for, in particular, services and within that, technological services. And typically the private sector piece does win out. The only time it really gets challenged is when not just you have elevated inflation, but when you have inflation that's perceived to be out of control. And I completely agree with Brij, right. We're debating unrounded monthly core inflation readings. And typically when you're debating unrounded monthly core inflation readings, it's not a sign that inflation is getting out of control. Right? Is it elevated? Yes.

Amar Reganti: Was it the rounding…?

Mike Medeiros: Is it runaway inflation? No. And so, I think when you have more support there, it allows the market and global investors to focus more on the private sector in the US, which remains robust.

Amar Reganti: Brij?

Brij Khurana: I would also break it out in terms of fixed income versus stocks. Most foreign holders of bonds actually hedge the currency risks because fixed income doesn't move as much as stocks. And so, they don't really want to take the currency risk. And so, they hedge it out for the most part. In the stock world it’s different. The view historically had been that when US stocks underperform and they go down, let me buy stocks unhedged because at least the dollar will appreciate. And so, what I think is interesting this year is, is that you had US stocks go down in April and the dollar sold off at the same time. And so, people were almost hit doubly. And so, investors were really faced, foreign investors were really faced with the choice. Do they want tosell their bond holdings? Well, their bonds are hedged, so they didn't end up selling that. They didn't want to sell their stocks either when they were down so much. And instead, what they did is they said, let's just start hedging a little bit more of the currency risk. Let's just actually start selling some dollars. And so, I think that has been the persistent flow is people still holding on to their US stocks but once but getting their hedges a little bit more in line, not taking as much US-dollar exposure they as they had previously. But I do think that is a trend that's likely going to continue. You are going to see people who had, you know, a lot of foreign holders of US equities had only twenty or thirty percent hedge ratios. And that makes a lot less sense if the dollar isn't behaving in a way where it all automatically goes up when stocks go down.

Amar Reganti: By definition, that would mean it's going to be more expensive down the road to hedge U.S. dollar assets, fixed income included, probably.

Brij Khurana: Correct. And I would also say there's just almost a persistent flow that when you see these dollar rallies, you see selling into them in a way that it was the opposite way for the last few years when you saw the dollar rallying, it would continue. It's almost like the momentum has gone the other way.

Amar Reganti: Ok so, let's get to the point that I feel like is part of every discussion these days: AI. From your seats, how do you think AI affects interest rates? In both the near and long term. I say near term, just because the amount of capital that's being expanded into it. And longer term, if you believe in the productivity discussions. I'll start with you, Brij, since you brought it up, and then we'll work back to Mike.

Brij Khurana: I think the way to square the circle is why do we have bond yields so high when we have low inflation expectations. We don't have worries about supply. I think how do you square all that. And I do think it is the AI story that, if you have a disinflationary growth story then yields should be higher. We shouldn't be worried about supply because we're going to have much higher growth in the future to pay off the debt. And look, I guess I'm actually not going to take a side on that issue, even if you might want me to. I don't know how productive AI is going to be at the end of the day. That being said, I would say a large part of the growth we have is based on that enthusiasm. So if you took out AI capex and related things this year, you would basically find out that we probably are close to recession. We probably have zero percent real growth in the US, and most of it has come from this AI investment cycle. And the point being is that maybe that persists for the next few years. But if the market ever starts repricing that and saying, well, this may be not as productive as we thought, then the question is what is the pillar of growth to take the US… to continue this the strong environment we've had. And I guess that's the point I would make for bond yields, is that the bond yields are almost pricing in the same Goldilocks environment of high growth, low inflation. And well, what if that doesn't happen? Then you know bonds can become a diversifier again to stocks in a way they really have not been for the last few years. The last few years, if stocks are down, bonds are down. If stocks are up, bonds are up. And the point is they make much more sense from an asset allocation perspective if they become what we call negatively correlated with stocks again. And I would argue given how dependent the economy is on this AI spending, the argument that bonds are going to be more negatively correlated going forward has increased.

