Speaker 1: Hello, and welcome to another episode of the All Thoughts Podcast.
Speaker 1: I'm Tracy Alloway.
Speaker 2: And I'm Joe Whysnal So Joe.
Speaker 1: The big story in markets up until relatively recently has
Speaker 1: been the bond sell off, Like quite a dramatic sell
Speaker 1: off across the fixed income space.
Speaker 2: Yeah, really over like I guess this is the last
Speaker 2: couple months. So the yield today, well, we can sort
Speaker 2: of talk about the bond market up until today, but
Speaker 2: you know, we had been like in the threes and
Speaker 2: the fours and then we got us almost besides four
Speaker 2: point nine percent on the tenure, I've had a little
Speaker 2: bit of a pullback. We're recording this October tenth, but
Speaker 2: we are very high by any recent standard.
Speaker 1: Yeah, it is not lost on me that we are
Speaker 1: recording our bond sell off episode on the day when
Speaker 1: treasuries are recording their best one day performance since I
Speaker 1: think March of last year. But you know, we're trying,
Speaker 1: We're trying. But you're right. The recent bond market itself,
Speaker 1: it was one of those times when you see a
Speaker 1: lot of superlatives around, a lot of like highest yields
Speaker 1: since two thousand and seven, a lot of talk of
Speaker 1: standard deviation moves when we try to start calculating, you know,
Speaker 1: how many trading days it would normal trading days it
Speaker 1: would take to get moves of this size. But the
Speaker 1: interesting thing about this whole dynamic is it's not really
Speaker 1: clear what the proximate cause of the sell off is.
Speaker 1: So you have a lot of people blaming you know,
Speaker 1: the recent FOMC meeting when they release the dot plot
Speaker 1: showing higher for longer. You have some people blaming oil.
Speaker 1: You have people talking about supply. Some people are looking
Speaker 1: at more technical aspects. You have some people blaming the
Speaker 1: term premium, which I find absolutely hilarious because to me,
Speaker 1: a higher term premium is like a symptom of the
Speaker 1: sell off, not the actual driver of it. But anyway,
Speaker 1: all of this means we really need to try to
Speaker 1: get into the weeds of what is happening here and
Speaker 1: what it might mean for the wider market.
Speaker 2: Right because even if okay, maybe last Friday, right after
Speaker 2: their jobs report, when we got that very brief spike,
Speaker 2: maybe that was the peak. Who knows. But I do
Speaker 2: think it's important to try to disambiguate these things because,
Speaker 2: as you said, like I guess it's one of those
Speaker 2: things when there's a lot of explanations for something, none
Speaker 2: of them are like very satisfying, Like a lot of
Speaker 2: deficit talk lately, but it's like what, like, Yeah, what
Speaker 2: did we all do? I think we knew that the
Speaker 2: deficit was really big for a long time. Is that
Speaker 2: recent FED meeting? But again, okay, like the twenty twenty
Speaker 2: four dods came up a little bit, but does that
Speaker 2: really outrageous four point nine percent on the tenure? Nothing
Speaker 2: is quite satisfying as to what happened and why we're
Speaker 2: at this sort of like new.
Speaker 1: Level exactly well put. So today I am very pleased
Speaker 1: to say we do, in fact have the perfect guest.
Speaker 1: We're going to be speaking to a bond analyst. I've
Speaker 1: been a fan of his research for a long time.
Speaker 1: He used to work with one of our other favorite
Speaker 1: All Thoughts guests, Josh Younger. We're going to be speaking
Speaker 1: with Jay Berry. He is the co head of US
Speaker 1: and stret strategy at JP Morgan. We're going to be
Speaker 1: trying to get a handle on what might be driving
Speaker 1: the moves in bonds, but also how you go about
Speaker 1: as an analyst trying to disaggregate all these different factors.
Speaker 1: So I'm very excited. Jay, Thank you so much for
Speaker 1: coming on our thoughts.
Speaker 3: Tracy, thanks so much for having me really appreciat being here.
Speaker 1: So I guess maybe just to begin with, I mean
Speaker 1: the simple question what is driving the sella, We'll start
Speaker 1: there and then we can try to dig into different pieces.
Speaker 3: Well, I mean, Joj just said there's a whole host
Speaker 3: of reasons that have been bantered about and that maybe
Speaker 3: none of them are all satisfying. But I really think
Speaker 3: it's the confluence of a number of different factors here.
Speaker 3: So I mean an aggregate, Now we're off the highs
Speaker 3: and yield, as you said, but we're still about one
Speaker 3: hundred basis points higher than we were in the middle
Speaker 3: of the summer. And to me, it's like, what's changed
Speaker 3: over that period? And I think the early part of
Speaker 3: the move you could say was definitively a story about
Speaker 3: the US economy and fundamentals, because I look back at
Speaker 3: where we were very early in the summer and where
Speaker 3: we are right now, and over that period, we increased
Speaker 3: our second half growth expectations at JP Morgan by about
Speaker 3: two and a half percentage points from like the mildest
Speaker 3: of recessions. If you can call it that to looking
Speaker 3: for above trend growth the second half of this year,
Speaker 3: and that's like a meaningful driver I think of the
Speaker 3: move and long term rates because it's given us more
Speaker 3: confidence that the recession may be a bit further off.
