Odd Lots - How the Biggest Bull Market Could Go on for a Whole Lot Longer

Episode Date: March 10, 2017

A few weeks ago on the Odd Lots podcast, we talked to Paul Schmelzing, a Ph.D candidate at Harvard, who explained how the bull market in U.S. Treasuries could come to a screeching halt. This week we examine the other side of the debate. Our guest is Srinivas Thiruvadanthai, director of research at the Jerome Levy Forecasting Center in Mount Kisco, New York. He explains how a combination of structural factors in the global economy and massive levels of debt could depress interest rates on government debt for years to come. In addition to explaining why the bond bull market of more than three decades can survive, Thiruvadanthai explains what everyone gets wrong on how inflation occurs.See omnystudio.com/listener for privacy information.

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That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor. Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Wisenthal. And I'm Tracy Allaway. So Tracy, remember a few weeks ago or a few months ago when we had that episode about how the bond bull market might come to a disastrous halt and people might lose billions all over the world?

A few months ago. I know it's been a long year so far, at least it feels like a long time, but it was only just in January. January, right? Oh, man. Has it really been that recently? It has been a long year. That's my excuse. So we talked to, we talked on that episode to Paul Schmeltsing. He's a, at Harvard University, and a researcher at the Bank of England. And he had a very interesting sort of theory about how this incredible bond bowl market that we've seen could come to a disastrous halt via some combination of inflation and banks having to liquidate their bond holdings and was all pretty gloomy.

Yeah. Well, you know I'm a sucker for financial market history. So the thing I really liked about that conversation was that he went back over 800 years of bond market history to draw an analogy with the current situation today and basically made a big call saying that we could have a bond market massacre. That's probably one of the worst we've ever. ever seen, right? Absolutely. So here's the good news, though. Not everyone agrees with Paul. And in fact, today we're going to do a follow-up episode, and we're going to talk to someone who takes the opposite view that there is no bond market disaster in the offing. Great. Let it never be said that we don't present both sides of the story, right, Joe?

Exactly. Even if someone has to wait several months or maybe in this case just a few weeks, even if you have to wait a while, we always like to have the opposite argument on the Outlots podcast. Excellent. So with us today to discuss this is Srinivostira Vedantai of the Jerome Levy Forecasting Center. And recently he wrote a piece of research arguing directly against Paul Schmeltsing's argument. and he explains why the bond market is not in some massively precarious state and ready for a sell-off. So I say we get to his argument. Yeah, I'm intrigued. Let's get him on.

All right, Serena Vos, thank you very much for joining us on the Adlots podcast. Thank you, Drew. So, first of all, let's talk about the Paul's piece. So he argued he, in this blog post that got shared quite widely from the Bank of England, he looked at historical bond. market sell-offs. And he noted that there are a few different kinds of bond market sell-offs. Some have to do with the creditworthiness of the issuer, the sovereign. Some have to do with inflation. Some are more technical. And he sort of zeroed in on this idea that in the 60s, we had this episode of an intense bond market sell-off due to inflation, and that there were also similarities to the

early 2000s in Japan, what do you call it a value at risk shock. You don't really find the analogies helpful. So tell us about your work. So, you know, I am also a sucker for long history. But in the case of the bond market, you know, the problem with long history is that we are in a world of fiat currency, which has really existed for 40 years. And even if you include the history entirely from the gold standard, the end of the gold standard. era in 34, you could say 70 years. But the problem with the pre-goldstep and the pre-World era is that most of the time there was a credit risk for sovereigns because they had to convert it into gold. So this is a really key point that I just want to make sure people understand,

which is that when governments were on the gold standard, there was actually a risk that they could just run out of money. So that they were kind of like a company in that regards. They you lend money to a company, the company might go bankrupt. Now, with governments mostly on fiat currency, there are still risks, but they're not about running out of money because fiat money can just be sort of created massively. And so, in other words, you look back 800 years, back when we were on the gold standard, those just aren't really comparable. They are not comparable. So the real issue is we are looking at the post-World War II history in terms of trying to understand and understand the bond market. And so he's, the main comparison is to the late 60s. People are

