Hi, and welcome to another edition of the Odd Thoughts podcast. I'm Tracy Alloway and I'm Joe Wisental, So Joe here. Um, here's a fun fact about where I am in my life. There is nothing that I enjoy talking about more than value at risk models. That I mean, I respect that. I bet there are people on the world who would look in the world who would think that was sad, especially the way you framed it about where you are in life. But as you know, Tracy, that only raises
my esteem of you. Okay, that's that's sweet, all right. Um. For listeners who don't know, Value at risk models are these sort of internal risk management models that banks usually use. Um, they look at their trading books, they see how much money they could lose on a given day within a certain probability, and then they adjust their positions according to that. So that was probably the geekiest intro um that I
could come up with from this episode. But the reason we're about to talk about VAR models, if you will, it's because something really really big has been going on in markets, right Joe. Uh, that's absolutely right. Uh. We're seeing a we've been seeing a bond market sell off exactly. The bond market, the biggest market in the world, government bonds, corporate bonds. They've been in this extraordinary bull market that's arguably lasted for decades, and it's too soon to declare
the bull market over. But every time bond sell off, people start to wonder, is this it is this the turn? Because if it is, if the if the bull market is finished, then people could probably lose a lot of money, right. Um, not just the banks who have these bar models in place and they might start to exceed the limits imposed by their bar models, but lots of pension funds, um, you know, people like you and I. Basically the entire game begins to change if the great bull run in
bonds finally comes to its inglorious end. But no one is sure whether or not that's happening yet. Um. So this is the thing that we're going to talk about today,
right right. Nobody knows whether it's happening yet. But the stakes are so high that every we're talking about it anyway, that the stakes are so high that you kinda if you're an investor, if your pension fund, if you're a bank, if you're whatever, you have to have a you have to be thinking about this question right now, right, So who better to think about this question and discuss it
with then Paul Schmeltzing. He is a PhD candidate at Harvard University and a visiting scholar at the Bank of England, and he wrote a really, really thought provoking post on the BOE website recently basically talking about historical bond market sell offs. And I mean, I have to bring up the title of this post because I just love it so much. It was Venetians, Vulcar and value at risk
Eight centuries of bond market reversals. Well, I say we just dive right into it and start to unpack this question of whether we're at risk of, as the title says, a bond market reversal. Paul, thanks so much for joining us today. Thank you so reading your blog post which goes through eight hundred years of bond market history, which
is pretty amazing. You actually found that in the history of bond market, bull runs the one um that we're currently in, although we may be coming to the end of its lasted three decades, there are only two others that have actually exceeded it in length, right, that's right, Tracy, and by the way, I share your enthusiasm for value at risk models. There's one other person that's good. So
that's right. I mean I started the data in the year twelve eighty five, so you really go back to the Italian city states, to Venice, to Genoa, who developed the first secondary markets and government bonds, and you start recording the global risk free rate from then onwards, and so over time you just trace the evolution of the financial center in the world. You go from the Venetians, to the Genoese, then to the Dutch, finally to the British and currently obviously the the U s tenure is
the risk free asset. And what I found is that when we hit below one d forty basis points in the US tenure last July, that was the lowest level that the risk free rate in normal terms has ever reached in almost eight hundred years of sovereign bond market history. In terms of length and heeled compressions. Since this bull market began in one as well, it's one of the
most remarkable episodes in recorded economic history. We're talking about a cumulative yield compression of about twelve hundred basis points. There's only the episode in the in the fourteen forties to the fourteen eighties that exceed this bull market in terms of yield compression. And as you rightly said, there's only one other bull market that also exceeded those two markets in terms of sheer length. That was the bull market of fifteen fifty eight to sixteen sixty four, which
almost lasted a hundred years. So that's where we are. I think this is one of the most marketable bond bull markets in all of recorded economic history. And unfortunately, the flip side of the story is of course that you know, if history is a guide, then the reversals of those bowl markets can be quite ugly as well. I think it's funny, you know, when people talk about the stock market, they say, oh, we haven't seen valuations
like this. It's two thousand or two thousand seven, and now we're talking about bonds and you're making references to bowl markets that we saw in the fourteen hundreds. So it really puts a perspective on it. I want to get into, you know, obviously the nature of selloffs, but before we don't want to ask a technical question. You you mentioned, you know the US ten uere, you know U S treasuries are the risk free instrument. Other bonds are sort of measured by their spread relative to the tenure.
