Why Treasuries Are 'Risky' Again

We all know that US Treasury yields have been surging, alongside bond yields all around the world. So what explains the selloff and does this mean that bonds are becoming fundamentally riskier? What happens if investors can no longer hedge stocks with government debt? And how do expectations of the Federal Reserve's "reaction function" fit in? In this episode, we speak with Carolin Pflueger, associate professor at the University of Chicago and a resident scholar at the Chicago Fed Bank, about her work on the bond market and central banks. We discuss why bonds have become more stock-like, what that means for yields, and the role of the Fed's credibility in making bonds “bond-like” again. See Odd Lots Live in Chicago! https://events.bloombergevents.com/event/OddLotsLiveChicago/summary 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

  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.

• 1:07Speaker 02

  If you listen to financial news, you know a lot of time is spent thinking about what's next. The next opportunity, the next investment, the next move. But sometimes what matters most is being ready for what you never saw coming. For more than 75 years, Cincinnati Insurance has worked with independent agents to help protect businesses, homes, valuables, and more. Because planning for the future isn't only about knowing what's next. It's about making sure you're ready for what you can't predict. Let Cincinnati Insurance make your bad day better. Find an independent agent at C I N F I N dot com.

• 1:44Joe Weisenthal?

  Hey, Odd Lots listeners. The Odd Lots tour continues, and our next stop is in Chicago.

• 1:48Tracy Alloway?

  That's right. Joe and I will be at the City Winery Chicago on October 15th for a live Odd Lots recording. Tickets are on sale now at Bloomberg dot com forward slash Odd Lots.

• 1:59Joe Weisenthal?

  And of course, a special thank you to Barclays for supporting Odd Lots Live.

• 2:03Tracy Alloway?

  So that's October 15th at City Winery in Chicago. Get your tickets now.

• 2:11Speaker 04

  Bloomberg Audio Studios, podcasts, radio, news.

• 2:26Tracy Alloway?

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

• 2:30Joe Weisenthal?

  And I'm Joe Weisenthal.

• 2:32Tracy Alloway?

  Joe, we're back in New York.

• 2:34Joe Weisenthal?

  Yeah.

• 2:34Tracy Alloway?

  But the Jackson Hole episodes continue.

• 2:38Joe Weisenthal?

  That's true. You know what, by the way, oh, my gosh. The 30-year rate, by the way.

• 2:43Tracy Alloway?

  Yeah.

• 2:44Joe Weisenthal?

  So it's just straight up the last few weeks, but it's right around as of the time that we're recording this. It's at 5.592. It has now hit the highest level since 2002.

• 2:56Tracy Alloway?

  Wow.

• 2:56Joe Weisenthal?

  So a few weeks ago, we were looking at the yield curve and saying, oh, they say, oh, now highest level since 2007. And then like it was 2004 was the other year, and now we're getting highest since 2002. It really is both extraordinary speed and scale.

• 3:11Tracy Alloway?

  Yeah. And the other thing that happened since Jackson Hole is we had a Fed rate hike.

• 3:16Joe Weisenthal?

  We had a Fed rate.

• 3:17Tracy Alloway?

  And yet yields continue to soar. And so there's an open question over whether or not that rate hike is having its intended effect in terms of dampening down financial conditions, things like that. And another big thing in the background, I feel like I have to list all these.

• 3:35Joe Weisenthal?

  All the big things in the background. Yeah, yeah.

• 3:37Tracy Alloway?

  But the other big thing is there's been this ongoing debate over Fed's communication style. The new communication framework. What does credibility mean when a central bank is in an inflation fighting environment and things like that? We have to talk about all this.

• 3:52Joe Weisenthal?

  Yeah, it's when you said another thing in the backdrop.

• 3:56Tracy Alloway?

  There's another one.

• 3:57Joe Weisenthal?

  Which of these, well, I was like, which of the many things are you going to choose here? Because you could have said, oh, you know, this is against the backdrop of large deficits, against the backdrop of AI spending and the fact that big hyperscalers are spending it and borrowing at rates that are like the size of like pretty big nations. You could have said in the backdrop of longstanding questions about US global hegemony and the link between war and the dollar and so forth, et cetera. And so there are many backdrops.

• 4:29Tracy Alloway?

  Yeah.

• 4:30Joe Weisenthal?

  There are infinite backdrops.

• 4:30Tracy Alloway?

  I could have gone on for a while, but I chose not to. No, there's so much going on at the moment.

• 4:34Joe Weisenthal?

  But it all that all relates to rates.

• 4:36Tracy Alloway?

  It all relates to rates, and we do, in fact, have the perfect guest, someone who can opine and share her research on many of these things. We're going to be speaking with Carolyn Fluger. She is an associate professor at the University of Chicago Harris School of Public Policy, as well as a visiting scholar over at the Chicago Fed. And she presented a very famous paper at Jackson Hole a couple of years ago. We didn't get a chance to talk to her when we were in Jackson Hole, but we're going to make it up right now. So Carolyn, thank you so much for coming on Odd Lots.

• 5:08Speaker 05

  Thank you for having me. It's really great to be here.

• 5:10Tracy Alloway?

  Why don't you give us the sort of 3,000-foot overview of your research? What's your specialty here?

• 5:17Speaker 05

  So most broadly, I'm interested in how the macroeconomy, monetary policy, and inflation are reflected in bond markets and are in turn shaped by them. I think that's a pretty interesting topic because.

• 5:30Joe Weisenthal?

  We do, too.

• 5:32Speaker 05

  You know, to me, the macroeconomy, inflation, unemployment, those are the big questions. They're not easy to answer, but that makes it all the more intriguing to me. And of course, financial markets are unique in that they're sophisticated, they're forward-looking. So a lot of these things get priced in, and that's what I find very interesting.

