Odd Lots - Pimco CIO Dan Ivascyn on the Biggest Fed Decision in Years

Episode Date: September 18, 2024

It’s Fed Day, and while everyone expects the central bank to cut benchmark interest rates, the key question is by how much? Will it be 25 basis points or 50? Investors are evenly split between the two possibilities, setting up one of the most uncertain meetings ever. So what does a big bond manager do on a day like this? In this episode, we speak with Dan Ivascyn, Group CIO at Pimco, where he manages the $158 billion Pimco Income Fund. He tells us what he’s expecting from the FOMC, and what he’s seeing in terms of financial conditions and the real restrictiveness of the monetary environment right now. He also walks us through what Fed day is actually like at Pimco, where he thinks the economy is going, and answers the question of whether — with rates finally going down — bonds might be back in favor.See omnystudio.com/listener for privacy information.

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of the Odd Lots podcast. I'm Tracy Allaway. And I'm Joe Wisenthall. Joe, we are here on the West Coast. Right now we're in Newport Beach. It's so nice. I love it down here so much. This is probably might be tied. Anyway, yes.

I will look for any excuse to come down to this part of the country. We can just listen to Joe Wax's lyrical about California. But we are here for work. Yes. In theory. We're here for the Future Proof Conference, which I think honestly all financial conferences should be like this. They should all take place on a beach with food trucks and we should just hang out outside and talk to each other about markets. Sounds good. But we're not on the beach right now. No, we are not. We are actually, well, let me just say no trip to the West Coast would be complete in terms of an all-boughts episode without hitting up PIMCO and stopping by.

That's right. That's right. The icon of Southern California investing in markets. And what a great time to be doing it because, of course, we're recording this on Monday. And on Wednesday, we have the big Fed decision. That's right. It's a huge, the almost virtually locked that we're going to see the start of the rate cut cycle. But there's still a lot of debate about 25 or 50, what they signal for the rest of the year, how significant is it, whether they choose one of the other. Definitely one of the most exciting, anticipated ones in years. And as of the time that we're recording this on Monday morning, there's. are still significant ambiguity. And who knows by the time you're listening to this, maybe there'll be

some leak in the media. Everyone will have settled on 50 or 25 or something. But at least as of right now, we don't really know what's going to happen. You mentioned ambiguity. And this is really the remarkable thing about this moment in time, which is everyone figures they're going to cut, but we don't know 25 or 50 bibs. And the crazy thing is, if you look at the swaps market right now, we're basically evenly split. Coin flip. Yeah. True excitement. Yes. All right. So without further ado, I'm just going to emphasize. We do, in fact, have the perfect guest to be talking about all of this. We're going to be speaking with Dan Iveson.

He is, of course, the Pimco Group CIO and a managing director here in Newport. Dan, thank you so much for coming back on all thoughts. Thanks. It's really exciting to do this and do it in person this time. Yeah, absolutely. And perfect timing, really. So I'm just going to jump into the big question. The big question.

25 or 50. What will it be? Sure. Real fast. I don't think it will matter that much unless you're betting on that front end contract. And we think it's going to be a close call. The guess based on the news flow this weekend is they may actually go 50. But I think the key point will be that this will either be a very doveish, 25 basis point cut or more balanced 50 basis point cut.

We think the Fed wants to get rates down. They believe they're in restrictive territory. And I think the key point is this is the beginning of a cutting cycle. And we haven't had one in quite some time. I've heard people say that if they go 25, that they could do it in a dove-old. way and perhaps signal via the dots that there will be more aggressive rate cuts for the rest of the year to balance that out. And that the question then would arise, well, if you're already saying that, why not just go 50? Just from your perspective, you know, how does the Fed think through

this question? Maybe it doesn't matter that much. And, you know, in the long sweep of history, maybe it doesn't. But how do you think the Fed is thinking through these options? Yeah, well, I think the first point to note is that the market's already done a lot of work for the Fed. You've seen the pricing of some pretty significant cuts going into year end. In fact, we now have well over 100 basis points of cuts priced in in another 125 to 150 the following year. So, you know, a combination of the data and some statements by Fed officials thus far has already used conditions. And I think what the Fed is concerned with is the fact that inflation isn't yet at Target. We've made some progress, but every time they speak at a dovish tone, you see stocks do pretty well, and credit spreads are near very, very tight levels or near the tights of this cycle.

So they're going to be walking a tight rope a bit in trying to ease conditions without easing too much without letting the markets get ahead of them and without letting some of these positive wealth effects, you know, potentially drive inflation higher. And again, through the combination of action signaling via the dots and the tone at the press conference and future correspondence with markets, they likely have enough tools in their disposal where even if they get something wrong in a narrow sense that they can course correct to get the market back on track as necessary. You mentioned tone of the meeting. And one of the arguments that has come up recently is this idea of, well, maybe they don't do 50 bits because they don't want to make everyone really worried that the economy is significantly. slowing down. Do you worry about like that side of the messaging at all? Is there the possibility that they go 50 and everyone's like, oh, it's worse than we thought? It's possible. I think the other mistake though, or concern I should say is that by going 50, the market gets further in front of them in terms of expectations for even more aggressive policy. So I think both risks are there.

