In short
Why US government bond yields—especially the long end—have surged, tying together dealer balance-sheet constraints, Treasury supply/demand, Fed–Treasury interactions, and recent Treasury buyback signaling.
Guest backgrounds
Daryl Duffy, Stanford University professor of finance; studies Treasury market plumbing, dealer balance sheets, and effects of Treasury buyback programs (currently coauthoring work with NY Fed economists Michael Fleming and Orr Shakar and Stanford PhD student Sam Witcherly).
Key claims
Yields reflect scarce dealer balance-sheet capacity (2020 showed dysfunction when dealers’ balance sheets were “dug out” by the Fed). The main driver now is supply of government debt relative to demand: foreign central banks aren’t adding, so domestic discretionary investors require higher yield compensation. The Fed avoids “fiscal dominance”/yield-curve-control. Treasury buybacks can clean up illiquid “off-the-run” bonds and can be used for unanticipated market needs.
Notable examples
March 2020 market dysfunction; Treasury buybacks aimed at “odd lots” clogging dealer balance sheets; Operation Twist comparison; 1950s Fed–Treasury Accord; Liz Truss/Bank of England gilt indemnification; yen intervention concerns.
Written by AI. May contain mistakes. Listen to the episode to check what was said.
Chapters
Tap a time to open that second in VOThemes of Jackson Hole Symposium
0:00 to 0:26
Discussion of the symposium's themes and bond yield concerns.
“Did you ever notice how you spend hours shopping online only to pause a checkout because you wonder if you trusted enough to hit buy now?”
Themes of Jackson Hole Symposium
2:46 to 3:54
Discussion of the symposium's themes and bond yield concerns.
“Well, Joe, we are still at Jackson Hole, where the official theme of this year's symposium is financial innovation in payments.”
Introducing Daryl Duffy
4:00 to 4:22
Hosts introduce guest Daryl Duffy and hint at topics to discuss.
“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.”
Exploring Bond Yields and Market Dynamics
4:22 to 7:34
Daryl discusses the impact of bond yields on the economy and treasury.
“He is, of course, professor of finance over at Stanford University.”
Inflation and Its Effects on Bond Markets
7:36 to 13:20
The conversation shifts to inflation and its effects on bond prices.
“So in Tracy's proverbial hedge fund, she has the$20 billion allocation to treasuries.”
Inflation and Its Effects on Bond Markets
14:12 to 14:37
The conversation shifts to inflation and its effects on bond prices.
“So even as the way people shop changes, the moment that matters most still feels familiar and deeply dependable.”
Impact of Debt Issuance on Central Bankers
15:53 to 21:44
Understand the implications of debt issuance for central bankers and market dynamics.
“This is kind of a cliched question, but that deluge of debt issuance, I guess, what does that actually mean for central bankers?”
Treasury Buyback Programs Explained
21:44 to 24:25
Learn about Treasury buyback programs and their effects on market liquidity and yields.
“What does your research actually say about, I guess, the impact and duration of Treasury buybacks?”
Analyzing Current Debt Maturity Trends
24:25 to 28:00
Explore the current state of U.S. debt maturity and its implications for the economy.
“But from your perspective in the last few weeks, there's nothing in the sort of classical measures of liquidity that were out of whack?”
Treasury Debt Issuance and Market Concerns
28:00 to 29:22
Discussion on the impact of short-term debt issuance on long-term yields.
“Microtwist sounds like one of those terrible Alco pops of the early 2000s, right?”
Show all 15 chapters
Fed Balance Sheet Shrinkage Debate
29:22 to 30:56
Exploration of the implications of reducing the Fed's balance sheet size.
“but one of them is the new Fed chair and the task forces that he's created, including one that's looking at the Fed balance sheet.”
Challenges of Reducing Fed Liabilities
30:56 to 33:19
Analysis of regulatory challenges in reducing Federal Reserve liabilities.
“So if you just do adding up, you know, if you want to reduce the assets, you have to reduce the liabilities one for one.”
Recommendations for Fed Task Force
33:19 to 35:50
Predictions about potential recommendations for the Fed's balance sheet management.
“And if you try to make them, markets get volatile and the Fed has to back off.”