• 5:49Joe Weisenthal?

  You said that you think about the way various things get reflected in the bond market, but then also how the bond market then reflects back on to, quote, "the real economy" or "the real world" or whatever. That part doesn't get discussed as much at CIN. It seems like, for the most part, people, when they think about the link between the real economy and the bond market, it seems like they mostly make, you know, it goes in one direction. So it's interesting to me that you said reflected back.

• 6:16Speaker 05

  Yes. So that brings me to my research on the policy reaction function. Now, what is a policy reaction function, just as a quick definition? Most simply, that's what markets or observers more broadly expect the Fed to do in response to economic conditions. So as a numerical example, if forecasters expect 2% inflation, they might forecast a 4% policy rate. If they expect 4% inflation, they might expect a 6% policy rate. So that would be a one-for-one adjustment, a perceived policy reaction coefficient of one.

• 6:57Speaker 05

  And that will, that matters, this policy reaction function matters for at least two reasons. And one of them comes back to your question, this reflection back, which is that if the policy reaction function is well-understood, then that means that as data comes out, unemployment, inflation, and so on, the policy rates will move in the direction that the Fed intended and thereby help with monetary policy transmission, or maybe even speed it up before the next FOMC meeting.

• 7:27Tracy Alloway?

  So this is the market doing, quote, "the Fed's work for it," potentially.

• 7:31Speaker 05

  Correct. Yes.

• 7:32Joe Weisenthal?

  But if, when you say only if the reaction function is understood.

• 7:37Speaker 05

  Correct. That's, that's why the understanding is important, right? So if there is, you know, whatever the intended policy reaction function is, you know, if it's well-understood, markets will adjust in response to inflation news coming out and unemployment news coming out and so on.

• 7:55Tracy Alloway?

  How are you actually measuring how the market incorporates its future expectations of Fed policy? Because there are a number of ways that you could do it, you know, some obvious ones, but what are you looking at specifically?

• 8:07Speaker 05

  Yes, that's a great question. I mean, I think the main point is that a policy reaction function can and should be measured. And what my co-authors and I have done, I will think of, is actually the most obvious way of doing it, which is, I think, always a good starting point. So this is joint work with my co-authors, Michael Bauer at the San Francisco Fed and Adi Sundaram at Harvard Business School. So we took two approaches. The first one is based on forecasts. We didn't run our own surveys because we wanted to know, you know, how have these perceptions changed over time, historically, over decades?

• 8:46Speaker 05

  And, you know, a policy reaction function is quite similar to a 1993-type Taylor rule, but there are important differences. The first difference is that it's forward-looking. So it's about expectations. The second difference is that it's a little bit shorter run. It's about the next couple of quarters, at most, the next couple of years. And traditional monetary policy rules are used to describe historical data in a backward-looking manner. What we said is, hang on, rather than using this historical data, let's just use forecasts, survey data, interest rate forecasts.

• 9:28Speaker 05

  And it turns out that every month, there's a lot of richness in terms of the forecasts that are being produced for the policy rate. And so we use this data from the blue chip of financial forecasters, which asks, what is your forecast for the Fed funds rate? And what are the underlying assumptions that you used for inflation and output to come up with this policy rate forecast? So it's, in a way, it's an ideal setup because it's asking, what is the rule for the Fed that you're plugging in? And so we just took this, this data that's forward-looking, you know, 30 to 50 forecasters, a couple of forecast horizons, up to six quarters out.

• 10:11Speaker 05

  And we ran the exact same regression that you would run for a monetary policy rule, but, you know, on this different data, forward-looking data. So, yeah, if you basically treat this, we can't run experiments on the macroeconomy, but if you treat this data as the best approximation of. An experiment on the macroeconomy, you know, we ran a regression of the forecasted Fed funds rate onto forecasted inflation and forecasted output relative to potential. And so the coefficients there on inflation would tell us when forecasters are forecasting high inflation, how much higher is the expected Fed funds rate and vice versa, for example.

• 10:55Speaker 05

  So that's the first methodology. The second one is closer to what I said about the macroeconomic announcement dates and rates moving in response. That's what you can use that also to obtain a market perceived rule. Just to say if inflation comes out higher or lower than expected, let's say inflation comes out higher than expected and interest rates, say the two-year rate goes up, goes up a lot. Then, you know, that is also a regression that we run. You need a couple of observations, of course. It's a rolling window. But you can run this regression of how much do yields change onto what's the inflation use on that day?

• 11:41Speaker 05

  And that gives another way of getting a perceived reaction function. It turns out that both of these methodologies often give very similar answers. And I love that because it makes me a lot more comfortable with either methodology.

• 11:55Joe Weisenthal?

  So one thing I'm curious about is, okay, you know, you look at market reactions and you get, there's one number there, right? There's a lot of different views in the market, but it's one number. Whereas if you're doing a survey, you're going to get, you know, you can average them together, but you can see all the different views. Something I'm curious about with the surveys or anything is whether we see historical changes over time with respect to, I suppose, the spread or the dispersion of views. Are there times where people in the market have, you know, there's a clear consensus of what market participants or forecasters perceive the reaction function to be?

• 12:38Joe Weisenthal?

  And are there times that we can point to where there is a lot of ambiguity on the part of market participants?

• 12:45Speaker 05

  Yes, that's, that's interesting. So we have focused on the variation over time in the point estimate of the reaction function.

• 12:56Joe Weisenthal?

  Got it.

• 12:57Speaker 05

  There clearly is a lot of heterogeneity across forecasters. We've looked at that a little bit, but we've really focused on how does it vary over time?

