What's Behind the Big Surge in US Government Bond Yields

Global bond yields are at their highest level since 2008, with the 30-year US Treasury touching 5% just before Treasury Secretary Scott Bessent announced a surprise increase of his department's bond buyback program and Fed Chairman Kevin Warsh made his hawkish speech at Jackson Hole. So what's driving yields higher? And what options do policymakers have to bring them down? In this episode we speak with Stanford Professor Darrell Duffie, who's been researching bonds for years, including presenting a paper at Jackson Hole in 2023 about how to fix the US Treasury market. A lot has changed since then, and at this year's Jackson Hole symposium, we caught up with Duffie to talk about everything going on in the bond market, as well as the challenge of shrinking the Fed's balance sheet. Get tickets to see Odd Lots live https://events.bloombergevents.com/event/ODDLOTSLA/summary in LA! See omnystudio.com/listener https://omnystudio.com/listener for privacy information.

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00Tracy Alloway?

  There are some market stories where you want every detail. Joe and I have made quite a few podcasts on that basis. But sometimes you've only got 10 minutes and just want to know what's moving markets fast. That's the Barclays Brief Podcast. Every week, experts from Barclays Markets and Research get you up to speed on what's happening and what to watch next. Concise, focused, and brief. Search Barclays Brief wherever you get your podcasts.

• 0:25Speaker 01

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• 1:48Joe Weisenthal?

  Hello, Odd Lots listeners. I'm Joe Weisenthal.

• 1:50Tracy Alloway?

  And I'm Tracy Alloway.

• 1:52Joe Weisenthal?

  We're the hosts of the Odd Lots Podcast, and we've got something exciting for you.

• 1:56Tracy Alloway?

  That's right. So one of the best parts of hosting our podcast is we get to actually meet and interact with our listeners, and we know we have some listeners over in Los Angeles.

• 2:05Joe Weisenthal?

  That's right. So if you're in L.A., we are going to be recording a live show, some live recordings at the Vermont Theater in Hollywood on September 17.

• 2:14Tracy Alloway?

  We have some really exciting guests lined up, have some really great conversations planned, so go ahead and get your tickets. You can find those over at Bloomberg dot com forward slash Odd Lots, or click the link below in the show notes and come and say hi when you're there.

• 2:33Speaker 04

  Bloomberg Audio Studios, podcasts, radio, news.

• 2:49Tracy Alloway?

  Hello and welcome to another episode of the Odd Lots Podcast. I'm Tracy Alloway.

• 2:53Joe Weisenthal?

  And I'm Joe Weisenthal.

• 2:54Tracy Alloway?

  Well, Joe, we are still at Jackson Hole.

• 2:56Joe Weisenthal?

  Yeah.

• 2:56Tracy Alloway?

  Where the official theme of this year's symposium is financial innovation in payments. However, the unofficial theme has to be what the heck is going on with bond yields and the Federal Reserve, because this whole meeting is coming against a backdrop of higher yields, particularly at the long end, a new Fed chair who seems to want to make a mark on the Fed and has started all these different task forces to look at things like comms and balance sheets. And then, of course, we also have a Fed that seems to kind of maybe be operating at cross currents to the U.S. Treasury, given that the Treasury is now buying back longer dated bonds and seemingly suppressing longer dated yields.

• 3:36Joe Weisenthal?

  There's so many different dimensions to what you described, right? So there is the formal, technical thing, there is the sort of relationship between the Fed and the Treasury, there is the new things going on inside the Fed, there's obviously the warmth in the economy. By the way, the sun just came out. We're recording outside, it's been rainy and cool all day, now it suddenly got hot again. Maybe that's a sign. Anyway, that's why it's fun to be in Jackson Hole, though. There are all kinds of different people we can talk to, including people who sit perfectly at this intersection of all the things that we're talking about.

• 4:09Tracy Alloway?

  That's exactly what I was going to say. So the guest for today, truly the perfect guest, someone who's able to sort of synthesize the macro and what's going on in the bond market, as well as some of the operations of the actual Treasury market. So truly the perfect guest, we're going to be speaking with Daryl Duffy. He is, of course, Professor of Finance over at Stanford University. So, Daryl, thank you so much for coming back on Odd Lots.

• 4:31Speaker 05

  Tracy, Joe, great to be back. Thank you.

• 4:34Tracy Alloway?

  Is there a connection between higher bond yields and the payment system? Basically, why are you here?

• 4:40Speaker 05

  Well, there can be. In March of 2020, when the markets became dysfunctional.

• 4:45Tracy Alloway?

  That's a good answer.

• 4:46Speaker 05

  The Fed had to step in and dig out the balance sheets of the largest dealers to keep the bond market moving, and bond yields jumped and were very volatile.

• 4:54Joe Weisenthal?