worried mostly about a long-term bond sell-off. They're not worried about a one-time sell-off like we've had this year, I mean last year, and we had in 2013 as well. I mean, it is pretty stomach-wrenching because a bond investor is not the one who's used to volatility, of course. But, so what is the difference, key differences between the 1960s and today? So if you go back to the 60s, and I was just looking at the data. The U.S. unemployment rate was, I think, less than four. Now, you would say that we are pretty close to it, but there's just no comparison between the late 60s labor market in terms of tightness in today, just based on the unemployment rate. And the reason is, if you look at the participation rate for prime age males, it was north of 90%. Everybody who had a job and wanted

a job, had a job pretty much. That's not the case today. And the... unemployment rate clearly understates the level of slack that is there in the economy. Number two, if you look at the global conditions, they were even tighter. Germany had a sub one-one-person unemployment rate at one point. Japan had less than 2%. All over the developed world, the labor markets were drumtight. They were, in fact, importing guest workers in Germany at that time. It might seem really strange in this day where we want to shut down immigration, but they were importing guest workers.

And if you look at the capacity utilization rates, they were all north of 90%. I mean, pretty much there was no spare capacity. So companies, I mean, the labor had bargaining power and companies had pricing power. So there could be the pass-through and a wage price inflation, which you need for inflation to pick up. All the conditions were there. On top of that, you also had a situation where the Fed was accommodative. I mean, if the Fed says, no, I'm not going to accommodate anything.

and I'm going to raise rates, the moment I see some inflation pick up, then you're not going to get the, you're not going to, even if you have a wage price spiral, it's not going to get started, right? Somewhere around the late 60s, the Fed started to change its tone. For whatever reasons, maybe they didn't fully understand. But I don't know, it's not like they didn't fully understand. They did understand. If you look at Arthur Burns, there was a recent paper in one of the feds.

He was really sophisticated, not the caricature that's made out. to be. He was incredibly sophisticated. But he thought that more needed to be done and the cost of doing it via monetary policy would be expensive in terms of unemployment. Serenovas, could you maybe just elaborate on the link between spare capacity and treasuries? Because I'm not sure I entirely follow your thinking on that point. Okay. So to get a long-term treasury sell-off, like the 67 to 71 sell-off that Paul was talking about, you need inflation to pick up. You need to have sustained pickup and inflation.

Otherwise, you're not going to get a treasury sell-off. If inflation hangs around 2%, there's no reason for treasuries to sell off. And what are the conditions that lead to a sustained increase in inflation? You need tight labor markets and labor bargaining power. You need tight capacity so that the labor costs can be passed on into prices. and, you know, of course, that sets off the wage price spiral. But if you, that alone is not enough.

I mean, a Fed needs to be accommodative of higher inflation for whatever other considerations they may have. Another point that you bring up in your work are the financial conditions. Yes. First, you talk about the real conditions are being very different. There's a lot more spare capacity, spare labor globally than there is now. You also say that financial conditions today are much different than they were in the 1960s. explain how they're different and why this two is important. Okay.

So if you look at the private sector balance sheets, whether in the U.S. or globally, which is both the asset side and the debt side, scale to GDP, they're very big. You know, the assets to GDP is at a record level. Debt to GDP's private sector is not at record, but close to it. So the other way to think about it is GDP is a broad measure of income in the economy. income as a percentage of the assets, asset base, is low. Now, the income servicing the debt and the assets is low. So if you're hiking the interest rates, if the interest rates are going up,

then for the leverage players, you know, you're now makes it less and less viable. The other way to think about it is if interest rates go up, valuations have to come down. Right. But when the balance sheet is big, the economy is no longer functional. like a normal economy, or the word normal is very bad. Let's just like the economy in the 60s, where you could focus on the real sector and ignore the balance sheets because the balance sheets are a function of the economy rather than the tail wagging the dog. But when balance sheets are big, you're getting a strong feedback loop from both sides. In fact, the balance sheets are having a preponderant effect on the economy, like wealth effects or like the housing bubble, right?

