WEBVTT - 62: How The Biggest Bull Market Could Come Crashing Down 0:00:08.320 --> 0:00:11.640 Hi, and welcome to another edition of the Odd Thoughts podcast. 0:00:11.680 --> 0:00:16.439 I'm Tracy Alloway and I'm Joe Wisental, So Joe here. Um, 0:00:16.480 --> 0:00:19.760 here's a fun fact about where I am in my life. 0:00:20.160 --> 0:00:24.280 There is nothing that I enjoy talking about more than 0:00:24.480 --> 0:00:29.840 value at risk models. That I mean, I respect that. 0:00:30.000 --> 0:00:32.320 I bet there are people on the world who would 0:00:32.360 --> 0:00:34.159 look in the world who would think that was sad, 0:00:34.320 --> 0:00:36.440 especially the way you framed it about where you are 0:00:36.479 --> 0:00:40.320 in life. But as you know, Tracy, that only raises 0:00:40.400 --> 0:00:44.640 my esteem of you. Okay, that's that's sweet, all right. Um. 0:00:44.720 --> 0:00:47.720 For listeners who don't know, Value at risk models are 0:00:47.760 --> 0:00:53.000 these sort of internal risk management models that banks usually use. Um, 0:00:53.040 --> 0:00:55.640 they look at their trading books, they see how much 0:00:55.720 --> 0:00:58.160 money they could lose on a given day within a 0:00:58.200 --> 0:01:02.680 certain probability, and then they adjust their positions according to that. 0:01:02.840 --> 0:01:05.640 So that was probably the geekiest intro um that I 0:01:05.640 --> 0:01:08.280 could come up with from this episode. But the reason 0:01:08.319 --> 0:01:12.000 we're about to talk about VAR models, if you will, 0:01:12.640 --> 0:01:15.080 it's because something really really big has been going on 0:01:15.200 --> 0:01:19.960 in markets, right Joe. Uh, that's absolutely right. Uh. We're 0:01:20.000 --> 0:01:24.280 seeing a we've been seeing a bond market sell off exactly. 0:01:24.760 --> 0:01:28.520 The bond market, the biggest market in the world, government bonds, 0:01:28.680 --> 0:01:33.920 corporate bonds. They've been in this extraordinary bull market that's 0:01:34.280 --> 0:01:38.360 arguably lasted for decades, and it's too soon to declare 0:01:38.400 --> 0:01:42.679 the bull market over. But every time bond sell off, 0:01:42.720 --> 0:01:46.240 people start to wonder, is this it is this the turn? 0:01:46.400 --> 0:01:49.200 Because if it is, if the if the bull market 0:01:49.320 --> 0:01:54.160 is finished, then people could probably lose a lot of money, right. Um, 0:01:54.200 --> 0:01:57.400 not just the banks who have these bar models in 0:01:57.480 --> 0:02:01.160 place and they might start to exceed the limits imposed 0:02:01.160 --> 0:02:04.560 by their bar models, but lots of pension funds, um, 0:02:04.600 --> 0:02:07.000 you know, people like you and I. Basically the entire 0:02:07.120 --> 0:02:11.400 game begins to change if the great bull run in 0:02:11.480 --> 0:02:16.040 bonds finally comes to its inglorious end. But no one 0:02:16.120 --> 0:02:19.280 is sure whether or not that's happening yet. Um. So 0:02:19.440 --> 0:02:22.000 this is the thing that we're going to talk about today, 0:02:22.080 --> 0:02:25.840 right right. Nobody knows whether it's happening yet. But the 0:02:25.919 --> 0:02:30.440 stakes are so high that every we're talking about it anyway, 0:02:30.480 --> 0:02:33.160 that the stakes are so high that you kinda if 0:02:33.200 --> 0:02:35.840 you're an investor, if your pension fund, if you're a bank, 0:02:35.919 --> 0:02:39.800 if you're whatever, you have to have a you have 0:02:39.880 --> 0:02:42.639 to be thinking about this question right now, right, So 0:02:42.800 --> 0:02:45.600 who better to think about this question and discuss it 0:02:45.639 --> 0:02:48.840 with then Paul Schmeltzing. He is a PhD candidate at 0:02:48.880 --> 0:02:52.320 Harvard University and a visiting scholar at the Bank of England, 0:02:52.600 --> 0:02:56.640 and he wrote a really, really thought provoking post on 0:02:56.680 --> 0:03:02.720 the BOE website recently basically talking about historical bond market 0:03:02.800 --> 0:03:05.960 sell offs. And I mean, I have to bring up 0:03:06.040 --> 0:03:08.120 the title of this post because I just love it 0:03:08.240 --> 