Understanding the Term Premium
35:50 to 37:30
Clarification on the term premium and its significance in yield curves.
“I think you believe it exists, but you don't believe that it's useful in any way.”
Understanding the Term Premium
43:36 to 44:02
Clarification on the term premium and its significance in yield curves.
“Some people use ChatGPT to answer questions.”
Transcript
Automatic transcript. May contain errors.0:00Tracy Alloway:Did you ever notice how you spend hours shopping online only to pause a checkout because you wonder if you trusted enough to hit buy now? Agentic Commerce is testing that moment more than ever. That's where PayPal comes in. With 25 years of checkouts, 400 million consumer accounts globally, and the benefit of fraud protection. So no matter where a purchase starts, it ends with trust. Built for payments, growth in Agentic. PayPal Open. Built for all business. Visit paypalopen.com. Some people treat ChatGPT like some kind of smart search engine, and some use it to get work done. ChatGPT Work is a new way of working in ChatGPT that can take action across your apps and files, stay with a project for hours if needed, and turn a goal into finished work.
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1:45Tracy Alloway:Hello, OddLods listeners. I'm Joe Weisenthal. And I'm Tracy Alloway. We're the hosts of the OddLods podcast, and we've got something exciting for you. That's right. So one of the best parts of hosting our podcast is we get to actually meet and interact with our listeners. And we know we have some listeners over in Los Angeles. That's right. So if you're in L.A., we're going to be recording a live show, some live recordings at the Vermont Theater in Hollywood on September 17th. We have some really exciting guests lined up, have some really great conversations planned. So go ahead and get your tickets.
2:17You can find those over at Bloomberg.com forward slash oddlots or click the link below in the show notes and come and say hi when you're there.
2:30Bloomberg Audio Studios. Podcasts. Radio. News.
2:45Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Allaway.
2:50Tracy Alloway:And I'm Joe Weisenthal. Well, Joe, we are still at Jackson Hole, where the official theme of this year's symposium is financial innovation in payments. 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 these different task forces to look at things like comms 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 U.S.
3:26Treasury, given that the Treasury is now buying back longer dated bonds and seemingly suppressing longer dated yields.
3:33Tracy Alloway:There's 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 in the economy. By the way, the sun just came out. We're recording outside. It's been rainy and cool all day. Now it 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.
4:06That's exactly what I was going to say. So the guest for today, truly the perfect guest, 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 Daryl Duffy. He is, of course, professor of finance over at Stanford University. So, Daryl, thank you so much for coming back on All Thoughts. 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.
4:39In March of 2020, when the markets became dysfunctional. That's a good answer. 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.
4:51Tracy Alloway: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 a, 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.
5:26Dealer balance sheets would get clogged again. But even with the massive amounts of trading we're seeing today, the dealers have more space yet. Could be capital regulations are not as strong. 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 or 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.
6:08The 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, as indicated in today's markets, is 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. I wish, but go on. And I'm calling from the Treasury Department, and I'm suggesting that you could take another 10. There's space on your own balance sheet to do that. Now, given the conditions that I described for the safe bonds, why wouldn't you?
6:57And 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. But the foreign central banks, they have had what they need for a long time now. 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, the 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.
7:33Tracy Alloway: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 NVIDIA. I've got the best assets, Joe, 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 is 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?
8:14Sure, 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 U.S., but especially the U.S. And government 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.
8:41Tracy Alloway:Debt to GDP ratios, no end in sight, et cetera. Certainly, that seems right. People could have said that five or six years ago. Well, they could have said that 2018, 2019. And they said it for years about Japan, and just rates kept going higher. Now they're going higher. But they said they kept going lower. What is it? What changed? Like, you could have told this story 10 years ago, and you could have laid out the demographics, and you could have talked about the lack of political appetite to cut spending, et cetera. 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.
9:20Yeah. 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. France 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 just volume. It's not, I mean, 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.
10:05Yeah, 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 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.
10:36No, that's absolutely right. And I wouldn't describe it as the hyperscalers crowding out the Treasury Department, but rather the other way around. Oh, interesting. Yeah, I mean,$32 trillion and rising at$2 trillion a year. There's nothing, I mean, it is true. 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, you know, I really think it's the Treasury and not just the U.S. Treasury, 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.