  The last time we talked was also at Jackson Hole, and we talked about this relationship between just the sheer volume of public debt that's traded these days and the sort of like scarce dealer balance sheet. And this is like, you know, often when people talk about the size of the debt, they talk about maybe like debt to GDP or something like that or whatever. This is like what you focus on then, and some of your work takes it from a different angle. Yes, talk about the volume, but just sort of the pipes that we have to run it through.

• 5:24Speaker 05

  That's right. And, you know, after that event in 2020, I said it would happen again, dealer balance sheets would get clogged again. But even with the massive amounts of trading we're seeing today, the dealers have more space yet. Could be capital regulations are not as strong, could be the dealers have recapitalized, but they're definitely in force.

• 5:45Tracy Alloway?

  I definitely want to talk more about that, but just on a basic level, when you look at yields on something like the 30-year above 5%, I know they've come in slightly today following the chairman's speech, but when you see a yield at that level, what do you think? What is it telling you?

• 6:01Speaker 05

  Well, if I'm the Secretary of the Treasury, it's telling me that the United States is spending a heck of a lot on interest expense, and I need to do what I can to get those yields down. The question is, what can the Treasury Secretary do? As an economist, I run the following thought experiment. Suppose, Tracy, I were to convince you there's no inflation risk. Inflation, as indicated in today's markets, is pretty stable going forward. The sovereign is not going to default.

• 6:34Speaker 05

  You are, let's say, a hedge fund, a macro hedge fund. You have 20 billion of the 10 years, and.

• 6:43Tracy Alloway?

  I wish, but go on.

• 6:44Speaker 05

  And I'm calling from the Treasury Department, and I'm suggesting that you could take another 10. There's space on your on your own balance sheet to do that. Now, given the conditions that I described for the safe bonds, why wouldn't you? The reason is, you already have what you chose to have at 5.3%, and in order to get you to buy 10 billion more, you need a higher yield to compensate you. The foreign central banks, they have had what they need for a long time now. They're not buying more. Foreign investors generally are not keeping up with the size of the bond market. So it's the discretionary investors, the mutual funds, hedge funds, banks, insurance

• 7:27Speaker 05

  companies, pension funds, that are yield sensitive and are being asked to take more of a pretty safe asset, but they're not going to do it unless they get more yield compensation.

• 7:37Joe Weisenthal?

  It's an interesting way to think about it. So in Tracy's proverbial hedge fund, she has the $20 billion allocation to Treasuries, but no one's paying Tracy just to hold Treasuries, right? So she presumably has a lot of other assets, risky assets. Maybe she's been in Nvidia.

• 7:52Tracy Alloway?

  I've got the best assets, Joe, the best.

• 7:54Joe Weisenthal?

  Maybe she's been in Korean chip stocks or all the other things. When we think about the pricing, though, to what extent does it make sense to think about a Treasury bond being as in competition for other theoretically investable assets? And when all those are flying to the moon, or many of them, like we've seen, does that have a sort of a reverberation onto the risk-free asset?

• 8:17Speaker 05

  Sure it does, and its other bonds included in that. The hyperscalers have famously been demanding a lot of investment by bond investors, and it's all piling on. But the biggest culprit is our governments generally, not just the U.S., but especially the U.S. And government, you know, deficits and debt to GDP are spectacularly high, and there's no end in sight. So this piling on effect, you know, I think it's mainly in the bond market.

• 8:44Joe Weisenthal?

  Debt to GDP ratios, no end in sight, et cetera, certainly, that seems right. People could have said that five or six years ago. Well, they could have said that 2018, 2019, and they said it for years about Japan, and just rates kept going lower. Now, now they're going higher. But they said they kept going lower. What is it? What changed? Like, you could have told this story 10 years ago, and you could have laid out the demographics, and you could have talked about the lack of political appetite to cut spending, et cetera. What changed fundamentally such that we got this reversal?

• 9:17Speaker 05

  Okay, so let's go back even further.

• 9:19Joe Weisenthal?

  Great.

• 9:19Speaker 05

  To when the IMF said 60% debt to GDP is the red line.

• 9:23Joe Weisenthal?

  Yeah.

• 9:24Speaker 05

  You should not want to go beyond that, and if you do, it's at your own risk. That number just kept getting higher and higher for all major governments. France now is also at 100% debt to GDP. So what's changed is the sheer volume of government debt relative to GDP, it marches on and on. 10 years ago, it wasn't anywhere near 100%, and the Treasury market was, let's see, if I recall, about 18 trillion. Now it's 31 trillion. So it's just volume. It's not, I mean, we, as Ken Rogoff remarked at lunch, there's a lot of regression to the mean in terms of long-term yields, and things come and go, but what's been coming is more and more bond debt.

• 10:08Tracy Alloway?