Throughout history, has there always been a an instrument that was considered the risk free of that time? Is at uh? Is that sort of always been part of the fixed income landscape? Good question, that's a great question, Joe. Yeah. I mean the term risk free asset is of course a modern concept um. But the practice that you basically always reference your debt to, you know, what is perceived as as the most reliable, the most stable financial center um.
That has a long tradition. Actually, so the Venetians back in the thirteenth century, we're always seen as the most advanced, most reliable providers of credit, and so throughout Europe, you know, the Princess Saying, the Holy Roman Empire in in all the other jurisdictions, they usually went to the Italian city states and basically asked for credit there, and so they had to deal with the conditions attached to the to the credit that was actually issued in Venice, and that
was that was the reference. Right now, If you go back further than the thirteenth century, things become more complicated because we're talking about a very very thin secondary market. Um, and it becomes very tough to to measure with a reliable frequency what the risk free rate is doing. But from the thirteenth century onwards we we kind of get secondary markets. People are trading this kind of stuff among each other, and so that's that's really where the risk
free history starts in a sense. So um is of course very very fun to go back in history and look at these other ball markets in bonds. Um. What actually happened when we saw those historical ball markets come to an end? Um? And how much can we extrapolate to modern markets, which are I'm assuming significantly more complex and very different to say the Venetians in four hundreds absolutely so before the twentieth century, the reversals in bond
markets were often driven by geopolitical events, right. Um. So when a certain major war broke out, you know, the major emperors defaulted on their debt, and that reversed the the Boulo bear market that was that was currently ongoing. Um. So for the two largest bond markets, the bull markets that we have, they came to an end because the Venetians were in a in a long and intense struggle with the Ottoman Empire over dominance in the Mediterranean Sea.
So back in those days, having the control of the trade routes, of the finance routes in the Mediterranean Sea was the most lucrative business that you could be in. And so at various points in in the fifteenth and sixteenth century, the Venetians lost major battles against the Ottomans. There was a famous battle at the Otranto in in the fourteen eighties which ended the one of the largest
bull markets that I recorded in the fourteen eighties. Um we have a similar defeat by the Venetians over Crete in the sixties sixties, which which ended the longest bull market by sheer length. And so those kind of dynamics really determine a lot of the a lot of the
reversals pre twentie century. When you also remember you didn't have active interventionist gentral banks back then, right unlike today, and so a lot was simply determined by the political developments of course, So to that extent, of course, we have to be careful to when we want to extrapolate to today. But that's why I really zoom into three
case studies. In the twentieth century in the in the remainder of the piece, because I think those are have a much higher relevance to the dynamics we are seeing today. So just to clarify something, in the old days, the bond market bull bond bull markets would essentially end when the credit worthiness of the issuer who seriously called into question, which you would expect to happen after major military defeat.
More modern um bond sell offs tend I mean, very few people think that there's much risk of the US or Japan not paying their debt. More modern bond sell offs tend to have other dynamics besides sort of calling into question the existence of the issuers. So what are first of all, is that a fair characterization? And be what are some of the factors that precipitate modern sell offs.
