Broken Market Signals Are Warning of the “End Game”

When you have a mechanism like passive investing that has grown so rapidly and so large, we need to consider the possibility that the price signals are not being driven by those facts. When a market increasingly becomes a mechanical system that is governed by regulations and rules, it no longer represents the collective wisdom of the crowds. It simply represents the extremes of the model that we have built for it. We will see volatility begin to rise exponentially. That's the warning sign that we're beginning to approach the endgame.

It's a pleasure to be here, Maggie. Thank you for having me back.

Well, the key issue is that the work that I've done around passive is often linked to the equity markets, but we're actually finding that some of the biggest distortions are now occurring in the fixed income markets, in particular the market for sovereign debt. We're seeing a quote-unquote puzzling lack of interest in the 30-year bond as it crosses over 5%. Now, there are narratives around that, right? We're worried about inflation, the US government is going bankrupt, etc., etc. But the reality is a 5% 30-year bond should actually be attracting a significant amount of attention. People should be paying attention to it for no other reason than it candidly meets most of the obligations that people have in retirement. I had a really interesting experience this past week. I spoke to a group of institutional allocators down in Asheville, North Carolina, and highlighted that we'd seen this radical change. We've gone from basically zero on long-term interest rates to well in excess of the inflation rate, near the highest level of real rates we've ever seen in history. This is very much at odds with almost all the evidence that we have from a demographic feature of what should actually be happening and what people should be doing with their retirement planning. And I asked a simple question: has anyone changed their allocations? And literally in a room of 500 institutional allocators, not one hand went up. Nobody is actually changing their allocations.

When you dig into the mechanics of what's actually happening, it really boils down to effectively an index phenomenon. The structure of passive investing in bond markets allocates, just like they do with equities, more capital to bonds that are trading at higher prices. When you have the period of zero interest rate issuance that we had for an extended period of time, basically from 2009 until give or take 2021, that creates conditions under which those low coupon instruments, as you raise interest rates, collapse in price. Many 30-year bonds or near 30-year bonds are now trading in the 50s. That means that far less capital is being allocated to them. They take up less weight in the index and they receive less interest, even as they would meet the vast majority of retirement obligations that people are facing. And so this was really what I highlighted for Secretary Bessent in the open letter: was that what we were seeing was not a market judgment on that 30-year bond, but rather a mechanical byproduct of how we choose to allocate our investments under government mandate. The regulatory framework is distinctly skewed towards a bias towards passive vehicles, and it unfortunately is creating the outcomes that we're now interpreting as the imminent collapse of, you know, the US government because it can no longer afford its entitlements, etc. None of that is actually true. So we are watching people miss an incredible opportunity that in my analysis is increasingly being driven by how we invest, not the thoughtful application of logic or understanding of financial markets.

I don't think that's what's going on. I'm certain that many people believe that. Unfortunately, I think that becomes a function of the market presents what we think of as truth. And when you have a mechanism like passive investing that has grown so rapidly and so large, both as a portion of the equity market and now as a portion of the fixed income market, we need to consider the possibility that the price signals that we're receiving are not being driven by those facts, right? Or those assertions, which I would argue are not facts. We can actually afford to service our debt. We can afford to do things, but because we think we can't, we're actually making bad choices.

Well, what it's providing is current income ultimately in an asset-protected manner. If you buy a 30-year bond with a 5% yield, you will receive that 5% yield for the next 30 years, and you're actually ultimately going to have the principal left over. So whether that's devalued by inflation or not is actually somewhat irrelevant. You're dead at that point. When you think about a historical withdrawal rate from a 401k and the target of 4%, that 5% alone allows you to get there with none of the equity risk, etc. Now, the great irony, as you're pointing out, is not only are people saying 60/40 is dead, there was a Wall Street Journal editorial that just was released, I believe it was the end of last week, saying the new model should be a 90/10, meaning you should have 90% in equities and 10% in bonds. This is ironic because the exact same analysis on the equity market would ultimately suggest that we're looking at forward expected returns that are below 2%. And so people are scrambling to buy a 2% expected return asset and foregoing a 5% return, far less volatile, far more stable asset that ultimately protects your portfolio, allows you to meet the objectives of a 401k and that 4% withdrawal rule, and nobody's taking advantage of it for the very simple reason that we're not seeing the price action support that narrative.

