#43 - David Dredge: Risk Management

31:12But it behooves you to pay his cost for the insurance and deliver goods every day. Whereas your competitors who don't buy insurance, they've gone out and hired weather forecasters, also known as economists, who tell them which weeks it's going to be safe to deliver ships based upon their forecast of the weather. Well, guess what? whenever they're forecasting bad weather is when the fees for shipping are the highest. The guy with the insurance is earning all of those fees because they're all sitting in the port. Meanwhile, guess what they find out eventually? The guys would, even if they have good forecasters, which, you know, these forecasters known as economists, I've not seen one of them that's good.

31:56But let's say hypothetically, they did have good forecasters. And these guys never once went out to sea without insurance when the weather turned out bad and was forecast as good. and they never once were sitting in the docks when the weather was forecast as bad and it turned out to be good and they could have been shipping at higher fees because the forecast was right what it turns out is there's a whole bunch of other ways to lose your ship too there's pirates there's exploding boiler rooms there's rocks there's all kinds of things which again is the perfect analogy for the financial markets i go to meetings and dinners and stuff conferences on risk every day, every week, every month, where some senior risk officer gets up and tells us about the risks they're worried about.

32:46And I, of course, always ask the same question, what about the risks you're not worried about? And they say, well, we're not worried about those. And I say, well, did you forecast COVID? Did you forecast the market rally after COVID in terms of having your ship out in the ocean? Did you forecast the breakdown and correlation between bonds and equities in 2022? Did you forecast the 55 % up year of NASDAQ in 2023? Did you forecast equities having their best first three quarters ever in 2024? I didn't forecast any of those things. So you consistently, your boat was sinking in things you didn't see coming, and your boat was sitting in the dock because you were afraid to take it out because your backward-looking thing said, well, the weather was bad last week.

33:38It'll probably be bad this week too. And this is what destroys wealth for end capital owners and arguably far too much transfers wealth to financial fiduciaries. It's really interesting. Whenever I turn on CNBC or read the paper, I often see somebody making a prediction about the future. Apparently, that's what people want to hear. Is your sense, and I'm assuming the answer is yes, that predicting what's going to happen next, a pointless exercise? Yeah. In fact, I wrote a, one of my notes is titled, The Pointlessness of Forecasting, one of my personal favorites, in July 2022. And again, it goes back to much of Hayek's work and guys like Frank Knight and GLS Shackle talking about uncertainty we don't know now of course i've become increasingly obsessed with a chap named stephen wolfram who's a physicist who's come up with this computational theory of the universe that says you know the only way to understand it is to do the computations and the computations are so immense to understand it the only way to do it is go through the time is you know actually live it.

34:48The only way to forecast the future is to get there. And that's true. And that's the whole point of, back to the quote, understanding is a poor substitute for convexity. We just don't know. And so the solution is to manage our payout and to optimize the geometric path that we're upon. It's pretty fascinating. It seems like if you ask the prognosticators what their track record is, almost all of them will over-attribute their success, meaning they remember the wins, they forget the losses, and there's no honest record keeping. And one of the things I find myself saying more and more, and one of the things that, I don't think of myself as a forecaster or a predictor, but we're pretty active observers.

35:40And given what we do, we get a pretty good window on the sort of structural risks and balances because we see where the leverage is because we're on the other side of it and the volatility we own. But one of the things I've kind of come to believe in the evolution of time and markets and economies is that much of what we talk about in terms of risk, geopolitics and politics, are actually downstream from economics. and that in reality, economics increasingly are downstream from markets. So one of the things that I talk to people, I have lots of friends in the industry, talk to people about a lot, particularly as this prediction of an imminent recession has been going on and on really since I blame the Bank of England for starting it in December 2021.

36:28First time they've ever forecast a recession in their history. And they've been forecasting it next quarter since Q4 2021. Still haven't gotten there. But, you know, people say, well, there's going to be a recession because of this, and therefore markets will go down. But my argument is that the purpose, in a sense, of the Greenspan put era, to a great extent, which evolved into inflation targeting, was to – actually, Greenspan said this at a breakfast I was at once after he'd retired – was to sort of break the dichotomy between their dual mandate. and that you could drive growth through the wealth effect of asset inflation and then not measure assets in your measure of price stability.