• 13:05Joe Weisenthal?

  Got it.

• 13:06Speaker 05

  But, you know, as one example, when there was a lot of agreement, you know, after late 2011 was when the Fed came out and gave very clear date-based forward guidance. Interest rates will be at zero at least until mid 2013. At that point, all the Fed funds rate forecasts collapsed to zero. And, you know, you see absolutely no dispersion. So that would be an example where, where that collapsed.

• 13:31Tracy Alloway?

  So what moves the needle when it comes to the market's policy reaction function? Is it, you know, the Fed actually doing something and raising or lowering rates? Or is it forward guidance? Is it having a press conference where they answer a question particularly well or badly? What do you observe in terms of what actually moves the needle?

• 13:53Speaker 05

  Great question. And that's, that's a question that my co-authors and I thought a lot about. I think, you know, just having measurement is extremely useful, whichever approach you choose, right? So in order, picking a framework or picking a communication strategy, evaluating it, I think is very important. So now what we looked at in terms of what moves the, the needle on the perceived reaction function? Let me take you back to 2020. It was not a good time for any of us. But so that was the time of the pandemic. Initially, inflation was extremely low. And in 2021, inflation then picked up. And there were some of these really big positive inflation surprises.

• 14:39Speaker 05

  And that was also the time where there was the discussion of, you know, is inflation permanent? Is it transitory initially?

• 14:46Tracy Alloway?

  The T word. We need to get a transitory clock.

• 14:48Joe Weisenthal?

  Yeah, yeah. Foreign.

• 14:49Speaker 05

  Yeah. The Fed initially just kept interest rates at zero. It was also the time when there was this now old new framework of average inflation targeting.

• 15:00Joe Weisenthal?

  Yeah.

• 15:01Speaker 05

  In 2021, yeah. So the, the interest rates stayed at zero for, for quite a while, even though inflation was running at five, six percent.

• 15:14Speaker 05

  And the perceived reaction function that we saw at that time was extremely flat. So there was a perception that, that the policy rate would stay at zero pretty much irrespective of economic conditions. And you saw that, for example, in May 2021, that was a particularly positive inflation surprise. That was an inflation surprise of almost half a percent. So annualized, the surprise component was six percent. That's huge.

• 15:48Tracy Alloway?

  Yeah.

• 15:48Speaker 05

  And the two-year rate didn't move, not at all. And you also saw that in the forecasts, which were all very, very close to zero. And that was true for the forecasters who had higher inflation expectations. That was true for the ones who had lower inflation expectations. So that's a little bit the nice thing about our data set. Because of course, there was a very big good ship transitory, as Powell called it at some point at the time. A lot of, lot of people thought inflation was transitory, but not everyone. And by looking at this set of different forecasters, we can also see the ones who thought that inflation would be higher. And all of them expected zero interest rates.

• 16:30Speaker 05

  And that, I think, is quite telling about, you know, the response that, that was anticipated at the time. And so then, you know, towards the end of 2021, the tone started to change and March 2022 was lift off. At first, just 25 basis points. And then we saw these really, really big interest rate hikes repeatedly. And so after the Fed started to act, that's when in our data, we see that the perceived inflation response really picks up. It basically goes from zero to one between, say, early 2022 towards the end of 2023. So there was a very big increase in the perceived inflation response,

• 17:15Speaker 05

  but it occurred late and only after the Fed had started to act. So we call that the learning from actions channel.

• 17:38Tracy 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.

• 18:03Speaker 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.

• 18:45Speaker 06

  The world of business is constantly evolving. Every day, new challenges, new opportunities, new ways of working. Comcast Business keeps you totally in step with secure AI-backed networking built to power the way modern business gets things done today in more than 100 countries around the world. That's some serious muscle. And get this, Comcast Business powers over 90% of the Fortune 500 and millions of small businesses. Behind it all, network engineers, cybersecurity specialists, support teams, thousands of experts answering your call at 2:00 AM like it's 2:00 PM, always on, always ready. That's a lot of coffee. One partner powering how business gets done

• 19:30Speaker 06

  for companies of every size, all around the globe. When you add it all up, no one does business like Comcast Business.

• 19:38Speaker 07

  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.

• 20:05Speaker 07

  Learn more at mastercard.com/smallbusiness.

• 20:09Joe Weisenthal?

  In a dream country that executes perfect monetary policy all the time, does it have a perfectly stable reaction function in central bank?

• 20:20Speaker 05

  That's a good question, and that goes back to, I think, the difference between a monetary policy rule and a reaction function.

• 20:28Joe Weisenthal?

  Right, right.

• 20:28Speaker 05

  I don't think it has to be a stable, it doesn't have to be perfectly stable over time. It also goes back to this much older discussion about rules versus discretion, right? If it was just a mechanical rule, then, you know, why are central banks needed at all? So there is, you know, their conditions change. I don't think it needs to be stable and, you know, the appropriate reaction may be different at different points in time. Actually, what we see in our data, we do a very simple exploration. We have an earlier paper in the Quarterly Journal of Economics, also with Michael and

• 21:11Speaker 05

  Adi, where we look at a longer time series of the perceived reaction to output. And we see that it varies over time and we try to systematize a little bit. When is this perceived reaction to output steep? When is it flat? And what we find is that it tends to be steeper during tightening cycles. So that's when Chair Bernanke or Yellen would have said, we're going to be quite data dependent. And you see that in the data in that there is a stronger perceived response to output, whereas easings are often sudden and then not much else is expected.

• 21:53Speaker 05

  So that that tends to be a time when the perceived policy reaction becomes flatter.

• 21:59Tracy Alloway?