0:03:11.880 so much. It was Venetians, Vulcar and value at risk 0:03:12.120 --> 0:03:16.400 Eight centuries of bond market reversals. Well, I say we 0:03:16.480 --> 0:03:20.560 just dive right into it and start to unpack this 0:03:20.680 --> 0:03:24.360 question of whether we're at risk of, as the title says, 0:03:24.480 --> 0:03:37.320 a bond market reversal. Paul, thanks so much for joining 0:03:37.400 --> 0:03:41.640 us today. Thank you so reading your blog post which 0:03:41.640 --> 0:03:46.040 goes through eight hundred years of bond market history, which 0:03:46.080 --> 0:03:50.480 is pretty amazing. You actually found that in the history 0:03:50.760 --> 0:03:54.640 of bond market, bull runs the one um that we're 0:03:54.680 --> 0:03:56.840 currently in, although we may be coming to the end 0:03:56.880 --> 0:04:01.080 of its lasted three decades, there are only two others 0:04:01.080 --> 0:04:04.960 that have actually exceeded it in length, right, that's right, Tracy, 0:04:05.120 --> 0:04:07.720 and by the way, I share your enthusiasm for value 0:04:07.720 --> 0:04:13.080 at risk models. There's one other person that's good. So 0:04:13.160 --> 0:04:16.120 that's right. I mean I started the data in the 0:04:16.240 --> 0:04:20.040 year twelve eighty five, so you really go back to 0:04:20.240 --> 0:04:24.920 the Italian city states, to Venice, to Genoa, who developed 0:04:24.960 --> 0:04:28.680 the first secondary markets and government bonds, and you start 0:04:28.800 --> 0:04:33.600 recording the global risk free rate from then onwards, and 0:04:33.640 --> 0:04:39.200 so over time you just trace the evolution of the 0:04:39.240 --> 0:04:42.880 financial center in the world. You go from the Venetians, 0:04:42.960 --> 0:04:46.840 to the Genoese, then to the Dutch, finally to the 0:04:46.880 --> 0:04:51.320 British and currently obviously the the U s tenure is 0:04:51.360 --> 0:04:54.880 the risk free asset. And what I found is that 0:04:54.920 --> 0:04:58.960 when we hit below one d forty basis points in 0:04:59.000 --> 0:05:03.120 the US tenure last July, that was the lowest level 0:05:03.520 --> 0:05:06.640 that the risk free rate in normal terms has ever 0:05:06.720 --> 0:05:12.040 reached in almost eight hundred years of sovereign bond market history. 0:05:12.240 --> 0:05:16.200 In terms of length and heeled compressions. Since this bull 0:05:16.279 --> 0:05:19.599 market began in one as well, it's one of the 0:05:19.640 --> 0:05:24.560 most remarkable episodes in recorded economic history. We're talking about 0:05:24.600 --> 0:05:29.040 a cumulative yield compression of about twelve hundred basis points. 0:05:30.040 --> 0:05:33.960 There's only the episode in the in the fourteen forties 0:05:34.000 --> 0:05:39.279 to the fourteen eighties that exceed this bull market in 0:05:39.400 --> 0:05:42.800 terms of yield compression. And as you rightly said, there's 0:05:42.880 --> 0:05:48.080 only one other bull market that also exceeded those two 0:05:48.440 --> 0:05:51.520 markets in terms of sheer length. That was the bull 0:05:51.600 --> 0:05:55.760 market of fifteen fifty eight to sixteen sixty four, which 0:05:55.760 --> 0:05:58.640 almost lasted a hundred years. So that's where we are. 0:05:58.680 --> 0:06:01.159 I think this is one of the most marketable bond 0:06:01.240 --> 0:06:05.920 bull markets in all of recorded economic history. And unfortunately, 0:06:05.920 --> 0:06:07.719 the flip side of the story is of course that 0:06:08.320 --> 0:06:11.280 you know, if history is a guide, then the reversals 0:06:11.480 --> 0:06:15.760 of those bowl markets can be quite ugly as well. 0:06:16.040 --> 0:06:18.400 I think it's funny, you know, when people talk about 0:06:19.000 --> 0:06:22.120 the stock market, they say, oh, we haven't seen valuations 0:06:22.160 --> 0:06:26.000 like this. It's two thousand or two thousand seven, and 0:06:26.040 --> 0:06:28.960 now we're talking about bonds and you're making references to 0:06:29.279 --> 0:06:32.080 bowl markets that we saw in the fourteen hundreds. So 0:06:32.120 --> 0:06:34.680 it really puts a perspective on it. I want to 0:06:34.680 --> 0:06:38.280 get into, you know, obviously the nature of selloffs, but 0:06:38.279 --> 0:06:40.679 before we don't want to ask a technical question. You 0:06:40.680 --> 0:06:44.240 you mentioned, you know the US ten uere, you know 0:06:44.400 --> 0:06:48.520 U S treasuries are the risk free instrument. Other bonds 0:06:48.560 --> 0:06:52.000 are sort of measured by their spread relative to the tenure. 