62: How The Biggest Bull Market Could Come Crashing Down

Tracy Alloway (0:08)

Hi, and welcome to another edition of the Odd Lots Podcast. I'm Tracy Alloway.

Joe Weisenthal (0:12)

And I'm Joe Weisenthal.

Tracy Alloway (0:14)

So, Joe, here's a fun fact about where I am in my life. There is nothing that I enjoy talking about more than value at risk models.

Joe Weisenthal (0:26)

That, I mean, I respect that. I bet there are people in the world who would think that was sad, especially the way you framed it, about where you are in life.

But as you know, Tracy, that only raises my esteem of you.

Tracy Alloway (0:42)

Oh, okay, that's sweet. All right, for listeners who don't know, value at risk models are these sort of internal risk management models that banks usually use.

They look at their trading books. They see how much money they could lose on a given day within a certain probability, and then they adjust their positions according to that. So that was probably the geekiest intro that I could come up with for this episode. But the reason we're about to talk about VAR models, if you will, is because something really, really big has been going on in markets, right, Joe?

Joe Weisenthal (1:17)

That's absolutely right. We're seeing a, we've been seeing a bond market sell off.

Tracy Alloway (1:23)

Exactly.

Joe Weisenthal (1:24)

The bond market, the biggest market in the world, government bonds, corporate bonds, they've been in this extraordinary bull market that's arguably lasted for decades. And it's too soon to declare the bull market over, but every time bonds sell off, people start to wonder, is this it?

Is this the turn? Because if it is, if the bull market is finished, then people could probably lose a lot of money.

Tracy Alloway (1:53)

Right. Not just the banks who have these VAR models in place, and they might start to exceed the limits imposed by their VAR models, but lots of pension funds, people like you and I. Basically, the entire game begins to change if the great bull run in bonds finally comes to its inglorious end. But no one is sure whether or not that's happening yet.

So this is the thing that we're gonna talk about today, right?

Joe Weisenthal (2:22)

Right. Nobody knows whether it's happening yet, but the stakes are so high that every...

Tracy Alloway (2:29)

We're gonna talk about it anyway.

Joe Weisenthal (2:30)

That the stakes are so high that you kinda... If you're an investor, if you're a pension fund, if you're a bank, if you're whatever, you have to have a...

You have to be thinking about this question right now.

Tracy Alloway (2:41)

Right. So who better to think about this question and discuss it with than Paul Schmelzing? He is a PhD candidate at Harvard University and a visiting scholar at the Bank of England. And he wrote a really, really thought-provoking post on the BOE website recently, basically talking about historical bond market sell-offs. And I mean, I have to bring up the title of this post because I just love it so much. It was Venetian's Volcker and Value at Risk, Eight Centuries of Bond Market Reversals.

Joe Weisenthal (3:15)

Well, I say we just dive right into it and start to unpack this question of whether we're at risk of, as the title says, a bond market reversal.

Tracy Alloway (3:36)

Paul, thanks so much for joining us today.

Paul Schmelzing (3:38)

Thank you.

Tracy Alloway (3:38)

So reading your blog post, which goes through 800 years of bond market history, which is pretty amazing, you actually found that in the history of bond market bull runs, the one that we're currently in, although we may be coming to the end of it, has lasted three decades. There are only two others that have actually exceeded it in length, right?

Paul Schmelzing (4:03)

That's right, Tracy. And by the way, I share your enthusiasm for value at risk models.

Tracy Alloway (4:10)

There's one other person, that's good.

Paul Schmelzing (4:12)

So that's right. I mean, I started the data in the year 1285 So you really go back to the Italian city-states, to Venice, to Genoa, who developed the first secondary markets and government bonds, and you start recording the global risk-free rate from then onwards. And so, over time, you just trace the evolution of the financial center in the world. You go from the Venetians to the Genoese, then to the Dutch, finally to the British, and currently, obviously, the US tenure is the risk-free asset. And what I found is that when we hit below 140 basis points in the US tenure last July, that was the lowest level that the risk-free rate in normal terms has ever reached in almost 800 years of sovereign bond market history. In terms of length and yield compression, since this bull market began in 1981 as well, it's one of the most remarkable episodes in recorded economic history. We're talking about a cumulative yield compression of about 1,200 basis points.