  So if if the market's perceived reaction function moves the most when when a central bank is actually doing something, so they're taking an action rather than perhaps just talking about it, what happens if a central bank wants to be gradual in terms of raising rates? Because we all remember 2022, the big liftoff, that was a pretty painful time for markets. Is there just an accepted trade off here where maybe you have to show the market that you're serious about inflation by actually doing something? And that helps the market change its perceived market function or its perceived policy function?

• 22:40Tracy Alloway?

  And then that helps with actually fighting inflation, but the offset or the trade off is that, you know, stocks are going to go down or there might be financial stability issues or something like that?

• 22:53Speaker 05

  Yes, that's, that's very interesting. That gets me to a different branch of my research, which is, which is about the risks in treasury bond markets. You know, I've worked on that for a long time going back. And a fact that you may be aware of, but many people aren't, is that treasury bonds were not always safe historically. So there were periods, especially during the 70s, 80s and 90s, when treasury bonds were viewed as quite risky. That was the period of bond market vigilantes, the inflation risk premium.

• 23:34Speaker 05

  And the way I measure that in the data is through the co-movement between bonds and stocks. So so pre 2000 treasury bonds were actually quite stock-like, if you will, in their correlation with the bond market. And that's a recent paper with John Campbell and Luis Vissera at Harvard. Now, post 2000 treasury bonds were safe in the sense that they had a negative correlation with the stock market. And then in the most recent period, these types of bond risks have gone up again. There are many ways, many reasons to care about this type of bond risk.

• 24:15Speaker 05

  Most simply, if you're holding a portfolio that contains bond and stocks, having a positive correlation means that there is nowhere to hide.

• 24:24Joe Weisenthal?

  Right.

• 24:25Tracy Alloway?

  Another reason why 2022 was so painful.

• 24:28Speaker 05

  That's right. And I think that is connected to monetary policy. So in the research that I've done on that, you know, I've asked, what has changed in these bond risks? Is it nominal? Is it real? Why has it changed? Can we attribute it to deeper forces, the nature of shocks, luck versus policy? And what does it mean for yields going forward? Or not necessarily going forward, but just what does it mean for yields? What I've found in this research is that inflation, the inflation component in nominal bonds plays an important role. That's a very natural decomposition.

• 25:09Speaker 05

  So the US Treasury issues regular nominal bonds, which pay $100 10 years in the future. And then it also issues bonds that pay $100 increased by the inflation index 10 years in the future. And that means if you hold these inflation index bonds or TIPS, you don't really need to fear inflation. Whereas when you hold nominal bonds, that's of course exposed.

• 25:35Tracy Alloway?

  Right.

• 25:36Speaker 05

  And so if you look over time, the bond risks were so positive in the pre 2000 period. And for that, actually, I need to go to UK data because they've had inflation-linked bonds for much longer. But in this UK data, you see that a big chunk of these bond risks were on the inflation side. And then post 2000, the inflation component became much smaller and both the nominal and the real treasury bond risks were negative. And then most recently, actually, the increase in bond risks has some similarities and some differences compared to the 1980s. The similarity is that bonds and stocks have moved together.

• 26:20Speaker 05

  Often when we see treasury bond yields going up, the stock market tanks. And but the difference is, A, it's not as big. We're not, we're not back to the 1980s yet, at least according to my data. The other difference is that a good chunk of it, most recently, has been in the index bonds. So it's not necessarily about the inflation component in the same way. So I think to understand the change from the pre 2000 to post 2000, an important component is, is the inflation part. Why is that? Well, in the 1980s, stagflation was the thing that everyone was talking about. If you have a stagflation and you hold nominal bonds, that's terrible.

• 27:04Speaker 05

  Because they become worth less. The recession is terrible for stocks, so then they move together and bonds are risky. Post 2000 recessions tended to be more of the demand variety, which means also that recessions tended to be lower inflation. And so nominal bonds benefit from low inflation. And so then in, in some of my work with, with John and Luis, we have shown that this can explain why treasury bond risks changed around 2000. What the interesting question is that still remains is, of course, you know, is it luck? You know, is this just if we experience supply shocks, is everything going to go back to the 1980s?

• 27:47Speaker 05

  Or is there also a degree of policy to it? So I have then, you know, lots of models and so on. But, you know, the punchline is that it really requires a perfect storm to go back to the 1980s risky bond markets. It requires the inflationary shocks, let's say, supply shocks. The typical one would be oil price shocks, or it could also be fiscal sort of lack of credibility, inflation expectations that start moving. So you need these type of inflationary shocks and you need a Fed that's willing to, willing or forced to accept a recession when these shocks happen.

• 28:32Speaker 05

  And I think that has been a little bit different in the past five years from, from the 1980s in the sense that the Fed has been able to move more gradually. So that's the big, that's really, I think of it as two big differences that happened around 2000. One is the supply shocks changed to demand shocks, but of course monetary policy also.

• 28:57Speaker 05

  Gained a lot of credibility and the way that shows up in my data is as a more gradual inertial monetary policy rule. And that has the advantage that when supply shocks happen, a more gradual rule may be able to stick a soft landing. And if that's getting priced in, it means that stocks don't need to fall at the same time as the bond market.

• 29:20Joe Weisenthal?

  Let's talk about, because you mentioned perfect storm, you mentioned oil price shocks. People look, you know, we said at the beginning, there are so many backdrops to this conversation. When you look at the interest rates where the 30 year is right now, what do you like? How do you decompose the factors just driving either in the last few years or even on the last few months or even weeks?