0:06:52.440 --> 0:06:56.839 Throughout history, has there always been a an instrument that 0:06:56.960 --> 0:07:00.800 was considered the risk free of that time? Is at uh? 0:07:00.960 --> 0:07:03.360 Is that sort of always been part of the fixed 0:07:03.360 --> 0:07:07.880 income landscape? Good question, that's a great question, Joe. Yeah. 0:07:07.960 --> 0:07:10.760 I mean the term risk free asset is of course 0:07:10.920 --> 0:07:16.280 a modern concept um. But the practice that you basically 0:07:17.360 --> 0:07:21.240 always reference your debt to, you know, what is perceived 0:07:21.320 --> 0:07:26.400 as as the most reliable, the most stable financial center um. 0:07:26.440 --> 0:07:30.640 That has a long tradition. Actually, so the Venetians back 0:07:30.640 --> 0:07:34.160 in the thirteenth century, we're always seen as the most advanced, 0:07:34.280 --> 0:07:39.360 most reliable providers of credit, and so throughout Europe, you know, 0:07:39.880 --> 0:07:42.920 the Princess Saying, the Holy Roman Empire in in all 0:07:42.960 --> 0:07:46.040 the other jurisdictions, they usually went to the Italian city 0:07:46.120 --> 0:07:50.280 states and basically asked for credit there, and so they 0:07:50.280 --> 0:07:53.320 had to deal with the conditions attached to the to 0:07:53.440 --> 0:07:57.360 the credit that was actually issued in Venice, and that 0:07:57.560 --> 0:08:00.880 was that was the reference. Right now, If you go 0:08:00.960 --> 0:08:05.560 back further than the thirteenth century, things become more complicated 0:08:05.600 --> 0:08:11.480 because we're talking about a very very thin secondary market. Um, 0:08:11.520 --> 0:08:15.560 and it becomes very tough to to measure with a 0:08:15.560 --> 0:08:18.800 reliable frequency what the risk free rate is doing. But 0:08:18.920 --> 0:08:21.760 from the thirteenth century onwards we we kind of get 0:08:22.160 --> 0:08:26.000 secondary markets. People are trading this kind of stuff among 0:08:26.040 --> 0:08:30.160 each other, and so that's that's really where the risk 0:08:30.240 --> 0:08:33.960 free history starts in a sense. So um is of 0:08:34.000 --> 0:08:37.480 course very very fun to go back in history and 0:08:37.520 --> 0:08:41.400 look at these other ball markets in bonds. Um. What 0:08:41.520 --> 0:08:46.440 actually happened when we saw those historical ball markets come 0:08:46.480 --> 0:08:50.679 to an end? Um? And how much can we extrapolate 0:08:51.080 --> 0:08:56.520 to modern markets, which are I'm assuming significantly more complex 0:08:56.559 --> 0:09:01.640 and very different to say the Venetians in four hundreds 0:09:01.960 --> 0:09:07.520 absolutely so before the twentieth century, the reversals in bond 0:09:07.559 --> 0:09:12.880 markets were often driven by geopolitical events, right. Um. So 0:09:13.000 --> 0:09:17.880 when a certain major war broke out, you know, the 0:09:17.920 --> 0:09:22.120 major emperors defaulted on their debt, and that reversed the 0:09:22.120 --> 0:09:26.240 the Boulo bear market that was that was currently ongoing. Um. 0:09:26.440 --> 0:09:29.760 So for the two largest bond markets, the bull markets 0:09:29.800 --> 0:09:32.400 that we have, they came to an end because the 0:09:32.520 --> 0:09:36.240 Venetians were in a in a long and intense struggle 0:09:36.280 --> 0:09:40.320 with the Ottoman Empire over dominance in the Mediterranean Sea. 0:09:40.960 --> 0:09:44.960 So back in those days, having the control of the 0:09:45.000 --> 0:09:48.440 trade routes, of the finance routes in the Mediterranean Sea 0:09:48.520 --> 0:09:53.040 was the most lucrative business that you could be in. 0:09:53.920 --> 0:09:56.880 And so at various points in in the fifteenth and 0:09:56.920 --> 0:10:02.119 sixteenth century, the Venetians lost major battles against the Ottomans. 