It means exactly the latter part of it, and it is happening globally. That was one of the components that I highlighted within my piece, is that we're increasingly starting to see the narrative that this is a global phenomenon. UK rates are selling off. Australia, which has a debt to GDP of around 25%, is seeing its rates follow the same pattern. Japan is seeing its rates sell off with far worse, quote-unquote, fundamentals than the United States has. They're all behaving identically. That suggests that there has to be something that is a broader mechanism rather than the specifics of the US government or the US dollar that is really behind this. And when you dig into it, you discover that it is indeed a mechanical process of how we've chosen to allocate our capital.

Well, there are two separate components to it. So when a bond is issued, it's issued with a coupon. So bonds that were issued in 2021, for example, would have been issued with typically a quarter percentage or a half percentage coupon associated with it. When you raise interest rates, when interest rates rise, the market has to accommodate that through an arbitrage phenomenon where that bond that has the exact same credit risk is treated on an equivalent yield basis to the newly issued paper that matches that maturity. So a 30-year bond that was issued in 2021 should have — and there's not really a 25-year issue, but if there were a 25-year issue — it should be trading at the exact same price as a coupon that was issued this year with a give-or-take 5% yield. When you adjust for that relationship, you have to lower the price of the bond. It doesn't reflect a credit assessment. It's not the same phenomenon that we would see within a high yield bond that is trading at a distressed price. It's simply a reflection of the forward expected return matching the current coupon to that lower coupon issue.

The reason that that creates a real problem in the banking system in particular is the phenomenon that was tied to Silicon Valley Bank. So when banks bought mortgages or they bought long duration US government debt in the early part of the 2020s, that paper has now fallen far below the levels that they acquired it at. It was issued at par. It's now fallen to between 55 and 75 cents. That creates a loss that if banks were to realize, that would actually impair their capital base and prevent, excuse me, prevent them from being able to lend or actually even function. They would be in violation of Basel regulations. Their reaction to that was to put this entire class of bonds into what's called the hold-to-maturity category. That allows them to avoid recognizing the loss. They're basically saying, 'Look, we're going to hold this for 25 years, and in 25 years, we're going to get our par back in the principal payment.' But that suddenly means that you've got basically illiquid and inactive capital within the banking system. That's what caused the distress for Silicon Valley Bank. Once you've put something into hold-to-maturity, when you receive requests from depositors to provide you with their funds back, you have to source that liquidity from somewhere. If you touch that hold-to-maturity category, you impair the entire portfolio and create conditions where you have to recognize that loss. And so banks will do almost anything to avoid doing that. The solution under Silicon Valley Bank was to create a lending facility from the US government where you could borrow, obtain liquidity. They would treat the instrument as if it was still par in that hold-to-maturity framework, and you could obtain liquidity against it. But that liquidity is being sourced at an expensive price, and it's costing you significantly more to borrow under that framework, given the current level of interest rates, than you're receiving on those assets. It's impairing bank profitability and reducing their willingness to lend to anything other than the most pristine credits. The US government, of course, being one of those.

My proposal is very straightforward: that the government should effectively reissue 30-year bonds and exchange the 65-cent market value for an equivalent market value of current coupon bonds. That does two things. One, it actually significantly liquefies those portfolios. It creates conditions under which banks can again begin tapping that credit, that capital, and recognizing that maybe they don't want to actually just lend to the US government. Maybe they want to lend to the private sector. The second thing that it does is it actually raises the current income going into banks, and that actually facilitates balance sheet repair as well. The last thing that it does is it actually reduces the quantity of US government debt outstanding, and that actually is obviously a benefit as well. It helps to address this narrative of whether or not the US government is overly indebted. This proposal would ultimately lower that indebtedness by about three-quarters of a percentage point. It's not going to change the world. It's not going to change anyone's total assessment of the financial stability of the United States, but it certainly helps. And more importantly, it gets the credit mechanism functioning in the banking system again with far less government intervention.