37:16And you could then do both. And if you think about really what's happened during the sort of low volatility of inflation era, that's exactly what was going on. The monetary policy, the low interest rates and QE was very much an asset inflation driven activity until the government joined in and the huge fiscal stimulus around the world in COVID. It didn't generate the CPI price inflation that they had defined as their price stability or what they call inflation measure. And so, so much of that wealth effect drives economic activity because the people who dominate that wealth also dominate consumption because they've got the dollars to spit.

38:03And economies that all logic says, oh, this economy should be slowing down or raising interest rates 500 basis points should slow the economy down. It doesn't happen because the wealth effect of continued inflated asset prices and greater income from those who own the majority of wealth of higher interest rates keeps the economy chugging around. And so the economy will go down when asset prices go down, not the other way around. And that wealth effect, which fuels the economy, also drives the wealth segregation as the rich get richer because they own all the assets that leads to the political and geopolitical instability and fragility in the system.

38:50And that's sort of, I don't know, that's a bit of an aside. I know we We weren't really talking about that, but that's increasingly how I sort of see the world and that fragility in the world as governments and central banks have created all this credit, true inflation, money and credit that has propped up these asset prices and the wealth of the top quartile of the world. There's something that I think is very unique about this industry. So obviously predicting the future in general is difficult. But it seems logical if you're an expert in an industry, you should have an edge in predicting what the future in your industry holds.

39:32But the challenge in the investment industry is much of that is in the price already. So there's another level beyond just actually predicting the future. It's predicting the future that's different from what the consensus views the future to be. Because even if you're right, and that's what everybody expects, it has no impact on the price. So that just makes it almost nearly impossible to predict the future. But we hear people who predicted X and Y and Z, and those are great stories. But what's often left out is the other 20 things they predicted that never happened. Yeah. And the fact, I know lots of people who could predict what an economic number is going to be or what a policy is going to be.

40:15But then they'll be wrong on what that means to the market. the market won't respond the way they thought they should there this is bad so market should this is bad for the economy so it should be bad for the market turns out it's not and so i'll agree with you alex i i say all the time the only thing that matters is positioning within that positioning in terms of the the return skew the fact the reason that returns are power law distributed not normally distributed is because of leverage it's very simple if if Everybody owned their house without a mortgage and house prices went down. Nobody would care.

40:54But once you introduce leverage and leverage in the bank that's providing the leverage to the homeowner, all of a sudden falling home prices become incredibly risky and power law driven falling asset prices. In my short career, all systemic risk issues have come out of the banking system because that's where all the leverage is. And when the banks get in trouble, then the system's in trouble because there's so much leverage and so little capital in the banking system and the turns and turns of moral hazard and the ever greater leverage created through regulatory guidelines, BIS regulatory capital.

41:41and you think you've learned your lesson and they impose a statutory leverage ratio. And then when it actually matters, they make everyone exempt from it and allow more leverage to go in. And I say all the time, you may have heard me say this on past, I think that's the first center on the Grant Williams podcast, Grant. Banks don't go out of business taking risk. Banks go out of business levering that which they can account for as riskless. it's similar to you're on a racetrack and you have a straightaway and no curves for a long enough period of time you go as fast as you can and and you feel like you don't even need brakes anymore and that's probably the time that the brakes are probably the most valuable that's exactly i mean exactly the way that the backward looking risk methodology of something like value at risk, you're always driving the slowest after the last sharp curve and driving the fastest at the end of the longest straightaway.

42:38The risk methodology is imposing a buy high sell low mentality. So this is the whole problem using Nassim's terminology is the lack of skin in the game. When you have skin in the game, that tacit knowledge, Pellagni's paradox, we can know more than we can tell. You create natural right skew distributions for yourself. You know that you can't recover from death. You know you can't recover from insolvency. You can't compound your way out of 100 % loss. So you don't take that kind of risk. So you're not using probabilistic decisions in things that can destroy you. And so you're trying to create a log distribution instead of a normal distribution of your outcomes.