0:10:02.600 --> 0:10:06.920 There was a famous battle at the Otranto in in 0:10:06.960 --> 0:10:11.680 the fourteen eighties which ended the one of the largest 0:10:11.720 --> 0:10:16.600 bull markets that I recorded in the fourteen eighties. Um 0:10:16.640 --> 0:10:20.319 we have a similar defeat by the Venetians over Crete 0:10:21.280 --> 0:10:25.040 in the sixties sixties, which which ended the longest bull 0:10:25.120 --> 0:10:28.800 market by sheer length. And so those kind of dynamics 0:10:28.840 --> 0:10:31.200 really determine a lot of the a lot of the 0:10:31.240 --> 0:10:35.520 reversals pre twentie century. When you also remember you didn't 0:10:35.520 --> 0:10:40.600 have active interventionist gentral banks back then, right unlike today, 0:10:41.240 --> 0:10:43.640 and so a lot was simply determined by the political 0:10:43.679 --> 0:10:46.360 developments of course, So to that extent, of course, we 0:10:46.440 --> 0:10:49.679 have to be careful to when we want to extrapolate 0:10:49.720 --> 0:10:53.080 to today. But that's why I really zoom into three 0:10:53.120 --> 0:10:56.480 case studies. In the twentieth century in the in the 0:10:56.520 --> 0:11:00.600 remainder of the piece, because I think those are have 0:11:00.720 --> 0:11:04.280 a much higher relevance to the dynamics we are seeing today. 0:11:04.400 --> 0:11:08.280 So just to clarify something, in the old days, the 0:11:08.320 --> 0:11:12.560 bond market bull bond bull markets would essentially end when 0:11:12.640 --> 0:11:17.760 the credit worthiness of the issuer who seriously called into question, 0:11:17.840 --> 0:11:21.120 which you would expect to happen after major military defeat. 0:11:21.800 --> 0:11:26.600 More modern um bond sell offs tend I mean, very 0:11:26.640 --> 0:11:29.280 few people think that there's much risk of the US 0:11:29.440 --> 0:11:33.080 or Japan not paying their debt. More modern bond sell 0:11:33.120 --> 0:11:37.400 offs tend to have other dynamics besides sort of calling 0:11:37.400 --> 0:11:41.560 into question the existence of the issuers. So what are 0:11:42.360 --> 0:11:44.680 first of all, is that a fair characterization? And be 0:11:45.320 --> 0:11:48.920 what are some of the factors that precipitate modern sell offs. 0:11:49.040 --> 0:11:52.160 That's a fair characterization, Joe Um. I mean I have 0:11:52.240 --> 0:11:55.360 to add, you know, sometimes bull markets came to an 0:11:55.480 --> 0:11:59.000 end in the past because the emperors simply through the 0:11:59.040 --> 0:12:02.240 bank as in right, I could see that I could 0:12:02.240 --> 0:12:05.560 see that having that effect. That that's actually a very 0:12:05.600 --> 0:12:08.760 that's actually a very frequent occurrence in the past. You know. 0:12:09.320 --> 0:12:13.040 So if you charge too too much interest, then you 0:12:13.040 --> 0:12:15.400 you you better leave the country or you have better 0:12:15.480 --> 0:12:20.040 have a good escape route. UM. Today, as you mentioned, 0:12:20.040 --> 0:12:23.439 the dynamics are slightly different. And I really zoom into 0:12:23.559 --> 0:12:25.800 three case studies in the twenty century that I think 0:12:25.920 --> 0:12:29.959 are relevant for for our current discussion. So the first 0:12:29.960 --> 0:12:32.240 really is when you look at the second half of 0:12:32.280 --> 0:12:36.040 the nineteen sixties. I think they're actually interesting parallels to 0:12:36.120 --> 0:12:40.319 the current backdrop that we see in bond markets. So remember, 0:12:40.320 --> 0:12:44.560 in the sixties, the backdrop is that we have the 0:12:44.679 --> 0:12:49.000 Lyndon Johnson administration being engaged in the Vietnam War. Right, 0:12:49.640 --> 0:12:54.040 that means a reasonable fiscal stimulus of around two and 0:12:54.080 --> 0:12:56.560 a fifty basis points to GDP in the second half 0:12:56.600 --> 0:13:00.200 of the sixties. Against that, we have a very tight 0:13:00.320 --> 0:13:04.080 used labor market, you know, very similar to today. UM. 0:13:04.120 --> 0:13:06.920 And what happens when you combine this sort of fiscal 0:13:06.920 --> 0:13:11.040 