Odd Lots - Josh Younger on the Soaring Cost of Climate Change and Understanding the SLR

Episode Date: March 25, 2021

What is the connection between the big trend in interest rates over the last several years and the cost of climate change mitigation? This is a question that's been analyzed by Josh Younger, a rates derivative strategist at JPMorgan. On the latest episode of Odd Lots, he discusses his work on interest rates and the cost of fighting climate change. We also discuss the significance of the Fed's SLR decision, and what it means for rates and bank balance sheets.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 Tracy Allaway. And I'm Joe Wisenthal. You know what you never see. Go on. That's pretty open-ended. Yeah, okay. Well, you know, as a journalist, I'm told to ask open-ended questions. But you never see, you never see anyone connect climate change with real yields and secular stagnation. But I enlarge those are pretty separate conversations. I mean, maybe the secular stagnation part, but I definitely do not see much conversation

connecting the dots between anything that's going on in interest rates or real rates or anything like that in climate. Yeah, that's exactly right. So despite the fact that every bank in the world seems to be really high on ESG right now, and certainly you and I are on the receiving ends of, you know, tons of. of press releases about what banks are doing in the space, you actually don't see that many people talk about climate change from a market's perspective, which is kind of weird because if you think about the battle, the climate change battle right now, so much of it is about estimating the costs and the benefits or the cost versus the benefits of actually tackling this issue.

And if you think about how you calculate cost and benefit, that's basically a market question, right? Like, you have to consider how the market is functioning and at what rate the market is actually rewarding action at any moment in time in order to come up with those kind of estimates. Yeah, I think that's right. I mean, I think if this is where, like, I sort of, like, struggle with some of this. there is this widespread expectation of like ongoing environmental degradation, potentially more economic and environmental catastrophes, horrendous things that will happen that may be associated with climate change. On the other hand, like from a market standpoint,

it still seems as though for the most part, most of the things that get priced, whether we talk about priced in, are more on the sort of like regulatory side. It doesn't feel like there are many examples of the environmental risks directly themselves manifesting in price just yet more about pricing in the sort of regulatory response or policy response to this sort of ongoing threat. Right. So I know I started this conversation by saying that you'd never see anyone talk about real yields and secular stagnation and climate change. But that's not strictly true because there is one person who has done it and they published a whole paper on the topic, which definitely caught my eye. But we're going to be speaking to Josh Younger again today.

He's a managing director at J.P. Morgan and also a multi-appearance odd lots guest. I think this is going to be his fourth time on the podcast. So we're going to get his thoughts on the climate change and the link to yield. but we're also going to go into some of the recent drama in the treasuries market. And in addition to him as having done work on this, he's sort of the perfect person to connect all these dots, because in addition to being a rate strategist, managing director at J.P. Morgan, he's also a trained astrophysicist. So the perfect person to connect science and interest rates. So I'm really looking forward to this conversation.

Excellent. Climate science meets interest rates. I love it. All right. Josh, welcome to Othlots yet again. Yeah, thanks for having it. It's great to be back. So I mentioned this idea that when we talk about climate change policy, we generally think about tradeoffs between cost versus benefit. And one of the things I'm really interested in is what traditional analysis looks like when it comes to cost benefit. on this topic because, I don't know, when I think about climate change, I think about the worst case scenario being that we basically all die from global warming and, you know, World War III breaks out over resources and the entire world collapses. So I've always been curious about how you

put a sort of a number around those sorts of scenarios. So maybe just to begin with, walk us through how people normally do that equation. How do they come up with that cost benefit framework? Yeah, sure. So it's a bunch of different steps. And it's really about connecting a few related, but sort of institutionally separate fields of study. So on the one hand, there's the client science itself, which is doing projections of global mean temperatures and sea level, sea level rises and various other types of forecasting. And those tended to go out, you know, 50, 100, 200 years. that is a highly non-linear, very complicated process that's usually done with supercomputers, with these simulations essentially. You can't do it with a pencil and paper. So that's the climate science angle. And then when we think about policy, the question is sort of what does that mean to humanity? What does it mean to us? And how do we start to try to quantify that? So on the one hand, you can think about the sort of more moral angle to this, which is what you're alluding to,

which is, you know, people dying in wars and famine and disease and so forth. And that's, you know, obviously the nut of it, but also very hard to put their numbers around. So there's a tendency to kind of think of this in economic terms, which is, you know, as horrible as all those outcomes sound, that they do ultimately boil down in some sense to a cost. You can put a dollar amount on it. Insurance companies do it all the time. and the economic impact of climate change, which incorporates all of these factors. So there's kind of the purely economic impacts, which is, you know, are coal mines productive?

Can we produce enough wheat? What's the net impact on consumption, like things like that? And then you can have the more banal-sounding mortality projections and other sorts of non-traditional economic impacts. And that ultimately gets boiled down to a dollar amount. And the process of putting those things together is what's generally referred to as integrated assessment models. So connecting climate science and economics with some other inputs as well. And the goal from that exercise is to try to inform policy because there's a real cost-benefit here. If we want to completely avoid climate change, we're all supposed to go back to a pre-industrial world where we don't burn carbon at all.

and we live on sort of independently self-sufficient farms, and we walk everywhere or maybe ride a bike, but even the bike's got to get produced. So, like, there's a cost that's not worth bearing to most of the world. And so between doing nothing and reversing the clock 15,000 years and undoing all technological development, there's some number that represents the acceptable cost to society. And the process here is trying to arrive at that number through this rough means. There's many ways to do it, but you're trying to get ultimately to that break-even, to that number, the acceptable cost to society, and how we track and measure that.