Well, the conditions are created in part because of the lack of the passive bid. So when you think about a dollar going in — I use the thought experiment in my Substack of a super simple bond index. Imagine there's only two bonds in the universe: there's a two-year bond and a 30-year bond, and at stage zero, they're 50/50 in terms of index construction. If the Federal Reserve lowers interest rates, that 30-year bond is going to rally sharply. It's going to rise quite a bit in price because the market has to do the opposite of what it did when it discounted them to 65 cents. It has to make them equivalent to a new issue coupon that's at a lower rate. That actually would skew the index towards longer duration bonds. And this is the condition that we saw basically from 2009 until give or take 2022, in which the bond indices became longer and longer duration as the Fed would cut interest rates with the expectation that this was providing some form of stimulus. It would cause those long-dated bonds to rise in price. That increase in price skews the index towards them. It's why the index had such extraordinary duration sensitivity going into the 2022 rate hikes that caused the catastrophic losses. The duration exposure of the index had risen by roughly 35% over the period from 2009 until give or take 2020.

When the Fed then hikes interest rates, the opposite happens. The index becomes underweight the long duration bonds and overweight the front of the curve. In my analysis of what a passive bond index represents today, it's about 35% underweight the duration component of it. That means when a dollar goes into a passive bond index, it's buying more of the front end and it's ignoring the back end — relatively ignoring the back end. That means the pricing is less efficient. It means that the demand is less, and it's created, among other things, the extraordinary rise of what's called the basis trade, which is effectively hedge funds recognizing that there is a mispricing that is occurring out here. They are shorting treasury bond futures, buying the off-the-run issues that offer very similar total yields but are being ignored, and therefore they can pick up between 10 and 20 basis points of additional return. They capitalize on that 10 to 20 basis points by leveraging themselves 50 to 1, so that you end up creating a return of 10%, quote-unquote, risk-free. That's not risk-free to the system. It's an extraordinary amount of leverage that's sitting out there. It exposes the US government to disruptions in the bond market when credit financing is called into question.

And that's exactly what we're trying to address with this type of proposal: reduce the opportunity for the arbitrage that exists in the basis trade, create a functioning credit market and treasury market in which people can honestly look at it and say, 'Okay, I'm buying a par bond that pays me 5% that allows me to achieve my retirement objectives,' and stop doing a lot of really silly stuff like engaging in strategies that are designed to create excess return by taking on significant additional risk.

Well, first, I think he absolutely would, and one of the benefits of the proposal is that it exposes the narrative that we don't need much higher rates, that rates are not stimulative. This is one of the really critical things I think for people to understand. If you remember, Maggie, in 2022 the narrative was, now we've got real interest rates, therefore value is going to outperform, right? Sanity will return to the stock market. Instead, as I predicted, we've seen the exact opposite. We went right back to what we were doing before. Again, this is a mechanical property of a passive-dominated market. The structure of the indices is such that they reward with more marginal capital prices that go higher. In equities that manifests itself in a rising stock market. In the case of bond markets, as I highlighted, it can create either neglect or enthusiasm for the long-dated securities. Unfortunately, where we sit right now, people are regularly running around and saying rates need to go much higher in order to quell the speculation or to attract people back to the 30-year bond. The math and the mechanics that I've laid out highlight that that's not the case. It is a structural feature of the market that can be addressed proactively, but it has to be done through the Treasury. The Treasury is responsible for issuance and retiring of US government debt. There could be an opportunity to involve the Fed through something that's called yield curve control. But candidly, that's a really inelegant, blunt tool that doesn't address the primary issue here. We need to at some point move to reforming the way that we invest. We need to move away from passive.

