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Speaker 1: Hi, and welcome to another edition of the Odd Thoughts podcast.

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Speaker 1: I'm Tracy Alloway and I'm Joe Wisental, So Joe here. Um,

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Speaker 1: here's a fun fact about where I am in my life.

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Speaker 1: There is nothing that I enjoy talking about more than

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Speaker 1: value at risk models. That I mean, I respect that.

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Speaker 1: I bet there are people on the world who would

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Speaker 1: look in the world who would think that was sad,

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Speaker 1: especially the way you framed it about where you are

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Speaker 1: in life. But as you know, Tracy, that only raises

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Speaker 1: my esteem of you. Okay, that's that's sweet, all right. Um.

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Speaker 1: For listeners who don't know, Value at risk models are

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Speaker 1: these sort of internal risk management models that banks usually use. Um,

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Speaker 1: they look at their trading books, they see how much

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Speaker 1: money they could lose on a given day within a

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Speaker 1: certain probability, and then they adjust their positions according to that.

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Speaker 1: So that was probably the geekiest intro um that I

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Speaker 1: could come up with from this episode. But the reason

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Speaker 1: we're about to talk about VAR models, if you will,

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Speaker 1: it's because something really really big has been going on

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Speaker 1: in markets, right Joe. Uh, that's absolutely right. Uh. We're

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Speaker 1: seeing a we've been seeing a bond market sell off exactly.

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Speaker 1: The bond market, the biggest market in the world, government bonds,

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Speaker 1: corporate bonds. They've been in this extraordinary bull market that's

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Speaker 1: arguably lasted for decades, and it's too soon to declare

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Speaker 1: the bull market over. But every time bond sell off,

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Speaker 1: people start to wonder, is this it is this the turn?

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Speaker 1: Because if it is, if the if the bull market

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Speaker 1: is finished, then people could probably lose a lot of money, right. Um,

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Speaker 1: not just the banks who have these bar models in

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Speaker 1: place and they might start to exceed the limits imposed

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Speaker 1: by their bar models, but lots of pension funds, um,

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Speaker 1: you know, people like you and I. Basically the entire

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Speaker 1: game begins to change if the great bull run in

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Speaker 1: bonds finally comes to its inglorious end. But no one

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Speaker 1: is sure whether or not that's happening yet. Um. So

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Speaker 1: this is the thing that we're going to talk about today,

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Speaker 1: right right. Nobody knows whether it's happening yet. But the

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Speaker 1: stakes are so high that every we're talking about it anyway,

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Speaker 1: that the stakes are so high that you kinda if

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Speaker 1: you're an investor, if your pension fund, if you're a bank,

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Speaker 1: if you're whatever, you have to have a you have

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Speaker 1: to be thinking about this question right now, right, So

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Speaker 1: who better to think about this question and discuss it

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Speaker 1: with then Paul Schmeltzing. He is a PhD candidate at

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Speaker 1: Harvard University and a visiting scholar at the Bank of England,

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Speaker 1: and he wrote a really, really thought provoking post on

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Speaker 1: the BOE website recently basically talking about historical bond market

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Speaker 1: sell offs. And I mean, I have to bring up

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Speaker 1: the title of this post because I just love it

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Speaker 1: so much. It was Venetians, Vulcar and value at risk

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Speaker 1: Eight centuries of bond market reversals. Well, I say we

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Speaker 1: just dive right into it and start to unpack this

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Speaker 1: question of whether we're at risk of, as the title says,

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Speaker 1: a bond market reversal. Paul, thanks so much for joining

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Speaker 1: us today. Thank you so reading your blog post which

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Speaker 1: goes through eight hundred years of bond market history, which

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Speaker 1: is pretty amazing. You actually found that in the history

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Speaker 1: of bond market, bull runs the one um that we're

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Speaker 1: currently in, although we may be coming to the end

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Speaker 1: of its lasted three decades, there are only two others

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Speaker 1: that have actually exceeded it in length, right, that's right, Tracy,

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Speaker 1: and by the way, I share your enthusiasm for value

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Speaker 1: at risk models. There's one other person that's good. So

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Speaker 1: that's right. I mean I started the data in the

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Speaker 1: year twelve eighty five, so you really go back to

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Speaker 1: the Italian city states, to Venice, to Genoa, who developed

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Speaker 1: the first secondary markets and government bonds, and you start

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Speaker 1: recording the global risk free rate from then onwards, and

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Speaker 1: so over time you just trace the evolution of the

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Speaker 1: financial center in the world. You go from the Venetians,

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Speaker 1: to the Genoese, then to the Dutch, finally to the

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Speaker 1: British and currently obviously the the U s tenure is

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Speaker 1: the risk free asset. And what I found is that

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Speaker 1: when we hit below one d forty basis points in

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Speaker 1: the US tenure last July, that was the lowest level

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Speaker 1: that the risk free rate in normal terms has ever

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Speaker 1: reached in almost eight hundred years of sovereign bond market history.