So, correct me, if I'm wrong here. My impression is that climate risk manifests itself in markets in all different kinds of ways, whether you see it in commodities, whether you see it. and insurance type of contracts, et cetera. But is it the case that what's being priced is not the climate risk itself, but rather the regulatory expectations or current policies of regulatory response

towards climate change? So like imagine an environment in which there was no climate science really or there was no will to action at all to address climate. Would it be showing up? Would we be seeing stresses regardless? So I think this brings up a really important point, which is climate change is the most important and obvious example of a real market failure. So capital markets and markets in general are just really bad at long-term planning.

And long-term in this case means 50 to 100 years. So it means that the risk priced into markets is much more along the lines of what you just described, which is how is the government going to react today rather than what is the net impact considering potential action? whether or not it's enough, and if it's more than enough or less than enough, like, what's the net impact? Like, what's the real forecast? So there's a world in which this is actually a somewhat exogenous process to the way markets think about risk. And that's just because, again, it doesn't get really priced in. This is a big part of the Stern and Stiekelet's critique, which is, you know, market pricing is based on individual incentives that are themselves, the product of

like a single generation of people. And so we're thinking about what is my preference as an individual investor over the next 50 years, as opposed to what is the societal aggregate preference in an intergenerational context, which prioritizes to the same extent the welfare of people who are living 100 years from now relative to my own. And so markets are really bad at that. And that's been a general critique of the way that climate risk has been modeled. It doesn't mean that markets can't tell you something about kind of the base case. So what we're doing in this paper, I think, is saying markets, because they don't anticipate these types of existential and long-term risks, they're kind of giving you a sense of the baseline rather than the climate change

scenario. So they're giving you a sense of how the market would perceive risk and pricing and time preference in the absence of climate change to some extent, because it's not going to be a get efficiently priced. And that's a problem because markets are not anticipating this extremely important risk factor, arguably the most important risk factor fundamentally. But it's convenient in the sense that you can extract from markets this kind of baseline time preference and other variables that lets you put that price on carbon, ultimately, to get a sense of what the cost benefit looks like because to get a cost benefit, you need to have with and without. Like to do a cost benefit, it's what I need to know is what's the world like without climate change and what's the

world like with climate change and how do I mitigate that impact? And because climate change is an endogenous process to the real world, but arguably an exogenous process to the market perspective on the real world, you can kind of do that somewhat efficiently. So, I mean, you mentioned the time preference of investors there. Can we talk a little bit more about that? Because the point that you're making about yields is that we're basically talking about the time value of money. And so they're going to factor into any big action that you actually undertake to fight climate change because it costs money. And you have to make that calculation as an investor, how much your money is worth going into a climate change initiative versus something else. So how are you thinking about the discount rate? And

like how much does that traditionally factor into cost-benefit analyses for climate change? Yeah, so maybe just taking a step back, like, why are we discounting these impacts at all? If climate change costs, I think the number is like a quadrillion dollars over the next hundred years, why are we not just using that? Why are we using this discounting effect? And from a first principle standpoint, interest rates reflect time preference in the sense that I can use my $100 today to go by, something or I can use it in a year. And if I'm going to delay that consumption by a year, then there's some value to me in that, right? There's some, there's some, there's some cost

in giving up that year of access to my money. And so that's the interest rate. I'm going to charge for it. So if interest rates are 1%, it means that the time preference reflects a 1% annualized cost to delaying consumption. Interest rates are observable, like we have many interest rate driven instruments. Treasury bonds are kind of a good example of that. There's also a rich and deep derivatives market, which is tied to other interest rates, and we can use that to infer time preference in that sense. So let's say we have an observation of time preference, and we've consolidated that into some running rate of interest, 1%, 2%, 3%, adjusted for inflation, because most of these estimates are done in inflation-adjusted terms. So then,

what we can do is say, well, climate change is going to cost a certain amount of money every year for the next hundred years. Because that money in the future is worth less, we're actually talking about it probably after this, but potentially more, but it's worth a different amount in the future than it is today than the discounted future value of those damages is what I should be willing to pay today to avoid them. And so that's the social cost of carbon, which is an incremental metric ton of carbon dioxide, what is the economic impact into the future, and what is the discounted value of that damage? Today, and if I'm thinking in terms of pure economics, the moral angle is important, but not necessarily part of that analysis, then I should be willing to pay

up to that discounted amount to avoid negative outcomes. I guess put a different way. We usually talk about the time value money as how much is the money worth to me today versus in a year, but you can also think of it equivalently as how much is it worked to me to avoid a loss in a year versus today. Those are, it's symmetric in that respect. So what is thinking about this framework get you? Like, okay, so you work through this, you like calculate the theoretical damages, do this sort of, uh, uh, this time value analysis. Where does it get you? And what does it tell you in terms of carbon pricing or connecting it to, uh, to your specialty like rates? Like, where does, What does the analysis say?