Speaker 3: But it's also helped sort of anchor FED expectations at
Speaker 3: higher levels as well. So, you know, we haven't really
Speaker 3: changed the expected peak in the FED funds rate since
Speaker 3: the early part of the summer, but we pushed out
Speaker 3: the timing and we've pushed it out from you know,
Speaker 3: at that time thinking it was going to happen around now,
Speaker 3: to sort of pushing it out to the early part
Speaker 3: of next year. But then the more powerful influence is
Speaker 3: that we've disinverted that money market curb a bit, and
Speaker 3: that you know, early in the summer, we were pricing
Speaker 3: about one hundred and fifty bases points of cuts for
Speaker 3: twenty twenty four. Now we're pricing in still cuts, but
Speaker 3: we've taken out about forty percent of that. So I
Speaker 3: think the first part was fundamental, but then I think
Speaker 3: the drivers began to shift, and more recently since September,
Speaker 3: you know, FED and growth expectations have been pretty stable,
Speaker 3: but inflation expectation has been rising, and we like to
Speaker 3: get five year ahead, five year inflation expectations from the
Speaker 3: tips market, from the inflation link treasury market, and those
Speaker 3: break even expectations have gone higher by about twenty five
Speaker 3: basis points over the past six weeks.
Speaker 2: Wait, this is the five year five year forward break even?
Speaker 2: Is that the exactly the thing that you like to
Speaker 2: look at. And I'll bring that up on my terminal
Speaker 2: while you're talking about it, So I understand, Okay, growth
Speaker 2: has picked up or versus expectation, certainly compared to the
Speaker 2: beginning of the year, when, as you say, like almost
Speaker 2: everyone expected recession. Now we're at above trend growth. Maybe
Speaker 2: it don't moderate, et cetera. What is the link between
Speaker 2: that and thirty year yields or the long end of
Speaker 2: the curve, Because of course I get it the short end.
Speaker 2: It's very easy to draw a very bright line between
Speaker 2: short term rate expectations and the two year bond or whatever.
Speaker 2: But then when you get further out, it's like, Okay,
Speaker 2: why does the growth picking up in Q four of
Speaker 2: twenty twenty three effect that people are going to pay
Speaker 2: for a bond that matures in the twenty fifties or whatever.
Speaker 3: No, I think there's still some sensitivity of policy that
Speaker 3: sort of reverberates through the term structure, and the sensitivity
Speaker 3: may decline the further act to go, but it's still there.
Speaker 3: So just for a number, you know, every one hundred
Speaker 3: basis point change in FED policy expectations three to six
Speaker 3: month forward tends to sort of change long term meals
Speaker 3: by about forty to forty five basis points. And similarly,
Speaker 3: like every change in year ahead growth expectations tends to
Speaker 3: move long term meals by five to ten basis points.
Speaker 3: So yeah, the further you go out the term structure,
Speaker 3: the more I think idiosyncratic it becomes. But there still
Speaker 3: is sensitivity to what's happening to the underlying economy and
Speaker 3: what's happening with FED policy. So I think it's still there,
Speaker 3: just with a lower sensitivity than at the very short end.
Speaker 1: How do you actually go about, as a strategist sort
Speaker 1: of decomposing the different moves into different factors or drivers.
Speaker 1: And I know that you have at JP Morgan, for instance,
Speaker 1: this fair value model of where you think Treasury should
Speaker 1: be trading. And I think last week you were saying
Speaker 1: that you thought that yields had overshot fair value, which
Speaker 1: you know, I'm guessing you didn't expect what happened over
Speaker 1: the weekend in Israel to actually happen, But it seems
Speaker 1: to have been quite precient because we have seen yields
Speaker 1: come down a little bit. But how are you actually
Speaker 1: analyzing the different drivers of a move in rates?
Speaker 3: Yeah, so you've talked about the fair value model. I
Speaker 3: think that's a key input to what we do because
Speaker 3: we try to identify empirically what have been the largest
Speaker 3: drivers of yields over time, and we can look back
Speaker 3: over windows of five or ten or fifteen years, and
Speaker 3: we've got a host of factors that are sort of
Speaker 3: always consistently in the framework. And we talked about FED policy, growth,
Speaker 3: and inflation expectations being the three key drivers, like the triumvirate,
Speaker 3: so to speak, and then other factors which at various
Speaker 3: points over the last you know, ten to fifteen years,
Speaker 3: have been important and less important. I mean, there was
Speaker 3: a time when with policy rates at zero and negative
Speaker 3: territory globally, we had the share of the bond universe
Speaker 3: that was trading it a negative yield globally because policy
Speaker 3: rates being anchored at very low levels helped anchor US
Speaker 3: rates lower and that was important but less important right now.