Yeah. So, I mean, it's been basically a decade since I've identified these issues. I started with the equity market. It's expanded into the fixed income market. It's become increasingly apparent that unfortunately I was correct in my analysis of what is actually going on. The academic literature is exploding around this. I collaborated on this letter with some of the academics I've worked with in the past. In particular, Valentine Hedad had a 2019 paper in which he laid out some of these components, basically the duration targets that exist within the institutional world, etc., and how those can be influenced by the changing character of coupon issuance. He had not connected it to passive investing, but now acknowledges that that is indeed what we are actually seeing. So we know that this is correct. It's just a question of do we choose to address it. It does have to be addressed through the Treasury. It does create the additional benefit of allowing the Fed to lower interest rates without perpetuating the narrative that this is, you know, yet another bailout, that the US government is captured by fiscal dominance, etc. None of those statements are true as of yet. They could become true. And I want to emphasize that if we don't address many of these issues, we will ultimately find ourselves under these conditions. But the narrative for why it's occurring is not actually why it's happening. So it is really important that we start to address this.

In terms of interest rates itself, I think it's really important for people to recognize how depressed the interest rate sectors of the economy are. Auto sales are running way below population-adjusted levels. That's a financed vehicle. Many forms of appliances are seeing incredibly depressed demand. Again, financed vehicles. If you consider the housing market, you're facing two pinchers that are hitting there. One is the much higher level of mortgage rates makes it uneconomic for people to sell their existing home, cash in that 2.75% mortgage that they secured in 2020 or 2021, and move to a new location, because the downgrade in house size that you would have as you retire is actually potentially going to increase your payment in today's world. And so there's an unwillingness of sellers, and at the same time the ability to build new product is impaired by those much higher financing rates. And as a result, we're seeing the lowest turnover we've ever seen in history for the US housing markets. They've lost their dynamism. And unfortunately, that is a byproduct of interest rates being higher than they should be. I want to be clear: I don't think we should have zero interest rates. Although I think if we continue down this path, we will ultimately be forced to go there again.

And so I really think that's actually critical for people to understand. This is not a morality issue or a bailing out of the banking system. The banking system maintains the losses. We are not changing any of those characteristics. We're simply restoring functioning to the US Treasury market in the context of what has transpired with passive investing and how we choose to allocate capital. The second thing is the narrative that interest rates need to be

Much higher is just empirically false. We actually know that the level of interest rates is quite restrictive. Unfortunately, we look at the stock market soaring and we say this is evidence of extraordinary speculation. Clearly, we need higher interest rates to combat this. Again, just not true. It's just not true. When a market increasingly becomes a mechanical system that is governed by regulations and rules, it no longer represents the collective wisdom of the crowds. It simply represents the extremes of the model that we have built for it.

Well, I think it's a combination of factors. One, interest rates are a very blunt tool. You are basically using a central planner approach to manage a market economy by trying to set the price of money for a particular group. The second component in terms of inflation is that the underlying characteristics of the economy are actually quite deflationary. The population pressures that existed in the 60s, 70s, and into the 1980s have largely been replaced by falling populations and declining labor forces. That means that the underlying interest rate has to be set lower, for the very simple reason that you don't have anywhere near the demand to maintain capital investment. If you think about what productivity or inflation captures in a purely fundamental sense, part of what you're trying to recognize is that you have a production possibilities frontier. It's an economic term that basically is the combination of labor and capital that produces the greatest possible outcome. When you have a rapidly growing labor force, you need to add capital at a rapid rate in order to maintain that capital-labor ratio that allows you to preserve your location on the production possibilities frontier. That means that the demand for capital, i.e., interest rates, will be high. That was the 1960s and 1970s for us. When you move into an environment in which population growth is slowing and turning negative, that means that the capital-labor ratio is actually going to rise even in the absence of investment. That means there's less demand for capital than there otherwise would be, and interest rates should be lower. Unfortunately, that's not the phenomenon that we're experiencing. And again, I tie it to the way we've chosen to invest and the way we've chosen to behave as a society.