Again, I think perhaps some of these concerns about the Fed being behind the curve or, you know, you know, to in front of the curve relative to where inflation is. I think they're interesting sound bites, but I and we do think that the Fed has enough tools to be able to navigate the next several months. I think the key for markets, though, is to really, really listen to what the Fed is saying. They are going to be looking at the data. Therefore, as market participants, we want to focus on the data. The data is ultimately going to be driving these outcomes. I think it's a really interesting period for markets, given that the data has been volatile. and we think it will likely continue to be quite volatile, creating ongoing uncertainty.

So setting aside whether they do 25 or 50 this week, the other big question is sort of, I guess, maybe more medium term or long term, but has the neutral rate of the long term, neutral rate of interest gone up since pre-COVID? And there continues to be a lot of discussion about this. No one really knows. Do you think there's been some sort of structural change in the economy over, I guess, basically the last four and a half to five years now, such that the neutral rate of interest is higher. And what has changed if so? So we think it may be a bit higher. A bit higher.

If you look back through economic history, these neutral policy rates, or this concept of an R-Star, is important, but it doesn't tend to move that quickly. And I think a lot of the research, including our own, and we dusted off a lot of older research and updated these studies. You know, the summer suggests that, yeah, our star may be a bit higher, but there's massive uncertainty. around this type of research. So again, I think the bottom line, as you said, is we don't know for sure. We suspect it's a little bit higher, but not as high as some more bearish folks out there think it may be. And the reasons for that, higher debt levels, the need for significantly more physical infrastructure investment, this cycle, less globalization, the desire for supply chain resiliency. We think are just a few factors contributing to the likelihood that our stars higher.

But just the implication, though, if it's only modestly higher, is at least from here, again, setting aside what they do this week, that there is substantial room for them to cut. And you'd expect their deep cuts from here. That's correct. And, you know, our thought process is, you know, maybe our star is half a percent higher. Okay. Not on the order of one, one and a half percent higher. So the bottom line is relative to a concept of neutral, even if neutral is closer to a three percent nominal funds rate or even a little bit higher, gives them a lot of room to get policy back to what they perceive to be neutral. And again, with any cycle, you can have overshooting to the downside, too, from a growth and inflation perspective. So there's always a chance that into a weaker economy than they and we currently anticipate, that they have room to shift into accommodative territory as well. What's your sense of financial conditions right now? Because you have great insight into the market. You buy mortgage bonds.

You buy credit. You buy treasuries, obviously. What are you saying in terms of the market right now? I'm thinking particularly of credit spreads. are still near cycle lows, basically. Yeah, so in aggregate, conditions still appear to be quite loose. When you look at stock markets near all-time highs, credit spreads very, very tight. From a very high-level macro sense, there's still a lot of liquidity in the system, a lot of confidence, a lot of momentum, positive momentum, and risk asset spreads are quite tight. But we know that looking at aggregate

measures can be misleading. If you're a lower-income consumer that doesn't own a home, where we know U.S. households have a lot of equity trapped in their property or in their primary residence, there we are beginning to see signs of weakness. Most of the debt that those households have incurred as floating rate in nature, and they're feeling a lot of pressure. You look at the floating rate credit markets, some of the lending that's occurred to some weaker quality borrowers to commercial real estate sector, you're seeing signs of stress there that are probably not as evident, you know, out there in the marketplace as they should be. So there are sectors of the market that we're beginning to see, deteriorate. We think that's what's on the mind of the Federal Reserve, that alongside, you know,

some of the more recent, you know, broad labor market weakness. I'll suggest that the Fed from a insurance or a risk management perspective, you know, should likely begin to get rates lower. And then again, carefully look at the data to just make sure and to calibrate, you know, to prevent a reacceleration of inflation into even looser financial conditions. If it's the case that our star is just a little bit higher than what it used to be, and perhaps some in the market are overestimating how much it's risen, what areas of the market specifically are either mispriced or are the most attractive under your assumptions? Well, good old-fashioned high-quality bonds would benefit to the extent that...