Yeah, I think it's important to keep in mind that models are flawed. Right. These models are very flawed. But we have to make a decision. We don't have the option to not make a call on this because climate change is going to happen one way or the other. And we need to take some steps to mitigate it, or lots of steps to mitigate it. But if we're unwilling to deindustrialize, which is kind of the ultimate and only complete solution, then we need to come up with what we're willing. to do. And so this analysis is an attempt to do that. And we're basically making our best guess

as to how much we should be willing to spend to avoid damage down the line. And it's convenient as a framework in two ways. One is it really does get you to policy, right? It gets you to a set of policies that the cost of which is immediate that you can at least justify on the basis of some framework. We need to come up with a reason why it's worth spending a trillion dollars today because everyone who is contributing those tax dollars is going to know why a trillion, why not two, why not half, where did this number come from? Flawed though those models may be, they get us to that. And two is, at least from a more near-term standpoint, from an observer's standpoint, we get a sense of how the government's likely to react. So we're not, we're focused a little bit on the policymaking process, but there's also the more near-term impact on how government policy evolves.

to the extent that this framework, this approach, is central to the government's policymaking process, it lets us kind of think like they think and come up with a sense of what the likely range of outcomes is. And the Biden administration has been very clear that the social cost of carbon is the single most important number in their climate change agenda. So, you know, we should we should get a better sense of how to get behind a value of that and what the right set of assumptions are, rather than sort of necessarily arguing about the utility of that number relative to other numbers. The last thing I'd say is this discounting effect. It is possible. It's kind of two approaches to this.

What we've focused on here is a market-driven discount rate, which is really measuring pure time preference. And that's extracted from, in this case, derivative markets, but you can get it from treasuries or other places. That's been pretty standard practice for a very long time. A common critique of that approach is that it prioritizes the, we sort of talked about it a second ago, you know, the current generations, individual perceptions of time preference, rather than societal aggregate, intergenerational perceptions of time preference. And it's explicitly amoral because it's just a number extracted from markets. And so what you can do is you can use that discount rate and you can take a more prescriptive approach, a normative approach, where you argue for what the right discount rate should be. incorporating factors like inequality between nations and within nations, incorporating the interaction between different countries, you can incorporate the risk of extinction. People have done that.

And so you can use that to quantify again the right number. And that becomes, in some sense, the thing you argue about. So on the one hand, there's the modeling process, which has its own uncertainties and legitimate critiques of that, but we have to come up with something. And on the other, you can sort of say, well, the market's saying the discount rate should be 1%, but I think it should be negative 10%, because I'm highly risk-averse when it comes to these things. And you can make a normative case for that. And therefore, it's worth spending more money than other discount rates would potentially imply. So it sort of consolidates that whole argument to a single number, which is convenient. It's reductive, but it's convenient for having this conversation.

So is the implication here that whatever you decide as the discount factor, is going to be like as much, is going to be as important as an input into your model as your climate change projections and things like that. Like, is the discount factor perhaps an underappreciated input into our models of climate change and cost benefit analysis? Yeah, it's massively important because of the long time frame's involved. So if you have a 1% annualized discount factor and you compound that over 100 years, years, you're talking about a very large effect. The thing that I think we wanted to highlight in this, which is in the past, there was this debate, which is normative discount factors tend to result

in lower numbers. Market-based discount factors at the time tended to result in higher numbers. So if we go back to 2007 when the Stern report came out, the real rate of interest over 30 years was something like 3%. And because you're compounding this over long periods, I forget the precise arithmetic is, but $100 in 50 years at a 3% discount rate is worth a couple of bucks. It has a very strong effect on the present value of those damages. And if you move that to a 1% discount factor, all of a sudden you got twice as much present value damages or three times as much over 100 years. So the debate was usually that markets are applying a higher discount rate than many economists and philosophers, frankly. thought was appropriate to the problem, and for all the reasons I mentioned. What's happened since then

is the long-term real rate of interest has come down a lot, and that's secular stagnation. That's, to some extent, an endogenous effect in that there could be some climate risk priced into that secular stagnation expectation. But the important observation is that this argument over whether or not normative discount factors, which are relatively low, I think 1% is the mean of some surveys of economists. Now the real rate of interest over 50 years is negative a half percent or something like that. The market versus normative approach has slipped in that markets are pricing negative time preference over long periods. And when you flip from a negative interest rate to a negative interest rate, all of a sudden, time inflates the value of damages rather than

discounting them. So discounting is really not the right word in a world of negative real rates. And so Now when we look out 100 years, that $100 of nominal damage is worth $300, $400. And so it really, it changes the way you think about the time distance to these effects. So, I mean, is the simple upshot then that in a period of ultra low real interest rates, then, setting aside climate, people look at a period of ultra-lo. low interest rates and also period of secular stagnation. And they say, okay, well, then this is like a natural period for the government to spend a lot of money, invest a lot in research generally, perhaps introduce such a sort of spending impulse and capital expenditure impulse to break us

out of this secular stagnation is the implication then that that just also applies even more so when thinking about addressing the climate threat in this economic environment? Yeah, it means that the self-corrective elements of economic growth just doesn't really apply. So if we have negative real interest rates over long periods of time, that means that we have basically an expectation

of negative real growth rates in equilibrium over long periods of time. And so you can sort of like, the narrative version of this argument is climate change is going to cause a lot of damage, but the cure is worse than the disease and we're going to spend too much money today and do too much economic damage today. So we're better off growing our way out of these issues.

That would be one line of argument, which is we want to let the economy grow because it will all be better off over the long run, even in the context of climate change-related damage if we allow for unfettered economic growth. And the secular stagnation hypothesis and the consistency of markets with that expectation, says that's just not true anymore. Like you're better off fixing problems today because the longer you wait, the bigger the problem's going to be. Right. And that was not true 10 years ago, at least in expectation. Now, secular stagnation, I should say, has been around for a long time as a concept. It originates from the late 30s. So basically after every major, every major recession,

there's been this wave of secular stagnation prognosticating. It kind of reminds me of the kids today, like all these kids in their phones, like they're never going to learn how to read. But it turns out that in the mid-1500s, there are a bunch of people who are worried that because of the printing press, no, would learn how to write books by hand anymore. So there's always like this hand-wringing in the presence of change. But this time might actually be different. And Larry Summers is obviously sort of associated with this argument. But the combination of demographics, the digital transformation, a global safety. Glut, the rise of Asia, like all of these, all the globalization trend, which is still in place. You know, all of these things point to lower, at least directionally, real growth rates over time.