  Yeah, can you say more about this idea of competition with hyperscalers? Because I see, some people seem to take it as a given, like the hyperscalers are issuing so much debt into the market, particularly longer-term debt, that like, it obviously has this crowding out effect. But then I see some other people, and they'll be like, oh, no, the buyers of U.S. Treasuries are different to the buyers of investment-grade bonds, and there's no way they're in competition with each other. But to me, it feels like the overall theme of the bond market right now is this additional duration that investors have to absorb.

• 10:40Speaker 05

  No, that's absolutely right. And I wouldn't describe it as the hyperscalers crowding out the Treasury Department, but rather the other way around.

• 10:46Tracy Alloway?

  Oh, interesting.

• 10:47Speaker 05

  Yeah, I mean, 32 trillion and and rising at 2 trillion a year. There's nothing, I mean, it is true, hyperscalers are perhaps going to hit a trillion of debt in the next couple of years. That's small compared to the Treasury Department. So I, you know, I really think it's the Treasury, and not just the U.S. Treasury, foreign finance ministries and legislatures around the world that are stuffing a lot of bonds into the hands of the same investors. Yeah, pension funds, insurance companies, they'll buy all of this and they make trade offs.

• 11:23Speaker 05

  And we see what's happening to yields.

• 11:25Joe Weisenthal?

  I just thought of a great idea for a sci fi story in which essentially the giant government debt loads, collapsed governments and these, you know, these AI building companies become the new sovereign.

• 11:38Tracy Alloway?

  That's what I've been saying. So that's in Margaret Atwood, one of Margaret Atwood's books. It's the companies basically replace the governments and you live in a corporate compound and everything is provided to you by the tech company.

• 11:50Joe Weisenthal?

  And the Claude yield and the Gemini yield. And those will be our new risk free. Boy, I want to get back to one more thing. So I get all of this, what you're saying. One word that hasn't come up, though, is inflation. And so when I think like a big difference between seven or eight years ago and now is that there's continued to be high inflation, years above target. And it turned out it was even a very aggressive rate hiking cycle, didn't get it back to target. Why couldn't it simply be that the reason for higher rates is the series of higher short term rates as expected? Because there are a lot of inflationary impulses. One among them may be spending.

• 12:32Speaker 05

  In the long run, inflation and bond prices go together. Fiscal theory of the price level. Read John Cochrane's book or maybe you have.

• 12:40Joe Weisenthal?

  We've never had John on the podcast. We really should do that.

• 12:43Speaker 05

  He would be perfect on this question. But today, if you look at forward implied inflation numbers coming from real and nominal bonds.

• 12:52Joe Weisenthal?

  Yeah.

• 12:53Speaker 05

  They're not showing alarm bells at all. It's true that we've had significantly more inflation than the Fed would like to see for the last five years. And as Kevin Warsh remarked this morning and others have spoken, the last part is a lot of work remaining to be done by the Fed. So yeah, inflation is a concern, but I don't. My view, I don't think that's what bond investors that are thinking about the 10s, 20s and 30 years, what's foremost on their mind? I think they're looking at the supply relative to the demand. Again, foreign central banks have had all that they need and they're not buying more. And it's mostly domestic discretionary investors

• 13:36Speaker 05

  that are being asked to take this additional supply and they just need more compensation.

• 13:56Joe Weisenthal?

  There are some market stories where you want every detail. Tracy and I have made quite a few podcasts on that basis, but sometimes you've only got 10 minutes and need to know what's moving markets and why. That's the Barclays Brief Podcast. Every week, experts from Barclays Markets and Research get you up to speed on what matters and what to watch next. About the time it takes to grab a coffee. So search Barclays Brief wherever you get your podcasts.

• 14:20Speaker 01

  Some people treat ChatGPT like some kind of smart search engine and some use it to get work done. ChatGPT work is a new way of working in ChatGPT that can take action across your apps and files, stay with a project for hours if needed and turn a goal into finished work. It's designed to help you move from a chaotic starting point to a reviewable first version. So all the source materials, briefs and scattered information that you have to grind through to turn into something useful can just become something useful. Put ChatGPT to work on your most ambitious ideas and projects. Get started at chatgpt.com by selecting work mode, available on plus and pro plans.

• 15:02Speaker 06

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• 15:29Speaker 06

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• 15:33Tracy Alloway?

  This is kind of a cliched question, but that deluge of debt issuance, I guess, what does that actually mean for central bankers? Because when you come to a conference like this, it feels like that's the obvious thing in the mix. And you hear little whispers of words like fiscal dominance, but no one actually talks about it in any direct way.

• 15:55Speaker 05

  Yeah, I think the Fed is studiously avoiding fiscal dominance. It would not entertain a discussion with the Treasury regarding yield curve control. The last time that happened, it was a very acrimonious end in the 1950s with the Treasury, the Fed Treasury Accord. People think the word accord means they had a good agreement. It actually means they had a really, really rough argument.

• 16:17Joe Weisenthal?

  Interesting.

• 16:18Speaker 05

  And the Fed supplied some support to the bond market, kicking and screaming for a short period of time and then got out of the business of yield curve control. And it won't want to revisit that.