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Speaker 1: In terms of length and heeled compressions. Since this bull

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Speaker 1: market began in one as well, it's one of the

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Speaker 1: most remarkable episodes in recorded economic history. We're talking about

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Speaker 1: a cumulative yield compression of about twelve hundred basis points.

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Speaker 1: There's only the episode in the in the fourteen forties

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Speaker 1: to the fourteen eighties that exceed this bull market in

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Speaker 1: terms of yield compression. And as you rightly said, there's

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Speaker 1: only one other bull market that also exceeded those two

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Speaker 1: markets in terms of sheer length. That was the bull

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Speaker 1: market of fifteen fifty eight to sixteen sixty four, which

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Speaker 1: almost lasted a hundred years. So that's where we are.

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Speaker 1: I think this is one of the most marketable bond

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Speaker 1: bull markets in all of recorded economic history. And unfortunately,

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Speaker 1: the flip side of the story is of course that

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Speaker 1: you know, if history is a guide, then the reversals

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Speaker 1: of those bowl markets can be quite ugly as well.

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Speaker 1: I think it's funny, you know, when people talk about

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Speaker 1: the stock market, they say, oh, we haven't seen valuations

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Speaker 1: like this. It's two thousand or two thousand seven, and

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Speaker 1: now we're talking about bonds and you're making references to

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Speaker 1: bowl markets that we saw in the fourteen hundreds. So

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Speaker 1: it really puts a perspective on it. I want to

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Speaker 1: get into, you know, obviously the nature of selloffs, but

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Speaker 1: before we don't want to ask a technical question. You

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Speaker 1: you mentioned, you know the US ten uere, you know

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Speaker 1: U S treasuries are the risk free instrument. Other bonds

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Speaker 1: are sort of measured by their spread relative to the tenure.

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Speaker 1: Throughout history, has there always been a an instrument that

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Speaker 1: was considered the risk free of that time? Is at uh?

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Speaker 1: Is that sort of always been part of the fixed

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Speaker 1: income landscape? Good question, that's a great question, Joe. Yeah.

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Speaker 1: I mean the term risk free asset is of course

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Speaker 1: a modern concept um. But the practice that you basically

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Speaker 1: always reference your debt to, you know, what is perceived

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Speaker 1: as as the most reliable, the most stable financial center um.

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Speaker 1: That has a long tradition. Actually, so the Venetians back

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Speaker 1: in the thirteenth century, we're always seen as the most advanced,

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Speaker 1: most reliable providers of credit, and so throughout Europe, you know,

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Speaker 1: the Princess Saying, the Holy Roman Empire in in all

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Speaker 1: the other jurisdictions, they usually went to the Italian city

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Speaker 1: states and basically asked for credit there, and so they

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Speaker 1: had to deal with the conditions attached to the to

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Speaker 1: the credit that was actually issued in Venice, and that

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Speaker 1: was that was the reference. Right now, If you go

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Speaker 1: back further than the thirteenth century, things become more complicated

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Speaker 1: because we're talking about a very very thin secondary market. Um,

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Speaker 1: and it becomes very tough to to measure with a

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Speaker 1: reliable frequency what the risk free rate is doing. But

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Speaker 1: from the thirteenth century onwards we we kind of get

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Speaker 1: secondary markets. People are trading this kind of stuff among

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Speaker 1: each other, and so that's that's really where the risk

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Speaker 1: free history starts in a sense. So um is of

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Speaker 1: course very very fun to go back in history and

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Speaker 1: look at these other ball markets in bonds. Um. What

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Speaker 1: actually happened when we saw those historical ball markets come

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Speaker 1: to an end? Um? And how much can we extrapolate

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Speaker 1: to modern markets, which are I'm assuming significantly more complex

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Speaker 1: and very different to say the Venetians in four hundreds

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Speaker 1: absolutely so before the twentieth century, the reversals in bond

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Speaker 1: markets were often driven by geopolitical events, right. Um. So

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Speaker 1: when a certain major war broke out, you know, the

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Speaker 1: major emperors defaulted on their debt, and that reversed the

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Speaker 1: the Boulo bear market that was that was currently ongoing. Um.