And that just means, again, directionally, the cost of weighting, the cost of inaction is higher. And we're using markets because they do a pretty good job of finding stuff like that. Like, markets are better at identifying regime change than we are. And you can see that just because, you know, the secular stagnation hypothesis and the implications for long-term interest rates, like the growth rates, that's been reflected to some extent in surveys of economists, for example, but the transition has been very gradual, whereas markets kind of priced this in in 2008 and have largely stayed in that range. So, you know, markets have done a decent job at least at a high level of, never mind the next 10, 15 basis points. you know, categorically, they've done a good job of spotting this shift in the way the world grows. And if we're shifting to a low to negative growth environment in the lead up to the really damaging impact economically of climate change, there's a much greater incentive to act now, and that's reflected in the social cost of carbon. Like, if when you, when you calculate,

even taking damages in sort of local nominal terms as a given, like, let's not argue about how calculating the dollar value of those damages, that's a separate conversation. Even if you take that as a given, just the way the environment and expectations have evolved means the social cost has gone up six, seven times over the past 10 years. And that really changes your cost benefit. That changes the way, how much you should be willing to spend to avoid it. So on that note, I mean, I was reading a Citigroup note by one of their strategists recently, Matt King. And apparently City's been having a bunch of client calls with Larry Summers, and Matt King was strongly suggesting that Larry Summers had sort of backed off the secular stagnation idea because of the

recent backup in yields, which seems like, I don't know, a bit of a knee-jerk reaction. But I'm curious, this idea that secular stagnation has multiplied the cost of climate change in action, how well does that stand up to? the recent changes in the treasury market, the volatility that we've seen, and the increase in yields? Yeah, so most of the move in yields has been in inflation expectations. So we're really focused for this purpose on the real rate of interest. And over 30 to 50 years, the real rate of interest is still negative. At least if, and there's some argument here, should I use treasury rate, should I use tips, shall I use derivative markets? And what we do here is we look at expectations,

for the federal funds rate, the Fed's target rate, over 50 years, for example, and adjust that for inflation expectations. And the reason we do that is when you're dealing with securities, and we talked about this back last March, securities have sort of different treatment under different circumstances. It's harder to hold a bond than a derivative, especially for a bank. So you're sort of baking in some of these nuances of balancing costs and things, but derivatives specifically are sort of an easier proxy. And so when we look at 50-year OIS swap rates, which is just expectations again for the federal funds rate

over the next 50 years, it's still negative, adjusted for inflation expectations. So directionally, you know, it may be more like four or five times over the past 10 years now rather than six or seven. The volatility in the social cost of carbon using market discount rates is potentially a critique that makes sense.

But directionally, it's still negative. So markets are pricing in negative real growth rates over very long periods of time. The other thing that I think is important to keep in mind is because we're talking about 50 to 100 years, the bond market stops at a 30-year instrument, but these risks go out much further. And derivatives conveniently trade 50, 60, in some cases, 100 years out. And the discount rate actually starts to decline after that 30-40-year point. And there's some technical reasons for that. There are some market flow-driven reasons for that.

But the discount rate over 60 years is less than the discount rate over 30 years by this measure, for example. So, you know, there is this, you could interpret that as greater risk of negative real growth rates over longer horizons and be sort of consistent with the demographic outlook. So that means, and that's also consistent with more normative arguments, which say, I should, to balance the scales, like these market interest rates are set by the current generation, and the next generation doesn't get a say. So I should give the current generation a haircut when I think about discount rates. And so over 60 years where I'm spanning a bunch of generations, that discount rate should be naturally lower because it's just scoping in many more people, most of which haven't been born yet. And so they should get a little bit of a leg up in the relative

value of their utility. And that naturally emerges from a market-based approach. It's kind of part of bond map to some extent. You know, that's also consistent with those arguments. So yeah, I think are we in a secular stagnation world or not is a much more extensive conversation in certain ways. But I think at the end of the day, like this move in treasury rates and move in interest rates generally is much more notable for its speed than its magnitude and really hasn't changed the underlying narrative that we can extract from markets over long periods of time. And that's why I'm saying, you know, 25, 50, 100 basis points between friends, you know, over long periods is really not that big a deal. And if we were to be having this conversation in the mid-90s or the early 80s,

we would say that's Tuesday. So, you know, we've gotten used to a very very low volatility world. And the outlook really hasn't changed in a fundamental way on the basis of these moves. And real rates themselves only started to adjust for the past few weeks. It's really been mostly an inflation expectations outlook. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline.

It's a commitment to your clients. We're talking top-grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com slash audio. That's vanguard. com slash audio.

All investing is subject to risk Vanguard Marketing Corporation distributor. So I'm still having trouble wrapping my head around something. Like, okay, because of very low real rates expectations, however you measure it, the cost of not doing anything about climate change is extremely high right now. And that part I get.