11:19And, you know, we see what's happening to yields.
11:22Tracy Alloway: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. So 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 Claude yield and the Gemini yield. And those will be earned risk free. But wait, I want to get back to one more thing. So I get all of this, what you're saying.
11:55Tracy Alloway:One word that hasn't come up, though, is inflation. And so what 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 higher rates 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. It's a fiscal theory of the price level. Read John Cochran's book, or maybe you have.
12:37Tracy Alloway:We've never had 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, 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.
13:19I 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.
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15:50LPL Financial LLC. Member FINRA SIPC. 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 Fed Treasury Accord.
16:29People 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?
17:11I've lost all sense of time. But recently 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 that in his view, market participants should have understood that a lower yield for the U.S. Treasury securities would be appropriate. And he said that he was signaling, he used the word signal, signaling to the market his belief that Treasury yields were too high.
17:57Now, I think we subsequently can see 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. Did you see what Trump said the other day? Oh, yeah, about military intervention.
18:31Tracy Alloway:Military intervention in the bond market. So I don't know, maybe James Carville wasn't thinking fully that the bond vigil... James Carville had not considered that the bond vigilantes could be bombed into submission, potentially. I don't know if he thought about that one. Well, even the mighty U.S. Treasury Department is not as powerful as bond markets when it comes to setting yields. 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.
19:22treasury 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 Besant 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.
19:39Tracy Alloway:I feel like classical discussions of interventions, they seem to work better when they are not volume-bound but by level-bound. And when it seems often the case when they're level-bound, you don't even have to spend anything. So you say, okay, 5 % is our line in the sand. And in theory, doesn't the Treasury have, it could just issue two-year bills and just take out the 30s. Would that, I mean, if Bassett 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.
20:17Tracy Alloway: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.
20:52It 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 Besson 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 taking a lot of risk.
21:44What 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? Well, I'm working right now with two economists at the Federal Reserve Bank of New York, Michael Fleming and Orr Shakar, and with my PhD student at Stanford, Sam Witcherly. And we are using the buyback data as well as turnover data on dealer balance sheets to understand the benefit of the original purpose of the buyback program, which is to go out and clean up the leftover bits and pieces of old treasury notes and bonds.
Read the full transcript
22:30Odd lots. Odd lots, yeah. This was stuff that actually wasn't really trading anymore, right? Yeah, it was clogging up dealer balance sheets and trading at lower prices then would be suggested by a smooth yield curve. And so the idea was, as explained by then Assistant Treasury Secretary Josh Frost, let's be regular and predictable and clean up these bits and pieces, make the Treasury market more liquid by replacing those with new liquid Treasuries, and implicitly make some money for the U.S. taxpayer by buy low, sell high. And that's a good program. Our research shows, well, it's in progress. You'll see the paper eventually.
23:10We'll have you back on.
23:12Tracy Alloway:You and your PhD student can come back on for that. It shows that that's effective. And by the way, I think it's totally legitimate that a Treasury Secretary or Treasury Department would step into the market and use the buyback program for unanticipated needs. So, for example, going back to March 2020. Yeah. it's totally legitimate that a finance ministry or a treasury department would say, it's our bond market, it's dysfunctional, it benefits us to step into that market and not leave it entirely to the central bank. You may remember the Liz Truss budget. Vaguely, yes. Vaguely, yeah. At that time, the Bank of England faced this dilemma.
23:48It was tightening its monetary policy, and at the same time, it had to buy gilts. And so it made a very clear distinction and soon afterwards sold those gilts. it's easier if the Treasury Department is involved. In the case of the U.K., it indemnified the Bank of England for the losses that it might have incurred. And in the case of the United States, the Treasury Department could use its own buyback program to add firepower. And that could be done on a scale of hundreds of billions, not the mere$4 to$8 billion that the Treasury Department has been speaking about over the last couple of weeks.
24:25Tracy Alloway:But from your perspective in the last few weeks, there's nothing in the sort of classical measures of liquidity that were out of whack? No, nothing. You know, dealer balance sheets seem to be in good shape. Bit offer spreads, market depth are in normal range.