That's a fair characterization, Joe Um. I mean I have to add, you know, sometimes bull markets came to an end in the past because the emperors simply through the bank as in right, I could see that I could see that having that effect. That that's actually a very that's actually a very frequent occurrence in the past. You know. So if you charge too too much interest, then you you you better leave the country or you have better have a good escape route. UM. Today, as you mentioned,
the dynamics are slightly different. And I really zoom into three case studies in the twenty century that I think are relevant for for our current discussion. So the first really is when you look at the second half of the nineteen sixties. I think they're actually interesting parallels to the current backdrop that we see in bond markets. So remember, in the sixties, the backdrop is that we have the
Lyndon Johnson administration being engaged in the Vietnam War. Right, that means a reasonable fiscal stimulus of around two and a fifty basis points to GDP in the second half of the sixties. Against that, we have a very tight
used labor market, you know, very similar to today. UM. And what happens when you combine this sort of fiscal expansion with a very tight used labor market, UM, was that CPI inflation started really to row from one and a half percent in the mid nineties sixties up to close to six percent by the end of the by the end of the decade, UM. And so I call
that case study the inflation reversal case study. UH. And and so I think that's relevant because just look at the sort of prints that we saw in the last couple of weeks. Just yesterday we had a major print, for instance, out of China that now records five and a half percent PPI inflation. We had prints from Germany which suggests that inflation there is accelerating at the highest speed in twenty three years. We had a US jobs report that recorded, you know, almost three percent average earlier
dot com. I mean to say that those kind of dynamics apparently start becoming relevant again. And so I think this is a useful case study to to really look for those kind of inflation reversal stories that that we've seen. The second case study is the so called bond massaccer, that is that pops up more and more in the in the in the literature. It was the most the most violent year for for long bond investors um. They lost one and a half trillion in in global bond
values within a year. Some people associate that with a fat funds hike in in February, but actually the tenure volatility started rising steeply in the third quarter of because of the the e r M crisis in Europe. You had emerging market volatility in places like Mexico which entered the Tequila crisis, uncertainty in Turkey, Venezuela, and so a lot of those kind of leveraged bets that were very
popular at the time just went sour very quickly. The thing to remember is, and that's why I said in the piece that I think we are probably heading for something worse than bond massacre. Those kind of sellers were over again because fundamentals changed very little back then. We're back in a very decent environment for bonds. They gained another eighteen percent in real terms, in real price terms, and it was more or less over after, you know,
the speculators had been washed out. And the third one really is the and Tracy will probably like this the this is my favorite. The value at risk shock in Japan in two thousands three. Explain that one what is that?
What is that? What does that mean? So, as Tracy mentioned earlier, banks typically operate with those kind of internal models that typically set a certain cushion for volatility and the average daily losses that you can add a maximum incur on on certain positions, and once you breach those thresholds,
those models suggested you have to sell certain holdings. In the Japanese case JGBS right, and the dynamics in Japan and the early two thousands are are also very interesting because there are a lot of perils to to our current environment. Remember, the Japanese were actually the first to engage in in large scale quantitative easing programs. They started their QUE program in two thousand one against the backdrop of long long disinflation and all those problems in the
nineties that most people will probably be familiar with. And what you saw is similar to today, or at least similar up until the first half, I guess you saw a massive flattening of of field curves in Japan because the bo j bought a lot of the outstanding issues um and that hurt banks. I mean, if you look at the topics, which is the Japanese banking Index, it's sold off massively since the introduction of that QUE program.
Only two sharply reverse course. In in the middle of two thousand three, when there were rumors about the potential tape ring by the bo j UM, some very big institutions, banking institutions had to be saved by the Japanese state. They bailed out the equivalent of their you know, Bear Sterns and Lehman in the in those years, Hizona Group was one of the most famous victims, but actually they didn't bail in a lot of the private holders of that inequity to that extent that people really got scared.
And so after that you had an increase in in steepness again, which which was great for the banks itself, because if you're engaged in maturity transformation, it's always nice. But the sort of volatility associated with with those kind of war models that that suddenly dictated a mass of dumping of bonds up until the middle of two thousands three heard everybody else who was not in the maturity transformation business. So, Paul, here's the thing that I really
liked about your blog post. Um. You so you divide these modern bond market selloffs into three categories, and the one that everyone tends to reach for, as you mentioned, is the bond massacre um. But you actually think that what we might be in for now is a mix um more of like the late sixty six and the early two thousand's with the bar crisis in Japan. Is that right, that's right? Yeah, yeah, I mean listening to your explanations of each three, it's not hard to imagine
how they could blend. And you know, if you have higher inflation pick up that makes fixed income less compelling. You start to get yourself off and then it spreads to UM. Then it spreads to the banks. To the banks because of their laws requirements have to dump and you get something mixed. So walk us through a little bit what the downside really looks like in terms of money lost, economic ramifications. If we were to get some sort of combination nineteen sixties two thousand three, where where
are the bodies going to turn up? So to speak. Yeah, So, in in purely qualitative terms we saw in the inflation reversal scenario, we saw in real terms. That's always important to U to take into account because, as I mentioned, cp I in in bear market years is actually double the average inflation. So we're always talking about real terms, right, So in the second half of the nineteen sixties, bond investors who were long US treasuries back then lost close
to in real terms within four years UM. Now that number is even higher. Of course, when we when we look at normal and take take the inflation into account. But I think, you know, it's it's not it's not purely unreasonable to expect at least that kind of dimension of losses when it's definitely when it's coupled with the sort of steepening scenario that that we saw in Japan.