We're talking high-quality corporate bonds here. High-quality, you know, really any type of high-quality bond. And what's nice about the high-quality bond market is that if you have a multi-year time horizon, the analysis isn't that complicated. You typically earn your yield. and then any type of incremental return you can get through thoughtful asset allocation or alpha generation is incremental return that you'll receive. To the extent that policy rates or neutral rates look very similar to where we were pre-COVID,

that creates room not only to realize upon very attractive real and nominal yields, but further prospects for price appreciation as well. And I think related to that point is that fixed income has historically done real well when bad things were happening elsewhere within your portfolio, when economic growth has been weak, really the 22 experience and this inflationary experience has been the exception to the rule. And we do think there's a good chance, you know, regardless of whether, you know, neutral policy rates are a little bit higher than they were pre-COVID, that we're getting back into that type of paradigm where fixed income not only has an attractive yield, but it will have defensive

diverse-fine characteristics, finally. And again, that takes some convincing for investors, given the battle wounds we all suffer during the 22 experience. You mentioned the idea of fixed income sort of coming back. How are you looking at pricing on the short end at the moment? Because as you said, one of the risks is that the market kind of gets ahead of itself right now in pricing, in rate cuts. And some people look at those shorter term maturities right now and think, like, well, maybe it is a little bit overdone. Yeah. So again, if you have a three to five year time horizon, this is really noise.

lock in some of these attractive, high nominal real yields, and then benefit from some of the most attractive income that we've been able to generate in a very, very long time. From a tactical perspective, though, it's been very, very target rich. And in looking at the yield curve today, we do think that the markets may be getting a little bit ahead of themselves in terms of near-term cuts. Yeah, we've had some employment weakness, but that we had a CPI number recently that surprised a bit to the upside. Earlier this year, data surprised in a more concerning fashion. So we think that over the course of the next few months, there are some risks of re-accelerating inflation, which may lead to less cuts that are pricing to the market. So what we're doing currently is reducing some of our exposure to the very, very front end of the yield curve. And I'm talking about one or two-year type maturities.

Then our favorite part to invest on behalf of our clients is really in the intermediate part of the curve in those five-year type maturities where you look at the market today and where you have a terminal. federal funds rate assumption in the market today, somewhere close to 3%. We think that's reasonable. That would be consistent of higher neutral rates relative to where we were pre-COVID and allow for some price appreciation if we were to get into a more challenging macro environment. So a lot of activity, you know, within the U.S. market, across markets, a lot of volatility in the front end of the curve. And right now we have been taking a little bit of risk off thinking that, you know, perhaps,

you know, over the next few months, people are a little bit optimistic about the Fed being will get rates down as quickly as people, or at least some people anticipate. Canadian women are looking for more. More to themselves, their businesses, their elected leaders, and the world are at them. And that's why we're thrilled to introduce the Honest Talk podcast. I'm Jennifer Stewart. And I'm Catherine Clark. And in this podcast, we interview Canada's most inspiring women.

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Subscribe today wherever you get your podcast. Can I ask a process question? These are actually my favorite questions, but you manage the, I think it's $158 billion PIMCO income fund. And I guess the mandate is preserve capital while generating income, which gives you the full suite of fixed income, basically, to look over. You could buy, you know, longer maturity treasuries, all types of corporate bonds, mortgage-backed securities,

obviously. How do these decisions land on your desk? Like when you're making these investment decisions, like what is the optionality that is actually presented to you? And then just to connect it back to the Fed, you know, on Wednesday, the Fed decision comes out. What does your day-to-day look like on a day like that? How quickly are you cutting positioning and what are the options available to you? Sure. You know, we take a long-term orientation. So a lot of what we do is about process, looking for repeatable sources of alpha or return relative to passive alternatives based on market inefficiencies, market frictions, looking to leverage that flexibility that were afforded in a strategy like the income fund. So in that sense, it's very process driven and it doesn't relate to a view

on the Fed or a view on the directionality of interest rates. And that tends to be a good portion of the incremental return that we generate. In addition to that, as you know, Pimpcos always had a very structured investment process. We get together and we talk about three to five year themes impacting markets every summer on a quarterly basis and we just finished this process last week. We get together talking about the outlook for markets across the 12 to 18 month period and that we have the investment committee. So I'd categorize portfolio construction as, you know, targeting a lot of low-hanging fruit tied to market frictions and inefficiencies. And then the overlay of tactical, more macro-oriented themes as well. And those will be done through a committee process. And then when you have a

volatility event like the Fed or a major data release, we stand poised to react. So, you know, on a day where the data may be surprising the market, where there may be some overshooting, we have orders in. It could come directly from myself or other teammates on the strategy. Perhaps we're coordinating across multiple strategies as well. But over a full cycle, those types of short-term tactical moves got a lot of the press. probably why I'm not as popular on CMBC. You know, when you talk about process long-term orientation, it's less fun. But it really is about a lot of process then standing by to take advantage of overshooting in markets when they really present.

I'm going to ask an even more specific, I guess, process type of question, but literally on Fed Day. What are you doing? Do you have the TV on and you're like chatting with people, IBM? Like, what is like your process of, you know, what is the process of consuming and and digesting and hashing out the views look like from, well, I guess you're on West Coast time. That blows my mind. So I guess the decision comes out at 11.