• 16:31Speaker 05

  They'll, the Fed, the FOMC will do everything possible not to get into fiscal dominance.

• 16:39Speaker 05

  So I think that's, that's my reaction.

• 16:41Tracy Alloway?

  So one of the reasons we wanted to speak to you is because you've done work on the impact of Treasury buyback programs in particular. And of course, I guess, was it a week or two ago? I've lost all sense of time, but recently we had.

• 16:54Joe Weisenthal?

  Over the last two weeks.

• 16:55Tracy Alloway?

  Yeah, we had Scott Beson announcing that he was increasing the size of the Treasury's buyback program. He cited liquidity concerns, but as far as I can tell, things looked pretty normal in the Treasury market at that moment in time. What do you think his thinking was?

• 17:12Speaker 05

  Well, from, from his remarks, he seemed to think that yields were too high irrespective of liquidity concerns. And that in his view, market participants should have understood that a lower yield for the US Treasury securities would be appropriate. And he said that he was signaling, he used the word signal, signaling to the market his belief that Treasury yields were too high. Now, I think we subsequently can see that while the market reacted quickly to that news, it reversed itself pretty quickly afterwards. Part of that related to the firepower of the Treasury Department relative to the bond market. I'm sure you remember James Carville's famous comments

• 17:57Speaker 05

  about the power of the bond market.

• 18:00Tracy Alloway?

  Anyone who has ever written about the bond market has used this quote as the lead for a column at some point, myself included.

• 18:06Speaker 05

  Yeah.

• 18:07Joe Weisenthal?

  Did you see what Trump said?

• 18:08Tracy Alloway?

  Oh, yeah, about military intervention.

• 18:10Joe Weisenthal?

  Military intervention in the bond market. So I don't know, maybe James Carville wasn't thinking fully that the bond vigil had not, James Carville had not considered that the bond vigilantes could be bombed into submission potentially. I don't know if he thought about that one.

• 18:26Speaker 05

  Well, even the mighty US Treasury Department is not as powerful as bond markets when it comes to setting yields.

• 18:32Joe Weisenthal?

  Yeah.

• 18:32Speaker 05

  We also saw in the, in the yen intervention, some signals that perhaps first we have a more activist Treasury Department than we've had in the past in terms of willingness to engage in financial market trades. And secondly, that there might be some concern that if things don't go well in Japan and the Japanese central bank needs to unload Treasuries, that that would add on to this piling on that we just discussed and cause problems for US Treasury, Treasury markets and the interest expense of the US government. So my impression, maybe I'm reading too much between the lines, is that Secretary Beson wanted the market to understand that the Treasury Department wasn't just going to sit there idly

• 19:15Speaker 05

  and, and take that, they wanted to be involved.

• 19:19Joe Weisenthal?

  I feel like classical discussions of interventions, they seem to work better when they're not volume bound by, but by level bound. And when it seems often the case when they're level bound, you don't even have to spend anything. So you say, okay, 5% is our line in the sand. And in theory, doesn't the Treasury have, it could just issue two year bills and just take out the 30s. Would that, I mean, if Beson very strongly feels that it's like these prices just do not, on some fundamental level, do not make sense. Could he just say, you know what? We're going to issue only two years or five years or whatever. We're going to buy 30 years anytime they get to 4.99%. And if you're a bond vigilante and you're thinking

• 20:03Joe Weisenthal?

  it's going to go earshorting, that you're going to get badly burnt.

• 20:08Speaker 05

  Well, that would be a formula for increasing the interest rate expense volatility for the US government because your debt maturity is going to be shorter and shorter.

• 20:18Joe Weisenthal?

  Right.

• 20:19Speaker 05

  And you're going to be rolling over that debt in auctions that will reflect current market conditions and a larger and larger fraction of your interest expense is going to be realized on a day-to-day basis. So that's, uh, US is still in pretty good shape. It has an average debt maturity of about six years. I also, you know, have the view that governments are just not powerful enough to control these trends with their own, you know, resources. Let's go back to the attack on the British pound that, in which Scott Beson had a role in 1992 when he was working with the Soros hedge fund.

• 21:03Speaker 05

  The British government was simply unable to defend the pound and it should never have tried. It used up a lot of its firepower that way. And so even, as I said, the US Treasury Department, if markets decide that yields are going to be at 6%, the US Treasury Department is not going to be able to have a strong say in that, not without, you know, taking a lot of risk.

• 21:23Joe Weisenthal?

  Yeah.

• 21:24Tracy Alloway?

  What is your research actually say about, I guess, the impact and duration of Treasury buybacks? Because this isn't the first time the Treasury is doing this. There's plenty of empirical instances that you can base your research on. What have you found previously?