But like, let's say like we did enact a series of policies right now that really did jolt the economy out of something that we call secular stagnation, which seems possible. I mean, you know, you mentioned the increase in real rates been very modest, but it's possible, you know, it's like if we were to get some sort of sustained fiscal stimulus and massive capital expenditures and all kinds of different things, like it seems possible at least that we could have a set of policies that would jolt us out of this whatever we've been in for the last decade. or longer. Does that then imply that the cost of inaction on climate like goes down? Like that's like, I don't quite sort of like get that link. It seems to me it's like, okay, there's like, there's like disaster waiting for us at some point within action. And either we want to do something about it or

not. But this idea that's like, okay, if suddenly things started roaring and companies started spending and investing and we saw wage growth and capital expenditure, the likes of which we haven't scene, how does that then imply that somehow the cost of an action goes down? So it depends on a couple of things. The first is, is inflationary or not? Like, is wage growth what's driving things? And if so, then we're not looking at a rise in real growth rate expectations as much as we're looking for a rise in nominal growth rate expectations.

And that means that an inflation-adjusted world, which is how we do all of this analysis, it won't really show up. But you could argue that there is a set of policies, whatever they are, that quote-unquote fix or help the United States transition to a more balanced economy, a economy with a higher equilibrium growth rate, and sort of mitigate not just the deflationary, but also the sort of negative growth impulse of things like digitalization and aging populations and so forth. And so, you know, the hypo, I guess, is like, if we can design a set of policies that boost real growth rates for a long period of time in a fundamental way, restructuring the economy such that we get sustained higher real growth rates, like should that change the way we think about climate change, especially because in doing so, we probably, not necessarily made the problem worse. Economic growth in carbon emissions are somewhat correlated. We certainly learned that last year. You know, I think there's a version of this where the boom you're describing is the conversion of the carbon economy to a zero-emission economy. And so in that context, the cost of climate change would be going down because you would be mitigating.

And so the two things are kind of the same. But if you, for example, were to imagine a scenario where all fossil fuel restrictions were lifted and we were just prioritizing growth at all costs, independent of the impact on the climate, the economic opportunity cost of inaction would go down, but that's where the normative arguments come in. So that would be something that people wouldn't want for other reasons than economics. I think what's convenient right now, especially from a policymaking standpoint, is the normative and descriptive arguments kind of line up in the sense that the economics, the economics motivate action, the moral imperative motivates action. And so the two things are saying the same thing. What you'd run into in the scenario you describe is, is a

conflict more along the lines of what was true 20 years ago. And, you know, how the world would behave under the circumstances is kind of hard to say. But that's an opportunity for less economically motivated arguments for climate change action to take place. And, you know, I guess that it sort of brings in the nonlinear and existential nature of the risk. And so, like, how much is survival worth to you? Right? It's sort of like, what's the value, what's the dollar value of the survival of modern civilization? I don't think it's just one-time global GDP.

So there's, you know, you run into this issue where economics is probably not the right framework to be thinking about that. But from a policymaking standpoint, the amount you should be willing to spend in a world of higher growth rates to mitigate the economic impact in isolation. of climate change would presumably go down. But there are lots of things we do as a country that are not necessarily purely economically motivate. Right. I guess in the long run, we're all dead and the discount rate doesn't exist. I want to talk a little bit more about the treasury market volatility because that's been

such a big topic for, well, anyone in markets recently. And it comes into the debate on secular stagnation and the connection to climate change. like we were talking about earlier. But more broadly, this is something that you've obviously been watching for a long time. And we had you on in the aftermath of the big March sell-off in U.S. Treasuries last year. I'm curious, what did you observe in the most recent bout of volatility? And do you think there's a sort of underlying connective tissue between these different dramatic events that we keep seeing in the Treasury market? So, you know, we had the most recent one.

We had the 2020 sell-off. We had repo madness the year before. We had the big flash. Well, it wasn't really a flash crash, but a flash swing in treasury yields a few years before that. Do you think there's a sort of underlying cause between all of those different events? So what's interesting about this event is I think it's, in a weird way, this is the healthiest. and most permissible or least worrying version of about of volatility in treasury markets that we've had in 10 years. And the reason I say that is each of the events you just described had some

underlying weirdness to it that seemed to conflict with the intuition of how things are supposed to go. So when treasuries rally 30 basis points in an hour, that's inherently weird. When cash futures basis positions, the relationship between Treasury futures and the cash bonds that are deliverable into them completely diverge like they did in March. That's weird. When you have a complete collapse in market depth that persists for a long period of time, we've had that several, on several occasions over the past 10 years, you know, the inability of dealers and others to make markets in a very liquid and safe asset. That's weird. We haven't seen really any of that here. What we've seen is a shift in expectations that happens all the time from a very low base

because there was a lot of pessimism early on about the long-term health of the economy and the long-term impacts of COVID. I think it's easy to forget now, but back last April May, the vaccine prognosis was 18 months at best, and even that's kind of aggressive, right? And even then if the vaccine is 60% efficacy, that's a great vaccine. And what we got instead was 95% efficacy in November. And two of them, and now three approved and more coming. So we're doing two million shots a day, not one million shots a day. I remember when Biden said we wanted 100 million people, 100 million shots in 100 days.