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26:58Tracy Alloway:I mean, one way to think about it is it's not that different from QE or Operation Twist. is some of these things that the central bank did in the 2010s to sort of change the shape or the slope of the yield curve. But that was in a time of below-target inflation and the central bank trying to cause things to reaccelerate. But on some level, does this look like efforts that classically you might expect to see in an environment where the central bank is trying to goose inflation? When you say this, meaning what action? The sort of the expanded buybacks, the attempt to depress the long end that sort of looks Operation Twisty.
27:42Tracy Alloway:But that was in an environment where we were sub 2 % to the frustration of the central bank. Yeah. So, well, first of all, I don't think this is stepping on the toes of the Fed. Okay. And I do think that it feels like a twisty type of operation, but a micro twist. Okay. The firepower that, you know, a few billion dollars, other than the signaling, a few billion is just not going to move the needle. Microtwist sounds like one of those terrible Alco pops of the early 2000s, right? I was thinking maybe it sounds like a dance. I would try a microtwist. Okay. Well, okay, but if the Treasury is issuing more short-term debt, which it is, does that solve the long-end yield problem, or does that just end up shifting the issue into money markets?
28:27Well, it does shift issuance into bills, and that's how buybacks are working with these particular operations. And yeah, so it means, as I mentioned, there's shorter and shorter debt maturity, but no alarm bells yet. The U.S. is not out of historical norms. It's actually a little bit longer maturity, average maturity than normal. And, you know, I'm not that worried yet. I mean, if they were to continue, and really the real action is in new issuance, not in buybacks. If they were to continue to keep the issuance of long-term securities at current levels, as they have been, and have forecasted that they will, if they were to keep doing that for years, then the piling up of short-term debt would eventually be notable, and it would cause concern.
29:18All right. So, you know, I talked in the beginning of all these different things that are happening at the moment. but one of them is the new Fed chair and the task forces that he's created, including one that's looking at the Fed balance sheet. Can you maybe put your Kevin Warsh hat on for a second? When he says he wants to shrink the size of the Fed's balance sheet, why is that desirable? Well, first, I'm not Kevin Warsh, so I'm not going to get inside his head. But judging from his speech around the G30 meeting last year, in which he was most clear on his views here, I think he worries that the Fed looks like it's too active in financial markets, that its footprint is too big, and that it has the image of possibly getting into fiscal policy.
30:13And so he wants to stay completely, my interpretation, he wants to stay clear of having created that impression. And a smaller balance sheet would signal that. I think the more interesting question is how could you do it? Yeah. Because it's easy enough to sell bonds on the asset side, but it's not easy to extinguish the liabilities on the other side of the balance sheet. That's right. Right. When we think about the Fed balance sheet, everyone always thinks about assets because we've gone through years and years and years of QE and no one ever thinks about liabilities. But how do you those two things have to be in balance?
30:49You can't shrink the asset side without shrinking the liability side. You reach that conclusion, Tracy, faster than almost anyone that I talk to. Oh, dear. OK. So if you just do adding up, you know, if you want to reduce the assets, you have to reduce the liabilities one for one. Let's take them in turn. You've got the Treasury General account. I don't think the Fed's going to call the Treasury and say, would you take some money out of your account at the Fed? Then you've got paper money. I don't think the Fed is going to put out advertisements saying, please, Americans and everybody else out there in the world that has paper money, would you mind turning it in so that we can reduce that liability?
31:25So that the only significant possible reduction is in reserves, meaning the deposits that commercial banks have at the Fed. And there is scope for doing that, but not with the current tools that the Fed has.
31:38Tracy Alloway:Would there be a regulatory change that would be necessary? Because we went years and years, right, with basically no balance sheet. And then, you know, then 2008 hit and suddenly there's all these reserves. Why can't we go back to what would it what would be the challenge of going back to 2000? Before Lehman, we didn't have that many reserves. Yeah, right, right. So what would be what would it take if we if for some reason we thought this is very important. And we want to get back to the real good old days of Fed balance sheet side. What would it actually take from a regulation perspective to get to just a 2005 looking banking system?