• 29:47Speaker 05

  Great. So let me, let me take a slightly bigger perspective because as academics, we have the, we have the luxury of looking at longer data, but hopefully this is useful. So if I look at the past five years, what has changed, I think, is that treasury bonds have become a lot riskier. That's the bond stock movement that I just talked about that has gone up a lot. And if you think about any sort of basic investment logic, if an asset is risky, investors should not be willing to pay as much for it. Or said differently, investors should require a higher return to compensate for holding this risk.

• 30:32Speaker 05

  And so because these risks have so gone up so much, that should really drive up the yield or drive down the price on bonds because they, they move inversely. And so that's something that I have been working on with Matteo and Broni from Boston College and Adi Sundaram from HBS. We have asked, you know, are these changing bond risks? Are they priced in? Can they help us explain some of these big trends in bond yields? You know, the 10 year yield was at 11 and a half percent in the eighties. Hard to imagine, no? And it came down a lot towards the 2010s. And then we've seen this very substantial reversal recently.

• 31:14Speaker 05

  And what we find is that the expected return that's priced in bond markets actually moves quite closely with bond stock cool movements in the data. Now you might think that's really simple, you know, why wouldn't we know that already? And the tricky thing is that at the same time, of course, a lot of other things changed in the bond market. Inflation came down and when studying bond markets, really we don't have that many, not as much of a cross section. We don't have as many different assets as if we're say, asking, you know, how is one stock price versus, versus another?

• 31:57Speaker 05

  So that in this kind of these big time trends can lead to forecast errors and surprises. So that realized returns can sometimes look very different from expected returns. Anyway, so if we take advantage of similar forecast data to what I talked about earlier, and we just say, well, what's the return that you would expect on say, a 10 year treasury bond if the yield next year turns out to hit exactly what informed forecasters were expecting it to be? And once you do that, so you take out some of this forecast error component, the relationship with bond stock movements is, is really striking.

• 32:40Speaker 05

  It's there for the US, it's across bond maturities. You can even see it across different developed markets, which had pretty different experiences sometimes. So there's really a, there's a pretty clear evidence that markets require a higher return when bonds are risky. And so we, once we quantify that a little bit, and I'll call it a back of the envelope calculation, what we find is that roughly maybe a quarter of the decline between the mid eighties and 2010s in the, the 10 year yield was due to treasury bonds becoming better hedges. The other part being, among other things, inflation expectations went down.

• 33:23Speaker 05

  But over the past five years, or let's call it 2020 through 2025, the increase in the 10 year yield was really, the majority was, you can explain with changes in bonds becoming more stock like. And, you know, of course, inflation expectations over the past five, six, seven years have been quite stable. We experienced high inflation, but if you look at long-term inflation expectations, they are quite stable. And I think that's the other side of the coin that, you know, bond yields going up then reflect increasing risks and in increasing required compensation for risks.

• 34:22Speaker 08

  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.

• 35:05Speaker 06

  The world of business is constantly evolving. Every day, new challenges, new opportunities, new ways of working. Comcast Business keeps you totally in step with secure AI-backed networking built to power the way modern business gets things done today in more than 100 countries around the world. That's some serious muscle. And get this Comcast Business powers over 90% of the Fortune 500 and millions of small businesses. Behind it all, network engineers, cybersecurity specialists, support teams, thousands of experts answering your call at 2am like it's 2pm. Always on, always ready. That's a lot of coffee.

• 35:47Speaker 06

  One partner powering how business gets done for companies of every size all around the globe. When you add it all up, no one does business like Comcast Business.

• 35:58Speaker 07

  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.

• 36:25Speaker 07

  Learn more at mastercard.com/smallbusiness.

• 36:28Speaker 08

  Running a business means you're always on the move. The Delta Sky Miles Reserve Business American Express Card is made for frequent travelers who want premium benefits that works as hard as they do. For a limited time, new Delta Sky Miles Reserve Business Card members can earn 200,000 bonus miles, the highest miles offered this year. And when you need to recharge or find a quiet place to work, the Delta Sky Club can turn a layover into precious productive time or a restful reset. You can enjoy 15 visits each medallion year to the Delta Sky Club when flying Delta and unlock unlimited Delta Sky Club access after spending $75,000 in purchases on your card during a calendar year. Plus, receive four one-time guest passes each medallion year so you can bring a colleague

• 37:13Speaker 08

  along. That's 15 Sky Club visits plus four guest passes for an annual value of up to $950. Value estimate based on $50 per visit rate to purchase additional visits or bring a guest to the Delta Sky Club. Apply today at www.delta.com/podcast. Offer ends 11/4/26. Minimum spending requirements and terms apply.

• 37:35Tracy Alloway?

  How do we make bonds more bond like again? Because, you know, if you think that what's driving yields is just investors asking for more compensation because the debt is perceived to be riskier than it has been previously, it feels like we need to return to a state where bonds could serve that hedging role or at least not be perceived to be as volatile or stock like as you described.

• 38:02Speaker 05

  I've liked to decompose that into luck versus policy. If you remember in the 1990s, during the great moderation, people were discussing, economists were discussing, was this luck or was this policy? And I think one can similarly think about that here. There is certainly an element of luck here. The, the nature of the shocks hitting the economy, you know, that changes. And then there is the element of monetary policy, which, as I mentioned before, having a more gradual approach to monetary policy priced in helps in keeping the bonds bond like.

• 38:44Speaker 05

  Now, what is needed in the background for this gradual approach is probably something that one would call central bank credibility. If the, if the, if the trust is there that eventually the central bank will do what is needed, then that's something that would, you know, in my models is something that can keep the bonds bond like.

• 39:05Joe Weisenthal?

  So that's interesting because.

• 39:09Joe Weisenthal?

  You mentioned at least market-based measures of inflation expectations or break evens. They have been pretty stable.