expansion with a very tight used labor market, UM, was 0:13:11.120 --> 0:13:16.120 that CPI inflation started really to row from one and 0:13:16.160 --> 0:13:18.760 a half percent in the mid nineties sixties up to 0:13:18.840 --> 0:13:21.480 close to six percent by the end of the by 0:13:21.480 --> 0:13:24.760 the end of the decade, UM. And so I call 0:13:24.880 --> 0:13:28.959 that case study the inflation reversal case study. UH. And 0:13:28.960 --> 0:13:31.640 and so I think that's relevant because just look at 0:13:31.679 --> 0:13:34.040 the sort of prints that we saw in the last 0:13:34.080 --> 0:13:37.360 couple of weeks. Just yesterday we had a major print, 0:13:37.400 --> 0:13:40.640 for instance, out of China that now records five and 0:13:40.679 --> 0:13:44.800 a half percent PPI inflation. We had prints from Germany 0:13:44.840 --> 0:13:48.960 which suggests that inflation there is accelerating at the highest 0:13:48.960 --> 0:13:52.559 speed in twenty three years. We had a US jobs 0:13:52.600 --> 0:13:56.160 report that recorded, you know, almost three percent average earlier 0:13:56.440 --> 0:13:58.599 dot com. I mean to say that those kind of 0:13:58.679 --> 0:14:03.480 dynamics apparently start becoming relevant again. And so I think 0:14:03.480 --> 0:14:06.280 this is a useful case study to to really look 0:14:06.320 --> 0:14:11.079 for those kind of inflation reversal stories that that we've seen. 0:14:11.640 --> 0:14:16.520 The second case study is the so called bond massaccer, 0:14:17.600 --> 0:14:22.080 that is that pops up more and more in the 0:14:22.200 --> 0:14:26.120 in the in the literature. It was the most the 0:14:26.160 --> 0:14:31.600 most violent year for for long bond investors um. They 0:14:31.680 --> 0:14:34.440 lost one and a half trillion in in global bond 0:14:34.520 --> 0:14:38.520 values within a year. Some people associate that with a 0:14:38.600 --> 0:14:45.480 fat funds hike in in February, but actually the tenure 0:14:45.560 --> 0:14:50.680 volatility started rising steeply in the third quarter of because 0:14:50.680 --> 0:14:54.840 of the the e r M crisis in Europe. You 0:14:54.960 --> 0:14:59.280 had emerging market volatility in places like Mexico which entered 0:14:59.280 --> 0:15:04.440 the Tequila crisis, uncertainty in Turkey, Venezuela, and so a 0:15:04.440 --> 0:15:07.400 lot of those kind of leveraged bets that were very 0:15:07.400 --> 0:15:11.280 popular at the time just went sour very quickly. The 0:15:11.280 --> 0:15:13.520 thing to remember is, and that's why I said in 0:15:13.560 --> 0:15:16.800 the piece that I think we are probably heading for 0:15:16.840 --> 0:15:22.000 something worse than bond massacre. Those kind of sellers were 0:15:22.040 --> 0:15:28.920 over again because fundamentals changed very little back then. We're 0:15:28.960 --> 0:15:32.720 back in a very decent environment for bonds. They gained 0:15:32.720 --> 0:15:36.280 another eighteen percent in real terms, in real price terms, 0:15:38.240 --> 0:15:40.560 and it was more or less over after, you know, 0:15:40.600 --> 0:15:44.200 the speculators had been washed out. And the third one 0:15:44.240 --> 0:15:47.200 really is the and Tracy will probably like this the 0:15:47.840 --> 0:15:52.000 this is my favorite. The value at risk shock in 0:15:52.080 --> 0:15:55.560 Japan in two thousands three. Explain that one what is that? 0:15:55.920 --> 0:15:58.680 What is that? What does that mean? So, as Tracy 0:15:58.760 --> 0:16:03.000 mentioned earlier, banks typically operate with those kind of internal 0:16:03.080 --> 0:16:08.800 models that typically set a certain cushion for volatility and 0:16:08.840 --> 0:16:12.400 the average daily losses that you can add a maximum 0:16:12.440 --> 0:16:17.720 incur on on certain positions, and once you breach those thresholds, 0:16:18.560 --> 0:16:24.000 those models suggested you have to sell certain holdings. In 0:16:24.040 --> 0:16:28.680 the Japanese case JGBS right, and the dynamics in Japan 0:16:28.840 --> 0:16:31.360 and the early two thousands are are also very interesting 0:16:31.400 --> 0:16:34.240 because there are a lot of perils to