32:11It's not going to happen, Joe, because back in 2005, liquidity regulations were much different.
32:18Tracy Alloway:OK. And the Fed didn't pay interest on reserves. So the banks were not in the least interested in holding reserves, because why would you hold reserves getting zero interest when you could invest the money in money markets and enter a full market rate? Today, in order to control inflation, the Fed is forced to pay an interest rate to banks that's roughly the market rate. And so, you know, if you ask a bank, well, why don't you give up some of those reserves? They might say, well, why? They're so useful for meeting liquidity regulations. They pay a full market interest rate. They're perfect for payment services.
32:53What's not to like? It's the Swiss army knife of finance. We're not going to give those up easily. And right here in Jackson Hole in 2017, Verala Charya and Raghurajan presented a paper describing a ratchet effect by which every time the Fed increases its balance sheet and adds reserves, the banks get addicted to having more of that extremely useful asset reserves. And they're reluctant to give it up. And if you try to make them, markets get volatile and the Fed has to back off. So a lot has changed. What would be your recommendation if you were on this task force? I think it's Stein who's heading it.
33:32But, you know, if war says, I want to shrink the size of the balance sheet and we have this reserves problem, what would you do? It's Jeremy Stein, Raghurajan, the same economist that spoke here about the ratchet effect, and Karen Dynan. All very noted, very credible, extremely wise and articulate economists. What they're going to do, what they're going to recommend, I don't know. But I think that they're going to take a very wide lens look at this. They're not going to look only at size. They're going to look at the composition of the assets. I predict that they will, and this is with no information from them, I predict that they will recommend reducing the quantity of long-term Treasury securities that the Fed holds and replacing those with Treasury bills in order to reduce the volatility of the Fed's interest expense.
34:22So, for example, if you back the reserves one-to-one with Treasury bills, then every time the Fed has to pay more interest to the banks to control inflation, it's getting more interest on their Treasury bills one-for-one. Paper money, they could continue to hold long-term securities. And I don't think the Fed feels good about having mortgage-backed securities. I think they're just going to let those roll off. So I think that could be in one area that they will get into is the composition of the assets. And on the liability side, it's hard to predict. In my own view, the Fed doesn't need to reduce the size of its balance sheet, but it should have the tools that would allow it to do that.
35:01Because if my hunch that this has politics around it is correct, the Fed never wants to be put into a corner by Congress over the size of its balance sheet without the tools that would allow the Fed to say, no, we're not going to increase our balance sheet as you would like us to do and buy the assets that you would like us to buy, but rather we can control our own balance sheet by reducing it if we need to. And those tools exist in theory, but they haven't been developed in practice by the Fed yet. They have been for other central banks. I have one more question, and it's not really a It's more of a favor, really.
35:46But 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. Let's let our guest talk. You're not going to defend yourself, Joe?
36:04Tracy Alloway:I'm a simple man. I look at a 30-year yield. I think it looks like a 30-year's worth of overnight rates. You just add them up, and I just, you know, that's how it would I assume. But then everyone's like, no, but the term premium. And then I say, okay, but what is it? They're like, well, we can't really measure it. And then all the models that we have to measure don't work. But trust us, it exists. This is why it's useful. 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 it? I really struggle with it.
36:35Tracy Alloway:So this is why we need a Stanford economist to straighten me out. Yeah, it's an easily measured concept. And 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. And then on top of that, there's a risk premium. And how to decompose that, you know, economists like John Cochran, who we mentioned earlier, with Monica Piazzese, have, you know, done some of the best work on that decomposition.
37:10and 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 this podcast with homework. I'm going to do some reading, yeah. Assigned reading. All right, Daryl Duffy from Stanford, thank you so much for coming back on All Thoughts. Really appreciate it. Tracy, Joe, it's always a pleasure.
37:39Tracy Alloway:Ask me back. We'll definitely do it again. Thank you so much.
