Odd Lots - 62: How The Biggest Bull Market Could Come Crashing Down

Episode Date: January 13, 2017

The stock market is currently in one of its longest bull markets ever, but that doesn't hold a candle to what's going on bonds. According to Paul Schmelzing, a PhD candidate at Harvard and a visiting researcher at the Bank of England, you have to go back more than 500 years (!) to find a bull market in bonds longer than than the one we're experiencing now. After bonds tumbled since last summer (especially since the election) there's a lot of interest in whether we're on the cusp of a major downturn. In this week's Odd Lots, Schmelzing walks us through the history of bull and bear markets in bonds and explains why we could see some gigantic losses ahead.See omnystudio.com/listener for privacy information.

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slash audio. That's vanguard.com slash audio. All investing is subject to risk vanguard marketing Corporation Distributor. Hi, and welcome to another edition of the Odd Lots podcast. I'm Tracy Allaway. And I'm Joe Wisenthal. So, Joe, 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. Oh, okay. That's sweet. All right. For listeners who don't know, value at risk models are these sort of internal risk management models that banks usually use. 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 that I could come up with for this episode. But the reason we're about to talk about VAR models, if you will, is because something really, really big has been going on in markets, right, Joe? That's absolutely right. 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 bonds sell off, people start to wonder, is this it? Is this the turn? Because if it is, if the bull market is finished, then people could probably lose a lot of money.

Right. Not just the banks who have these var models in place and they might start to exceed the limits imposed by their var models, but lots of pension funds, 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. 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 going to talk about it anyway. That the stakes are so high that you kind of, if you're an investor, if you're a 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 than 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 a 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 Venetian's Volker 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 that we're currently in, although we may be coming to the end of it, has 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 you 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 1285. 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 Venice. to the Genoese, then to the Dutch, finally to the British, and currently, obviously, the US 10-year is the risk-free asset.

And what I found is that when we hit below 140 basis points in the US 10-year last July, that was the lowest level that the risk-free rate in normal terms has ever reached in almost 800 years of sovereign bond market history. In terms of length and yield compression since this bull market began in 1981 as well, it's one of the most remarkable episodes in recorded economic history. We are talking about a cumulative yield compression of about 1,200 basis points. There's only the episode in the 1440s to the 1480s 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 1558 to 1664, which almost lasted 100 years.

So that's where we are. I think this is one of the most remarkable bond bull markets in all of recorded economic history. And unfortunately, the flip side of the story is, of course, that if history is a guide, then the reversals of those bull 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 since 2000 or 2007. And now we're talking about bonds and you're making references to bull markets that we saw in the 1400s. So it really puts a perspective on it.

I want to get into, you know, obviously the nature of sell-offs. But before you do, I want to ask a technical course. question. You mentioned, you know, the U.S. 10-year, U.S. Treasuries are the risk-free instrument. Other bonds are sort of measured by their spread relative to the 10-year. Throughout history, has there always been an instrument that was considered the risk-free of that time? 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. But the practice that you basically always reference your debt to what is perceived as the most reliable, the most stable

financial center, that has a long tradition, actually. So the Venetians back in the 13th century were always seen as the most advanced, most reliable providers of credit. And so, throughout Europe, you know, the princes, say, in the Holy Roman Empire, 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 credit that was actually issued in Venice. And that was the reference rate. Now, if you go back further than the 13th century, things become more complicated because we are talking about a very, very thin secondary market and it becomes very tough to measure with a reliable frequency what the risk-free rate is doing.

But from the 13th century onwards, we kind of get secondary markets. People are trading this kind of stuff among each other. And so that's really where the risk-free history starts in a sense. So it is, of course, very, very fun to go back in history and look at these other bull markets in bonds. What actually happened when we saw those historical bull markets come to an end? 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 the 1400s? Absolutely. So before the 20th century, the reversals in bond markets were often driven by geopolitical events, right? So when a certain major war broke out, you know, the major emperors defaulted on their debt,

and that reversed the bull or bear market that was currently ongoing. So for the two largest bond markets, the bull markets that we have, they came to an end because the Venetians were 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 the 15th and 16th century, the Venetians lost major battles against the Ottoman.

There was a famous battle at the Otranto in the 1480s, which ended one of the largest bull markets that I recorded in the 1480s. We have a similar defeat by the Venetians over Crete in the 1660s, which ended the longest bull market by sheer length. And so those kind of dynamics really determine a lot of the reversals. pre-20th century, when you also remember you didn't have active interventionist central 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 20th century in the remainder of the piece, because I think those have a much higher relevance. to the dynamics we are seeing today. So just to clarify something, in the old days, the bond market, bond bull markets would essentially end when the creditworthiness of the issuer who seriously called into question, which you would expect to happen after major military defeat.

More modern bond sell-offs, I mean, very few people think that there's much risk of the U.S. 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 issuer. So what are, first of all, is that a fair characterization? And B, what are some of the factors that precipitate modern sell-offs? That's a fair characterization, Joe. I mean, I have to add, you know, sometimes bull markets came to an end in the past because the emperor simply threw their bankers in jail, right?

I could see that having that effect that not good for market. That's actually a very frequent occurrence in the past. So if you chart too much interest, then you better leave the country or you better have a good escape route. Today, as you mentioned, the dynamics are slightly different. And I really zoom into three case studies in the 20th century that I think are relevant for our current discussion. So the first really is when you look at the second half of the 1960s, I think they're actually

interesting parallels to the current backdrop that we see in bond markets. So remember in the 60s, 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 250 basis points to GDP in the second half of the 60s. Against that, we have a very tight U.S. labor market, you know, very similar to today. And what happens when you combine this sort of fiscal expansion with a very tight U.S. labor market was that CPI inflation started really to roll from 1.5% in the mid-1960s up to close to 6% by the end of the decade.