43:27But when you get into a world of financial fiduciaries, and that skin in the game, tacit knowledge is no longer relevant, all of a sudden, you know, the academia and regulators come in with a short world. And they say, okay, we're going to function this way. And we're going to, you know, instead of putting brakes on the car, we're going to assign probabilities based upon past historical frequencies of what we think future curves might be, and then create this inverse logic around what risk is saying, well, there hasn't been a curve for a long time. So it's increasingly safe to go fast, which is exactly why you get the market dynamic of gradual ups and sharp downs.

44:09I think that's completely accurate in my experience. But there's also another level, which is even if you're aware of those things, there's a human condition at play where a lot of investing is counterintuitive because we can't see the returns of the future. We can only see the returns of the past. I think it's somewhat natural to extrapolate the past into the future as humans and flaws in that way. It seems like you have that added layer of challenge that humans face where they're extrapolating the past into the future, and that can cause you to crash. Right. Exactly that. I linked a paper from one of the sort of other leaders of chaos economics, a guy named Doin Farmer, who's just written a new book.

44:55But I think one of his papers last month, just building a computational model that shows that the power law distribution, the negatively skewed power law distribution of returns comes from leverage. And he builds a simple model that says there's two types of market participants. There's sort of market makers and there's fundamental investors. and the fundamental investors can use leverage. And the better they perform, the more money they attract and the worst performing ones, the less money. And the guy who performs the best during the good times is the guy using leverage. So he gets more money, so he uses more leverage.

45:29And so eventually the system, as you go through a good period, attracts more and more leverage. And all of a sudden the value investor who would be the buyer in falling prices because he sees better value becomes a forced seller because the leverage has made him vulnerable and thus creating the left-held return distributions that we're also familiar with. And that's exactly the point, is that that track record of the past rewards the risky behavior. And you get more leverage in the whole system, obviously, that again, probably the best analogy of how markets and economies function, again, going back to chaos theory, is sort of the specific field of self-organized criticality, which gives the forest fire, but the computer model of a sand pile.

46:16What causes the avalanche is the last grain of sand. It just becomes sufficiently fragile and the fingers of fragility woven in connectivity within the sand pile. It doesn't require some exogenous effect. It just needs one last grain of sand and it triggers the avalanche that triggers the connectivity of the next avalanche. And that's really the market. Eventually enough of that leverage builds up, particularly if you've got some market manipulator trying to prop up the sand pile, aka central banks, governments, and government moral hazard. And it gets more dangerous, preventing every fire until there's so much fire risk in the forest, you've got no choice to prevent fires, which creates more fires in the forest.

46:58And then eventually, all of Yellowstone National Park burns down, because you've created the GFC, and you destroyed the system. And then you start over again, and that risk builds again. Again, in terms of what we do for a living, our effort is to simply be on the other side of that risk building. So we say to people over time, in terms of how we talk about building tell-risk strategies, our objective is to grow the potential insurance that we could provide. And that's step one. Step two is to have it at the largest it's ever been right before you need it because we are just the inverse of the risk building in the market before it topples over.

47:41I've heard you talk about this concept of focusing on divergences rather than optimizing for the mean. Would you talk about that? And I've heard an example about the S &P 500's returns over a long period of time. Yeah. And so it turns out, again, in the geometric compounding, when you make that return path, a multiplicative path, and once it gets multiplicative, it becomes exponential. as opposed to an arithmetic path, you'll find out that the optimizer, if you ran some sort of optimizer, it's going to tell you you should be positively convex because what drives the compounding is divergences from the mean.

48:18If you're looking at the additive path of arithmetic returns, it's going to say target the mean because what happened this period doesn't matter next period, which is obviously wrong in capital growth between somebody's starting of savings and they're retiring. Now you can see that very clearly and we show examples just using the S &P. We do a 40-year monthly series of S &P returns and so 480 months and we look at if you miss the 10 best months or you miss the 10 worst months. What does that do to the compounding path? And so those 10 best months are roughly two percentiles of the months and the 10 worst months, the other wings, two percentiles.

