The Bond Sell-off and the AI Bubble

When Paul Krugman wanted to talk with someone who understood the AI bubble, he called Paul Kedrosky, as did Derek Thompson. Though I'm much less of a fan of Thompson than of Krugman, the fact that a writer best known for pushing the techno-optimist influenced abundance agenda picked a tech critic known for appearing on Ed Zitron's podcast says a lot about Kedrosky's standing.

Last week Zitron posted a discussion with Kedrosky entitled "The Hidden Recession Beneath The AI Bubble" which walked through the grim economic implications of the AI bubble. It was a bleak and densely packed fifty-four minutes, including a long and depressing discussion of balance sheet recessions. There's no way to boil this down (I actually listened to the whole thing twice to make sure I got the nuances), but this one bit jumped out. [Apologies for the quality of the transcript.]

Yeah. Yeah. So, so normally the Treasury market, which is a multi-trillion-dollar market, is so large and liquid that unless you are a sovereign, meaning another country issuing debt on the scale and with the same sort of security as the United States, um, you really—it's really hard to influence it just through issuance, meaning that just because I'm selling Treasuries, or I'm—or not Treasuries, I'm selling comparable-duration debt, it's really hard to have an impact on Treasuries because it's such a big, large, and unusually liquid market.

So one of the things that happened a month ago was that this thing we call AI capex and this staggering amount of issuance, much of which has a duration, meaning the length of time over which the bond becomes due, uh, the debt becomes due, is on the—it varies from 5 to 15 years, but let's call it a median duration of 10 years. It began to seem like it was—something unusual was going on in Treasuries.

And so, as we sort of work through the math, and then this has now become fairly widely accepted, that AI capex issuance was actually—had become so large that it was beginning to bleed into the Treasury market. And so one of the reasons why we had this Treasury market freakout is because of the unprecedented amount of AI-related debt being issued.

And that in turn was causing a sell-off in Treasuries as people said, you know what, given the choice—and this is a remarkable thing—given the choice between owning 10-year Treasuries backed by the full faith and credit of the United States or owning 10-year debt backed by a hyperscaler's, um, pristine—and I have that in air quotes—uh, credit rating, I'd rather—I’d rather have the latter at the margin.

That just doesn't happen. I mean, there's no reason why someone historically would do that because obviously sovereign debt is backed by the full faith and credit of the country, and in particular, in the case of the United States, you can print your own currency. So it's like you'd have no—there's no prospect of default other than deflating it away.

So having that happen was an artifact of two things. One was the crazy scale of issuance, which is now approaching in excess of a trillion dollars.

Well, like, all AI debt is approaching the—and—and more than 60% of AI financing is now debt-financed, up from something like 15 to 20% a year ago, and it's now the largest piece of the investment-grade marketplace. It's now the largest piece of the high-yield marketplace. It is literally taking over global debt markets.

And we had this unprecedented phenomenon literally a month ago where it caused—this in part caused this global bond freakout in the Treasury market because the scale was so large, and the counterparties, the hyperscalers, for crazy reasons were seen as such secure credits that it began to literally compete with the—the most [laughter]—the highest-scale sovereign in the world's debt issuance, which is the United States.

And that was—I think the currency of the world, the currency of the world, was that AI capex as a currency was beginning to compete with the dollar in a really sort of loose sense. So, so that was the next one that really caught my attention because that has consequences because, you know, in turn, as the cost of financing the US deficit rises, then—or—and its existing debt, the cost of servicing it rises, then obviously that has consequences in terms of the United States's fiscal position.