Speaker 1: Hello, and welcome to another episode of the Odd Thoughts podcast.
Speaker 1: I'm Tracy Alloway and I'm Joe Wisn't all you know
Speaker 1: what you never see go on? That's that's pretty open ended? Yeah, okay, well,
Speaker 1: you know, as a journalist, I'm told to ask open
Speaker 1: ended questions, but you never see you never see anyone
Speaker 1: connect climate change with real yields and secular stagnation. But
Speaker 1: I in large, those are pretty separate conversations. I mean,
Speaker 1: maybe the secular stagnation part, but I definitely do not
Speaker 1: see much conversation connecting the dodge between anything that's going
Speaker 1: on in interest rates or real rates or anything like
Speaker 1: that in climate Yeah, that's exactly right. So despite the
Speaker 1: fact that every bank in the world seems to be
Speaker 1: really high on E s G right now, and certainly
Speaker 1: you and I are on the receiving ends of you know,
Speaker 1: tons of press releases about what banks are doing in
Speaker 1: the space, you actually don't see that many people talk
Speaker 1: about climate change from a market's perspective, which is kind
Speaker 1: of weird because if you think about the battle, the
Speaker 1: climate change battle right now, so much of it is
Speaker 1: about estimating the costs and the benefits or the cost
Speaker 1: versus the benefits of actually tackling this issue. And if
Speaker 1: you think about how you calculate costs and benefit, that's
Speaker 1: basically a market question, right, Like you have to consider
Speaker 1: how the market is functioning and at what rate the
Speaker 1: market is actually rewarding action at any moment in time
Speaker 1: in order to come up with those kind of estimates. Yeah,
Speaker 1: I think that's ruing. I mean, I think if this
Speaker 1: is where like I sort of like struggle with some
Speaker 1: of this. There is this widespread expectation and of like
Speaker 1: ongoing environmental degradation, potentially more um economic and environmental catastrophes,
Speaker 1: horrendous things that will happen that may be associated with
Speaker 1: climate change. On the other hand, like from a market standpoint,
Speaker 1: it still seems as though, for the most part, most
Speaker 1: of the things that get priced, whether we talk about
Speaker 1: priced in, are more on the sort of like regulatory side.
Speaker 1: It doesn't feel like there are many examples of the
Speaker 1: of the environmental risks directly themselves manifesting in price, just
Speaker 1: yet more about pricing in the sort of regulatory response
Speaker 1: or policy response to this sort of ongoing threat. Right. So,
Speaker 1: I know I started this conversation by saying that you'd
Speaker 1: never see anyone talk about real yields and secularis TechNation
Speaker 1: and climate change. But that's not strictly true, because there
Speaker 1: is one person who has done it um and they
Speaker 1: published a whole paper on the topic, which UM definitely
Speaker 1: caught my eye. But we're going to be speaking to
Speaker 1: Josh Younger again today. He's a managing director at JP
Speaker 1: Morgan and also a multi appearance All Thoughts guest. I
Speaker 1: think this is going to be his fourth time on
Speaker 1: the podcast, so we're gonna get his thoughts on the
Speaker 1: climate change and the link to yields, but we're also
Speaker 1: going to go into some of the recent drama in
Speaker 1: the treasuries market and I and in addition to him
Speaker 1: as having done work on this, he's sort of the
Speaker 1: perfect person to connect all these duds because in addition
Speaker 1: to being a rape strategist managing director at JP Morgan,
Speaker 1: he's also a trained astrophysicist, so the perfect person to
Speaker 1: connect science and interest rates. So I'm really looking part
Speaker 1: of this conversation excellent, Um, climate science meets interest rates.
Speaker 1: I love it all right, Josh, welcome to All Thoughts
Speaker 1: yet again. Yeah, thanks for having It's it's great to
Speaker 1: be back. So I mentioned this idea that when we
Speaker 1: talk about climate change policy, we generally think about trade
Speaker 1: offs between cost versus benefit, And one of the things
Speaker 1: I'm really interested in is what traditional analysis looks like
Speaker 1: when it comes to cost benefits on on this topic,
Speaker 1: because I don't know. When I think about climate change,
Speaker 1: I think about the worst case scenario being that we
Speaker 1: basically all die from global warming and you know, world
Speaker 1: War three breaks out over resources and the entire world collapses.
Speaker 1: So I've always been curious about how you put a
Speaker 1: sort of a number around those sorts of scenarios. So
Speaker 1: maybe just to begin with, walk us through how people
Speaker 1: normally do that equation. How do they come up with
Speaker 1: that cost benefit framework? Yeah? Sure, So it's it's a
Speaker 1: bunch of different steps, and it's it's really about connecting
Speaker 1: a few related but but sort institutionally separate fields of studies.
Speaker 1: So on the one hand, there's the client science itself,
Speaker 1: which is doing projections of global mean temperatures and sea level,
Speaker 1: sea level rises and various other types of forecasting, and
Speaker 1: those tended to go out hundred years um. That is
Speaker 1: a highly nonlinear, very complicated process that's usually done with
Speaker 1: supercomputers with these simulations, essentially you can't do it with
Speaker 1: a pencil and paper. Um, So that's the climate science angle.