37:55So, Joe, that was great. I know we've been meaning to talk about the Treasury buyback, so I'm glad we could get into that. I was thinking, you know, he mentioned the Treasury general account at the Fed, which is like the Treasury's checking account. And you always hear this stat that it covers five days of government expenses or something like that. And I always think about the headlines saying, oh, ordinary Americans, you know, half of ordinary Americans only have enough money to cover three months expenses. And then I'm like, what about the Fed?
38:23Tracy Alloway:I'm being somewhat facetious. Sorry, what about the Treasury? But, like, it is kind of crazy. Five days. Yeah. I guess it is kind of crazy. But, you know, just thinking I would just issue more debt. What if Trump actually bombs the bond market? What happens to the Treasury? So it is weird that we actually haven't talked about that quote very much, but such as life. We'll find the perfect guest to talk about it. Such as life in 2026. I thought that was really good. I actually did not fully understand previously why buybacks exist in the normal term. Okay, setting aside why there's the deviation from the typical schedule, why they exist in the first place, and this idea that, like, what is the point of having these sort of off the run, we're, you know, Is that some 27 year bomb that's sitting out there that no one wants whatever that it just sort of makes sense to have a regular A regular sweep of that.
39:13Tracy Alloway:You know what they call it in crypto world? What? It's dust So for example like like abandoned assets kind of it's kind of like if there'll be little flex of like point zero zero zero two Bitcoin on like some wall or something. But because there's a transaction fee with all of them, you can accumulate this dust and it's not economical to move it off of them that creates all kinds of issues and stuff. It's sort of similar. I remember, weren't there some startups at one point who were trying to like collect all the dust and roll it up into something substantial? The other thing I was thinking just about the buyback program now is, I mean, you almost have an issue with the reaction function of the treasury now.
39:58If it's citing market liquidity in order to increase the size of the buybacks, but the treasury market seems to be operating pretty normally. And then everyone starts focusing on the yield as Daryl was saying, like, oh, it seems like Besant just doesn't think the yield is at the right level. Well, then suddenly you have this target that investors are maybe going to be watching for signs that the treasury is going to come back in.
40:23Tracy Alloway:I think Besson really just misses being a hedge funder. It's like, he's like, no, this is like, the yield is too high. It's like an opportunity to buy, right? And he's like intervening in the yen and stuff. I think this is like, he's in his comfort ground when he's making moves like this. Well, I will say, as of the moment we're recording, he's probably above water on his treasury purchases, right? So I thought so too. Yeah. Except, so this is what I thought. I was like, oh, this is a good trade. Evidently, the purchase, this is what two people on Twitter told me this, because I thought that too.
40:55Tracy Alloway:It must be true, Joe. The purchases start September 9th. So there was the announcement that came. I see. So had he, anyway. But I had that same thought. Oh, it's looking like a pretty good trade now. All right. Stay tuned for the Odd Lots episode tracking Besson's trade. But shall we leave it there for now? Let's leave it there. Okay. This has been another episode of the Odd Lots podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway. And I'm Joe Weisenthal. You can follow me at The Stalwart. Follow our producers, Carmen Rodriguez at CarmenArmand, Dashiell Bennett at Dashbot, Kale Brooks at Kale Brooks, and Kevin Lozano at KevinLoydLozano.
41:27And for more OddLots content, you should check out our daily newsletter. You can find that at Bloomberg.com forward slash OddLots.
41:32Tracy Alloway:And you can chat about all of these things 24-7 in our Discord, discord.gg slash OddLots. And if you enjoyed this conversation, then please leave a comment or like the video, or better yet, subscribe. Thanks for watching and listening.
41:51Thank you.
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From the publisher
Global bond yields are at their highest level since 2008, with the 30-year US Treasury touching 5% just before Treasury Secretary Scott Bessent announced a surprise increase of his department's bond buyback program and Fed Chairman Kevin Warsh made his hawkish speech at Jackson Hole. So what's driving yields higher? And what options do policymakers have to bring them down? In this episode we speak with Stanford Professor Darrell Duffie, who's been researching bonds for years, including presenting a paper at Jackson Hole in 2023 about how to fix the US Treasury market. A lot has changed since then, and at this year's Jackson Hole symposium, we caught up with Duffie to talk about everything going on in the bond market, as well as the challenge of shrinking the Fed's balance sheet.
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