• 21:38Speaker 05

  Well, I'm working right now with two economists at the Federal Reserve Bank of New York, Michael Fleming and Ora Shakhar, and with my PhD student at Stanford, Sam Witterly. And we are using the buyback data as well as turnover data on dealer balance sheets to understand the benefit of the original purpose of the buyback program, which is to go out and clean up the leftover bits and pieces of old Treasury notes and bonds.

• 22:10Joe Weisenthal?

  Odd lots.

• 22:11Speaker 05

  Odd lots, yeah.

• 22:11Tracy Alloway?

  But this was stuff that actually wasn't really trading anymore, right?

• 22:15Speaker 05

  Yeah, it was clogging up dealer balance sheets and trading at lower prices than would be suggested by a smooth yield curve. And so the idea was, as explained by then Assistant Treasury Secretary Josh Frost, let's be regular and predictable and clean up these bits and pieces, make the Treasury market more liquid by replacing those with new liquid Treasuries and implicitly make some money for the US taxpayer by buy low, sell high. And that's a good program. Our research shows, well, it's in progress. You'll see the paper eventually.

• 22:50Joe Weisenthal?

  We'll have you back out. Yeah. Your PhD student can come back on for that.

• 22:54Speaker 05

  It shows that that's effective. And by the way, I think it's totally legitimate that a Treasury Secretary or Treasury Department would step into the market and use the buyback program for unanticipated needs. So for example, going back to March 2020.

• 23:07Joe Weisenthal?

  Yeah.

• 23:09Speaker 05

  It's totally legitimate that a finance ministry or Treasury Department would say, it's our bond market, it's dysfunctional, it benefits us to step into that market and not leave it entirely to the central bank. You may remember the Liz Truss budget.

• 23:24Tracy Alloway?

  Vaguely, yes.

• 23:25Joe Weisenthal?

  Vaguely, yeah.

• 23:26Speaker 05

  At that time, the Bank of England faced this dilemma. It was tightening its monetary policy and at the same time it had to buy gilts. And so it made a very clear distinction and soon afterwards sold those gilts. It's easier if the Treasury Department is involved. In the case of the UK, it indemnified the Bank of England for the losses that it might have incurred. And in the case of the United States, the Treasury Department could use its own buyback program to add firepower. And that could be done on a scale of hundreds of billions, not the mere four to eight billion that the Treasury Department has been speaking about over the last couple of weeks.

• 24:05Joe Weisenthal?

  But from your perspective, in the last few weeks, there's nothing in the sort of classical, uh, classical measures of liquidity that were out of whack?

• 24:14Speaker 05

  No, nothing, nothing. You know, dealer balance sheets seem to be in good shape.

• 24:19Joe Weisenthal?

  Okay.

• 24:19Speaker 05

  Bit offer spreads, market depth are in normal range.

• 24:38Speaker 01

  Some people treat ChatGPT like some kind of smart search engine and some use it to get work done. ChatGPT work is a new way of working in ChatGPT that can take action across your apps and files, stay with a project for hours if needed, and turn a goal into finished work. It's designed to help you move from a chaotic starting point to a reviewable first version. So all the source materials, briefs and scattered information that you have to grind through to turn into something useful can just become something useful. Put ChatGPT to work on your most ambitious ideas and projects. Get started at chatgpt.com by selecting work mode, available on Plus and Pro plans.

• 25:20Speaker 06

  This is Robert Smith from Business History. If you're listening to this, there's a good chance you're a small business owner. And like every small business owner, you started with a dream to do what you love and watch it grow. What you probably didn't dream about, keeping up with cyber threats. That's where Mastercard can help with access to tools that help identify cyber threats to better protect your business. Building your dream business, priceless. For cybersecurity in a changing world, there's Mastercard. Learn more at mastercard.com/smallbusiness.

• 25:50Speaker 07

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• 26:50Joe Weisenthal?

  I mean, one way to think about it is, it's not that different from QE or Operation Twist as some of these things that the central bank did in the 2010s to sort of change the shape or the slope of the yield curve. But that was in a time of below target inflation and a central bank trying to cause things to re-accelerate. But on some level, does this look like efforts that classically would, you might expect to see in an environment where the central bank is trying to goose inflation?

• 27:23Speaker 05

  When you say this, meaning what action?

• 27:26Joe Weisenthal?

  The sort of, uh, the, um, the expanded buybacks, the attempt to depress the long end.

• 27:31Speaker 05

  Oh, yeah.

• 27:31Joe Weisenthal?

  That sort of looks Operation Twist-y. But that had, you know, that was in an environment where we were sub 2% of that, to the frustration of the central bank.

• 27:40Speaker 05

  Yeah, so, uh, well, first of all, I don't think this is stepping on the toes of the Fed.

• 27:43Joe Weisenthal?

  Okay.

• 27:44Speaker 05

  And, uh, I, I do think that it feels like a Twist-y type of operation, but a micro twist.

• 27:50Joe Weisenthal?

  Okay.