49:01And over that 480 month, 40 year compounding path, the 10 best months contribute 30 % of the long-term compounded annual growth. And the 10 worst months contribute about 40%. The middle 460 months contribute the other 30%. They're almost meaningless. They basically just net off. I draw that picture and show that over a football pitch. So you think about the old traditional normal probability bell curve, you draw it on average in the middle, the soccer ball is in the middle of the pitch 50 % of the time. But none of what matters to the outcome happens at the average. All of the outcome is determined in the two percentiles of times that it spins in their respective penalty boxes and so again you come back to the same solution from a portfolio risk investment perspective hire a good goalkeeper and put more goal scores on the pitch and fight the incentive literally in the financial industry the incentive structure uh putting a bunch of midfielders on the pitch that pass the ball where the fans eyes are attracted to because that's where the ball spins most of the time because it actually has no impact on the outcome of the match.

50:22The outcome of the match is driven by preventing goals and scoring goals. So breaks and drive faster. So let's talk about some potential economic risks that you're seeing by looking at the hedges. Are there any risks or hedges that you find to be very cheap in today's market? There's a few things that we can still see in the market where we can still see uncapitalized risk. So in a sense, what we're looking for is that uncapitalized risk. Now, obviously the sort of mother of all uncapitalized risks in the system, everybody knows about because they know the losses are there. They're just not being accounted for.

50:58And so that's in duration, supposedly riskless government bonds. So, I mean, everybody knows that, I don't know where it is Now, last year, Bank of America had$138 billion of unrealized losses in their whole to maturity U.S. Treasury portfolio. Everybody knows that the Fed has a trillion dollar loss. Everybody knows that pension funds have massive unrecognized losses in Europe and insurance companies in Taiwan. So there's still, and you can see that in terms of the ball markets in our books, that there's still significant exposure in the system to long-end interest rates and to government debt.

51:41In general, whether that risk is because of rising interest rates again, arguably maybe that's the risk in the U.S. Treasury market, or to credit. But remember, Basel decided to treat all OECD sovereign bonds as zero risk weighted assets. So you have the particular issue in Europe. I would argue the risk is greater in Europe because no matter who you are in Europe, in the Eurozone, your bonds across the Eurozone get treated as zero risk weighted assets. So you see the problem previously was Italy, but now it's very much France, where there's no capital protecting not just the interest rate risk of those holdings and hold to maturity books, but also the credit risk.

52:22And so if the market wants to price credit risk into French bonds or Italian bonds or Greece bonds, it's immediately a problem because there's no capital supporting that risk. Now, it doesn't moustaticize because they don't have to account for it. They can just say it's unrealized losses and they're continuing to be underwritten and funded by their governments and funded by their respective central banks. So that's still a big deal. And this is why I've been saying for a long time now that central banks will keep the curve inverted until they get to the recession. Because if they let the curve un-invert and they lose control of the back end, it's a big problem.

53:00Which, again, the Fed cutting 50 basis points, you see the immediate risk of steepening in the back end is a problem. And that will continue to be a problem. So that's one. Obviously, what we've seen throughout this year and earlier this year, in particular, was some real compression of FX volatility. And in particular, major FX pairs. Now, of course, the one everyone talks about and everyone's cognizant of a Japanese yen, that FX volatility was super, super cheap in September of 2021. And has gotten bid up as dollar yen went from 100 to 160. and wasn't as cheap. But obviously the scale of the carry positions in yen are very significant.

53:45If you've read any of my stuff, you know I've been saying forever that Japan will be the trigger. Japan, after 30 decades of one of the greatest market manipulations in the history of the world, zero interest rates, QE on a scale that dwarfs anybody else, when they stop and go the other way, it has shock effects that is hard to fathom. In the realm of chaos theory and predictability, it's hard to figure out the emergence effect of this stuff. It's like a 30 year straight away, right? The insurance is going to be very, very cheap. It's going to be tricky to figure out how to go back the other way.