Amar Reganti: Okay, Mike, what are your thoughts?

Mike Medeiros: If you want to talk about how the technology is going to evolve from here, we probably have the wrong two people.

Amar Reganti: Wrong three people, to be fair.

Mike Medeiros: And so, I have no clue how to evolve from here. I think if the technology stopped today where it's at, we probably wouldn't see much more in terms of productivity. But I think you have to assume, given the pace of advancement, that we do continue to see more and more breakthroughs from a technology perspective. One thing I find interesting is that the markets are treating a prospective productivity shock from AI very similar to previous productivity cycles. And so, if you go back to World War II, there are two major productivity cycles, one from 1950 to 1970, the second from 1994 to 2004. From an aggregate perspective, both were very similar. Trend growth improved, led by productivity, but also with more than one percent growth in the labor force. On balance, the labor market benefited from the increase in productivity, meaning on net, more jobs were created over that period than lost. And third, from a fiscal perspective, debt to GDP came down in both of those periods, without the need for fiscal tightening. I think this type of productivity we could be getting from AI could look different and that would have different implications for fiscal policy and also for interest rates for that matter. 

So, the first difference is the labor force. Like one of the things Brij and I talk a lot about is just a shift in the labor force dynamics that the demographics in the US and much of the developed world are much worse than any of the cycles I just mentioned. What's been holding it up has been immigration, and that's starting to go the other way. We can debate how effective the restrictions are, how effective deportations are. But it's pretty clear in the data that the foreign-born labor force has been slowing since Q1. And that means, from a trend growth perspective, productivity has to be that much higher to lift trend growth. So that's number one. 

Number two is the type of technology, right? There is certainly a lot of speculation that the type of technology could lead to more job displacement over the next three to five years. That, I think, would be really important in the fiscal piece, because part of the saying “there's the only free lunch in economics is productivity growth” comes from the fact that when you get these productivity booms, you get disinflation, and it helps the denominator and the numerator from a debt-to-GDP perspective. If you look at the CBO's alternative forecast, a half a percentage point increase in total factory productivity growth stabilizes debt to GDP, which would be a huge deal. Debt to GDP is projected to rise to 120 percent over the next 10 years. That assumes, though, that you get the revenue benefits from the increase in trend growth as it relates to employment. If that's not there, then it could look very different from a revenue intake perspective, and it could not be the fiscal free lunch that it has been in the past.

Amar Reganti: So which do you think will have a larger effect on rates: a period of robust growth driven by productivity or a resulting reduction in debt to GDP? 

Mike Medeiros: I think it's really important because I think it heavily depends on the impact it has on the labor force. Brij mentioned disinflation through the breakeven curve. Totally. It is apparent in market pricing for that risk assets near all-time highs. That is exactly what you would expect stocks and bonds to do if we're about to get a big increase in productivity. If you get that coming through without the jobs, then that opens up a host of potential issues, not just from a fiscal perspective, but also the response to that. If we're in a world where  growth from productivity is three to four percent, but the unemployment rates heading to six, eight, ten percent, I find it highly unlikely governments, not just in the US but globally, sit idly by, meaning cash transfer programs, government investment, or even universal basic income. That all has a pretty significant cost. And so, to me, if you get any signs of that coming through, and again, this could be the next two years, it could be next year. I'm skeptical of that, but it could take a while to manifest. To me, the front end would be anchored by the Fed. It would have to respond to the rise in the jobless rate. The back end, though, could start to reflect more term premium in the fact that the cost of implementing these AI-type government policies is going up at a time when debt levels are elevated. So to me, that could result in a much steeper curve, right? We've had a pretty big steepening in the yield curve year to date, but that could be worth another 100 to 200 basis points there.