But what are you doing? What can we, if I close my eyes, what can I imagine this going on in your offices at that time? Well, I remind my colleagues, and, you know, as you talk to others over time, they'll mention this. I remind people it's less important than people think it is. I know, but still, we all, we know. But we still, I'm glued to it, even though I know in the end, the heat. death of the universe means none of it's important. But like, what do you know, like what are you doing? But here's what we do. And we do it, you know, pretty much every time. We make sure we're around

for the Fed announcement. We're usually in our trading seats. Okay, fun. Nearly, uh, regardless of what other activities are going on that day, we immediately read the release. We have some type of word smithing, you know, more quant type analysis or, you know, of the actual words where we get a, you know, doveish and a hawkish score just based on the readout relative to prior, readouts, and then we all listen to the press conference. As soon as the press conference ends, we run into the investment committee room. We typically have our advisor, Ben Bernanke, there. Of course, we have the recent vice chair. That's useful. Not bad. It is. It's not a bad advisor to have hot staff on Fed Day. Good, good to have been around. And of course,

Rich Clareter rejoined us, the recent vice chair as well. So, you know, Rich will join as well as our various Fed watchers and other macro thinkers. And we go around the table, talk about the outlook or talk about the conclusion, the press conference, any other data that was released, and then we conclude with the question as to whether anyone did anything in response to the Fed number, should we change portfolio positioning? As Bill Gross used to remind us, you can't trade a Fed call in the market per se. I guess you could trade, you know, Fed Funds futures, but it's always important to take, you know, whatever type of macro release there is or a decision that's made and translate it pretty quickly into an investment decision. Sometimes we trade a little bit,

Sometimes we don't trade at all. Occasionally we'll trade a lot based on that information. And we always leave with a roadmap on what we're going to do during the remaining trading day on that particular Fed release day and then put together a game plan if necessary for future trading sessions as well. Tracy, I just got to say if they hit a microphone in that room, it would be the greatest macro podcast in the history of podcasts. I really would love to hear that. If you ever decide to do that, Dan, let us know. And we will gladly record a fly on the wall.

episode of odd lots at your investment committee. Okay, but since we can't really do that, but we're talking about FOMC date. What about early August when we had the big market sell-off? What was that time period like for you? Because I imagine on the one hand, it was sort of knuckle-clenching for a lot of market participants. But on the other hand, a lot of people talked about the opportunity to come in and buy stuff that was briefly on sale. Yeah, so overnight in Japan, we did some trading. Most of the flow was really in the volatility markets and the equity markets. So it was a little bit less of an event within fixed income,

but there was a chance to take advantage of some local overshooting that occurred in the Japanese market. Then even earlier in the day, U.S. time, some ability to trade global fixed income markets and take advantage of some overshooting there. But again, given the size of the move, a lot of time spent that day just talking about potential implications for overall markets, positioning, questions around. Japan, maybe we were missing something in terms of embedded leverage over in that market. And then, again, of course, things settle down relatively quickly. Again, another, you know, important point regarding that event, again, is that you had a

situation where you have a little bit of weakness in the labor market data, a little bit of a surprise in the Japanese market from a policy perspective, and pretty big moves. And this time, these moves coincided with a big rally in the front of the bond market. So, again, a reminder that we're getting to a point now from a valuation perspective. and where we are in the macro cycle, that fixed income may exhibit these types of insurance-type characteristics once again. And then the second point, probably the most important point, is that when markets are expensive, it takes less negative surprise to create bigger moves.

And this is the world we're living in today. Equity valuations are stretched. There's a lot of reliance on central banks to engineer positive economic and financial market outcomes. Credit spreads are tight. And any time you have this type of dynamic, you just have to be prepared for bouts of volatility, boats of overshooting, and as an active asset manager, that's where we can shine by having the flexibility necessary to be buying when other people are selling somewhat indiscriminately

and not getting caught up into forced sales activity ourselves. I'm glad you brought it back around to the sort of hedging insurance role that fixed income can play in times like this. So looking back over the last several years, you know, one of the things that really struck me from like basically the financial crisis to COVID was just this. beautiful relationship of stocks and bonds from the investor perspective because you're getting paid by your bond holdings, stocks were going up. And then the moment you had some stock weakness, the capital appreciated, just like this beautiful line that went up when you combined the two. And then as you

mentioned, 2021 and 22, like that broke down, obviously. And bonds didn't provide that same ballast that went up every time when stocks went down. I'm curious if you've seen a change from a business perspective and a distribution perspective over the last few years where you've had to go back out and convince clients of the role for bonds in the portfolio and remake that pitch to them and whether there is sort of a persistent, maybe something that will last while, skepticism. Okay, you don't get the same insurance effect. Meanwhile, yes, you get coupon payment, but when you look at the insane returns that people are getting in tech stocks, you're like, well, what's this little 5% return?

getting for me. And so I'm curious whether the sales pitch or the client pitch has changed at all over time because of the experience of the last few years. It has. Now, we focus on value versus passive alternatives. So our pitch is, you know, invest with PIMCO. We're going to provide you with a better experience relative to what you can get in passive portfolio alternatives. So we think over time, if we can do that, clients will come. And it was hard. Coming out of the GFC when interest rates were near zero, where policy rates were at zero or below zero for many, many years, It really planted the seeds for major change within the fixed income industry. And then you had the inflation.