54:19But, you know, you know, and obviously China is another part of that factor. But Europe, in particular this year, in terms of cheap vol, you know, some of the cheapest vol. And again, we don't, we say vol, but most of what we live in is probably more accurate than third and fourth moment. So skew and vola vol, but got historically cheap. And some of the major currency pairs, euro, Swiss franc, sterling, Aussie dollar, New Zealand dollar had historical cheap convexity pricing. So sort of wing pricing, volatility and volatility that presented for guys like us, really, really super opportunities to build really highly convex, very cost efficient payout structures that, you know, the philosophy insurance is you want it to cost the least if you don't need it and pay off the most if you do.

55:14As it turns out, those things that have the most compressed convexity, where you can buy the most highly asymmetric products at the cheapest price are exactly that. The problem with the U.S. equity vol market from a dedicated tail risk perspective is it's the easiest place in the world to buy vault. And most people in the world, to the extent they measure risk, measure their risk as S &P beta, as their correlation to S &P in their overall portfolio. Now, in reality, their risk is their correlation assumptions, but they don't measure that, which is exactly why it's their risk. But because so many people measure their risk as their sort of correlation to S &P or to MSCI, mostly S &P, and then the easiest buying vol is generally fairly complicated and difficult with one notable exception.

56:03There's a future on the implied volatility of S &P index called the VIX future. And it's the easiest place in the whole world for somebody to go and buy pure vol. Now, the benefit of that is that it attracts so much of the demand for hedging that it's persistently expensive. And so there's a a premium that you have to pay to buy protection in S &P. Now, that premium doesn't necessarily exist in other markets where there's a better balance of volatility, supply, and demand. And that's where we tend to prefer to go fishing. But sometimes that skew creates other opportunities and other dynamics that are of interest to us.

56:46And another way to summarize what you just said is that if insurance is obvious and readily available, it's probably going to be expensive. And so you have to search for pockets where it's not as well known. That's where you get the value. Yeah, correct. Buying vol is like collecting liabilities. Selling vol is like collecting assets. The system has set it up so it's very simple for people to acquire assets. It's more complicated for people to acquire liabilities. It's easy to buy a stock or buy a bond. It's hard to issue a stock or issue a bond. It's hard to short them. So likewise with volatility, you can buy all sorts of products that embed short volatility.

57:32It's harder to find products that construct positive convexity and long volatility. And so in markets where there's this proliferation of products with embedded short volatility, that compresses it. And if it's a market where it's hard to buy the volatility, it's where you get the supply and demand imbalances. There's a lot of focus on the Fed and what they're going to do. They were raising rates, now they're starting to cut rates. And we know the Fed has the dual mandate to maintain reasonable growth and try to have price stability. But what about an implied third mandate that nobody really talks about, which is to do all that without increasing systemic risk?

58:12How do you think about that? Again, I've been around a long time and through my past sins, I know a lot of central bankers and I still speak to some of them regularly in formal or informal ways. I would argue their number one focus is on what they would call financial stability. Now, their stated priority in general is price stability. In many cases, the ECB and Bank of England, it's explicitly their priority. The Fed is actually somewhat unique where it's a dual mandate. Most of them have a primary mandate and growth or employment is a secondary mandate. But I would argue all of them, their number one focus is financial stability.

58:53And because they know that if they break the system again, they have to step in again and bail out the banks and buy all the assets. And they have to step in and do QE regardless of where their price stability mandate is to, you know, a la Silicon Valley Bank, right? They had to step in and provide the BTFP repo, which was in effect growing their balance sheet again, even as they're in the stated path of shrinking their balance sheet in their supposed effort to constrain rising price indices. So I think financial stability is probably the number one thing they actually care about. And all things eventually come down to protecting the banking system.