Brij Khurana: I think I think that could happen. Though initially what I'm more concerned about is if you have that stronger growth that could raise short-term inflation. So you have so much spending going into the economy that you get short-term inflation I think is probably too mispriced on the low side. People aren't expecting inflation. And that's why I think, almost, the Fed pricing at the front end of the curve, basically what the market thinks the Fed's going to do. It's still pricing in the Fed getting to three percent next year, which is another 100 basis points of cuts from here, which seems like a lot if you are still growing as high as we expect, so, I think on a short-term perspective, I'm a little bit more nervous on the inflation side of things. But I also think the impact of AI really on labor income matters, and also with how the Fed's going to interpret it. So right now, if you hear all of the Fed talk, it's all saying, well, we have much lower labor demand, but we also have less labor supply because we have less immigration, and that's actually keeping the unemployment rate relatively low. My interpretation of that is it just means less income coming into the economy. Right? Less labor demand and less labor supply just means less income. Almost half of consumption is with the top ten percent of income levels. And so, you have a very bifurcated economy where rates are restrictive for the lower-income consumer, they're restrictive to small businesses. And they're not restrictive at all if you're investing in AI capex. I mean, they can print bond yields at whatever size they want, at whatever price.

Mike Medeiros: And I think the Fed has to manage to the aggregate. They're aware that there are pockets of weakness in the economy. And so, I think the Fed needs to be aware of the bifurcation, but for them, they need to see enough weakness in any sector of the economy start to bleed through into the aggregate. My baseline is the economy will be above trend. lower unemployment rate but also elevates shorter-term inflation risks at a time when you're getting these exogenous shocks too.

Amar Reganti: Okay. Well, look, I think we've covered a lot and, like, all of these things, in part or in total, go into how you view the world of interest rates. And, and they're not sticky and fixed. They shift as the data shifts. So it's very possible you two could be at completely different sides of the table when it comes to thinking about the directionality of interest rates in a given quarter, month, year. So, one last question. How should investors and asset allocators think about interest rates and fixed income in their overall asset allocation? I will start with Brij first.

Brij Khurana: I think the takeaway I would have is that most markets right now are priced for the Goldilocks opportunity, which you have low inflation, high growth. Whether or not that stocks whether or not that's bonds. And I made the argument earlier. And I guess the way I would put it is we've never been at a time where there's more things that could upset that apple cart. Inflation could pick up because of AI spending. Growth could come down from lower labor income. And so, you know we're going to see how this all evolves. Asset prices are almost pricing in one economic scenario, which is Goldilocks. And if you're thinking from an asset allocation perspective, when the market's all on one side, it's important to think about, does your portfolio stand up into the different economic environments that could materialize from here? Could it be slower growth? Could it be higher inflation? And think about what assets would do well in those environments. 

Amar Reganti: A very unstable equilibrium.

Mike Medeiros: Yeah, I completely agree with that. And one of the things about financial stability risks, given the starting point on valuation is they typically, not always, but typically rates are the mechanism that can cause repricing in some of those. And so, as valuation of risk assets continues to grow, I think it becomes much more sensitive now to any rise in rates. And so, for me, like putting all of this together from cyclical, structural perspective, from a fixed income point of view, right, to me, the level of yield curves on a six- to 12-month horizon, still look too flat, meaning they could steepen a little bit further. And we're at a point now, I think, we're just in terms of level of yields — this is in the US — valuations are starting to look on the rich side relative to the potential nominal growth outlook over the next six months or so and also on a cross-asset basis that Brij alluded to also.

Amar Reganti: Well gentlemen, thank you for taking the time today to have this discussion. I found it fascinating to hear where your views diverge and overlap on the direction of interest rates and the dynamics behind them. It’s always good to talk to both of you.

Mike Medeiros: Thanks Amar. 

Brij Khurana: Same here.

Views expressed are those of the speaker(s) and are subject to change. Other teams may hold different views and make different investment decisions. For  professional/institutional investors only. Your capital may be at risk. Podcast produced November 2025.

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