And then you had the very violent sell-off in 2022, where not only did bonds not insure much of anything, they themselves went down a lot. Yeah. Yeah, the mark to market on those were insane at the time. I remember doing a headline that was like, this was for corporate bonds, but it was like demonstrational portfolio of IG bonds. And it was down like 30% at that period. Anyone holding fixed income, especially as a retirement option, would have been massively hit.

Absolutely correct. And in some sense, it was a prerequisite to get value back in fixed income markets. But if you go back several years, because rates were near zero or outright negative in major parts of the developed world, people were forced to look for alternatives. What you've seen over that period is massive growth in floating rate, lower quality corporate credit. That's very unusual when you go back several decades. And historically floating rate, lower quality corporate credit is quite dangerous because when you have an economic shock, short rates go down. That floating rate, lower quality credit, just as it becomes more risky, sees its yield drop and drop quite considerably, especially if policy rates or neutral rates are as low as some people may think. So you're getting paid less and the odds of default are going on. That's correct.

And we have a dynamic now where you've seen the lower quality floating rate credit markets grow in the order of, you know, a couple trillion dollars in size. And that was due to the fact that it was really the only game in town. There was no real attractive yield at high quality markets. Today there is. What we know is coming up most likely in a few days is that these short rates are going to begin to go down again. So you have a really, really interesting dynamic in the market where people rushed into these floating rate sectors and segments of the market. Their yields are going down. You don't have the ability to lock in those longer real rates.

So we do think this could be a meaningful turning point. And I think, again, at looking at fixed income from the standpoint of a 30, 40, 50-year time horizon, it's really been the exception of the rule the last several years where you've had this dynamic in play, where duration was a really, really bad thing and where you really needed to perhaps reach a little bit to maintain an attractive income in some of the more economically sensitive or riskier areas of the bond market. Now, if you have a hard landing, this dynamic can turn quite quickly back towards the old days. If you have a softer landing scenario, this dynamic will play out much more slowly. But it does create what could be the next wave of interest into fixed rate, longer maturities within the fixed income market.

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on the Bloomberg business app or listen to the podcast. That's Bloomberg this weekend. Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg television, radio, and wherever you get your podcasts. Okay, so speaking of credit and floating rate loans, do you feel pressure or competition at all from, I guess, the proverbial growth of private credit? The booming private credit market, is that something that either makes it harder for you guys to secure paper or? maybe makes the yield on that paper a little bit lower. What does that mean for your business? From an investment perspective, it's actually a really good thing. And in fact, even some of the

growth of the ETF market has been positive. A lot of these rules-based strategies we see in the ETFs, the daily disclosure of activity within the ETFs, has created frictions in certain more complex areas of the market that have led to the ability to more easily generate active alpha within our strategies. On the private credit side, it's a bit more nuanced. We are seeing more risk get transferred into private markets, which ironically has made the traditional high yield markets much more robust. I can't tell you how many times we look at credits within the high yield corporate bond space. We say, look, we're looking at these financials. Maturities coming up. This company cannot afford to pay this coupon rate to refy their debt, only to find out a private

credit manager has taken them out with a pick deal. So instead of having to pay the full coupon interest currently, they have the option in the private credit markets to get a more aggressively structured transaction. We've seen this dynamic off and on throughout my time within the industry. And again, it is leading to some friction in markets, some opportunity as well. So yes, if more and more risk gets transferred to the private markets over time, it will lead to a reduced opportunity set. But for an active investment management perspective, those types of frictions actually create opportunities to generate alpha versus passive alternatives. So this is interesting. I just want to clarify. So from an abstract level, I certainly understand how market frictions are what create

mispricings and therefore the opportunity to generate alpha. But when you talk about the private credit space creating these frictions, can you just sort of clarify that a little bit more like what that looks like or math it out for us. Yeah. So again, in looking at, first of all, some of the lower quality areas of the market, a lot of these pretty significant flows have impacted technicals across the credit sector more broadly. So analyzing and understanding the type of risk transfer going on in the private markets can really improve your ability to generate return, make good credit decisions within the traditional

high yield or even the bank loan universe. I think that another big dynamic and private credit today relates to a lot of flows within two insurance platforms. Insurance companies are regulated entities. They're mostly regulated based on rating. And this feels a little bit similar to even the years leading up to the global financial crisis, where there's increasing influence from rating agencies. Now, radio agencies try their best to rate risk and assess risk, but there's increasingly