Everyone said, well, that's kind of ambitious. And now we did it in 60. So, like, there has been truly a shift in the outlook. And when you had a massive deflationary shock that was expected to persist for 18 to 24 months, and it turned out it's only going to persist for 6 to 12, there's going to be a bigger vision in inflation expectations. And that's what you saw initially. So the most of the move in treasury yields has been on the inflation expectations side, even though real rates have started to catch up.

there has been some positioning effect, but you don't see the same sort of, I think negative convexity or forced hedging is often blamed for a lot of these things. And there's certainly been some of that, but that's all anecdotal. And the price action suggests that this was really just changes in fundamental exposure, is not forced activity by saying mortgage hedgers or there's some CTA effect. But you're not seeing the sort of persistent. relationships and weird relationships between different assets and asset classes that you would expect if it was one of these sort of forced liquidation or other sort of chasing your tail type events. And the last thing I'd say, which I was frankly somewhat surprised to see is even though we

had a 20 basis point move in treasuries on a few weeks ago, the high frequency community has been persistently making markets through this volatility. And that's pretty unusual. Usually they drop off a lot more aggressively when Volpicks up, and it's a sign of a much more healthy market microstructure than we saw, especially last March. And so, like, I guess my reaction, all of this is a bit of a, not a yawn, but I'm certainly not as worried as I think the headline price action would suggest, because when you revise your expectations dramatically, you should see dramatic changes in prices. The question is, have we overshot or otherwise exacerbated that repricing?

or are we broadly consistent with the move in fundamental expectations? And I think the latter is mostly true. We can point to occasional bouts of that sort of like position squeezes and so forth. Like one of the things we were watching is there was a lot of carry trading that built up over this low for long environment. When that happens and things start to move and those positions get pressured, you usually see the biggest reaction. in the highest carry positions. So the most attractive carry trades tend to be the ones that do the poorest when things start to really reprice.

And you definitely saw that at times. That's why, for example, five-year treasures move the most across the curve on that one big day a few weeks ago. That's not a fundamental thing. That's a position squeeze. But at the end of the day, that's a day or two here or there. I don't mean to be too sanguine about it because at some point, everybody's a convexity hedger, meaning like, there's a large community.

of levered holders who are very P&L sensitive and a lot of them were long duration. So, you know, rates back up enough. And if the levered community is chasing that from a positioning standpoint, it can end up exacerbating things. But that only goes so far. And I think at this point, price action is just a lot healthier than, say, the tamper tantrum, or certainly March 2020 or 2011 after the U.S. downgrade or the European sovereign debt crisis, all of these more existential at steaming events. Like, this is much more benign in a lot of ways. So I should just note here we are recording this March 16th, 2021. It's actually a day before a Federal Reserve decision. So, you know, listeners should note that. I'm curious

about something you mentioned looking at the high-frequency market maker community and their ongoing making of such markets, even during the worst of the volatility, a few weeks ago, what are the specific data points that you look like? When you talk about treasury market microstructure, such that we're beyond just looking at price, but how well the price is actually working, what are the things that tell an observer that, yes, price aside, it was very volatile on a historic level, but actually it still looks like a, just a functioning market? Yeah, so we don't have all the information because a lot of these systems obscure information in various ways to protect privacy, so there's anonymity concerns and so forth.

But when we think about the Treasury market in particular, there's kind of two categories of trading. The first is what you would call in the old world voice trading or dealer-to-client trading where, say, a large central bank has a few billion dollars worth of treasuries to move, and they call up their dealer, and they say, I'd like to sell you, you know, two billion, you know, triple old fives. And dealer says, okay, I'll pay you this many basis points from, from the dollar. the hot run and markets this wide and bigger enterprise. It's a much more familiar kind of

human interaction kind of thing. And it happens in very chunky fashion. We don't see that, really. There is some reporting of that to regulators, and certainly if you work at a broker deal, you can hear about generically transactions like that. But there's no systematic source of data that's available to public that lets us track that activity. But what's useful is, is that no single dealer is going to want to hold $2 billion worth of triple old fives. So what tends to happen is that transaction gets broken up into pieces and socialized across the dealer community through a variety of transactions, some through the futures markets, some through cash markets. But there are these interdealer brokers that facilitate

the distribution of that risk across the dealer community. And how that happens in detail is sort of a much more technical conversation, but suffice to say the risk gets broken up and distributed. And we can observe much more granular and rich data on that process. So that's useful in the sense that the liquidity of the interdealer market will determine the liquidity those dealers can offer to their clients because your ability to get out of risk is going to be directly related to your willingness to put on risk and how much you were willing to charge for that. So we spend a lot of time looking at those transactions. And what we have is basically every order in the interdealer broker market, going back 15 years, you know, buy, sell, change the price,

change the amount, change the level, you know, cancel the order. We have all that. It's basically just a debug output that's been piped in a text file. And we can sift through that and try to make as much use of it as we can. And one of the things that we've done is we said, how quickly did this order react to anything else that happened in the market? Because we don't know who's placing it, but we know some fraction of the participants in that interdise. dealer market are so-called high frequency. So how fast was this thing? And we find that about 80 to 85% of orders now are reacting very quickly to something else that happened. And we know that's very likely to be high frequency because when we plot up a histogram, if we look at the

distribution of timing of those events, there's a very strong peak at eight milliseconds. And the question is, what's significant about eight milliseconds? Well, that's the time it takes for email to get from New York to Chicago. So that's people checking the pit, coming back to New York, trading the cash market. So you can see these little features that are indicative of what you think you're seeing, because we again don't know who's trading. We just know that they're trading. The high frequency is one of those things that relies on strong and resilient market infrastructure to be profitable. And that's the liquidity that's on the screen until you need it, and then it's all. And so when we track that, you know, that goes from.

from 80% of the market to 40% of the market under periods of real stress. This past few weeks, it really hasn't dipped that much. It's gone down to maybe 65, 70%, but it stayed pretty resilient. And that means that your on-screen liquidity, what you see in the market as available to transact, is really there. And that has not always been true. And so, like, that's a sign of healthy market infrastructure. Eating well shouldn't be complicated, but somehow it turns into recipes, prep, cleanup,

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of the actual system. But if we look at it from a more macro perspective, I'm wondering at what point do you see the rise in yields or I don't want to say treasury market dysfunction because, you know, as you put it, the recent bout of volatility wasn't nearly as bad as we'd seen in some previous instances. But at what point do the current events in the treasury market become a problem for the Fed or at least something that it feels it has to push back against? So I think the memory of last March is that not just that rates were moving a lot, but that price discovery was broken.