Speaker 3: So that starts, and you know, if we have a
Speaker 3: sort of center universe about where we think fed policy,
Speaker 3: growth and inflation are headed, that's a starting point. And
Speaker 3: you're right, like when we adjusted for those factors, there
Speaker 3: was a point last week where it looked like we
Speaker 3: were trading about thirty five or forty basis points too high,
Speaker 3: where you know, you're talking about standard deviations. Before that
Speaker 3: was something like a two and a half standard deviation
Speaker 3: move relative to fair value in our framework, and one
Speaker 3: which we hadn't seen since this time last fall, after
Speaker 3: the uk LDI.
Speaker 1: Crist Right, which was the other big bond sell off.
Speaker 3: And really since the spring of twenty twenty two. So
Speaker 3: I think, you know, we take notice of that because
Speaker 3: it's hard to say, you know, I think we've all
Speaker 3: been pretty humble to the fact that the economy has
Speaker 3: been resilient. It's been tough to call, but we have
Speaker 3: to have something that sort of centers like where should
Speaker 3: rates be and how far have they gone? And this
Speaker 3: was at least a flag to us that they'd gone
Speaker 3: too far.
Speaker 1: You mentioned sort of factors driving the US Treasury price
Speaker 1: and how those have evolved over time. Can you spell
Speaker 1: that out in a little bit more detail, Like I
Speaker 1: would be very curious to hear more about what is
Speaker 1: driving moves now versus say, maybe pre twenty twenty.
Speaker 3: Yeah, I mean, I think you know pre twenty twenty.
Speaker 3: We just briefly talked about one of those factors, low
Speaker 3: and negative policy rates elsewhere meant that even as the
Speaker 3: US was increasing rates during the twenty fifteen through twenty
Speaker 3: eighteen cycle, that was something that helped anchor long term
Speaker 3: yields at lower levels. And you could see the influence
Speaker 3: there when you talk about the hedge dyel pickup for
Speaker 3: US bonds for versus most foreign currency pairs, and that
Speaker 3: has since of course eroded because basically ever made every
Speaker 3: major develop market central bank has been increasing policy rates
Speaker 3: at a rate. And the last of which that's out
Speaker 3: there the Bank of Japan, we think at some point
Speaker 3: will completely lose its YCC band and well at some
Speaker 3: point exit negative interest rate policy next year. So that
Speaker 3: was an important factor which we now don't have as
Speaker 3: a factor in the model.
Speaker 2: The Bank of Japan. It was like about a month
Speaker 2: and a half ago or two months ago, like sometime
Speaker 2: in August. I forget that because I have to admit,
Speaker 2: like all these Bank of Japan had lines about whether
Speaker 2: they're going to like keep the ten years er or whatever,
Speaker 2: like they all sort of blur. But there was like
Speaker 2: some news that happened. It was something the Bank of
Speaker 2: Japan that like changed the entire tenor of the market
Speaker 2: all at once. Can you remind me of what I'm
Speaker 2: like forgetting here.
Speaker 3: Yeah, Joe. In late July, the Bank of Japan basically
Speaker 3: allowed jgbs in the tenure sector to try trade even
Speaker 3: wider around it's sort of plus or minus fifty basis
Speaker 3: point target and effectively kind of gave you notice that
Speaker 3: at some point it was getting closer to completely removing
Speaker 3: that Y series.
Speaker 2: They're having their highest inflation in years too.
Speaker 3: Right exactly, Okay, exactly, So, I mean I think on
Speaker 3: a partial basis, you can argue that was a catalyst
Speaker 3: as well.
Speaker 2: Can you talk about when you talk about these foreign buyers,
Speaker 2: as you say this sort of like price in sensitive
Speaker 2: demand from a foreign sector, the disappearance of these price
Speaker 2: in sensitive foreign buyers, how much does that affect rates
Speaker 2: versus say, just like rates volatility.
Speaker 1: By the way. This is why I really wanted to
Speaker 1: get Jay on for this podcast, because he wrote a
Speaker 1: great note about a year ago basically talking about the
Speaker 1: retreat of price and sensitive buyers in the form of
Speaker 1: foreign central banks and the FED as well as it
Speaker 1: was winding down its balance sheet. I think I wrote
Speaker 1: it up under the headline JP Morgan is worried about
Speaker 1: who's going to buy all the bonds and at the
Speaker 1: time it got a lot of pushback. But fast forward
Speaker 1: a year and again it seems like you were broadly
Speaker 1: directionally correct.