a gap between the type of structures necessary to put into certain vehicles. that are sourced of demand for private credit relative to our own views on the inherent credit quality of those particular instruments. And the fact that you're back now, even over the last few years to so much capital optimization going on across these platforms that there is opportunity to do your own work. Compare that work to ratings out there across both the public and the private credit space and be able to make really, really good relative decisions versus those entities, those big players and growing players in the market that need a rating, that they need some type of structuring

in order to optimize capital under a evolving regulatory framework. So those are the type of frictions that we talked about earlier that are good to have around. Yeah. Because it does allow you to, you know, generate return in mandates that are less inherently constrained in that regard. Since you mentioned regulatory framework, how closely are you following something like the Basel endgame proposals? Because this is the forgotten event risk of this week is also we're supposed to get the unveiled Basel endgame suggestions or proposal. And those include a lot of potentially new guidance for how banks holds things like MBS and treasuries and mark-to-market losses on things like that.

Yeah. So we follow what's going on with Basel rules. There's also a lot of work being done across various insurance regulators, even a lot of work going on, you know, across the regulatory regimes that impact various mutual funds and in other positions here in the U.S. and over in Europe. So these are going to be important. Again, for the standpoint of good, well-functioning markets, you know, we think that a lot of these regulatory regimes should be looked at. We think that a lot of the regulation that got put in place post-global financial crisis turned out to be perhaps a bit backward-looking, a bit aggressive. But all these types of regulations create these types of frictions that we look to exploit, again, in some of our more flexible active

strategies. So they're going to impact what banks can do, what risk needs to get laid off. And we've seen increased activity even there too with these various SRT transactions and other aggressive transactions on the capital optimization side. But again, all this may not be so good for financial market efficiency, but these types of activities are very, very good from an active asset manager perspective in order to come in and take advantage of these frictions for the end investor. Are you involved at all in synthetic risk transfers? Is that something of interest to you? We are. In fact, I was a trader of this space back when I first joined Pimp back in the late 1990s, and we have a lot of folks here that I've looked at.

Oh, this is like old school SRT if you're talking about the 1990s. It is. And SRTs are similar in many respects. It's a different flavor each time. And it's an interesting segment of the market. There's simple deals to some degree, but then there's a lot of complexity in terms of understanding waterfalls, how losses are allocated, you know, the documentation detail. So they tend to be popular in the sense that you look at it, the risk, and you say,

hey, look, I could get a very, very attractive coupon. If I avoid losses up to this point, you know, I'll have a good investment outcome. But again, a lot of inherent complexity. So we've been involved for a long time. We've done a few deals recently. We think it's an interesting area of the market. But it's an area of the market where back a year and a half or so ago, when the regional banks were going through a lot of challenges, there was really good value for the end investor sourcing that risk.

today with all of the money chasing some of these opportunities, some folks apparently or appearing to compete based on market share as opposed to prudent underwriting, there's times where some of these SRT deals are getting done and getting done at levels quite advantageous to the banks that are selling that risk. And not surprisingly, when you have that dynamic in play, you're going to see more and more of these transactions. So it requires a lot of nuance and some good value there, but there's pockets of froth even in that SRT market today. That's interesting. By the way, listeners, if you're just tuning in, Tracy and I did an episode with Michael Shemmy several weeks ago all about how SRTs work. So a good primer to go back to and check that out. I want to go back to the macro for a minute and

sort of where we started and thinking about where we're going over the next several years. And we're in an era of very high deficits historically. You mentioned, you know, there's talk about, you know, all this like friend-shoring talk and reorientation of supply chains, that's costly. Geopolitical tensions have risen. That's going to be costly on multiple fronts if it persists. In politics changes, you know, obviously there was the sort of more comfort with fiscal expansion and things like that. And, you know, in a way that we might not have expected years ago. All these things like, you know, looking out a few years, how are you thinking about these changes that are coming or these risks and how they're going to change? the flavor of markets over time.

Yeah, so a few points. One, interesting that we had a pretty extensive discussion today. We didn't talk about inflation too much. Yeah. Tell us more. What's going to happen with inflation? That's yesterday's news. No, actually, we probably should.

Tell us more. Yeah, but I bring that up only because we do think, to answer your question, you know, over the next several years, even though inflation may come down from a cyclical perspective, it's likely here to stay. So then why do you think that we've only seen such a modest increase in the neutral rate, if inflation here is now going to be sort of like structurally, at least somewhat higher? Well, we think inflation may be a little bit higher structurally, at least the base case. We think that the risks around inflation will likely be more symmetric.