you know, when it starts affecting the real economy in a meaningful way, now you have to start worrying about what the impact of, if you have inflation and the fear of inflation and interest rates go up, what does it do to debt service, what does it do to asset valuations, and then the feedback into wealth effects and the ability to borrow. I mean, I was hoping for a kind of cheery picture and a rebuttal of the bond market massacre thesis, which this is, but it's not exactly optimistic because you're arguing that essentially, the economy remains super fragile, and we have lingering risks in the financial system and certainly

sort of vulnerable borrowers who would be in a lot of pain if we did get a sharp rise in interest rates. It's not a happy scenario. Well, happy depends on who you are. I mean, I think if you can remain in this so-called Goldilocks scenario where inflation doesn't pick up a lot and interest rates remain a lot, you can sustain this. And we have sustained this for five, six years now. So I'm not saying that it's going to be sustained. I would tend to be on the more baddish side on that. That said, yes, bottom line is if you look at the asset side of the economy and the debt side, the U.S. has actually had some made some progress on the dead side, but if you look at it, globally, it is much worse than it was in 2008. So one way or the other, you have to bring those

down. What is the painless way to bring those down? And I don't know. I don't think there's a painless way to do it. So it's still pretty bleak. All right, before we, before I forget, we don't, you work at the, uh, Jacob Levy Forecasting. Jerome Levy Forecasting Center. My apologies. It has the word forecasting in the name. So I'm going to ask you for a forecast. Back in the early 80s, the 10-year yield, it topped out around 16%. Today, the 10-year yield as we're recording this podcast 2.48%. People, you know, so it's been this incredible over 30 year decline in interest rates, which corresponds to a bond market rally.

For the last 10 years at least, you always hear, it can't go any lower. And then it invariably does go lower. So what's your forecast? Where could we see long-term interest rates go before this cycle ends? When the next recession will, I think, bring the ultimate lows in bond. I think the 10-year will drop below 1%, probably half a percent. Below around half a percent.

So we're around 2.5 percent now. So there's still a lot of capital gains to be had. And the third year, I think, will go to 1.5. We've seen these kind of interest rates. In Europe, we've seen negative interest rates. So it's not like, and this is the safest asset in the world. I mean, in the next recession, there's going to be a lot of political turmoil as well. You can imagine already with the kind of weak recovery, we have all kinds of political

pressures globally. And there won't be too many safe assets left. Right. Yeah, can we talk more about the political pressures? Because, of course, we are seeing these expectations of fiscal stimulus out of the Trump administration driving inflation expectations to a certain extent and also impacting treasury yields. Do you think that's warranted? Yeah, sure. I mean, if you're going to get a fiscal stimulus of the order of, I mean, if you go back to candidate Trump's plan, I think I'm going back a year ago at least, I looked at some of the

plans. If you take them at face value, you're talking about a $600 billion stimulus on the upside and maybe even something on the low side of $300 to $400 billion. And let's say some of it is tax cut for the very upper income, which is most of it is going to be saved, so offset by increase in saving. Even so, you're talking. about $150 to $200 billion in corporate taxes, tax cuts and $400 billion in personal tax cuts, that's a huge stimulus even before we start talking about infrastructure spending. That's going to move the needle. One of the things I'll tell you, that's why in the short term we have reduced our own bond

positions because this is an unprecedented step. Usually we are long-term investors and bonds. We have written this 30-year bull market being invested. fully all the time because you can't be too smart about these. We are not traders. That said, because of the potential for stimulus and for short-term reflation, we have actually reduced our position in bonds. So your basic position is that the Trump stimulus, if it does happen, could really move the dial on bond, but not so much that it shakes the underlying trends that we've seen over the last 30-plus years. Yes. Yes. You know, going back,

to the 1960s for a second. And we, you and I had an exchange on Twitter kind of about inflation and what really drives it. And you made an interesting point, which is that inflation is not really, you know, I think, who is at Milton Friedman? Inflation is always an everywhere, a monetary phenomenon. And I think you said inflation is always in everywhere a political phenomenon. And that really we have this fantasy that there could be a federal, the Federal Reserve could just have this dial and turn it to 2%, 3%, 4% inflation, and that it's just sort of this technocratic thing that we just sort of set the level and sort of aim for it.

And when you say it's never really like that, that it's sort of a myth or a fantasy that the Fed could do that. Explain this a little bit further, this misconception that everyone has about what really drives inflation. In fact, today I think the Wall Street Journal had an article about people, we don't understand inflation. And I think a week ago, they had a paper by Chiquetti and a bunch of others on what predicts inflation, it's inflation itself.

So, I mean, I think here is a basic issue with the monetary view of inflation. If the monetary view of inflation were right, we would have a pretty stable velocity, but we don't have velocity of money keeps changing around a lot, you know, So, which means the very basic, the money, quantity of money equation doesn't work. Now, you know, they have bells and whistles. They have sophisticated explanations now, but those are all post-facts, justification, rationalizations rather than a basic understanding. But, you know, I mean, inflation is a very complicated process. But let's start with what happens, what you need to get inflation up.