• 27:51Speaker 05

  The firepower that, you know, a few billion dollars, other than the signaling, a few billion dollars is just not going to move the needle.

• 27:58Tracy Alloway?

  Micro twist sounds like one of those terrible Alco Pops of like the early 2000s, right?

• 28:02Speaker 05

  I was thinking, maybe it sounds like a dance.

• 28:04Joe Weisenthal?

  I would try a micro twist.

• 28:05Tracy Alloway?

  Okay. Well, okay, but if, if the Treasury is issuing more short-term debt, which it is, does, does that solve the long-end yield problem or does that just end up shifting the issue into money markets?

• 28:19Speaker 05

  Well, it does shift issuance into bills and that's how buybacks are working with, with these particular buyback, these particular operations. And yeah, so it means, as I mentioned, there's, uh, shorter and shorter debt maturity, but no alarm bells yet. The US is not out of historical norms. It's actually a little bit longer maturity, average maturity than normal. Uh, and, you know, I'm not that worried yet. I mean, if they were to continue, uh, and really the real action is in new issuance, not in buybacks, if they were to continue to keep the issuance of long-term securities at current levels as they have been and, and have forecasted that they will, if they

• 29:02Speaker 05

  were to keep doing that for years, then the piling up of short-term debt would eventually be notable and it would, it would cause concern.

• 29:10Tracy Alloway?

  All right. So, you know, I talked in the beginning of all these different things that are happening at the moment, but one of them is the new Fed chair and the task forces that he's created, including one that's looking at the Fed balance sheet. Can you maybe put your Kevin Warsh hat on for a second? When he says he wants to shrink the size of the Fed's balance sheet, why is that desirable?

• 29:34Speaker 05

  Well, first, I'm not Kevin Warsh, so I'm not going to get inside his head. But judging from his speech around the G30 meeting last year, which, in which he was most clear on, on his views here, I think he worries that the Fed looks like it's too active in financial markets, that its footprint is too big and that it has the image of,

• 30:02Speaker 05

  Possibly getting into fiscal policy. And so he wants to say completely, my interpretation, he wants to stay clear of having created that impression. And a smaller balance sheet would signal that. The, I think the more interesting question is, how could you do it?

• 30:21Tracy Alloway?

  Yeah.

• 30:22Speaker 05

  Because it's easy enough to sell bonds on the asset side, but it's not easy to extinguish the liabilities on the other side of the balance sheet.

• 30:31Tracy Alloway?

  That's right. When we think about the Fed balance sheet, everyone always thinks about assets because we've gone through years and years and years of QE and no one ever thinks about liabilities. But how do you, those two things have to be in balance. You can't shrink the asset side without shrinking the liability side.

• 30:44Speaker 05

  You reached that conclusion, Tracy, faster than almost anyone that I talked to.

• 30:47Tracy Alloway?

  Oh, dear. Okay.

• 30:48Speaker 05

  So if you just do adding up, you know, if you want to reduce the assets, you have to reduce the liabilities one for one. Let's take them in turn. You've got the Treasury general account. I don't think the Fed's going to call the Treasury and say, would you take some money out of your account at the Fed? Then you've got paper money. I don't think the Fed is going to put out advertisements saying,

• 31:08Tracy Alloway?

  Open your wallet, sink it back.

• 31:09Speaker 05

  Please, Americans and everybody else out there in the world that has paper money, would you mind turning it in so that we can reduce that liability? So that the only significant possible reduction is in reserves, meaning the deposits that commercial banks have at the Fed. And there is scope for doing that, but not with the current tools that the Fed has.

• 31:31Joe Weisenthal?

  Would that be a regulatory change that would be necessary? Because we went years and years, right? With basically no balance sheet and then, you know, then 2008 hit and suddenly there's all these reserves. Why can't we go back to, what would it, what would be the challenge of going back to?

• 31:46Tracy Alloway?

  Before Lehman, we didn't have that many reserves.

• 31:47Joe Weisenthal?

  So what would be, what would it take if we, if for some reason we thought, this is very important, we want to get back to the real good old days of Fed balance sheet side? What would it actually take from a regulation perspective to get to just a 2005 looking banking system?

• 32:03Speaker 05

  It's not going to happen, Joe. Because back in 2005, liquidity regulations were much different.

• 32:10Joe Weisenthal?

  Okay.

• 32:10Speaker 05

  And the Fed didn't pay interest on reserves. So the banks were not in the least interested in holding reserves because why would you hold reserves getting zero interest when you could invest the money in money markets and under a full market rate? Today, in order to control inflation, the Fed is forced to pay an interest rate to banks that's roughly the market rate. And so, you know, if you ask a bank, well, why don't you give up some of those reserves? They might say, well, why? They're so useful for meeting liquidity regulations. They pay a full market interest rate. They're, they're perfect for payment services. What, what's not to like? It's the Swiss Army knife of finance. We're not going to give those up easily. And right here in Jackson Hole in 2017,

• 32:53Speaker 05

  Beral Charia and Raghu Rajan presented a paper describing a ratchet effect by which every time the Fed increases its balance sheet and adds reserves, the banks get addicted to having more of that extremely useful asset, reserves, and they're reluctant to give it up. And if you try to make them, markets get volatile and the Fed has to back off. So a lot has changed.