So again, you go back to the GFC in the years, you know, following the GFC, most of the challenge for central banks would get inflation back up towards target. Yeah, kept missing on the downside. And we think, you know, over the next several years for the reasons we talked about, inflation risks will be more symmetric, which creates opportunities for investors. to source inflation protection across portfolios. We also think, to your point, there's going to be more geopolitical uncertainty. Deficits are high.

Many countries, including the U.S., which jumps out as being a government that can't continue to run these types of deficits indefinitely. And we think because deficits are high, because market participants generally believe that central banks and fiscal agents had something to do with inflation this cycle, you're likely to have less policy activism on an ongoing basis. So this feels like, you know, a market the next several years that will have to stand on its own merits more than it has in the past, less influence from policymakers, more local volatility, less synchronized growth cycles, with the risk of meaningful geopolitical uncertainty as well. A lower strike price on the Fed put, so to

speak? And probably a lower strike price on the put, but the power of the Fed may be less than it's been in the past because of this very, very challenging inflationary situation we were in after the very activist policies during the COVID period. So, yeah, I think it's premature to say that the Fed and other policymakers aren't going to be there during extreme bouts of volatility. There is a question, though, from our perspective, as to whether they could be as impactful as they've been in the past. Again, good for active asset management, but there's a risk management reminder in there that you got to be a little bit more humble about the risks of overshoot. And you're going to be a little bit more shooting the risks of harder landing scenarios, the risk that, you know, as fixed income investors,

would have to go in alone, so to speak, and not rely on central banks to bail out some of the underperforming areas of the market. You know, Tracy, it's interesting when we had that volatility in early August. None of the Fed speakers played ball with the talk of like emergency rate cuts. Oh, yeah. Like, you know, because that was in there. And they did not. And they were very cautious.

And they didn't, they didn't really talk about the market volatility. And they said, we're just going to see the data. It was very interesting how, like, they were cool throughout the whole thing. I know it's only six weeks ago, but I've already forgotten that whole period. But some people were calling for a hundred basis point emergency cut, right? Okay. When I think about event risk on the horizon, okay, the return of inflation, the hard landing scenario, but also geopolitical risks, which you just brought up.

And if I'm thinking back to the idea of bonds as a hedge, and I'm thinking about U.S. Treasuries, it feels like U.S. treasuries aren't necessarily a good hedge for, a particular flavor of U.S. political risk. How do you hedge for that type of volatility? Well, one thing that we've done, and it's not just related to the election, is to maintain a lot of portfolio liquidity. Liquidity means flexibility. Liquidity is a form of positive optionality.

If you have a volatility event associated with our election or some of these other geopolitical risks that are out there, markets can overshoot. I think a key theme in generating return for an active asset manager is being there to counter trade the market if you do have overshooting. And I think that this election set up is one where it's a coin flip. And uncertainty is only increasing going into this election period. So we don't yet have conviction in terms of what's going to happen. We just want to have a bit more flexibility. That's point one. Second point, when you step back and look at the likelihood of generating attractive returns the next few years, the U.S. is not the only game in town anymore.

Rates for negative elsewhere in the world outright negative, not even on an inflation-adjusted basis. And these markets have reawakened, particularly from the standpoint of a U.S. dollar-denominated investor. So you do have options versus the U.S. The Australian bond market, the U.K., both markets out yield the United States, opportunities to diversify into other developed markets. Even Japan on a hedge basis has some interesting yields out in the long end of the yield curve. So, you know, we have over the course of the last several months have been using the full breadth of the PIMCO platform, the flexibility across a lot of our mandates to diversify a bit away from the U.S. And again, that theme will likely continue where investors to optimize their portfolio

should look outside the U.S. at both higher quality and lower quality markets out there in the world. And we do think some diversification away from U.S. higher quality interest rate exposure makes a lot of sense at this point in the cycle. I'm going to ask a really ignorant question. And maybe you're just going to say, no, that's not a thing day. Do you have a capacity to buy Chinese government bonds, which have done extremely well, and the long end of the curve has come way down there? We do. And, you know, they have exposure to that market? We have very little exposure to their market. They got, you know, yields, you know, 2% type zone, you know, in the higher quality of the market, but an example of less synchronized

global growth cycles. Their growth slowing, no inflation problem. It, in theory, is a decent diversifier. I think the problem just in the market right now is a lot of that's priced into the Chinese mark. So the last time we spoke to you, I think it was August 2022, something like that. And a lot of- Turning points. Yeah. We turned to Dan. Well, and a lot of the conversation was about the potential for a recession, a housing slowdown, things like that. And of course, fast forward to September of 2024. And corporate credit has held up phenomenally well. I'd take the point about disparities between, you know, lesser quality and higher quality. The housing market. has been pretty robust more than a lot of people would have expected. Thinking back over the past couple of years, what have you learned from that experience and how do you incorporate it into the PIMCO investment strategy? Well, this was a exceptionally unique cycle. We had a global

pandemic, something we none of us had witnessed in our lifetime, sudden stop of the economy, massive, massive policy response, and an inflationary environment that many of us didn't see in our actual trading career. The young folks at PIMCO, even less so. So, I think it's just a reminder that the unexpected can happen. And it's important, again, to have appropriate humility from a portfolio construction perspective, think about diversification carefully. Risk management's critically important, not just defensive risk management, but having a risk management mindset because you can go through these unique periods.