59:36Now, as long as they think the banking system can survive raising interest rates when price stability has gotten out of the quarter and they look bad for, well, they look stupid for creating something called average inflation targeting. Just before inflation explodes higher, they've said, we're going to let it run hot. And then, of course, when they let it run hot, it becomes highly reflexive. And then they call it transitory and they end up looking dumb. So they do what they do and they get away with it because they've set the rules up so the banks don't have to account for the losses. And yet, in a sense, they need to get to a recession or a slowdown so that people will continue to own the back-end bonds at what are now, if not necessarily higher levels of inflation indices, but certainly higher volatility of inflation indices and higher volatility of interest rates.

1:00:31And the big benefit that bonds presumably had in a 60-40 type portfolio was one, they had really low volatility. And two, they had this intermittent correlation benefit because central banks cut rates when equity prices fell. And they created that Greenspan put your this negative correlation. But that becomes a problem now, both in trying to manage the price stability mandate, the growth mandate, and the ultimate mandate, which is the financial stability mandate. And then you've got the throwing problem of what has become commonly talked about in terms of the fiscal dominance situation that the governments have put all of the central banks in by basically relinquishing any independence they supposedly had by running debt beyond 100 % of debt to GDP, where their ability to continue funding at interest rates that may or may not be necessary to suppress inflation raises question of the central bank's freedom and flexibility to do what they would need to do.

1:01:35Because governments, not just the US government, but the world over, Japan, obviously the biggest question mark, How does the government finance themselves at 260 % of debt to GDP if Bank of Japan had to go to positive real interest rates? It's hard to imagine. The math gets a bit scary. If you were elected the next Fed chair and you were truly independent, how would you approach getting us out of the current economic situation? That's a dangerous question. Well, the first thing I would do is solve exactly what we were just talking about. I would start breaking up the big banks, and I would force a lot more capital into the banks.

1:02:18And I would try to, if it was me, I would start a drive to reimpose Glass-Steagall and take the highly risky investment banking businesses back out of the regulatory umbrella and safety net, deposit insurance and implicit guarantees of banks, and go back to the market disciplining of high risk investment banking businesses, and partners capital and their capital at risk instead of governments and taxpayers at risk of that stuff being embedded in government. Well, in the case of GSIBs, globally systemic important banks, explicitly government-guaranteed entities. So I would try to reduce the financial stability emphasis that currently exists within central banks and their regulatory functions by, in effect, reimposing Plastiva and putting more discipline back in the market mechanism, less in the moral hazards realm.

1:03:21Once you've done that, then you become far more flexible in how you use interest rates. I would again advocate now, whether it's the right rule or not, I would advocate for something like the Taylor rule, where you take discretion away from these guys, because these guys don't know. They're no better. In fact, based on their track record, they're worse forecasters than what are generally bad forecasters, even in the private sector where the guy has some accountability. These guys are absolutely proliferately bad forecasters. So you don't want them to have discretion. You should never, I would, I would, firstly, I've said this a very long time, so I don't mind saying it.

1:03:58This may sound a little flippant, but nobody should ever have interest rates lower than 2%. It's just madness. Bank of England never went below 2 % during the Great Depression and World War II. Why did they go to zero after the GFC and COVID? Were those worse than the Great Depression and World War II? Somehow I doubt it. But it's just so dangerous when you get there. You create, as I say all the time, what did they think would happen? What did they think after years and decades of zero interest rates and QE and explicitly saying we're running these policies to incite inflation, that average inflation targeting, we're going to run hot to get the average back up.

1:04:44We're no longer going to treat 2 % as sort of a ceiling. we're going to treat it as a target and a floor we're going to go above it what did you think was going to happen obviously we're going to get to a point where you needed to raise interest rates at exactly the time the system's too sensitive to it the financial stability issue is so high because you've been at zero and and qe for so long big balance sheets and the government's inevitably at zero and qe are going to blow through what historically was you know well historically and structurally deemed the the limit of 60 percent under the maastricht treaty everyone's going to blow through it and so you just create this madness and this loop that we're caught in now very hard to get out of so uh break up the bank split up investment banking and i had this argument when they did tarp i said you've got everything in tarp tell everyone they can come out anytime they want no restrictions but they they lose the guarantee They go do any business they want.