• 33:19Tracy Alloway?

  What would be your recommendation if you were on this task force? I think it's Stein who's heading it. But, you know, if worse says, I want to shrink the size of the balance sheet and we have this reserves problem, what would you do?

• 33:30Speaker 05

  It's Jeremy Stein, Raghu Rajan, the same economist that spoke here about the ratchet effect, and Karen Dinan, all very noted.

• 33:38Joe Weisenthal?

  Yeah.

• 33:38Speaker 05

  Very credible, extremely wise and articulate economists. What they're going to do and what they're going to recommend, I don't know. But I think that they're going to take a very wide lens look at this. They're not going to look only at size. They're going to look at the composition of the assets. I predict that they will, and this is with no information from them. I predict that they will recommend reducing the quantity of long-term Treasury securities that the Fed holds and replacing those with Treasury bills in order to reduce the volatility of the Fed's interest expense. So for example, if you back the reserves one to one with Treasury bills, then every time the Fed has to pay more interest to the banks to control inflation,

• 34:22Speaker 05

  it's getting more interest on their Treasury bills, one for one. Paper money, they could continue to hold long-term securities. And I, I don't think the Fed feels good about having mortgage-backed securities. I think they're just going to let those roll off. So I think that that could be in one area that, that they will get into is the composition of the assets. And on the liability side, it's hard to predict. In my own view, the Fed doesn't need to reduce the size of its balance sheet, but it should have the tools that would allow it to do that. Because if my hunch that this has politics around it is correct, the Fed never wants to be put into a corner by Congress

• 35:05Speaker 05

  over the size of its balance sheet without the tools that would allow the Fed to say, no, we're, we're not going to increase our balance sheet as you would like us to do and buy the assets that you would like us to buy. But rather, we can control our own balance sheet by reducing it if we need to. And those tools exist in theory, but they haven't been developed and practiced by the Fed yet. They have been for other central banks.

• 35:35Tracy Alloway?

  I have one more question, and it's not really a question. It's more of a favor, really. But can you, can you convince Joe that the term premium is a useful concept? He doesn't believe in it. I think you believe it exists, but you don't believe that it's useful in any way.

• 35:53Speaker 05

  You're not going to defend yourself, Joe?

• 35:56Joe Weisenthal?

  I'm a simple man. I look at a 30-year yield. I think it looks like a 30 years' worth of overnight rates. You just add them up and I just, you know, that's, that's how, that's how, what I assume. But then everyone's like, no, but the term premium. And then they say, and then I say, okay, but what is it? They're like, well, we can't really measure it. And then all the models that we have to measure don't work. But trust us, it exists.

• 36:14Tracy Alloway?

  This is why it's useful.

• 36:15Joe Weisenthal?

  And then they say, and then they say, oh, well, they need, Treasury investors need compensation for risk, to which I say, just Treasury investors? As if there's something special about they, like, I really, I really struggle with it. So this is why we need a Stanford economist to straighten me out.

• 36:31Speaker 05

  It's a, yeah, it's an easily measured concept. And so it tells everyone the value of short-term versus long-term money and interest rates. But then decomposing it is the hard part. So you mentioned, you know, there's the path of expected short-term interest rates. That's built in. That in its, of itself reflects inflation.

• 36:51Joe Weisenthal?

  Right.

• 36:51Speaker 05

  And then on top of that, there's a risk premium. And how to decompose that, you know, economists like John Cochrane, who we mentioned earlier, with Monica Pietrissi, have, you know, done some of the best work on that decomposition. And it changes over time depending on, one of the things that we just discussed earlier, which is the volume of Treasury issuance. That elevates the entire curve and it elevates it more in the future if you don't think that the fiscal deficits are going to go down.

• 37:20Tracy Alloway?

  All right, Joe's going home from this podcast with homework.

• 37:23Joe Weisenthal?

  I'm going to do some reading, yeah.

• 37:24Tracy Alloway?

  Assigned reading. All right, Daryl Duffy from Stanford. Thank you so much for coming back on All Lots. Really appreciate it.

• 37:30Speaker 05

  Tracy, Joe, it's always a pleasure. Ask me back.

• 37:32Joe Weisenthal?

  We will definitely do it again. Thank you so much.

• 37:47Tracy Alloway?

  So Joe, that was great. I know we've been meaning to talk about the Treasury buyback, so I'm glad we could get into that. I was thinking, you know, he mentioned the Treasury general account at the Fed, which is like the Treasury's checking account. And you always hear this stat that it covers five days of government expenses or something like that. And I always think about the headline saying, oh, ordinary Americans, you know, half of ordinary Americans only have enough money to cover three months expenses. And then I'm like, what about the Fed?