• 39:17Tracy Alloway?

  Yeah.

• 39:17Joe Weisenthal?

  So two things that call us to mind. First of all, I'm curious if you have a theory for why? Because if you have a central bank that's now missed its inflation target for five years, more or less at this point, is it surprising that

• 39:34Joe Weisenthal?

  that the market has not said, you know what? Over the next 10 years, I do not feel as confident that the Fed will hit its inflation target as I used to, because I've already seen that you could go five years and it's not there. And then B, like, to my mind, if it is, like, doesn't that imply that actually the Fed has, is still seen as quite credible for all of their misses? Like, if there, if already the market is pricing in stable inflation, not very high above target, then why shouldn't we just surmise that, okay, the Fed is perceived as quite credible?

• 40:09Speaker 05

  Yes, that's, that's interesting. So I'm, I'm not an expert on how inflation expectations are formed.

• 40:16Joe Weisenthal?

  Okay.

• 40:16Speaker 05

  My, my colleague at Chicago, Stefan Nagel, has some really interesting work on that. He's, he has really interesting things, work, work on that.

• 40:27Speaker 05

  Now, what I think we do see is that the point estimate, the level of the long-term inflation expectations has remained relatively stable.

• 40:36Joe Weisenthal?

  Yeah.

• 40:37Speaker 05

  But at the same time, we have seen more volatility and we have seen a delinking between the nominal and the real bonds. So before 2000, if you were looking at nominal 10-year treasuries versus the inflation-indexed bonds, the correlation was very high.

• 40:58Joe Weisenthal?

  Yeah.

• 40:58Speaker 05

  Because no one was really thinking about inflation. But that correlation went, has changed. So even though, on average, I think the inflation, the average long-term inflation that's priced in looks, looks very stable, you know, we have seen changes that are probably related to more uncertainty. And that's, that's something that also in my 1980s paper, for example, I asked, you know, what's the counterfactual that explains best the bond markets, the bond risks in 2021, 2022? And the answer was a combination of 1980s supply-style shocks combined with a more inertial

• 41:42Speaker 05

  monetary policy like in the 2000s. And so that, that's something that generates more, more inflationary shocks. But the response of real rates and nominal rates is different because the monetary policy that's priced in is, is a little more inertial.

• 41:59Tracy Alloway?

  I don't know if you've done any specific research on, on this per se, but we started out talking about various mega trends.

• 42:06Joe Weisenthal?

  Yeah.

• 42:06Tracy Alloway?

  Of which there are many. And maybe one of them we didn't mention is that the holders of US debt has changed very dramatically in recent years. So for instance, you have a lot more hedge funds present in the market. Do you notice anything, or do you think about the changing, I guess, buyer base for US treasuries at all and how it might relate to some of your work?

• 42:29Speaker 05

  That, so the buyer base is certainly interesting. It's not really what my, my research is about. What I, you know, what I, what I can say is that if you think about changing bond yields, right? So you, there has been, there was, for a long time, there was a discussion, is it a decline in the natural rate, which would be, you know, productive growth? Is it a change in the demand for scarce, safe assets? Or is it a, is it a change in the safety of treasuries themselves? What I can say is that the change in the safety of treasuries themselves is a substantial component.

• 43:11Speaker 05

  That doesn't mean that the other aspects don't matter, but there's certainly something to the changing riskiness of treasury bonds.

• 43:20Joe Weisenthal?

  So one of the things that people talk about a lot is just like, okay, let's say we perceive the central bank to be still fairly, still credible, inflation is going to come back down at some point, maybe a little more volatile than we look. There are many aspects of the US policymaking apparatus that I would say we could neutrally describe as volatile, right? So we obviously have a very volatile tariff schedule that has changed a lot over the last year and a half. There are two wars going on, and particularly the war in Iran specifically.

• 44:02Joe Weisenthal?

  There's at least a few different, there's all the spending associated with it. There's the shock to the price of oil. And then there's the question of whether the US is even, has a powerful enough military to win a war if it wanted and actually recapture the strait. And so then you start talking about like, well, you know, dollar hegemony and the US is the superpower and that has the effect. And it's like, wait, is the US the superpower that we thought it was? Does this say anything? Is it all of these questions, whether this sort of, just this sort of, the physical strength of the US as a power and the domestic policy volatility? How much is that part of the story?

• 44:44Speaker 05

  Great question, yes. So, yeah, I have done a little bit of work thinking about the interlink between geopolitics and the safety in bond markets. I'll say that, you know, I, I find that is even a little bit broader and a longer horizon than what I usually study. But if you go back very far to the development of bond markets, they were pretty closely linked to winning wars and financing wars.

• 45:11Joe Weisenthal?

  Yeah.

• 45:13Speaker 05

  Hamilton recognized this in his, in his address about the public debt in 1790, where he said, look, most countries that are involved in a war need bond markets and the US credit is, and I'll quote here, is the price of our liberty. So he was very aware of that. A famous example, or maybe the most famous example of, this would also be the UK. The UK had a functioning, deep bond market with low borrowing rates prior to the Napoleonic Wars, and that helped it a lot. And then in turn, winning these wars made it the undisputed military and financial power for several decades to come.

• 45:59Speaker 05

  So you see that during this time, UK government borrowing rates were, were really low and stable. And then, of course, the US in the second half of the 20th century has held a similar position with being the militarily strongest country, having low borrowing rates, and so on. So there's reason to think that these two advantages, military and financial, they're interlinked. And so what we, what I've thought about with my co-author Pierre Redd from Columbia is in a model where financial markets can become deeper and financial, the capacity to borrow can take different levels.