to our 0:16:34.240 --> 0:16:38.960 current environment. Remember, the Japanese were actually the first to 0:16:39.040 --> 0:16:45.400 engage in in large scale quantitative easing programs. They started 0:16:45.400 --> 0:16:49.240 their QUE program in two thousand one against the backdrop 0:16:49.320 --> 0:16:53.440 of long long disinflation and all those problems in the 0:16:53.520 --> 0:16:58.640 nineties that most people will probably be familiar with. And 0:16:59.160 --> 0:17:02.720 what you saw is similar to today, or at least 0:17:03.080 --> 0:17:07.560 similar up until the first half, I guess you saw 0:17:07.560 --> 0:17:12.879 a massive flattening of of field curves in Japan because 0:17:12.920 --> 0:17:16.040 the bo j bought a lot of the outstanding issues 0:17:17.119 --> 0:17:19.880 um and that hurt banks. I mean, if you look 0:17:19.880 --> 0:17:25.080 at the topics, which is the Japanese banking Index, it's 0:17:25.080 --> 0:17:29.320 sold off massively since the introduction of that QUE program. 0:17:29.400 --> 0:17:33.119 Only two sharply reverse course. In in the middle of 0:17:33.160 --> 0:17:37.080 two thousand three, when there were rumors about the potential 0:17:37.200 --> 0:17:42.320 tape ring by the bo j UM, some very big institutions, 0:17:42.520 --> 0:17:46.160 banking institutions had to be saved by the Japanese state. 0:17:47.320 --> 0:17:50.080 They bailed out the equivalent of their you know, Bear 0:17:50.160 --> 0:17:55.200 Sterns and Lehman in the in those years, Hizona Group 0:17:55.320 --> 0:17:58.399 was one of the most famous victims, but actually they 0:17:58.440 --> 0:18:02.080 didn't bail in a lot of the private holders of 0:18:02.440 --> 0:18:06.119 that inequity to that extent that people really got scared. 0:18:06.720 --> 0:18:11.040 And so after that you had an increase in in 0:18:11.080 --> 0:18:14.200 steepness again, which which was great for the banks itself, 0:18:14.240 --> 0:18:18.600 because if you're engaged in maturity transformation, it's always nice. 0:18:19.160 --> 0:18:23.080 But the sort of volatility associated with with those kind 0:18:23.080 --> 0:18:27.680 of war models that that suddenly dictated a mass of 0:18:27.920 --> 0:18:31.560 dumping of bonds up until the middle of two thousands 0:18:31.600 --> 0:18:34.120 three heard everybody else who was not in the maturity 0:18:34.119 --> 0:18:38.160 transformation business. So, Paul, here's the thing that I really 0:18:38.200 --> 0:18:41.360 liked about your blog post. Um. You so you divide 0:18:41.440 --> 0:18:44.719 these modern bond market selloffs into three categories, and the 0:18:44.760 --> 0:18:48.240 one that everyone tends to reach for, as you mentioned, 0:18:48.520 --> 0:18:53.720 is the bond massacre um. But you actually think that 0:18:53.760 --> 0:18:56.439 what we might be in for now is a mix 0:18:56.800 --> 0:19:00.720 um more of like the late sixty six and the 0:19:00.760 --> 0:19:04.159 early two thousand's with the bar crisis in Japan. Is 0:19:04.200 --> 0:19:07.760 that right, that's right? Yeah, yeah, I mean listening to 0:19:07.840 --> 0:19:11.800 your explanations of each three, it's not hard to imagine 0:19:12.240 --> 0:19:14.480 how they could blend. And you know, if you have 0:19:14.880 --> 0:19:18.760 higher inflation pick up that makes fixed income less compelling. 0:19:18.800 --> 0:19:20.960 You start to get yourself off and then it spreads 0:19:21.000 --> 0:19:24.240 to UM. Then it spreads to the banks. To the 0:19:24.280 --> 0:19:27.280 banks because of their laws requirements have to dump and 0:19:27.440 --> 0:19:30.840 you get something mixed. So walk us through a little 0:19:30.840 --> 0:19:34.560 bit what the downside really looks like in terms of 0:19:35.080 --> 0:19:38.760 money lost, economic ramifications. If we were to get some 0:19:38.840 --> 0:19:44.560 sort of combination nineteen sixties two thousand three, where where 0:19:44.560 --> 0:19:48.040 are the bodies going to turn up? So to speak. Yeah, So, 0:19:48.720 --> 0:19:53.399 in in purely qualitative terms we saw in the inflation 0:19:53.480 --> 0:19:58.320 reversal scenario, we saw in real terms. That's