1:05:44There's no more guarantee. And you sort of effectively reimpose Glass-Steagall and the banks that stay in TARP have the deposit insurance protection and no longer can do high risk, high compensation activities. That's what I do. So would you share your best guess about whether there's some master plan to try to navigate us to a soft landing? And I don't mean from high inflation and try to avoid a recession, but more about navigating from our massive debts that just seem to grow because we have these perpetual deficits. Or do you feel like these big issues aren't really that well understood and therefore an accident is more likely?

1:06:27Well, I think an accident is inevitable because there always will be self-organized criticality. You'll build up sufficient fragility and the system will reset. That will always be the case. Bifurcation maps and chaos theory. So it's inevitable. It's just a question of how long you can keep preventing forest fires until you get ever more fire risk. I don't see any plan coming from anywhere other than more debt. I don't see it. I mean, there's no indication from the current government, the competing parties for government in the U.S. or other places. um i've been as i was as i'm getting ready to write my note for tomorrow i'm sitting here reading mario draghi's a sanctioned report on the future of european competitiveness and his only solution for better competitiveness in europe is 800 billion dollars a year more borrowing at the central level to be spent i guess because blowing through 100 of debt to GDP at each state level apparently hasn't gotten enough competitive.

1:07:33So you need to do more borrowing at the central level to go get that competitiveness. And so I think personally, the biggest risk is still the same one. It's keeping up with the asset inflation. And asset inflation seems to me their only solution. It's their number one driver of growth. and it keeps the rich people happy, which seems to be a political positive. And so I think, you know, I go back to it from an investment perspective, you've got to participate, protect. You know, the failings that most people have made, certainly since GFC, is they've under-participated. They've under-protected themselves from the asset inflation drive.

1:08:18And then, you know, everyone thought, well, COVID, boom. And then, boom, off we go again. You know, NASDAQ doubles again and again. And so, you know, I come back to this sort of barbell philosophy. You've got to protect yourself from that right tail. But if you're going to play the right tail, you better have some good breaks. Because, you know, whatever the next GFC or COVID or Asian crisis or tequila crisis or European credit crisis or Japan bubble burst or the, you know, China bubble burst that we've been going through for the last two years. You know, it's probably a bad one. And so you'll want to have some protection against it while you're going out and taking risks.

1:08:55But the solution never has been and still is not owning things with bounded upside that don't provide downside protection. And obviously, the biggest one of those is bonds. And owning government bonds is though it has some sort of portfolio benefit. When the guy selling them to you has a stated policy of trying to debase his own debt, doesn't strike me that that's going to provide a good retirement 20, 30, 40 years down the road. It certainly hasn't for people retiring this year that own bonds. I mean, especially imagine since I was in Netherlands last week, you know, if you think 60, 40 has done bad, imagine what 20, 80 is doing in your pension funds.

1:09:36I mean, places like that, you know, when yields got to negative, you got 80 % bonds, you have, you have, you know, public sector pension funds in Europe that were down 40, 45 % in 2022. Good luck compounding back out of that at a 3 % yield. Disaster. You talked about a fragile system. So these are often exposed during a major shock. A couple of years ago, interest rates jumped 5 % unexpectedly in a relatively short period of time. Are you surprised by the lack of collateral damage following the recent interest rate increases, or do you think it just takes time to manifest itself? In a sense, nothing surprises me because I don't have any expectations of the future.

1:10:22Yeah. I think, again, I had this conversation with a friend last night. I think particularly in the US, but stock markets are up everywhere. Property markets are through the moon everywhere. the wealth effect is more than enough to sustain the economy. And people who are earning at the higher interest rates, it's a cash flow positive for them. People, particularly in the U.S., where you can take out 30-year mortgages and where corporates have access to the world's deepest capital markets for issuing long-dated bonds can borrow. So borrowers have had a significant benefit from these rising interest rates.