There are two separate phenomena that are intersecting. The first is in the 1970s we shifted from defined benefit plans, which created retirement as a stream of income in which you effectively received an annuity. You worked for any number of years, you contributed into your retirement, that turned into a stream of income that replaced the income that you received when you worked in your retirement. That approach actually allows you to socialize and spread out the risks of unknown longevity. In the 1960s and 1970s we encountered the downside risks of that in the private market, primarily because we'd seen a fairly significant rise in expected life expectancy, which meant the people that contributed into the system were likely to take withdrawals for a longer period of time. We chose to remove that liability from corporations. We retained it on the public sector, by the way, which is one of the reasons people look at public sector employees and say, 'What are you complaining about? You've got a pension. You don't have to worry about this stuff.' When we chose to go to defined contribution, it actually has a very perverse effect because you don't know how long you're going to live and I don't know how long I'm going to live. We all have to save assets and accumulate assets for the worst-case possible outcome. We're not replacing income. We're now hoarding assets with the expectation that we'll be able to sell those assets in the future to be able to fund our retirement.

That actually creates a dramatic outward, rightward shift in the aggregate demand for financial assets, and is largely responsible for the financialization that we've seen in our economy. Your working life basically exists to stockpile financial assets that you hope will last through your retirement. It's no longer about replacing income. It's about having enough that you think you're going to survive. How much is enough? It's got to be more than I already have. So this is actually creating the social disruption where the boomer generation is accumulating and hoarding assets that the younger generation is competing with as they're trying to begin the process of saving for their retirement. That's one of the phenomena that we've created. It was a misapplication of theoretical finance and a misunderstanding of actuarial behavior that we're just now coming to terms with. There's a phenomenal paper that was released earlier this year, gentleman's name is Coimbra, in which he evaluates this shift from defined benefit to defined contribution. And what he finds is exactly what I articulated: a dramatic increase in demand for financial assets, a surge in the price of those financial assets, which shows up as a much lower cost of equity, which is the forward expected return from equity investments, and perversely a much higher cost of financing the government. To put some parameters on that, under a defined benefit plan the cost of equity would average about 7%. Under defined contribution that falls to between 1.5% and 3%. So a fantastic increase in the valuation of equities. At the same time the cost of financing the government more than doubles. And so by virtue of how we've chosen to build our retirement systems, by making every individual responsible rather than acknowledging that we exist as a collective who have a social responsibility to make sure that people are taken care of in their old age, and converting those claims into an income stream, we've instead moved into an asset-hoarding environment.

The second phenomenon is a byproduct of that. Once you decide you're going to force everyone to invest on their own, the vast majority of people aren't investors. They don't have that experience base. They aren't capable of analyzing the individual securities and selecting appropriate investment methodologies. As a result, we chose a shorthand approach — the index, and the passive index at that — which was not selected because it was academically robust, as Rob Arnott wrote back in 2005. I believe the primary reason we chose market cap weighting for our passive index construction was because it was easy to implement. Unlike almost any other allocation mechanism, it doesn't require you to continually rebalance the portfolio. The market theoretically does it for you. If something goes up in price, you now own more of it. If something goes down in price, you now own less of it. That unfortunately morphed into an idea that this was the most academically robust and thoughtful way to invest. But it's not at all true. We're talking about a subset of assets. We're talking about publicly traded equities in the United States. That means you're ignoring the privately held companies. Many institutions have tried to diversify into privates for precisely this reason. It also means perversely that you're ignoring the entrepreneurial ventures and the human capital that exists for the vast majority of individuals. The local owner of the bodega receives no benefit from the flow of these retirement assets. In fact, they now have a competing asset for their own entrepreneurial ventures that says, 'Hey, guess what? You can get a fantastic return on a tax-advantaged basis if you allocate your savings to the S&P 500. If you decide to put it into your bodega, you don't get those benefits.' And as a result, we're seeing a collapse in entrepreneurship in the country. That's empirically borne out. So we have decided to do this to ourselves by virtue of trying to follow effectively a model of the economy that bears no resemblance to the actual economy itself.