And that's why I refer to two, you know, potentially the perfect storm in in bond markets that that we could see, because as you rightly mentioned, it's it's really a blend of factors that you to occur in isolation in many other sellers. So for instance, as I mentioned, we didn't actually have a large change in inflation, right and still bond markets took a huge hit irrespective of
of sound fundamentals. The same is true for Japan. But now we're really combining fundamentals with you know, these other factors that have to do with bank balance sheets, with positioning of of speculators, and I think those kind of factors make make four potentially more gloomy scenario than than the second of the nineteen sixties. Even so, Paul, I'm just I'm curious like this. This was a piece posted on the Bank of England's blog that got a lot
of attention. What's been the response to it so far, and you know, especially from regulators like those at the BOE. Has anyone been talking to you about this? How many concerns have you heard since you posted this? But of course I'm not the only one who's who's concerned about the bond market. I mean, in recent months quite a few people, especially from the investment side, have have come
out and warned about the dynamics. I didn't have anybody from the regulatory side reach out to me so far, and I have to stress, of course I'm I'm not speaking for the Bank of England here, um, but I think you know, we we should regulators definitely should be aware of those kind of trends and really should be aware also of the of the quite historic proportions of
the of the price distortions that we're talking about. Um. Really, if we if we are saying seeing that it's it's an eight hunded year event that we are seeing in in in bond markets, I think we should we should be paying more attention to it than we have so far. Yeah, I think that's a bit of an understate admit that we should be paying more attention if this could be a once in eight hundred year event away. Paul Schmeltzing
very fascinating, also very gloomy. Paul Schmeltzing is getting a PhD student at Harvard also visiting researcher at the Bank of England. Really appreciate you coming on. Thanks so much, Joe. Was that was that too gloomy a podcast for this early in the year. Uh, it was pretty gloomy. It
was pretty scary. And you know, like I mentioned early on, anytime you're talking about going back to the four hundreds to find precedent for where we're where we are right now, I think you have to sit up and pay attention. But I thought that was great. I love talking to Yeah, it's really interesting. Um. I mean, we could have talked
a lot about of our models. But one thing I find interesting in particular is the tension between the regulations that we've had come in post two eight financial crisis and what's happening now in that a lot of regulators wanted banks to hold safe assets, right, the risk free asset, as you pointed out, and so now we do have banks um that have even greater proportions of their portfolios based in their home market bonds. And again the concern is if we get that big sell off, rather than
having the regulation make the banks safer. Um, we could just be exacerbating this problem, right, I think this is a This is a like people who aren't immersed in this might get confused because we talked about US treasuries as save haven risk free assets, and they're deemed to be not save haven or risk free, not because you can't lose money in them, but because we think the US govern a mint is the most credit worthy institution in the world, and so unlike say lending to an
oil company or lending to a tech company, or lending to an emerging market, there's virtually no risk that the government won't be able to pay back the debt. But there are all other ways an investment in these or these investments could lose a lot of money. And I really like the way Paul just sort of walked through the different ways you can lose money on a safe haven asset. Yeah, how can I lose money on a
safe haven asset? Let me count the ways. Piling into ultra long end of the curve because it's the only way to make money while being safe at the same time, does in retrospect seemed like a recipe for trouble down the road. Yeah, alright, so this is definitely a big theme to watch for this year, and um, well, I guess we'll have to revisit it. Yeah. No, that's I think really worth emphasizing that it's this isn't just sort
of like interesting historical perspective. This is happening. These questions are being post to the market right now. We've seen yields jump a lot since this summer. UH bonds sold off more after the US presidential election, So this is of implicate, this matters to traders and investors right at this moment, and I think his work is a great place to start in terms of UH thinking about what
potential downside scenarios could look like. Yeah, and I'm sure we'll be talking about it a lot more with a lot of other people, but let's leave it at that for this week. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway. And I'm Joe Wisenthal. You can follow me on Twitter at the Stalwarts. This has been another episode of the Odd Lots Podcast. Thanks for listening to