1:11:06And the people who would be heard and the people that if you thought about, oh, this is going to cause a crash, is the guy who owned the bonds. But the guys who own the bonds are central banks, banks, pension funds that don't account for the losses. So the gains, the benefits to the borrower of those mortgages, of those long dated bonds they issued, et cetera, is out there loving life, living large. The guys who should be bankrupt and blowing up, Silicon Valley Bank did, but everyone else, they're not reporting the losses. The Fed's not reporting the losses. The government's happy to keep spending.

1:11:45Yeah. So, yeah, I'm not surprised because I didn't expect the market to crash. I did, in a sense, expect interest rates would go up because I could see how all was priced in 2020 and 2021. want. But I don't think higher interest rates hurt economies the way we're told it does. I think most economies function pretty well at higher interest rates because savers benefit. And to the extent you could borrow long, which in the US you could, it's just the guy who owned the bonds and the guy who owns most of the bonds or sharp world regulated entities that don't account for it the way somebody would if it was their own money.

1:12:34And obviously it helps when the government runs massive deficits and throws money into the system to help buffer some of this. Yeah. The biggest borrower at these now higher rates is the government. But Janet Yellen shows you she doesn't mind borrowing short at the highest point the yield curve she's happy to do it she's not going out of business her negative cash flow isn't driving her to the poor house she doesn't care so you know she's happy to issue more five percent bills over and over and over and over again if a corporation had her funding structure they'd probably be in a bit of trouble but she's not in trouble she's the biggest borrower and the fed was the biggest owner so they have the biggest unrealized loss and they're I don't want to use the word, the Ponzi scheme just carries on.

1:13:25I recall back in 2011, I believe it was, when there was a view that treasuries are grossly overvalued, that the only buyer is the government, they're going to step away, they're not going to buy anymore. And just about everybody thought it was one of the worst investments you can make. Yet we had an unexpected recession and treasuries rallied massively. How do you think about the relationship between the demand for the bonds and then how that demand can suddenly shift when you have a recession and the market starts to discount falling interest rates? As I said earlier, I think in a sense, this is what the central banks decided they wanted.

1:14:03They wanted to invert that yield curve, get people to believe the recession is coming so they'd continue to hold on to the back end bonds. not let the back end blow through 5 % or whatever in the U.S. And so I think they would like, in a sense, a recession. Of course, they want a mild one. They don't want all a bunch of defaults because then the banks are back in trouble again. But I think they're playing exactly that game where certainly how many times, depending on how you measure them, there's been four to seven pivots by the Fed where they've come out and basically said, oh, you know, the recession's coming.

1:14:43Now, the Bank of England said it every quarter for three years. So there very much has been a narrative around, and you can see quite clearly, certainly with the Fed's actions recently, the asymmetry in their bias, right? They were holding rates at zero and still doing maximum QE when their measure of inflation, PCE, was at six. now they're cutting 50 basis points in their measures it just barely below three you know wait a minute you know i saw some note from somebody you know well now that inflation is sustainably below three the fed should normalize interest rates as though normal as well is the environment we've had post gfc which in fact is the greatest anomaly in all of interest rate history As I said, the Bank of England didn't even go below two during World War II.

1:15:35But when we were consistently above one, we threw the whole kitchen sink to get it back to two. We did ZERP and QE and everything, you know, FAIT and everything we possibly could do. You know, one and a half, 1.8, we still got to be at zero. But we're slightly below three, and so we need to cut rates down from five. there's an almost obvious asymmetry. And I quote all the time, Arthur Burns, sort of mea culpa speech, where he says exactly that, you know, in his failings in the 70s of squashing the inflation and then continuing to spike back up again, every time it started to come down saying, you know, there's an obvious sort of institutional asymmetry bias of how we think about it.

1:16:20We're very quick to respond to slowing economies and very slow to respond to heating economies. And I think the Fed's no different today. Well, Dave, this has been fascinating. I appreciate you sharing all your insights. I know it's late at night in Singapore, so I appreciate you staying up to discuss all your perspectives about risk with us. It's great. I was very extensive, very well-prepared, and I appreciate you invited me along. I'm very glad Matt introduced us, and it's been a lot of fun to talk to you. Please do stay in touch. Will do. Thank you. Thanks for listening. We hope you enjoyed this episode.

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