Speaker 3: No, I think it's an important driver over a longer
Speaker 3: period of time. Like it's hard to say, and Tracy,
Speaker 3: you said this before, like whether it's the proximate cause
Speaker 3: of the selloff, but I think in the background, it's
Speaker 3: something that's contributing to what's going on because to us
Speaker 3: at JP Morgan, you know, we look at three sets
Speaker 3: of buyers who have been the main price in sensitive
Speaker 3: sources of demand for the better part of the past
Speaker 3: two decades at various points. And you talk about the
Speaker 3: foreign demand story, I mean, we know that FX reserves
Speaker 3: peaked about seven or eight years ago. The dollars share
Speaker 3: of those reserves have been coming down. But there's a
Speaker 3: point in time at the beginning of the century where
Speaker 3: FX reserves were growing so rapidly and the share of
Speaker 3: those reserves held in dollars were so rapidly that the
Speaker 3: deposit of that savings into the US, I think was
Speaker 3: something that kept long term rates low. And your remember
Speaker 3: chair green Span talking about this and the conundrum in
Speaker 3: two thousand and five about why long term rates were
Speaker 3: not rising even as the FED was tightening. So that's
Speaker 3: a key driver right there, and we look at it.
Speaker 3: FX reserves we don't really expect to grow appreciably from here,
Speaker 3: and we're not in the d dollarization camp, but the
Speaker 3: dollar share of those reserves have been on a downward
Speaker 3: trend as central banks globally have been diversifying. So it's
Speaker 3: just saying that if that was a tailwind for rates
Speaker 3: for the better part of the first half of this,
Speaker 3: you know, last twenty years, it's not there the second one.
Speaker 3: And this was more local or the US banks where
Speaker 3: they bought about three quarters of a trillion of treasuries
Speaker 3: over twenty twenty and twenty twenty one when supply was heavy,
Speaker 3: largely due to the fact that deposit growth at strip
Speaker 3: loan growth. And now we know deposits have stopped coming
Speaker 3: down like they did in the spring, but they're not growing.
Speaker 3: And I think one would think even as deposit growth
Speaker 3: picks up, that banks, after what's happened here, might generally
Speaker 3: speaking bias their purchase is shorter along the yield curve,
Speaker 3: which with less duration risk. And then the final piece
Speaker 3: of the puzzle is the FED. And I think we
Speaker 3: lose this that even though we're coming to the end
Speaker 3: to the FED policy rate tightening cycle, or we think
Speaker 3: it's actually concluded, balance sheet policies operating in the background,
Speaker 3: And just as the boj JO was really important at
Speaker 3: the end of July, I think chair pals comments at
Speaker 3: the July press conference were is equally important because a
Speaker 3: reporter asked him about whether the FED could continue to
Speaker 3: do QT while it actually lowers interest rates as inflation
Speaker 3: comes down next year, and he made the point that
Speaker 3: you'd be normalizing both the policy levers may be in opposition,
Speaker 3: but you're normalizing the balance sheet as you're normalizing rates.
Speaker 3: And I think the extended runway for QT matters because
Speaker 3: we found over a longer period of time the FED
Speaker 3: stock of holdings matters for yield levels and as that
Speaker 3: unwind that should slowly keep long term rates anchored at
Speaker 3: higher levels and re steep and yielders.
Speaker 1: So you have these longer term factors I guess happening
Speaker 1: in the background the retreat of these three groups of
Speaker 1: price insensitive buyers. Just going back to some of the
Speaker 1: short term catalysts here. You know, you mentioned term premium
Speaker 1: in the intro. Term premium is one of those concepts.
Speaker 1: I feel like it gets bandied around quite a lot.
Speaker 1: Not everyone quite understands what it means, but also there
Speaker 1: is no consensus, like.
Speaker 2: Myself, but you're not. I'm about to learn something that
Speaker 2: I've always been want to.
Speaker 1: But see you're missing out, Joe, because you should just
Speaker 1: start saying term premium. Just blame everything on the term
Speaker 1: premium and just use it as a scapegoat for any
Speaker 1: like any move that you don't agree with or that
Speaker 1: you are on the wrong side of. That's how most
Speaker 1: people seem to use it. But okay, maybe just to
Speaker 1: begin with, what is the term premium and what has
Speaker 1: happened to it in recent weeks?
Speaker 3: Yeah, so the term premium in you're right, is nebulous
Speaker 3: term I think is the extra compensation required for investors
Speaker 3: to buy longer duration assets.
Speaker 1: That is a perfect definition that I'm pretty sure I
Speaker 1: have used in my own copy before.
Speaker 3: Just made sure I googled it before. But I think
Speaker 3: there's a number of ways to look at it, and
Speaker 3: I think we can start and just talk about our
Speaker 3: fair value framework, and I think we can say everything
Speaker 3: outside of these fundamental drivers, one might possibly attribute to
Speaker 3: term premium that in the absence of being able to
Speaker 3: explain with growth and inflation and FED policy expectations, that
Speaker 3: that's a driver. There. There's also a series of very
Speaker 3: widely watched academic models. There's the ACM model from the
Speaker 3: New York Fed, the kim Wright model that the Federal
Speaker 3: Reserve Board in DC watches, which are a series of
Speaker 3: I think no arbitrage term structure models which are kind
Speaker 3: of mean reverting in nature, and those were sitting relatively
Speaker 3: low until recently, and they actually would attribute most of
Speaker 3: the sell off over the past six weeks to term premium.