And so I call that case study the inflation reversal. case study. 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 5.5% PPI inflation. We had prints from Germany which suggests that inflation there is accelerating at the highest speed in 23 years. We had a US jobs report that recorded, you know, almost 3% average hourly earnings. 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 really look for those kind of inflation reversal

stories that we've seen. The second case study is the 1994 so-called bond massacre that pops up more and more in the literature. It was the most violent year for long bond investors. They lost one and a half trillion in global bond values within a year. Some people associate that with a Fed funds hike in February 1994. But actually, the 10-year volatility started rising steeply in the third quarter of 1993 because of the ERM 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 the 1994 Bond massacre, Those kind of sellers were over again by 1995 because fundamentals changed very little back then. By 1995, we were back in a very decent environment for bonds. They gained another 18% in real terms, in real price terms in 1995.

And it was more or less over after the speculators had been washed out. And the third one really is the, and Tracy will probably like this. This is my favorite one. the value at risk shock in Japan in 2003. Explain that one. What does that mean? So as Tracy mentioned earlier, banks typically operate with those kind of internal models that typically set a certain cussion for volatility and the average daily losses

that you can at a maximum incur 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 2000s are also very interesting because there are a lot of parallels to our current environment. Remember, the Japanese were actually the first to engage in large-scale quantitative easing programs.

They started their QE program in 2001, against the backdrop of long, long disinflation and all those problems in the 1990s 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 of 2016, I guess, you saw a massive flattening of yield curves in Japan because the BEOJ bought a lot of the outstanding issues. And that hurt banks. I mean, if you look at the topics, which is the Japanese banking index, it sold off massively since the introduction of that QE program, only to sharply reverse course in the middle of 2003 when there were rumors about a potential

tapering by the BOJ. Some very big institutions, banking institutions had to be safe. by the Japanese state. They bailed out the equivalent of their, you know, Bear Stearns and Lehman in those years. Rezona Group was one of the most famous victims. But actually they didn't bail in a lot of the private holders of debt inequity to that extent that people really got scared. And so after that, you had an increase in steepness again, 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 those kind of VAR models that suddenly dictated a massive dumping of bonds up until the middle of 2003 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. So you divide these modern bond market sell-offs into three categories. And the one that everyone tends to reach for, as you mentioned, is the 1994 Bond Massacre. But you actually think that what we might be in for now is a mix more of like the late 60, 1960s and the early 2000s with the VAR 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 pickup, that makes fixed income less compelling. You start to get your sell off, and then it spreads to the banks, the banks because of their loss 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, 1960s, 2003, where.

Where are the bodies going to turn up, so to speak? Yeah, so in purely qualitative terms, we saw in the inflation reversal scenario, we saw in real terms, that's always important to take into account, because as I mentioned, CPI 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 1960s, bond investors who were long U.S. Treasuries back then lost close to 40% in real terms within four years. Now, that number is even higher, of course, when we look at normal and take the inflation into account. But I think, you know, it's not purely unreasonable to expect at least that kind of dimension of losses.

definitely when it's coupled with the sort of steepening scenario that we saw in Japan. And that's why I refer to potentially the perfect storm in bond markets that we could see. Because as you rightly mentioned, it's really a blend of factors that used to occur in isolation in many other sellers. So for instance, in 1994, as I mentioned, we didn't actually have a large change in inflation, right? And still, bond markets took a huge hit irrespective 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 speculators. And I think those kind of factors make for a potentially more gloomy scenario than the second after the 1960s even. So, Paul, I'm just, I'm curious, like 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?

Well, of course, I'm not the only one who's concerned about the bond market. I mean, in recent months, quite a few people, especially from the investment side, 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 not speaking for the Bank of England here. But I think, you know, regulators definitely should be aware of those kind of trends and really should be aware also of the quite, historic proportions of the price distortions that we are talking about. Really, if we are seeing that it's an 800-year event that we are seeing in bond markets, I think we should be paying more attention to it than we have so far.

Yeah, I think that's a bit of an understatement that we should be paying more attention if this could be a once-an-eight-year event. Anyway, Paul Schmelting, very fascinating. also very gloomy. Paul Schmelting 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 too gloomy a podcast for this early in the year? 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 1400s 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 him. Yeah, it's really interesting. I mean, we could have talked a lot about VAR models. But one thing I find interesting in particular is the tension between the regulations that we've had come in post-2008 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 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 bank safer, 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 talk about U.S. Treasuries as safe haven risk-free assets. And they're deemed to be not safe haven, a risk-free, not because you can't lose money in them, but because we think the U.S. government 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. Right. 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 seem like a recipe for trouble down the road? Yeah. All right. So this is definitely a big theme to watch for this year. And I guess we'll have to revisit it. Yeah. Let's, uh, 2017. 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 posed to the market right now. We've seen yields jump a lot since this summer. Bonds sold off more after the U.S. 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 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 stalwart. This has been another episode of the Oddlods podcast. Thanks for listening. I'm June Grasso, inviting you to join me for the Bloomberg Law podcast. Every weekday, we help you make sense of the legal stories that shape the nation and the world. Listen for complete analysis of the biggest court cases, the latest actions from Congress and regulators, and the legal moves driving the markets. from corporate law to constitutional law and from state courts to the Supreme Court. At Bloomberg Law, we go beyond the day's headlines.

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