• 46:42Speaker 05

  How does this shape this interaction between financial markets and the military equilibrium? And so the, the basic idea is that if bond markets are really minuscule, they don't matter, right? Whoever has an exogenous advantage, if it's a natural moat or a mountaintop or whatever it is, that country is going to be the safest. It's going to be able to borrow at the lowest rate and end of story.

• 47:15Speaker 05

  If financial capacity is a little bit higher, something different can happen. The country that maybe starts with an exogenous advantage may be able to save its way little by little into having a financial and military advantage. And in our model, there's something like a tipping point. If the system starts out on the one side, one hegemon keeps getting stronger and stronger. If the system starts out on the other side, you get convergence to the other hegemon. And then if borrowing capacity is very high, debt to GDP ratios are very high, the causality,

• 47:58Speaker 05

  if you will, can flow in the other direction with financial market expectations becoming self-fulfilling. So if financial markets expect that one country is safer, they offer lower financing rates, and that allows for this investment to happen and which makes the, the expectations justified. Now, this last case, we think of more as, my co-author and I think more of as a hypothetical. It's not necessarily what has happened, but it's kind of an interesting thing to think about, that there could be a hegemonic transition that doesn't even involve war. It's just financial markets deciding and pricing in their expectations.

• 48:39Tracy Alloway?

  Who has the best AI agent?

• 48:43Joe Weisenthal?

  Have you seen the yield on, what do you think, what do you think the yield on the Chinese, actually, the Chinese 30-year bond is?

• 48:52Tracy Alloway?

  Uh, tell me.

• 48:54Joe Weisenthal?

  2%.

• 48:55Tracy Alloway?

  Wow.

• 48:55Joe Weisenthal?

  So, again, you know, not putting words in the guest's mouth, but, you know, like talking about, people are talking about a hegemonic transformation without a war. So we're at like 5.6. By the way, we're recording this September 29th. Who knows what it's going to be by the time we're listening? But yeah, the yield on the Chinese 30-year bond, 2% right now.

• 49:17Tracy Alloway?

  That's crazy.

• 49:18Joe Weisenthal?

  Yeah.

• 49:18Tracy Alloway?

  I remember there was a moment a few years ago where a bunch of people got really into Chinese bonds, I guess because they had added to the index. So that would be an obvious catalyst. Um, I wanted to go back to the perceived policy reaction function for a second and maybe talk about some of the recent things that Kevin Warsh has said. So he talked about wanting, you know, markets to be the ball, I guess. But he has also emphasized financial conditions, which are market-driven. And there seems to be a little bit of circularity there, I guess, where the Fed, you know, maybe

• 49:58Tracy Alloway?

  is reacting to market-driven financial conditions, but then markets are reacting to, still to what they think the Fed will do. Is, is there any way of disaggregating those two? Or like, how do you get away from that reflexivity?

• 50:13Speaker 05

  So, yeah, I can't really talk about.

• 50:18Speaker 05

  What Warch would say, you'd need to, you'd really need to ask him yourselves. What we did try in our estimation of the perceived reaction functions is we, we tried to include something about financial conditions. We included forecasts of the B double A, triple A spread, which, which get reported in the same data set. If I remember correctly, there was a little bit of a coefficient on that, but it didn't really change any of the, of the other responses. So yeah, it's certainly a discussion whether the Fed responds to financial conditions because they reflect the macroeconomy or whether there's something separate.

• 50:59Speaker 05

  But we found that kind of in terms of the response to the macroeconomy that it didn't really, it didn't really change that all that much.

• 51:06Joe Weisenthal?

  What's your view on supply as a factor in bond yields? This is a big question. People, well, they're good, bond yields are going up straightforwardly because they're issuing so many of them. How does supply fit into your framework?

• 51:20Speaker 05

  Yeah, supply is interesting and my framework supply is, is very simple in the sense that, you know, in the end, the exposure, we're all taxpayers and to the extent that we're also holding bonds.

• 51:33Joe Weisenthal?

  Yeah.

• 51:34Speaker 05

  It's just, you know, going from one pocket to the other. Now, of course, the, the, the real world is a lot more complicated. There are people who are long bonds, there are people who are short bonds. In the paper with, where we look at how are bond stock co-movements priced? I think that's the closest that I can come to saying how, how this is priced, right? So you might have the idea that while bond markets are totally separate from the stock market, you know, it's all about, you know, it's all about a type of investor who's holding too many bonds and thereby if bonds become more volatile or this investor has to hold even more bonds, that's when, when they're not going to be willing to pay as much for bonds.

• 52:18Speaker 05

  That's when the prices fall and the yields go up. What is interesting, I think, what we find is that there is actually something about the co-movement with the stock market, which would suggest that these, that these bond risks are at least to a first order priced against the stock market. That doesn't mean that, you know, additional, additional specific bond market exposure for these investors doesn't matter. It's probably there also. But it's, I, I think it's just kind of interesting that there is exposure to the stock market that matters for whether investors, you know, hold, end up holding too much risk or not.

• 53:01Joe Weisenthal?

  I remember during the first Trump administration, when he passed the tax cuts and they knew it was going to widen the deficit and people were like, oh, where's the money going to come from? And that whole time I was just thinking, well, he just passed it, he just passed a tax cut. We know where the money is going to come from. A bunch where people have dollars in, in their accounts and maybe they're not going to go out and buy treasuries necessary with it, but maybe they'll go out and buy a boat and then the boat owner will buy some stock and then the stockholder will buy some treasuries. Like you do, it is, it does seem as though like, you know, when, when you see these fiscal events, they're often corresponding with some other part of the ledger having more cash in the pocket.