So, you know, something that was issued three months earlier than another bond that were functionally the same instrument with the same credit, we're trading at very different prices. And that's only if you thought the price you could get was really the price. And so the Fed is not specifically concerned with rates rising. And especially if it's inflation expectations moving up, I think that's a sign of healthy recovery. They're concerned from when we talk about market functioning, we're not talking about volatility in isolation.

We're talking about price discovery, really. And the question is, can markets assign realistic prices to securities in a realistic period of time and a decent enough size to facilitate the broader functioning of the market? Are they introducing sort of the risk of a market failure in which there just is not enough intermediation capacity to keep things flowing. So, you know, that's, that's more, that's much more existential. That's much more concerning. There's not a real sign that that's imminent in any respect right now. You see some, some dispersion in the pricing of securities, but we think that's more attributable to the details of how banks invest for their portfolio and potential regulatory changes,

which are important, but to have an event like last March, you need two things. You need an underlying vulnerability, and you need an event of sufficient magnitude, a shock that's big enough to kind of expose and widen that crack. And so the COVID shock in the context of balance sheet constraints on bank market banking was precisely that. So the risk had been there all along. It just took a big enough shock to expose it and widen it and turn it into something much more concerning. Now, I think on the one hand, we don't really have that vulnerability,

although we'll see what happens with the regulatory outlook. We're likely to get some color on that or some clarity on that pretty soon. But more importantly, this just doesn't seem like the kind of shock that's of sufficient magnitude to drive a wedge through that vulnerability in the first place. So you just don't have the same set of weakness, and you don't have, the same magnitude of shock. So I hate to say everything's going to be fine because that's famous last words. But we could have a big move in rates. And I think it's important to say again, like that's happened before and will happen again. Markets reprice as the view changes, as the expectations change because the world changes and sometimes dramatically. But so long as

the market is reflecting accurately that underlying fundamental shift in expectations, there's nothing to be, quote, unquote, concerned about, at least from a market functioning standpoint. Now, we may not like the way the world's going. And, you know, inflation running away is clearly a problem that the Fed would have to deal with. But that's a macroeconomic issue. That's not a market's issue. So you did kind of allude to this, the sort of upcoming sort of regulatory questions, of course, after, you know, in the wake of the crash, the market crisis, whatever, last March, one of the things the Fed did was basically make it, I guess you describe it, such that the banks could hold unlimited amounts of treasuries without any sort of like penalty on their

total assets. So again, the proviso, when we're recording this, we don't know exactly what we'll hear by the time this comes out. Can you just like walk us through the tension here and is sort of like how we should think about this question of the SLR and how big it could be regarding depending on how the Fed acts with extending this program. Yeah. So SLR, the supplementary leverage ratio is a fairly blunt regulatory instrument. So it basically says you as a bank need to hold capital relative to the overall size of your institution.

So it doesn't matter what you have. However much you have of it, make sure you have 5% in capital. at the holding company level and 6% for your bank operating companies. So the issue there was that back last March, there was just a ton of demand for liquidity, and people had been holding treasuries as a cash surrogate. So the thought was, treasuries are risk-free, they are highly liquid, they pay a yield. So instead of just earning cash returns, I'm going to buy a five-year treasury, and if I need to sell it, I can sell it at low cost.

And the issue is that banks facilitate that sale because the vast majority of trading happens with bank affiliated dealers. And those dealers are subject to these regulations. I think it's a little bit of a misnomer to say that balance sheet constraints were strictly binding last March, meaning banks simply ran out of capacity. They had plenty of capacity. Actually, it's kind of a misnomer. The SLR was never explicitly binding last March. So if it wasn't binding, then what was the problem? And I've been out there talking about how balance sheet constraints were a problem. But if they weren't strictly binding, then where did the stress come from?

And the answer is it's less about your institutional constraints and more about your local constraints. So if you're assigned a commodity and asked to distribute it among different businesses. So bank has $100 worth of balance sheet. And some of it goes to the Treasury desk, some of it goes to the credit desk, some of it goes to the equities desk, some of it goes to the repo desk, some of it goes to the repo desk, some of it goes to, the FX desk, you have to allocate this scarce commodity, but you need to make sure that at an institutional level, you have enough or you don't go over budget. So that means those assignments are pretty rigid, and it's hard to reallocate. I think there's also a sense that banks are highly efficient in their use of their balance sheet, and they are, like we're talking about, over long periods,

but not necessarily over short periods. And so you can run into a situation where a treasury trading desk or a repo desk, which uses a ton of balance sheet and is very volatile and its use of balance sheet, can run into local limits that are part of the business management and planning capital planning process. But the institution's got plenty of access, but they are constrained. And so they start to act like the institution is balance sheet constrained, even though it's really just a local effect. What the SLR Carvets did is they said those treasuries don't contribute to your leverage exposure. So Treasury Desk use as much as you want, basically.