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Speaker 1: So for the two largest bond markets, the bull markets

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Speaker 1: that we have, they came to an end because the

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Speaker 1: Venetians were in a in a long and intense struggle

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Speaker 1: with the Ottoman Empire over dominance in the Mediterranean Sea.

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Speaker 1: So back in those days, having the control of the

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Speaker 1: trade routes, of the finance routes in the Mediterranean Sea

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Speaker 1: was the most lucrative business that you could be in.

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Speaker 1: And so at various points in in the fifteenth and

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Speaker 1: sixteenth century, the Venetians lost major battles against the Ottomans.

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Speaker 1: There was a famous battle at the Otranto in in

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Speaker 1: the fourteen eighties which ended the one of the largest

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Speaker 1: bull markets that I recorded in the fourteen eighties. Um

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Speaker 1: we have a similar defeat by the Venetians over Crete

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Speaker 1: in the sixties sixties, which which ended the longest bull

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Speaker 1: market by sheer length. And so those kind of dynamics

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Speaker 1: really determine a lot of the a lot of the

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Speaker 1: reversals pre twentie century. When you also remember you didn't

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Speaker 1: have active interventionist gentral banks back then, right unlike today,

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Speaker 1: and so a lot was simply determined by the political

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Speaker 1: developments of course, So to that extent, of course, we

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Speaker 1: have to be careful to when we want to extrapolate

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Speaker 1: to today. But that's why I really zoom into three

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Speaker 1: case studies. In the twentieth century in the in the

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Speaker 1: remainder of the piece, because I think those are have

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Speaker 1: a much higher relevance to the dynamics we are seeing today.

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Speaker 1: So just to clarify something, in the old days, the

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Speaker 1: bond market bull bond bull markets would essentially end when

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Speaker 1: the credit worthiness of the issuer who seriously called into question,

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Speaker 1: which you would expect to happen after major military defeat.

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Speaker 1: More modern um bond sell offs tend I mean, very

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Speaker 1: few people think that there's much risk of the US

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Speaker 1: or Japan not paying their debt. More modern bond sell

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Speaker 1: offs tend to have other dynamics besides sort of calling

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Speaker 1: into question the existence of the issuers. So what are

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Speaker 1: first of all, is that a fair characterization? And be

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Speaker 1: what are some of the factors that precipitate modern sell offs.

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Speaker 1: That's a fair characterization, Joe Um. I mean I have

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Speaker 1: to add, you know, sometimes bull markets came to an

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Speaker 1: end in the past because the emperors simply through the

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Speaker 1: bank as in right, I could see that I could

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Speaker 1: see that having that effect. That that's actually a very

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Speaker 1: that's actually a very frequent occurrence in the past. You know.

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Speaker 1: So if you charge too too much interest, then you

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Speaker 1: you you better leave the country or you have better

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Speaker 1: have a good escape route. UM. Today, as you mentioned,

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Speaker 1: the dynamics are slightly different. And I really zoom into

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Speaker 1: three case studies in the twenty century that I think

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Speaker 1: are relevant for for our current discussion. So the first

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Speaker 1: really is when you look at the second half of

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Speaker 1: the nineteen sixties. I think they're actually interesting parallels to

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Speaker 1: the current backdrop that we see in bond markets. So remember,

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Speaker 1: in the sixties, the backdrop is that we have the

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Speaker 1: Lyndon Johnson administration being engaged in the Vietnam War. Right,

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Speaker 1: that means a reasonable fiscal stimulus of around two and

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Speaker 1: a fifty basis points to GDP in the second half

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Speaker 1: of the sixties. Against that, we have a very tight

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Speaker 1: used labor market, you know, very similar to today. UM.