Speaker 3: I think we've done a paper on this, and we
Speaker 3: think that there's some idiosyncrasies with the way that these
Speaker 3: models are constructed because they are sampled over a period
Speaker 3: of declining rates that they attribute a lot more to
Speaker 3: changes in policy expectations than term premium. So it turns
Speaker 3: they can be less sort of influential or less I
Speaker 3: think insightful. They're still very valuable, just less inciseful at
Speaker 3: these turns. And then there's finally more empirical ways to
Speaker 3: measure it too, because there's survey based measures of where
Speaker 3: economists expect policy rates to be, like the survey professional forecasters, yeah,
Speaker 3: and the survey of primary dealers, where you can observe
Speaker 3: where economists think policy rates will be over the next
Speaker 3: five to ten years, and you can compare them to
Speaker 3: ten year rates to get a sense of the extra
Speaker 3: compensation that's required.
Speaker 2: Right, So this is the key, right, because the basic
Speaker 2: idea is a long rate is just a series of
Speaker 2: overnight rates, and so that gap, if you have some
Speaker 2: estimate of where the overnight rates are going to be
Speaker 2: over the next ten years, then you look at the
Speaker 2: yeld them. Theoretically, that gap is the turn.
Speaker 3: The term premier.
Speaker 2: Exactly Can you talk about sentiment? And you know that
Speaker 2: strikes me tracy that we were recording this basically literally
Speaker 2: a month after we interviewed the bond King Bill grows,
Speaker 2: in which he said he doesn't own any bonds, and
Speaker 2: so it really strikes me that is like, well, people
Speaker 2: hate bonds right now, like people really hate them, and
Speaker 2: everyone like in that month since we talked about first
Speaker 2: of all, when we had that conversation, the ten years
Speaker 2: closer to four point two percent, So very timely call.
Speaker 2: But you know, in that month, I do not recall
Speaker 2: there's so much talk about the deficit. There's so much
Speaker 2: talk about what at all of these dates, higher inflation
Speaker 2: higher for longer we can't get it under control? Like
Speaker 2: how do you measure sentiment and how much does that
Speaker 2: drive some of these moves.
Speaker 3: I'm glad you asked that, Joe, because I think it
Speaker 3: can be really influential over shorter periods of time, say
Speaker 3: four to six weeks. So there's a host of metrics
Speaker 3: that we like to watch from the CFTC's data on
Speaker 3: sort of speculative positioning in interest rate futures, some more
Speaker 3: empirical models that sort of track the performance of hedge
Speaker 3: funds and asset managers. But my favorite ends very close
Speaker 3: to my heart because it's been something I've been working
Speaker 3: with for like more than two decades, is our weekly
Speaker 3: JP Morgan Treasury Client Survey. It's a bit of a
Speaker 3: misnomer because it's really our duration survey of the aggregate
Speaker 3: exposure of our rates franchise, and every week we ask
Speaker 3: the same number of clients in our franchise whether they're long,
Speaker 3: neutral or short duration, either outright or relative to bench mark.
Speaker 3: And we've found that when that measure sort of moves
Speaker 3: very sharply away from average levels, it can have a
Speaker 3: mean revert effect on yield the opposite direction. So you
Speaker 3: talk about sentiment, I think everyone through the spring and
Speaker 3: summer was trying to handicap when the FED would be
Speaker 3: done raising rates, thinking the next move is going on hold,
Speaker 3: which would be the precursor to rates moving lower. And
Speaker 3: our survey back in July and August was as long
Speaker 3: as it had been in over a decade, and it
Speaker 3: gave you a signal that over the next five to
Speaker 3: six weeks there could be some risk that rates move
Speaker 3: higher on a systematic basis, and that's what we've had
Speaker 3: now walk that forward in our latest survey, which is
Speaker 3: about a week old right now, is back at its
Speaker 3: most neutral level since April. So I get the sense
Speaker 3: that perhaps part of this move over and above the
Speaker 3: fundamentals could be investors reassessing those duration positions as we've
Speaker 3: priced higher for longer. Where you talk about the supply
Speaker 3: of dynamic here at work, maybe that's in the background
Speaker 3: against the backdrop of large deficits. But I think sentiment
Speaker 3: is a really large driver over shorter periods of time.
Speaker 1: So two questions on that. One, there has in this
Speaker 1: argument that as yields go up and prices go down,
Speaker 1: you are going to see some maybe buy the dip
Speaker 1: buyers start to come in and support the market. So
Speaker 1: one would you expect that to happen? And then two
Speaker 1: on the duration portion of it, like how much appetite
Speaker 1: is there for duration structurally in the financial system nowadays?
