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. I guess you're not going to defend yourself, Joe.
I'm a simple man. I look at a 30-year-old. I think it looks like 30 years' worth of overnight rates. You just add them up, and I just, you know, that's how it is. That's what I was. I never was like, no, that's a term premium. And then they say, and then I say, okay, but what does it look like? Well, we can't really measure it. And then all the models that we have to measure don't work. But trust us, this is what they show you. 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... I really, I really struggle with it. So this is why we need a Stanford economist to straighten me out.
It's a, yeah, it's an easily measured concept. Okay. 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 itself reflects inflation. Right. 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 Piazzi, 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.
All right. Joe's going home from his podcast with homework. I'm going to do some reading, assigned reading.
Hello, and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway, and I'm Joe Weisenthal. Well, Joe, we are still at Jackson Hole. Yeah. Where the official theme of this year's symposium is Financial Innovation in Payment. 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 seems to want to make a mark on the Fed, and has started all of these different task forces to look at things like columns 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 US Treasury, given that the Treasury is now buying back longer-dated bonds and seemingly suppressing longer-dated yields.
There are 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 and the economy. By the way, the sun just came out. We're recording outside. It has been rainy and cool all day. Now it's 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.
That's exactly what I was going to say. So the guest for today, truly the perfect guy, 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 Darrell Duffie. He is, of course, professor of finance over at Stanford University. So Darrell, thank you so much for coming back on Odd Lots.
Tracy, Joe, great to be back. Thank you.
Is there a connection between higher bond yields and the payment system? Basically, why are you here?
Well, there can be. In March of 2020, when the markets became dysfunctional, 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.
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. 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 massive amounts of trading we're seeing today, the dealers have more space yet. Could be capital regulations are not as strong. It could be the dealers have recapitalized, but they're definitely in force.
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?
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 is, as indicated in today's markets, pretty stable going forward. The sovereign is not going to default. You are, let's say, a hedge fund, a macro hedge fund. You have 20 billion of the 10 years, and I wish, but go on. And I'm calling from the Treasury Department, and I'm suggesting that you could take another 10. This based on your own balance sheet to do that. Now, given the conditions that I described for the safe bonds, why wouldn't you? And 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 don't. 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, mutual funds, hedge funds, banks, insurance 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.
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... I thought the best asset, maybe the best. 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 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?
Sure it does. And it's 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 US, but especially the US 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. Debt to GDP ratio is no one in sight, etc.
Is certainly that seems right. People could have said that five or six years ago. Well, they could have said that in 2018, 2019. And they said for years about Japan, interest 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 ten years ago, and you could have laid out the demographics, and you could have talked about the lack of political appetite to cut spending, etc. What changed fundamentally such that we got this reversal?
Okay. So let's go back even further to when the IMF said 60% debt to GDP is the red line. Yeah. 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. Finance 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. Ten 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.
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.
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, the volume. Yeah, I mean, 32 trillion and rising at 2 trillion a year. There's nothing, I mean, it is true the 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 US Treasury, but 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. And, you know, we see what's happening to yields.
I just thought of a great idea for a sci-fi story in which essentially these giant government debt loads collapse governments, and these, you know, these AI-building companies become the new sovereign. That's what I've been saying. 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 and the clawed yield and the Gemini child. And those will be our new risk-free. But I want to get back to one more thing. So I get all 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 a higher rate is the series of higher short-term rates as expected because there are a lot of inflationary impulses? One among them may be spending.
In the long run, inflation and bond prices go together. This fiscal theory of the price level, read John Cochrane's book, or... Yeah, maybe you have never heard John on the podcast. We really should do that. He would be perfect on this question. But today, if you look at forward-implied inflation numbers coming from real and nominal bonds, yeah, 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 that are being asked to take this additional supply. And they just need more compensation.
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.
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. Interesting. 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. The Fed, the FOMC, will do everything possible not to get into fiscal dominance. So I think that's my reaction.
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 scholars... Two weeks. Yeah, we had Scott Bessent 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?
Well, from his remarks, he seemed to think that yields were too high, irrespective of liquidity concerns. And in his view, market participants should have understood that a lower yield for U.S. Treasury securities would be appropriate. And he said that he thought he was signaling. He used the word signaling to the market his belief that Treasury yields were too high. Now, I think we subsequently can concede 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 about the power of the bond market.
Anyone who has ever written about the bond market has used this quote as the lead for a column at some point, myself included. Yeah. Did you see what Trump said the other day? Yeah. About military intervention in the bond market. So I don't know, maybe James Carville wasn't thinking solely that the bond 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.
Well, yeah. Well, even the mighty U.S. Treasury Department is not as powerful as bond markets when it comes to setting yields. Yeah. We also saw 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 U.S. Treasury markets and the interest expense of the U.S. government. So my impression, maybe I'm reading too much between the lines, is that Secretary Bessent wanted the market to understand that the Treasury Department wasn't just going to sit there idly and take that. They wanted to be involved.
I feel in classical discussions of interventions, they seem to work better when there are not volume-bound, but by level-bound. And when it seems, and often the case when they're level-bound, you don't even have to spend anything. You say, okay, 5% is our line in the sand. And in theory, does the Treasury have... it could just issue two-year bills and just take out the 30s. Would that, I mean, if it 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 it's going to go, you're shorting debt, you're going to get badly burned.
Well, that would be a formula for increasing the interest rate expense volatility for the U.S. government because your debt maturity is going to be shorter and shorter, 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, the U.S. 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 in which Scott Bessent had a role in 1992 when he was working with the Soros hedge fund. 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 U.S. Treasury Department, if markets decide that yields are going to be at 6%, the U.S. Treasury Department is not going to be able to have a strong say in that, not without, you know, taking a lot of risk.
Yeah. What does 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?