And as we talked about earlier, when valuations are stretched, it doesn't necessarily take a global pandemic type shock to create some challenges. and opportunities for the firm or the strategy that's well positioned. I think looking back on the last few years, a lot of this inflation likely will be perceived as being at least temporary or due to very, very unique COVID supply chain complications and this massive fiscal stimulus that occurred. But we got a lot to learn, a lot to analyze,

and I think going forward, plenty of uncertainty as well. So, you know, we try to be careful about being too overconfident. We get the behavioral finance folks always in our ears reminding us that people like myself tend to be prone to overconfidence unless we protect our clients from our own natural instincts. And again, just trying to learn, continue to read the economic history books compared to the current environment. Again, leveraging the team. You know, investing as a team sport. And you don't have to take wildly big macro bets to just generate lots of small return across a variety of sectors, parts of the globe.

And again, if you do that well, it adds up into a good client experience at the end of the day. All right, Dan Iverson. I'm so glad we could catch up with you in person on the West Coast. Thank you so much for coming back on Offlop. Thank you so much, Dan. That was great. Thanks so much. Joe, that was fun. That was really fun. What a treat to get to talk to Dan Ivison. Right before Fed Day. Yeah. Also, I was thinking, like, can you imagine being in that room with Ben Bernanke and Richard Clarita? Actually, when he said that, I had this like, like, it didn't quite register to me. He's like, oh, we have our advisor, Ben Bernanke. And I was like didn't like I was like what does he say? And I was like is he like speaking like metaphorically.

It's like no, but when you're PIMCO, you can really hire Ben Bernanke on Fed Day to talk to about what just happened. Yeah, must be nice. Okay. Well, there is a ton to pull out of that conversation. One of the things that struck me was very early on, you know, he talked about the credit cycle and what's been going on there. And I guess the downsides of looking at aggregates, which is even when you see credit spreads, falling or staying very, very low in totality, it does conceal pockets of weakness and pain for like the least quality names in there and parts of CRE and things like that. And I think

that is worth remembering as we kind of talk about, well, the Fed's cutting rates and we haven't had that hard landing scenario that a lot of people thought would emerge. There are these pockets of weakness out there. Totally. Which of course has contributed to why just so many people are confused about the economy because you can sort of point to anything and tell the story you want. I also thought it was sort of interesting and, you know, I get like, there's a lot of logic to it, this idea of like, okay, for a couple years there, bonds did not play the role in people's portfolios that they might have gotten used to. And I really just think like we, and by we, I just mean like investors, like people who put their money with other people or in some form.

Like, we just had it so easy in the 2010s because like really, it was just like this beautiful synergy of stocks and bonds, various flavors of 60, 40, what have you, like, it all worked out and you, like, didn't lose money. And 2022 in particular was, like, a sharp reminder. And you, like, pointed to the stats, like, no, like, that paradigm, like, broke in a really big way. And so the question to my mind is still, like, okay, even if inflation is, like, come down, we do see fixed income providing this sort of insurance hedging role that it did. Like, Are people going to be like totally comfortable allocating that much to fixed income, especially because of kind of what we were talking about at the end there. There are these different macro dynamics, geopolitical dynamics, political dynamics that could change basically how bonds trade.

One day in the future we'll tell our children that a successful investment portfolio was basically just 60, 40. And that was it. That's how easy it was. It's so easy. We didn't know how good we had it. But you're right. I do think the memories of that like very dramatic mark to market loss are going to stay with us for a while. Yeah.

So it was interesting to hear Dan talk about this idea of like having to go out to clients and repitch bonds as a useful hedging instrument in your portfolio. And I kind of, I wonder how quickly attitudes will adjust once again. I guess it depends on what happens this week and beyond. We will see. All right. Shall we leave it there? Let's leave it there. This has been another episode of the Oddlots podcast.

I'm Tracy Alloway. You can follow me at Tracy Allaway. And I'm Joe Wisenthall. You can follow me at the stalwart. Follow our producers, Kerman Rodriguez, at Kermann Armin, Dashel Bennett, who is out here in Newport Beach with us. Kale Brooks at Kail Brooks. Thank you to our producer, Moses, on Dom.

For more Odd Lots content, go to Bloomberg.com slash oddlots, where we have transcripts, a blog, and a newsletter. And you can chat about all of these topics 24-7 in our Discord. Discord.g.g slash oddlots. And if you enjoy oddlots, if you like it when we talk to very large bond investors on the West Coast, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes, absolutely add free.

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