Speaker 1: And I guess a simpler way of asking that is
Speaker 1: why buy a bond at all? Especially at a time
Speaker 1: you know what I understand, Maybe you're a pension fund
Speaker 1: and you have long liabilities and you're trying to match
Speaker 1: them or something like that. But on the other hand,
Speaker 1: you do have the FED really taking a harsh look
Speaker 1: or a harsher look at duration risk, telling banks big
Speaker 1: buyers of bonds, as we were discussing earlier, that they
Speaker 1: are going to be looking at interest rate exposure and
Speaker 1: things like that. So what is the attraction of bonds
Speaker 1: at all in the current market now?
Speaker 3: I think that's a great question, And I mean, bonds
Speaker 3: are an investment alternative that are viable for the first
Speaker 3: time in fifteen or sixteen years here right. I mean
Speaker 3: you talked about it about the opening treasurey yields hitting
Speaker 3: you know, PREGFC highs.
Speaker 2: Across the curve.
Speaker 3: You know, aggregate fixed income yields for like an aggregate
Speaker 3: fixed income bond in next are probably still close to
Speaker 3: six percent right now, and so I think that's a
Speaker 3: viable investment alternative just for a broadly diversified portfolio. So
Speaker 3: I think that means there's probably a pool of asset
Speaker 3: managers that could have demand for bonds over time. But
Speaker 3: I think that's only one piece of the puzzle because
Speaker 3: it takes, you know, a very attractive yield level, which
Speaker 3: we've got, but also it takes sort of more stable returns.
Speaker 3: And you started to see that at the beginning of
Speaker 3: the year when yields started to stabilize, infunds inflows excuse me,
Speaker 3: into bond funds started to accelerate, but that sort of
Speaker 3: petered back when volatility began to pick up, and because
Speaker 3: now year to date we've got fixed income returns negative
Speaker 3: for the third consecutive year. So perversely, I think it's
Speaker 3: a little bit of like a chicken and egg. You
Speaker 3: need the attractive yields, but you need stable returns as well,
Speaker 3: and we haven't gotten that yet with the speed of
Speaker 3: the backup, but it's been talked about a lot. I mean,
Speaker 3: you look at the money and Government and Treasury Money
Speaker 3: Market Fund. It's over four and a half trillion dollars,
Speaker 3: and that obviously increased as bank deposits were falling earlier
Speaker 3: this year. But I think there's reasons to think that
Speaker 3: as yelled stabilize and you consider the fed on hold,
Speaker 3: there's room for that money to extend out along the curve.
Speaker 3: So that's one big buyer right there. I think the
Speaker 3: others that we've looked to in the past are the
Speaker 3: US Pension Fund Community Defined Benefit in Nature, and that's
Speaker 3: a three and a half trillion dollar universe an AUM.
Speaker 3: Their funded ratios are above one hundred percent, really sustainably
Speaker 3: for the first time since the financial crisis, and their
Speaker 3: fixed income ACID allocation has been rising for the past
Speaker 3: decade plus I think they had an existential moment back
Speaker 3: in twenty eleven twelve, when funded ratios were well under
Speaker 3: one hundred percent and their fixed income ACID allocation was
Speaker 3: only something like thirty five percent for managing a longer
Speaker 3: duration liability. But it's now over fifty percent, and one
Speaker 3: would think that there's probably more room for demand there.
Speaker 3: But again, I think the nature and speed of these
Speaker 3: moves mean that most active investors who have I think
Speaker 3: more leniency before they add duration are sitting back waiting
Speaker 3: to see sort of vowel receid.
Speaker 1: First, that's interesting that the upside of this violent bond
Speaker 1: sell off might be pension funds being sort of fully
Speaker 1: funded for the first time in a long time. But
Speaker 1: on that note, so one thing you often hear in
Speaker 1: the bond community is that drawdowns don't necessarily matter. Or
Speaker 1: you know, prices are going down, but these are marked
Speaker 1: to market moves, and you know your yield is going
Speaker 1: up at the same time, and so what does it
Speaker 1: matter if the mark to market is going down because
Speaker 1: eventually you would expect to get all your money back
Speaker 1: from the US Treasury. Is that a viable claim? Or
Speaker 1: you know, is it possible for everyone to look through
Speaker 1: these violent moves, or I guess another way of asking
Speaker 1: it is at what point do these become more of
Speaker 1: an issue?
Speaker 3: So I think you should be able to look through them.
Speaker 3: But for more active managers who are managing versus a benchmark,
Speaker 3: I mean, we can look at series of returns on
Speaker 3: a weekly or a monthly basis and see how those
Speaker 3: various funds are doing relative to their peers. So I
Speaker 3: think you know there is some psychology to not deviate
Speaker 3: too far away from more average excess returns are headed.
Speaker 3: And I think that's important because excess returns over and
Speaker 3: above index, which index being negative for the last three years.