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Speaker 1: And what happens when you combine this sort of fiscal

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Speaker 1: expansion with a very tight used labor market, UM, was

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Speaker 1: that CPI inflation started really to row from one and

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Speaker 1: a half percent in the mid nineties sixties up to

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Speaker 1: close to six percent by the end of the by

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Speaker 1: the end of the decade, UM. And so I call

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Speaker 1: that case study the inflation reversal case study. UH. And

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Speaker 1: and so I think that's relevant because just look at

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Speaker 1: the sort of prints that we saw in the last

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Speaker 1: couple of weeks. Just yesterday we had a major print,

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Speaker 1: for instance, out of China that now records five and

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Speaker 1: a half percent PPI inflation. We had prints from Germany

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Speaker 1: which suggests that inflation there is accelerating at the highest

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Speaker 1: speed in twenty three years. We had a US jobs

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Speaker 1: report that recorded, you know, almost three percent average earlier

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Speaker 1: dot com. I mean to say that those kind of

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Speaker 1: dynamics apparently start becoming relevant again. And so I think

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Speaker 1: this is a useful case study to to really look

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Speaker 1: for those kind of inflation reversal stories that that we've seen.

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Speaker 1: The second case study is the so called bond massaccer,

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Speaker 1: that is that pops up more and more in the

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Speaker 1: in the in the literature. It was the most the

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Speaker 1: most violent year for for long bond investors um. They

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Speaker 1: lost one and a half trillion in in global bond

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Speaker 1: values within a year. Some people associate that with a

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Speaker 1: fat funds hike in in February, but actually the tenure

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Speaker 1: volatility started rising steeply in the third quarter of because

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Speaker 1: of the the e r M crisis in Europe. You

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Speaker 1: had emerging market volatility in places like Mexico which entered

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Speaker 1: the Tequila crisis, uncertainty in Turkey, Venezuela, and so a

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Speaker 1: lot of those kind of leveraged bets that were very

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Speaker 1: popular at the time just went sour very quickly. The

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Speaker 1: thing to remember is, and that's why I said in

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Speaker 1: the piece that I think we are probably heading for

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Speaker 1: something worse than bond massacre. Those kind of sellers were

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Speaker 1: over again because fundamentals changed very little back then. We're

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Speaker 1: back in a very decent environment for bonds. They gained

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Speaker 1: another eighteen percent in real terms, in real price terms,

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Speaker 1: and it was more or less over after, you know,

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Speaker 1: the speculators had been washed out. And the third one

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Speaker 1: really is the and Tracy will probably like this the

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Speaker 1: this is my favorite. The value at risk shock in

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Speaker 1: Japan in two thousands three. Explain that one what is that?

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Speaker 1: What is that? What does that mean? So, as Tracy

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Speaker 1: mentioned earlier, banks typically operate with those kind of internal

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Speaker 1: models that typically set a certain cushion for volatility and

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Speaker 1: the average daily losses that you can add a maximum

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Speaker 1: incur on on certain positions, and once you breach those thresholds,

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Speaker 1: those models suggested you have to sell certain holdings. In

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Speaker 1: the Japanese case JGBS right, and the dynamics in Japan

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Speaker 1: and the early two thousands are are also very interesting

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Speaker 1: because there are a lot of perils to to our

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Speaker 1: current environment. Remember, the Japanese were actually the first to

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Speaker 1: engage in in large scale quantitative easing programs. They started

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Speaker 1: their QUE program in two thousand one against the backdrop

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Speaker 1: of long long disinflation and all those problems in the

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Speaker 1: nineties that most people will probably be familiar with. And

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Speaker 1: what you saw is similar to today, or at least

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Speaker 1: similar up until the first half, I guess you saw

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Speaker 1: a massive flattening of of field curves in Japan because

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Speaker 1: the bo j bought a lot of the outstanding issues

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Speaker 1: um and that hurt banks. I mean, if you look

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Speaker 1: at the topics, which is the Japanese banking Index, it's

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Speaker 1: sold off massively since the introduction of that QUE program.

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Speaker 1: Only two sharply reverse course. In in the middle of

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Speaker 1: two thousand three, when there were rumors about the potential

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Speaker 1: tape ring by the bo j UM, some very big institutions,

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Speaker 1: banking institutions had to be saved by the Japanese state.

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Speaker 1: They bailed out the equivalent of their you know, Bear

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Speaker 1: Sterns and Lehman in the in those years, Hizona Group

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Speaker 1: was one of the most famous victims, but actually they

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Speaker 1: didn't bail in a lot of the private holders of

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Speaker 1: that inequity to that extent that people really got scared.

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Speaker 1: And so after that you had an increase in in

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Speaker 1: steepness again, which which was great for the banks itself,

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Speaker 1: because if you're engaged in maturity transformation, it's always nice.