always important 0:19:58.359 --> 0:20:03.040 to U to take into account because, as I mentioned, 0:20:03.200 --> 0:20:07.000 cp I in in bear market years is actually double 0:20:07.119 --> 0:20:10.640 the average inflation. So we're always talking about real terms, right, 0:20:11.520 --> 0:20:14.760 So in the second half of the nineteen sixties, bond 0:20:14.800 --> 0:20:19.960 investors who were long US treasuries back then lost close 0:20:20.040 --> 0:20:24.800 to in real terms within four years UM. Now that 0:20:24.920 --> 0:20:26.879 number is even higher. Of course, when we when we 0:20:26.920 --> 0:20:30.440 look at normal and take take the inflation into account. 0:20:30.960 --> 0:20:34.399 But I think, you know, it's it's not it's not 0:20:34.520 --> 0:20:39.200 purely unreasonable to expect at least that kind of dimension 0:20:39.240 --> 0:20:42.919 of losses when it's definitely when it's coupled with the 0:20:43.080 --> 0:20:46.240 sort of steepening scenario that that we saw in Japan. 0:20:46.720 --> 0:20:50.800 And that's why I refer to two, you know, potentially 0:20:51.160 --> 0:20:54.320 the perfect storm in in bond markets that that we 0:20:54.400 --> 0:20:57.840 could see, because as you rightly mentioned, it's it's really 0:20:57.840 --> 0:21:02.440 a blend of factors that you to occur in isolation 0:21:03.160 --> 0:21:07.480 in many other sellers. So for instance, as I mentioned, 0:21:07.520 --> 0:21:10.280 we didn't actually have a large change in inflation, right 0:21:10.800 --> 0:21:15.040 and still bond markets took a huge hit irrespective of 0:21:15.040 --> 0:21:18.679 of sound fundamentals. The same is true for Japan. But 0:21:18.760 --> 0:21:23.840 now we're really combining fundamentals with you know, these other 0:21:23.920 --> 0:21:28.159 factors that have to do with bank balance sheets, with 0:21:28.359 --> 0:21:33.280 positioning of of speculators, and I think those kind of 0:21:33.280 --> 0:21:38.280 factors make make four potentially more gloomy scenario than than 0:21:38.359 --> 0:21:41.800 the second of the nineteen sixties. Even so, Paul, I'm 0:21:41.840 --> 0:21:45.919 just I'm curious like this. This was a piece posted 0:21:46.000 --> 0:21:48.560 on the Bank of England's blog that got a lot 0:21:48.600 --> 0:21:52.680 of attention. What's been the response to it so far, 0:21:52.920 --> 0:21:56.479 and you know, especially from regulators like those at the BOE. 0:21:56.760 --> 0:21:59.600 Has anyone been talking to you about this? How many 0:22:00.680 --> 0:22:04.639 concerns have you heard since you posted this? But of 0:22:04.640 --> 0:22:07.600 course I'm not the only one who's who's concerned about 0:22:07.840 --> 0:22:12.119 the bond market. I mean, in recent months quite a 0:22:12.160 --> 0:22:16.000 few people, especially from the investment side, have have come 0:22:16.000 --> 0:22:19.800 out and warned about the dynamics. I didn't have anybody 0:22:19.800 --> 0:22:22.880 from the regulatory side reach out to me so far, 0:22:23.600 --> 0:22:25.439 and I have to stress, of course I'm I'm not 0:22:25.520 --> 0:22:28.959 speaking for the Bank of England here, um, but I 0:22:29.000 --> 0:22:33.080 think you know, we we should regulators definitely should be 0:22:33.119 --> 0:22:35.879 aware of those kind of trends and really should be 0:22:35.920 --> 0:22:40.040 aware also of the of the quite historic proportions of 0:22:40.119 --> 0:22:44.680 the of the price distortions that we're talking about. Um. Really, 0:22:44.680 --> 0:22:47.959 if we if we are saying seeing that it's it's 0:22:48.000 --> 0:22:52.240 an eight hunded year event that we are seeing in 0:22:52.240 --> 0:22:54.920 in in bond markets, I think we should we should 0:22:54.920 --> 0:22:58.480 be paying more attention to it than we have so far. Yeah, 0:22:58.480 --> 0:23:00.399 I think that's a bit of an understate admit that 0:23:00.440 --> 0:23:02.600 we should be paying more attention if this could be 0:23:02.640 --> 0:23:05.680 a once in eight hundred year event away. Paul Schmeltzing 0:23:06.600 --> 0:23:11.560 very fascinating, also very gloomy. Paul Schmeltzing is getting a 0:23:11.720 --> 0:23:15.879 