Speaker 3: Excess returns for the asset manager community have been, on
Speaker 3: the average pretty challenging the last couple of years, so
Speaker 3: I think there is a degree of sensitivity there. So
Speaker 3: I think that's sort of an impactful story there, which
Speaker 3: means that there is some sort of psychology, particularly as
Speaker 3: the fundamentals are shifting, to kind of neutralize your positions
Speaker 3: more quickly, even though you may be able to look
Speaker 3: through it. And then there's a separate story about flows,
Speaker 3: which is over and above the existing stock of aum
Speaker 3: you've got that you probably need to see returns stabilize
Speaker 3: before you see incremental inflows from investors out of money
Speaker 3: market funds or out of other asset classes into fixed
Speaker 3: income as well.
Speaker 2: Can we talk a little bit more about supply. I
Speaker 2: mean we talked about the demand or the lack of
Speaker 2: the price and sensitive demand. It really feels to me
Speaker 2: like awareness of deficit. People always talk about deficits and
Speaker 2: high deficits, but it really feels to me like focus
Speaker 2: on deficits in the last month or so reached some
Speaker 2: like fever pitch when you talk to clients. Did you
Speaker 2: notice that as well, like just a lot of conversation
Speaker 2: about deficits, Joe, I.
Speaker 3: Haven't had as many conversations about deficits and treasury supply
Speaker 3: over my I think most of my career as versus
Speaker 3: what I've had the last couple of months. Well, it's
Speaker 3: hit a fever.
Speaker 2: Pitch, And so how do you think about deficits as
Speaker 2: a driver or like decomposed like supply the supply side
Speaker 2: when you talk to like attributing aspects of this right move?
Speaker 3: Yeah, I mean, I think supply matters in the context
Speaker 3: of that demand that we're just talking about, And there's
Speaker 3: a big shift that's happening. But to your point, I
Speaker 3: haven't learned anything incrementally new over the past six weeks
Speaker 3: or so that I didn't know a few months ago.
Speaker 3: And I think we've known that deficits over the next
Speaker 3: ten years are expected to be wide for some time,
Speaker 3: and maybe you can say incrementally the last couple of months,
Speaker 3: because yields have risen, the expectations over inter six spents
Speaker 3: at the federal level are higher, thus even adding to
Speaker 3: that pressure. But I think people look at the Treasury's
Speaker 3: quarterly refunding announcement on all August first as being a
Speaker 3: seminal driver there where the Treasury made and announced a
Speaker 3: series of pretty large increases to coupon auction size, is
Speaker 3: the first since the pandemic era, and sort of foreshadow
Speaker 3: to the bond community that these were likely to continue
Speaker 3: for a number of quarters at a time. That's been
Speaker 3: on our minds for some time, Like our issuance forecast
Speaker 3: for some time, I've been calling for a pretty sharply
Speaker 3: so like anyone.
Speaker 2: Who was plugged in saw that some of these coming.
Speaker 3: But I think maybe the fact that it was like,
Speaker 3: you know, the whites of the Treasury's eyes and actually
Speaker 3: seeing it mattered, but it's large, and I think we
Speaker 3: think coupon issuance and treasuries is going to double next
Speaker 3: year from this year. And in duration terms, you know,
Speaker 3: we think we're running about two point three trillion and
Speaker 3: ten year treasury equivalents this year. We're probably going to
Speaker 3: issue about three trillion and ten year equivalents next year.
Speaker 3: So it's a thirty five percent increase in duration supply
Speaker 3: into next year. And I think it matters because deficits
Speaker 3: as a share of GDP are larger now with the
Speaker 3: economy sitting above trend and growth and the unemployment rates
Speaker 3: sitting well below four percent, that I think just in
Speaker 3: the background there's concerns that when there's a downturn, how
Speaker 3: big will these deficits be.
Speaker 1: Yeah, So we are recording this on October tenth, and
Speaker 1: the benchmark yield on the ten year treasury is down
Speaker 1: from I think it was like four point eight seven
Speaker 1: percent last week. It's now at four point six percent,
Speaker 1: partly because of this flight to safety that we've seen.
Speaker 1: Pulling it all together, you know, we talked about the
Speaker 1: long term factors here, including the decline of price and
Speaker 1: sensitive buyers booming supply some of the short term technicals.
Speaker 1: What's your outlook going into twenty twenty four? And I
Speaker 1: guess I don't mean to sound mean or incredulous when
Speaker 1: I say this, but like, how can you have any
Speaker 1: certainty at this point about what's going to happen when
Speaker 1: what we've seen for the past year is this continued
Speaker 1: defiance of expectations.
Speaker 2: No.
Speaker 3: I think there's a lot of humility there, because if
Speaker 3: we had sat here, you know, nine to ten months
Speaker 3: ago and talked about the outlet for twenty twenty three,
Speaker 3: we would not have pegged ten yere yield sitting at
Speaker 3: four sixty two like they are right now. But as
Speaker 3: I think ahead and I look into the end of
Speaker 3: this year in twenty twenty four, let's think about the economy,
Speaker 3: and again we're not in the recessionary camp, but we
Speaker 3: see and we forecast growth moving below trend under the
Speaker 3: weight of the shift in policy rates that we've had,
Speaker 3: but also because there's other incremental factors with higher energy prices,
Speaker 3: with the beginning of student loan repayments. Coming back to
Speaker 3: think that growth will be slower next year than it
Speaker 3: was this year. We think FED policy is likely at
Speaker 3: a standing point with respect to policy rates that it's
Speaker 3: on hold, which is typically something over a longer period
Speaker 3: of time that's been supportive of yields stabilizing. And we
Speaker 3: think inflation is coming down, but coming down very slowly.