Like, this is not going to be a problem. You know, don't go crazy and make sure you know how much you got. But, like, if you need balance sheet, you know, your need for additional balance sheet is not going to affect my capital planning at an institutional level, at least as long as these carve-outs are in place. And therefore, you can be much more flexible with how that desk operates. And so they don't run into these constraints as frequently. That's about mitigating market failure risk. It's not about reducing leverage constraints in real. real time. It's about clipping the tails of these more problematic outcomes, especially at a

period of time when the trajectory was towards an acceleration in the use of balance sheet. So it wasn't the level, it was the path of growth and the way that that was affecting local behavior. So those rules were put in place to avoid those market failure risks. They've been largely effective at doing so in combination with Fed purchases. But, you know, but But they're going to expire at the end of this month. So the question is, are they going to get extended? If so, for how long and in what form? And they're going to be extended in a format.

And there's a distinction between how the bank operating company, which is the deposit-taking institution, and the dealer, which is part of the holding company, how they are separately affected by these rules. But I think that this specific issue of market functioning risk is a dealer issue, which means it's a holding company issue, which means the question is, on the one hand, you know, how, how is this going to be treated after March 31st? And on the other, how's that can affect the way that these institutions behave internally and manage their balance sheet exposure? Because that's where the sort of real risk factors lie in practice. The issue here is that we're

coming into the end of this period with less buffer at an institutional level than was true early last year. So banks would be entering a balance sheet constrained world, or at least a world in which SLR is in principle binding with less buffer. That means more rigid internal allocations and economies of balance sheet, which means greater market functioning risk. And so, you know, that's a scenario where, in principle, if this keeps going, you could run into a world

where there is a need to sell and raise liquidity on the part of the real economy, the non-banks. And it would be much harder for dealers to intermediate that under those circumstances. Again, you'd need a shock of sufficient magnitude to really exacerbate that and turn that into a real issue. But the risk is greater, all else equal, if banks have less flexibility in the way that they allocate that balance sheet. Okay, well, clearly a lot going on in the Treasury market. And we do have that Fed meeting coming up.

We are recording before it. So it'll be interesting to see how everything shakes out. So thank you so much, Josh, for coming on for your fourth all-thought's appearance and also for connecting the world of real yields with climate change, which not many people do. Thanks. Spanning 15, 20 orders of magnitude in an hour. That was great. Thank you so much, Joe. Yeah, thanks very much. So, Joe, I found that conversation very interesting, a little bit technical, but I do think this broad idea that the way we think about climate change or the way we make these cost-benefit calculations is tied to estimates of the time value of, of money, the discount rate, as much as our actual estimates of how climate change is proceeding

and climate change damage. I think that's really interesting because, I don't know, like the climate change question seems to be framed so much in science, which, you know, for obvious reasons, people talk about it from a scientific perspective, but people don't really talk about it from an economic perspective except in a broad sense that, well, you know, you have to trade off economic growth for restrictions on pollution and things like that. They don't actually get into things like interest rates all that much, I think. No, it's super interesting because it does feel like there is this, you know,

I think a lot of people would accept this premise that something like climate change, which is slow-moving, global in nature, affects everyone, but also at very sort of like indeterminate times in the future is like a very like hard thing for like markets to price. But the idea of still using market pricing concepts to try to get an estimate of the cost of inaction, which is I guess basically what we're talking about. The cost of an action is a really sort of like it's a really interesting exercise. Yeah.

And also just the broad point about how the last time we did a really, really big climate change report was the Stern report back in, gosh, I can't even remember when that was. Was that like 2006 or something? like that. I think he said 2007. 2000. Okay. Yeah. Like, and back then, interest rates were completely different to what they are now. And, you know, his estimate of how much that changes the calculation is just something that, well, I certainly hadn't thought of it before. But I guess, like, I still have some issue with this idea that's like, okay, like, there is this like looming humanitarian catastrophe. Maybe we're already seeing aspects of it played out, playing out. playing out.

And it's like either we want to do something about it or not. And so it's kind of weird still for me to wrap my head around this idea that, well, that would have been a certain cost in 2007, but the real interest rate environment has changed from 2007 to 2021. And so now there's like a total sort of like different cost benefit analysis. But I guess still just this idea that's like, all right, if we accept certain premises about the cost of capital, how much is it costing us to wait is sort of a useful frame in terms of thinking about policy?

Yeah, you can see there's something distinctly awkward about, you know, telling someone, we're sorry that your house is underwater from climate change, but it's because the interest rate changed between the last time that we made an estimate of how much it would cost to fix this problem and now. Like, there's something, yeah. Yeah, and he hinted at that, like future generations or people who aren't born yet, don't get a vote. But it's like, oh, we're going to do something about climate, but the real interest rates were sharply positive at the time and things were growing. And so the time

value of money discounted 50 years from now. Like, it wasn't really that much. It does sort of like raise some like, I guess kind of awkward. Yeah. I mean, I guess Josh mentioned this, but there's the sort of financial imperative and the moral imperative as well, right? But maybe, I don't know, Maybe by focusing on the financial imperative, that's a way to get more people involved in the whole project. And, you know, maybe the end sort of justify the means, right? Yeah. And again, like, the rules are going to come from somewhere, right? Like, that's sort of what I took away.

It's like someone, how politicians around the world address this, like they're still built things like carbon pricing or other regulations that may have some impediment to slow the economy or may, you know, need some. a guess of like, okay, how much do we invest in X or Y? Like, the rules have to come from somewhere and so trying to, like, get ahead of this by, like, thinking about how these models might get shaped as AI use for X or set. Yeah, absolutely. All right.

Should we leave it there? Yes, leave it there. Okay, this has been another episode of the All Thoughts podcast. I'm Tracy Allaway. You can follow me on Twitter at Tracy Allaway. And I'm Jill Wisenthal. You can follow me on Twitter at the stalwart. follow our producer Laura Carlson.

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