• 38:14Joe Weisenthal?

  What about the Treasury?

• 38:15Tracy Alloway?

  I mean, somewhat facetious, sorry, what about the Treasury? But like, it is kind of crazy, five days.

• 38:20Joe Weisenthal?

  Yeah, I guess it is kind of crazy, but you know, just thinking, oh, you should issue more debt.

• 38:25Tracy Alloway?

  What if Trump actually bombs the bond market? What happens to the Treasury's account?

• 38:29Joe Weisenthal?

  It is weird that we actually haven't talked about that quote very much, but such is life.

• 38:34Tracy Alloway?

  Well, find the perfect guest to talk about it.

• 38:35Joe Weisenthal?

  Such is life in 2026. I thought that was really good. I actually did not fully understand previously why buybacks exist in the normal term. Okay, setting aside why there's the deviation from the typical schedule, why they exist in the first place, and this idea that like, what is the point of having these sort of off-the-run, we're, you know, is that some 27-year bond that's sitting out there that no one wants, whatever, that it just sort of makes sense to have a regular, a regular sweep of that. You know, what they call in crypto world?

• 39:07Tracy Alloway?

  What?

• 39:08Joe Weisenthal?

  It's dust. So for example, like,

• 39:10Tracy Alloway?

  Like abandoned assets, kind of.

• 39:12Joe Weisenthal?

  It's kind of like if there'll be little flecks of like 0.0002 Bitcoin on like some wall or something. But because there's a, because there's a transaction fee with all of them, you can accumulate this dust and it's not economical to move it off of them. That creates all kinds of issues and stuff. It's sort of similar.

• 39:31Tracy Alloway?

  I remember, weren't there some startups at one point who were trying to like, collect all the dust?

• 39:35Joe Weisenthal?

  Collect all the dust.

• 39:36Tracy Alloway?

  And roll it up into something substantial?

• 39:38Joe Weisenthal?

  Probably, yeah.

• 39:39Tracy Alloway?

  The other thing I was thinking, just about the buyback program now, is, I mean, you almost have an issue with the reaction function of the Treasury now. If, if it's citing market liquidity in order to increase the size of the buybacks. But the Treasury market seems to be operating pretty normally.

• 40:00Joe Weisenthal?

  Yeah.

• 40:00Tracy Alloway?

  And then everyone starts focusing on the yield. As Daryl was saying, like, oh, it seems like Besen just doesn't think the yield is at the right level. Well, then suddenly you have this target that investors are maybe going to be watching for signs that the Treasury is going to come back in.

• 40:15Joe Weisenthal?

  I think Besen really just misses being a hedge fund. Like, he's like, no, this is like, it's, the yield is too high. It's like an opportunity to buy, right? And you're like intervening in the end and stuff. I think this is like, he's in, he's in his comfort ground when he's making moves like this.

• 40:30Tracy Alloway?

  Well, I will say, as of the moment we're recording, he's probably above water on his Treasury purchases, right?

• 40:36Joe Weisenthal?

  So I thought so too.

• 40:37Tracy Alloway?

  Yeah.

• 40:38Joe Weisenthal?

  Except, so this is what I thought. I was like, oh, this is a good trade. Evidently, the purchases, this is what someone on Twitter, two people on Twitter told me this, because I thought that too.

• 40:47Tracy Alloway?

  That must be true, Joe.

• 40:47Joe Weisenthal?

  The purchases start September 9th. So there was the announcement that came.

• 40:51Tracy Alloway?

  I see.

• 40:52Joe Weisenthal?

  So had he, anyway. But I had that same thought, oh, it's looking like a pretty good trade now.

• 40:57Tracy Alloway?

  All right. Stay tuned for the Odd Lots episode tracking Besen's trade. But shall we leave it there for now?

• 41:01Joe Weisenthal?

  Let's leave it there.

• 41:02Tracy Alloway?

  Okay. This has been another episode of the Odd Lots Podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway.

• 41:07Joe Weisenthal?

  And I'm Joe Weisenthal. You can follow me at TheStalwart. Follow our producers, Carmen Rodriguez at Carmen Armin, Dashal Bennett at Dashbot, Kao Brooks at Kao Brooks, and Kevin Lozano at Kevin Lloyd Lozano.

• 41:19Tracy Alloway?

  And for more Odd Lots content, you should check out our daily newsletter. You can find that at Bloomberg.com/oddlots.

• 41:24Joe Weisenthal?

  And you can chat about all of these things 24/7 in our Discord, discord.gg/oddlots.

• 41:30Tracy Alloway?

  And if you enjoyed this conversation, then please leave a comment or like the video, or better yet, subscribe.

• 41:36Joe Weisenthal?

  Thanks for watching and listening.

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