The most important component of cost is, of course, labor costs, right? So if you look at the economy is a circular flow. So if prices go up and they reflect in higher incomes, then people have bid up, then those prices can be justified by people having higher incomes because they can go and, again, purchase those things, right? Which then bids up the prices. That's how you get a wage price spiral.

I'm keeping the Fed out of the picture for now. In our economy, so the critical thing is the way the labor should have some bargaining power to be able to say, okay, prices have gone up, I need to be able to get my wage hikes. But if you have an economy with a tremendous amount of slack, which we have had over the last six, seven years. But generally speaking, if you look at the last 30 years,

most of the time we have spent above Nairu, according to the CBO's definition of Nairu. If you look at the unemployment rate, most of the time it has been above Nairu. Whereas if you'll go back to the 50s and 60s, we used to spend most of the time under Nairu. Okay. So the labor doesn't have the bargaining power.

And of course, unionization has declined. There are other factors as well. There's global competition. There was not much global competition in the 50s and 60s. So we don't have inflation, the underlying dynamics for the wage price spiral. On top of that now comes in how does the Fed policy change and what are the reactions to it, which there is some political element to it, clearly. The Fed is not completely immune to politics, as much as we would like to believe.

And if you, the Fed has done some research, I think the Yash Mehra, he has broken down the inflation into three separate distinct episodes, the period up to 56, post-war period up to 66, and 66 to 82 and 82 onwards. So if you look at the early period, there is not much pass-through from, the wage price inflation dynamics never really got started because the Fed used to take the punch bowl, You know, William Martin, who has made the famous statement, our job is to take the punch bowl away. And this broke down in the 6 to 6 to 86 to 82 period

where there was much more of the wage price spiral dynamics. And then post-82, it has not. But there is more than just the Fed taking away the punch bowl. Joan Robinson had a very perceptive essay. So much credit is given to Phelps and Friedman, but all of these was presaged by Joan Robinson and the other Keynesians. I think this wasn't 61. She was writing about how we have such tight employment, high employment in the immediate post-war era,

but we haven't seen the inflation pick up. And she said part of this is this is a solidarity and the sense of national purpose that the war engendered. And there was a sense of restraint among labor, especially and unions, because there was a lot more unionization back then, that we should, you know, we should not be greedy or, you know, we have to, there is a larger shared purpose. And, you know, I was talking to David and my partner, and he was telling me the other day that there was a general sense that you would get wage hikes

that would be commensurate with productivity. That was the general sense in the 50s and the 60s. What broke the trend was, I think it was a machinist union. I'm not 100% sure it was a machinist union in 66 who got a 6% raise or something like that that broke that trend. And then the other unions now obviously had to catch up to that. And then you got started with the wage price spiral.

Well, I mean, on that note, is there any chance that we get something that encourages some sort of wage increase in the coming years? Because you're painting, again, like a pretty bleak picture that involves basically labor being on the back foot for many, many more years to come, which is coming. kind of depressing. Yes, and this is the problem, you know. I mean, generally speaking, if you look at this, I'm going to now, now I'm going to talk about long history. If you look at the history of capitalism, generally speaking, it has been outside of wars, there have been very few periods of inflation.

And the only period of inflation that we've had significantly outside of wars is the 1970s. and that has somehow colored the whole profession that, oh, inflation control, inflation targeting, this and that. But really, capitalism is characterized not by scarcity, which is what inflation is a manifestation of in some sense. Of course, there's other things too. It's not just scarcity as we just looked at. It's also capitalism is generally characterized by glut.

You always are looking for markets. That's the whole thing. I mean, even Adam Smith understood that. Right. That's kind of, that's the aim of capitalism, right? Even Adam Smith, he didn't completely say it in so many words, but he said that, you know, the extent of specialization is constrained by the extent of the market. So the real constraint has always been the market, demand in some sense.