• 53:41Speaker 05

  That's right. Yeah. So that's in economics, that's called recording equivalence. I think it's just a powerful argument, right? You always need to think about where, where does the money come from? Where does it go? And of course, in reality, all of this is violated, but as a first approximation, I think it's still useful to think about.

• 53:59Joe Weisenthal?

  It doesn't work in, in reality, but it works in very, it works in theory and it has robust explanatory power. No, I've always found that to be very compelling.

• 54:08Tracy Alloway?

  Perfect for podcasts and posting online. All right, Carolyn, thank you so much for coming on Odd Lots. Really appreciate it.

• 54:15Speaker 05

  Thank you. My pleasure.

• 54:18Tracy Alloway?

  So Joe, that was fascinating. Truly the perfect guest for this particular moment in time. My big takeaway, bonds got to be more bond-like.

• 54:38Joe Weisenthal?

  Bonds got to be more bond-like. By the way, I think, maybe I'll make this a chart of the day or something in the newsletter. You should just look at the spread between the generic Chinese 10-year and the US 10-year.

• 54:51Tracy Alloway?

  Yeah.

• 54:52Joe Weisenthal?

  Because not only is it dramatic, it, I mean, it just, it just flipped during COVID. Like that, like the, the US was yielding much less than, US 10-year yields were yielding much less than their Chinese counterparts up until late 2020. And since then, it's been a rocket. And now there's a 300, over 350 basis point spread between the two of them. It's pretty striking.

• 55:18Tracy Alloway?

  That's on the spread. I would just argue that the longer-term downward trend in Chinese bonds looks like it started in like late 2018, 2019, when they were added to the indices. So there's an argument to be made that the benchmark index providers are the future shapers of global hegemonies.

• 55:38Joe Weisenthal?

  Well, either way, I like the idea of, I mean, there's, it's really powerful idea that it's like, can you have like a handing off of the hegemon? Can you, classic.

• 55:48Tracy Alloway?

  We all can struggle with this word.

• 55:50Joe Weisenthal?

  Can you have a handoff from the hegemon in the financial markets alone?

• 55:54Tracy Alloway?

  Yeah.

• 55:55Joe Weisenthal?

  But it's really interesting thinking about the way this compounds, right? Because if you have the financial advantage, if you could borrow money more cheaply, then you can reinvest that money into economic productivity, military and so forth. And then you're like, you could see how these things compound and snowball over decades. And okay, so the US now wants to embark on this big effort of industrialization. We had that conversation with Chris Power of Hadrian in LA, talking about the ship gap or the robotics gap, et cetera. Well, we might do that, we might, but like, it's going to cost us a lot more to, just from a sort of dollar standpoint or resource standpoint than it would have been, say, 10 or 15 years ago.

• 56:37Tracy Alloway?

  You can meme invest your way to military superiority. You just have to come up with a better story than the other guy and convince investors.

• 56:45Joe Weisenthal?

  That's right.

• 56:46Tracy Alloway?

  All right. Shall we leave it there?

• 56:48Joe Weisenthal?

  Let's leave it there.

• 56:49Tracy Alloway?

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

• 56:53Joe Weisenthal?

  And I'm Joe Weisenthal. You can follow me at the Stalwart. Follow our producers, Carmen Rodriguez at Carmen Armand, Dashell Bennett at Dashbot, Cale Brooks at Cale Brooks, and Kevin Lozano at Kevin Lloyd Lozano. And for more Odd Lots content, go to Bloomberg.com/oddlots or have a daily newsletter and all of our episodes. And you can chat about all of these topics 24/7 in our Discord, discord.gg/oddlots.

• 57:16Tracy Alloway?

  And if you enjoyed this conversation, if you like it when we talk about the bond market, 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 ad-free. All you need to do is find the Bloomberg channel on Apple Podcasts and follow the instructions there. Thanks for listening.

• 58:06Speaker 08

  If you're a business owner, you need a card that can keep up. With the Delta SkyMiles Reserve Business American Express Card, everyday purchases transform into miles you can use towards future travel. So business as usual can lead to a well-deserved getaway. And for a limited time, card members can earn 200,000 bonus miles, the highest miles offered this year. Whether you're traveling for business or planning your next adventure, now's a great time to make every purchase go further. Apply today at www.delta.com/podcast. Offer ends November 4th. Minimum spending requirements and terms apply.

• 58:42Speaker 02

  If you listen to financial news, you know, a lot of time is spent thinking about what's next? The next opportunity? The next investment? The next move? But sometimes what matters most is being ready for what you never saw coming. For more than 75 years, Cincinnati Insurance has worked with independent agents to help protect businesses, homes, valuables, and more. Because planning for the future isn't only about knowing what's next, it's about making sure you're ready for what you can't predict. Let Cincinnati Insurance make your bad day better. Find an independent agent at C I N F I N dot com.

• 59:19Speaker 06

  For big business, AI opened up a world of promise, but that world of promise turned into a world of pain. Costs spiraling, data trapped, security and governance risks multiplying, and ROI out of reach. That's why enterprises turn to Boomi to connect data, apps, and AI, helping them operate securely, efficiently, and at scale. Boomi turns a world of AI pain into a world of AI gain. As Boomi says, "We got you." Head to boomi.com. That's B O O M I dot com. The world of business is constantly evolving and Comcast business keeps you totally in step with secure AI-backed networking in more than 100 countries.

• 1:00:01Speaker 06

  They're powering over 90% of the Fortune 500 and millions of small businesses. That's a lot of muscle. And behind it all, thousands of experts answering your call at 2:00 AM like it's 2:00 PM. One partner powering how business gets done for companies around the globe. When you add it all up, no one does business like Comcast business.