PhD student at Harvard also visiting researcher at the Bank 0:23:15.920 --> 0:23:30.640 of England. Really appreciate you coming on. Thanks so much, Joe. 0:23:30.840 --> 0:23:33.760 Was that was that too gloomy a podcast for this 0:23:33.840 --> 0:23:37.600 early in the year. Uh, it was pretty gloomy. It 0:23:37.680 --> 0:23:41.080 was pretty scary. And you know, like I mentioned early on, 0:23:41.960 --> 0:23:46.080 anytime you're talking about going back to the four hundreds 0:23:46.119 --> 0:23:49.760 to find precedent for where we're where we are right now, 0:23:50.760 --> 0:23:53.440 I think you have to sit up and pay attention. 0:23:53.840 --> 0:23:56.320 But I thought that was great. I love talking to Yeah, 0:23:56.359 --> 0:24:00.639 it's really interesting. Um. I mean, we could have talked 0:24:00.720 --> 0:24:03.879 a lot about of our models. But one thing I 0:24:03.960 --> 0:24:09.520 find interesting in particular is the tension between the regulations 0:24:09.560 --> 0:24:13.240 that we've had come in post two eight financial crisis 0:24:13.920 --> 0:24:17.280 and what's happening now in that a lot of regulators 0:24:17.320 --> 0:24:21.880 wanted banks to hold safe assets, right, the risk free asset, 0:24:21.960 --> 0:24:24.240 as you pointed out, and so now we do have 0:24:24.359 --> 0:24:28.639 banks um that have even greater proportions of their portfolios 0:24:28.760 --> 0:24:32.320 based in their home market bonds. And again the concern 0:24:32.400 --> 0:24:34.520 is if we get that big sell off, rather than 0:24:34.560 --> 0:24:38.760 having the regulation make the banks safer. Um, we could 0:24:39.000 --> 0:24:41.960 just be exacerbating this problem, right, I think this is 0:24:42.000 --> 0:24:45.040 a This is a like people who aren't immersed in 0:24:45.080 --> 0:24:49.160 this might get confused because we talked about US treasuries 0:24:49.920 --> 0:24:53.399 as save haven risk free assets, and they're deemed to 0:24:53.440 --> 0:24:55.919 be not save haven or risk free, not because you 0:24:55.920 --> 0:24:59.359 can't lose money in them, but because we think the 0:24:59.480 --> 0:25:02.560 US govern a mint is the most credit worthy institution 0:25:02.680 --> 0:25:06.000 in the world, and so unlike say lending to an 0:25:06.000 --> 0:25:08.920 oil company or lending to a tech company, or lending 0:25:08.920 --> 0:25:11.959 to an emerging market, there's virtually no risk that the 0:25:12.000 --> 0:25:14.399 government won't be able to pay back the debt. But 0:25:14.480 --> 0:25:18.480 there are all other ways an investment in these or 0:25:18.520 --> 0:25:21.919 these investments could lose a lot of money. And I 0:25:22.000 --> 0:25:25.080 really like the way Paul just sort of walked through 0:25:25.640 --> 0:25:30.000 the different ways you can lose money on a safe 0:25:30.000 --> 0:25:33.399 haven asset. Yeah, how can I lose money on a 0:25:33.440 --> 0:25:37.400 safe haven asset? Let me count the ways. Piling into 0:25:37.800 --> 0:25:41.600 ultra long end of the curve because it's the only 0:25:41.600 --> 0:25:44.359 way to make money while being safe at the same time, 0:25:44.880 --> 0:25:48.760 does in retrospect seemed like a recipe for trouble down 0:25:48.760 --> 0:25:51.720 the road. Yeah, alright, so this is definitely a big 0:25:51.760 --> 0:25:54.520 theme to watch for this year, and um, well, I 0:25:54.560 --> 0:25:59.159 guess we'll have to revisit it. Yeah. No, that's I 0:25:59.200 --> 0:26:02.840 think really worth emphasizing that it's this isn't just sort 0:26:02.880 --> 0:26:08.000 of like interesting historical perspective. This is happening. These questions 0:26:08.000 --> 0:26:10.200 are being post to the market right now. We've seen 0:26:10.240 --> 0:26:14.359 yields jump a lot since this summer. UH bonds sold 0:26:14.400 --> 0:26:17.280 off more after the US presidential election, So this is 0:26:17.480 --> 0:26:22.240 of implicate, this matters to traders and investors right at 0:26:22.240 --> 0:26:25.439 this moment, and I think his work is a great 0:26:25.480 --> 0:26:28.879 place to start in terms of UH thinking about what 0:26:28.920 --> 0:26:32.080