So we just have a couple of minutes to wrap up here, and I want to sort of get your take on ultimately, you know, probably the bond bull market is. going to last forever. Right? I mean, at some point it will turn around. You mentioned the Trump stimulus as being a cause to think that in the short or medium term rates could rise. But beyond the stimulus, it strikes me that at least in theory, Trumpism represents or could represent a real ideological break from the way the government and policy has been run. It's not just the stimulus. It's a sort of disdain or skepticism of free trade. It's a disdain. It's a disdain. It's a disdain. for, I think a lot of like, will we sort of free enterprise assumptions. So I'm curious, A,

whether what you think could ultimately be the thing that breaks the bond bull markets back, and B, whether a more muscular, fully fleshed out Trumpism beyond just, okay, here's a stimulus boost, could be the kind of thing that really turns things around. Oh, yeah, I mean, something much more muscular than just a stimulus could certainly, I mean, yeah, nothing is set in stone. You know, you can, things are always, always subject to change and there's always uncertainty about these things. And so, yes, something could do that. And I think the way the bond bull market typically ends, and if you look back in the history, is when private balance sheets are lean, you go back to 1949, which is the end of 46 or 49 is the end of the bond bull market.

The private balance sheets, there was no debt. and stock valuations were incredibly crazy. I mean, you know, the dividend yield was a few, several percentage point higher than dividend yield on than the 10-year yield. You know, so you're talking about assets that are yielding risk assets far, far more than cheap assets, than risk-free assets. And so you had a situation, there's no debt, tremendous amount of cash on the private balance sheet. Interest rates could go up a lot and nobody would be under stress because they had no debt. They would in fact be benefiting from higher interest rate on cash. That's the kind of, we won't necessarily get to that kind of situation.

But let's say the next recession brought down asset values and debt, we already had some correction. We have further correction. And then we ease that process with even running bigger deficits. And our debt goes to 150% of GDP or something like that. Then you have a situation where government debt is now a large part of the private assets. Right. So the private balance sheet is now much more heavily loaded on safe assets. And the risk assets are cheaply priced, relatively speaking.

That's when you can withstand interest rate hikes. It doesn't matter. I mean, interest rates can go up a lot. I mean, look at 1981, wherever the home prices were. Interest rates were already at 15%. So, you know, they could go to 20% but people have already seen the worst of it. So that's the kind of situation which leads to bond bear markets. Thank you very much for joining us, Srinivas Tiru Vedanta of the Jerome Levy Forecasting Center.

Really appreciate you coming on. I learned a ton in that discussion. Thank you, Joe. Thank you, Tracy. Thank you. So, Tracy, I really enjoyed that episode. I love the fact that, A, another big economic history lesson, but also having the chance to discuss sort of economic theory and also how it applies to the market. Yeah, well, talking about financial history, I thought he made a really excellent point about over the extremely long run capitalism is not characterized by scarcity.

It's kind of characterized by supply or abundance. That's the entire goal, right? And that that's intrinsically a deflationary force. I thought that was really interesting. Yeah, and this idea that the inflation that we saw in the 70s, has been so large in our economic thinking today. And you have to, you know, you have to realize that probably a lot of the people who are in charge of policy right now or the people writing, are doing strategy at big funds and banks, probably a lot of them cut their teeth during that

inflation and the period right after and have sort of always been living in that time, vicarious or living in that time ever since then. Yeah, that's a super interesting point that I think probably doesn't get enough attention. Just to play devil's advocate, though, I mean, there is a sense of, there's a tinge of this time is different around this whole argument, right? And that the the bull market and bonds can go on for substantially longer than it ever has in all of history. And I understand his arguments. One thing I wonder about, and I think Paul Schmeltzing got to this idea was the difference between the financial system now versus ancient history, right? Like now we have a much more complex system. We have banks with sophisticated risk models

and we have the potential for a negative feedback loop if we did get a big sell-off in bonds. And we didn't really talk about that. Yeah. Anytime, you know, as you say, there's always that this time is different fear and every time you have a bull market and you're saying, oh, it could go on forever it's sort of, or a long time. That's sort of a reason to be nervous. On the other hand, there's just been so much skepticism about this whole bull market. So usually when you have a long bull market, you just have, you just accumulates more and more believers over time. But this bull market has really never had many believers as far as I can tell. So sort of from a psychological standpoint, yeah, I mean, either way, someone is going to be surprised here, right?

Either the bull market keeps going from. for a really long time or it comes crashing down. Either way, it's going to be a big deal. On that note, this has been another episode of the Odd Lots podcast. I'm Joe Wisenthal. You can follow me on Twitter at The Star Wars. And I'm Tracy Allaway. I'm on Twitter at Tracy Allo. And you can follow Srinivaz on Twitter at T-E-A-S-R-I. I'm June Grosso, 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

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