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Speaker 1: But the sort of volatility associated with with those kind

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Speaker 1: of war models that that suddenly dictated a mass of

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Speaker 1: dumping of bonds up until the middle of two thousands

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Speaker 1: three heard everybody else who was not in the maturity

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Speaker 1: transformation business. So, Paul, here's the thing that I really

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Speaker 1: liked about your blog post. Um. You so you divide

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Speaker 1: these modern bond market selloffs into three categories, and the

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Speaker 1: one that everyone tends to reach for, as you mentioned,

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Speaker 1: is the bond massacre um. But you actually think that

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Speaker 1: what we might be in for now is a mix

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Speaker 1: um more of like the late sixty six and the

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Speaker 1: early two thousand's with the bar crisis in Japan. Is

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Speaker 1: that right, that's right? Yeah, yeah, I mean listening to

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Speaker 1: your explanations of each three, it's not hard to imagine

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Speaker 1: how they could blend. And you know, if you have

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Speaker 1: higher inflation pick up that makes fixed income less compelling.

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Speaker 1: You start to get yourself off and then it spreads

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Speaker 1: to UM. Then it spreads to the banks. To the

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Speaker 1: banks because of their laws requirements have to dump and

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Speaker 1: you get something mixed. So walk us through a little

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Speaker 1: bit what the downside really looks like in terms of

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Speaker 1: money lost, economic ramifications. If we were to get some

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Speaker 1: sort of combination nineteen sixties two thousand three, where where

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Speaker 1: are the bodies going to turn up? So to speak. Yeah, So,

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Speaker 1: in in purely qualitative terms we saw in the inflation

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Speaker 1: reversal scenario, we saw in real terms. That's always important

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Speaker 1: to U to take into account because, as I mentioned,

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Speaker 1: cp I in in bear market years is actually double

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Speaker 1: the average inflation. So we're always talking about real terms, right,

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Speaker 1: So in the second half of the nineteen sixties, bond

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Speaker 1: investors who were long US treasuries back then lost close

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Speaker 1: to in real terms within four years UM. Now that

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Speaker 1: number is even higher. Of course, when we when we

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Speaker 1: look at normal and take take the inflation into account.

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Speaker 1: But I think, you know, it's it's not it's not

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Speaker 1: purely unreasonable to expect at least that kind of dimension

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Speaker 1: of losses when it's definitely when it's coupled with the

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Speaker 1: sort of steepening scenario that that we saw in Japan.

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Speaker 1: And that's why I refer to two, you know, potentially

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Speaker 1: the perfect storm in in bond markets that that we

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Speaker 1: could see, because as you rightly mentioned, it's it's really

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Speaker 1: a blend of factors that you to occur in isolation

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Speaker 1: in many other sellers. So for instance, as I mentioned,

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Speaker 1: we didn't actually have a large change in inflation, right

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Speaker 1: and still bond markets took a huge hit irrespective of

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Speaker 1: of sound fundamentals. The same is true for Japan. But

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Speaker 1: now we're really combining fundamentals with you know, these other

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Speaker 1: factors that have to do with bank balance sheets, with

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Speaker 1: positioning of of speculators, and I think those kind of

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Speaker 1: factors make make four potentially more gloomy scenario than than

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Speaker 1: the second of the nineteen sixties. Even so, Paul, I'm

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Speaker 1: just I'm curious like this. This was a piece posted

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Speaker 1: on the Bank of England's blog that got a lot

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Speaker 1: of attention. What's been the response to it so far,

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Speaker 1: and you know, especially from regulators like those at the BOE.

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Speaker 1: Has anyone been talking to you about this? How many

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Speaker 1: concerns have you heard since you posted this? But of

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Speaker 1: course I'm not the only one who's who's concerned about

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Speaker 1: the bond market. I mean, in recent months quite a

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Speaker 1: few people, especially from the investment side, have have come

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Speaker 1: out and warned about the dynamics. I didn't have anybody

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Speaker 1: from the regulatory side reach out to me so far,

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Speaker 1: and I have to stress, of course I'm I'm not

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Speaker 1: speaking for the Bank of England here, um, but I

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Speaker 1: think you know, we we should regulators definitely should be

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Speaker 1: aware of those kind of trends and really should be

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Speaker 1: aware also of the of the quite historic proportions of