Speaker 3: So we've had a very strong disinflationary impulse the last
Speaker 3: three months. We think that's probably past its peak, and
Speaker 3: that the journey from three percent annualize inflation to two
Speaker 3: percent is going to take some time. So the Fed's
Speaker 3: probably done tightening, but we think the fed's also on
Speaker 3: hold for the next ten or eleven months or so,
Speaker 3: all the while QT is still going on in the background.
Speaker 3: So I think we can historically go back and look
Speaker 3: at the end of FED tightening periods as being very
Speaker 3: positive for yields peaking and coming back down. But I
Speaker 3: think these are the reasons a FED on hold for
Speaker 3: longer while balance sheet policy is still kind of sitting
Speaker 3: in the background working, and not just in the US
Speaker 3: but globally too, because the ECB and the Bank of
Speaker 3: England are doing QT, and one would think that the
Speaker 3: Bank of Japan might have to defend its purchases or
Speaker 3: its YCC target less forcedly as well. This is something
Speaker 3: that's going to keep rates elevated for a longer period
Speaker 3: of time versus what we've seen in prior FED on
Speaker 3: hold periods, particularly when inflation remains above the FEDS two
Speaker 3: percent targets. So we see scope if there's some mean
Speaker 3: reversion here back to our model fair value for rates
Speaker 3: to fall about thirty basis points. But beyond that, I
Speaker 3: think it's a struggle to think that yields will be
Speaker 3: much lower if the FEDS on hold. But QT is
Speaker 3: going on and inflation is coming down, but we're past
Speaker 3: the peak of the disinflationary impulse that we've had.
Speaker 1: Yeah, this was kind of Austin Goolsby's point as well,
Speaker 1: that you know, even a hold is kind of a
Speaker 1: continued tightening of financial conditions. Ja Berry, thank you so
Speaker 1: much for coming on thoughts. Appreciate you doing this at
Speaker 1: relatively short notice.
Speaker 3: Tracy, Jeff, thanks a lot.
Speaker 2: For having me. Yeah, thank you so much.
Speaker 1: That was great, So, Joe, I thought that was a
Speaker 1: really good overview of all these different factors going into
Speaker 1: the sell off at the moment, and it does seem
Speaker 1: kind of complicated, and there is still this overarching question
Speaker 1: I think over the timing in the past two weeks
Speaker 1: and like, yes, the dots move slightly higher, but was
Speaker 1: that really enough to spark like this big, almost historic
Speaker 1: sell off that we've seen in bonds. I think to
Speaker 1: Jay's point, it does feel like there are some more
Speaker 1: technical aspects that might be driving it.
Speaker 2: You know, there were a couple of things that stood
Speaker 2: out to those technical points, like his observation about sentiment
Speaker 2: and the fact that you know, up until basically July,
Speaker 2: up until maybe July August, everyone was thinking like, oh,
Speaker 2: the peak was in, you know, inflation is going to
Speaker 2: come down, and so there was just this sort of
Speaker 2: long treasury bid. Is interesting that you know, you sort
Speaker 2: of confirmed my hunch that there's just been this like
Speaker 2: real big pickup in like deficit talk the way we
Speaker 2: haven't seen in a while. Anyway, I really I've found
Speaker 2: that to be a very helpful conversation.
Speaker 1: Yeah, it's kind of funny to think that, like everyone
Speaker 1: woke up on like October fifth and decided to become
Speaker 1: a bond vigilante, but they didn't, like, they didn't feel
Speaker 1: like that a month or two ago.
Speaker 2: I mean, we knew like about the trillions and deficits
Speaker 2: for you know, as far as the eye can see,
Speaker 2: but it does. You know, it is weird, right. There
Speaker 2: hasn't been a ton of new information between you know whatever.
Speaker 2: That recent peak was on Friday and a month before.
Speaker 2: But I do think it was sort of like that
Speaker 2: month basically between our Bill Gross interview and now. It's
Speaker 2: just the amount of negativity and in the intensity of
Speaker 2: hatred towards Bond it just seemed to get wild.
Speaker 1: The Bond King called it, yeah, all right, shall we
Speaker 1: leave it there?
Speaker 2: Let's leave it there.
Speaker 1: This has been another episode of the ad Thoughts podcast.
Speaker 1: I'm Tracy Alloway. You can follow me at Tracy Alloway and.
Speaker 2: I'm Joe Wisenthal. You can follow me at the Stalwart.
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