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Speaker 1: the of the price distortions that we're talking about. Um. Really,

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Speaker 1: if we if we are saying seeing that it's it's

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Speaker 1: an eight hunded year event that we are seeing in

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Speaker 1: in in bond markets, I think we should we should

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Speaker 1: be paying more attention to it than we have so far. Yeah,

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Speaker 1: I think that's a bit of an understate admit that

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Speaker 1: we should be paying more attention if this could be

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Speaker 1: a once in eight hundred year event away. Paul Schmeltzing

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Speaker 1: very fascinating, also very gloomy. Paul Schmeltzing is getting a

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Speaker 1: PhD student at Harvard also visiting researcher at the Bank

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Speaker 1: of England. Really appreciate you coming on. Thanks so much, Joe.

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Speaker 1: Was that was that too gloomy a podcast for this

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Speaker 1: early in the year. Uh, it was pretty gloomy. It

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Speaker 1: was pretty scary. And you know, like I mentioned early on,

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Speaker 1: anytime you're talking about going back to the four hundreds

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Speaker 1: to find precedent for where we're where we are right now,

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Speaker 1: I think you have to sit up and pay attention.

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Speaker 1: But I thought that was great. I love talking to Yeah,

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Speaker 1: it's really interesting. Um. I mean, we could have talked

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Speaker 1: a lot about of our models. But one thing I

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Speaker 1: find interesting in particular is the tension between the regulations

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Speaker 1: that we've had come in post two eight financial crisis

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Speaker 1: and what's happening now in that a lot of regulators

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Speaker 1: wanted banks to hold safe assets, right, the risk free asset,

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Speaker 1: as you pointed out, and so now we do have

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Speaker 1: banks um that have even greater proportions of their portfolios

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Speaker 1: based in their home market bonds. And again the concern

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Speaker 1: is if we get that big sell off, rather than

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Speaker 1: having the regulation make the banks safer. Um, we could

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Speaker 1: just be exacerbating this problem, right, I think this is

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Speaker 1: a This is a like people who aren't immersed in

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Speaker 1: this might get confused because we talked about US treasuries

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Speaker 1: as save haven risk free assets, and they're deemed to

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Speaker 1: be not save haven or risk free, not because you

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Speaker 1: can't lose money in them, but because we think the

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Speaker 1: US govern a mint is the most credit worthy institution

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Speaker 1: in the world, and so unlike say lending to an

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Speaker 1: oil company or lending to a tech company, or lending

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Speaker 1: to an emerging market, there's virtually no risk that the

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Speaker 1: government won't be able to pay back the debt. But

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Speaker 1: there are all other ways an investment in these or

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Speaker 1: these investments could lose a lot of money. And I

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Speaker 1: really like the way Paul just sort of walked through

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Speaker 1: the different ways you can lose money on a safe

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Speaker 1: haven asset. Yeah, how can I lose money on a

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Speaker 1: safe haven asset? Let me count the ways. Piling into

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Speaker 1: ultra long end of the curve because it's the only

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Speaker 1: way to make money while being safe at the same time,

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Speaker 1: does in retrospect seemed like a recipe for trouble down

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Speaker 1: the road. Yeah, alright, so this is definitely a big

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Speaker 1: theme to watch for this year, and um, well, I

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Speaker 1: guess we'll have to revisit it. Yeah. No, that's I

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Speaker 1: think really worth emphasizing that it's this isn't just sort

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Speaker 1: of like interesting historical perspective. This is happening. These questions

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Speaker 1: are being post to the market right now. We've seen

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Speaker 1: yields jump a lot since this summer. UH bonds sold

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Speaker 1: off more after the US presidential election, So this is

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Speaker 1: of implicate, this matters to traders and investors right at

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Speaker 1: this moment, and I think his work is a great

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Speaker 1: place to start in terms of UH thinking about what

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Speaker 1: potential downside scenarios could look like. Yeah, and I'm sure

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Speaker 1: we'll be talking about it a lot more with a

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Speaker 1: lot of other people, but let's leave it at that

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Speaker 1: for this week. I'm Tracy Alloway. You can follow me

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Speaker 1: on Twitter at Tracy Alloway. And I'm Joe Wisenthal. You

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Speaker 1: can follow me on Twitter at the Stalwarts. This has

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Speaker 1: been another episode of the Odd Lots Podcast. Thanks for

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Speaker 1: listening to