Speaker 1: And then when we think about policy, the question is
Speaker 1: sort of what does that mean to humanity? What does
Speaker 1: it mean to us? And how do we start start
Speaker 1: to try to quantify that. So on the one hand,
Speaker 1: you can think about the sort of more moral angle
Speaker 1: to this, which is what you're alluding to, which is,
Speaker 1: you know, people dying in wars and famine and disease
Speaker 1: and so forth, and that's you know, obviously that the
Speaker 1: none of it, but but also very hard to put
Speaker 1: numbers around. So there's a tendency to kind of think
Speaker 1: of this in economic terms, which is, you know, as
Speaker 1: horrible as all those outcomes sound, that they do ultimately
Speaker 1: boiled down in some sense to a cost. You can
Speaker 1: put a dollar amount on it. Insurance companies do it
Speaker 1: all the time. And uh, the economic impact of climate
Speaker 1: change which incorporates all of these factors. So there's there's
Speaker 1: kind of the purely economic impacts, which is, you know,
Speaker 1: our coal mines productive, can we produce enough wheat? What's
Speaker 1: what's the net impact on consumption? Like things like that,
Speaker 1: And then you can have the more banal sounding mortality
Speaker 1: projections and and other sorts of sort of nontraditional economic impacts,
Speaker 1: and that ultimately gets boiled down to a dollar amount um.
Speaker 1: And the process of of putting those things together is
Speaker 1: what's generally referred to as as integrated assessment models. So
Speaker 1: connecting climate science and economics with some with some other
Speaker 1: inputs is well um. And the goal from that exercise
Speaker 1: is to try to inform policy because there's a real
Speaker 1: cost benefit here. Um. You know, if we want to
Speaker 1: completely avoid climate change, we're all supposed to go back
Speaker 1: to a pre industrial world where we don't burn carbon
Speaker 1: at all and we live on sort of uh independently um,
Speaker 1: self sufficient farms, and you know we walk everywhere or
Speaker 1: maybe ride a bike, but even the bike's got to
Speaker 1: get produced. So like, there's a cost that's not worth
Speaker 1: bearing to most of the world. And so between doing
Speaker 1: nothing and reversing the clock fifteen years um and undoing
Speaker 1: all technological development, there's some number that represents the acceptable
Speaker 1: cost to society, and the the process here is trying
Speaker 1: to arrive at at that number through this rough mean.
Speaker 1: There's many different ways to do it, but you're trying
Speaker 1: to get ultimately to that break even to that number
Speaker 1: that the acceptable cost to society UM, and how we
Speaker 1: track and measure that it correct me if I'm wrong here.
Speaker 1: My impression is that climate risk manifests itself in markets
Speaker 1: in all different kinds of ways. What do you see
Speaker 1: in commodities, whether you see it in insurance type of contracts, etcetera.
Speaker 1: But is it the case that the what's being priced
Speaker 1: is not the climate risk itself, but rather the regulatory
Speaker 1: expectations or current policies of regulatory response towards climate change.
Speaker 1: So like, imagine an environment in which there was no
Speaker 1: climate science really or there was no will to action
Speaker 1: at all to address climate would it be showing up?
Speaker 1: Would we be seeing stresses regardless? So I think this
Speaker 1: brings up a really important point, which is climate change
Speaker 1: is the most important and obvious example of a real
Speaker 1: market failure. So capital markets and markets in general are
Speaker 1: are just really bad at long term planning, and long
Speaker 1: term into case means fifty to a hundred years um.
Speaker 1: So uh, it means that the risk price into markets
Speaker 1: is much more along the lines of what you just described,
Speaker 1: which is how is the government going to react today?
Speaker 1: Rather than what is the net impact considering potential action,
Speaker 1: whether or not it's enough, and if it's more than
Speaker 1: enough or less than enough, like what's the net impact,
Speaker 1: Like what's the real what's the real forecast? So, um,
Speaker 1: there's a world in which this is actually a somewhat
Speaker 1: exogenous process to the way markets think about risk um
Speaker 1: and and that just because again it doesn't get really
Speaker 1: priced in. This is a big part of the stern
Speaker 1: instiguilers critique, which is, you know, market pricing is based
Speaker 1: on individual incentives that are bay that are themselves the
Speaker 1: product of like a single generation of people. And so
Speaker 1: we're thinking about what is my preference as an individual
Speaker 1: investor over the next fifty years as opposed to what
Speaker 1: is the societal aggregate preference in an intergenerational context, which
Speaker 1: prioritizes to the same extent the welfare of people who
Speaker 1: are living a hundred years from now relative to my own.
Speaker 1: And so markets are really bad at that UM, and
Speaker 1: that's been a general critique of the way that climate
Speaker 1: risk has been modeled. Um, it doesn't mean that markets
Speaker 1: can't tell you something about kind of the base case.
Speaker 1: So what we're doing in this paper, I think is
Speaker 1: in saying markets because they don't anticipate these types of
Speaker 1: existential and long term risks, they're kind of giving you
Speaker 1: a sense of the baseline rather than the the climate
Speaker 1: change scenario. So they're giving a sense of how the
Speaker 1: market would perceive risk and pricing and time preference in
Speaker 1: the absence of climate change to some extent, because it's
Speaker 1: it's not going to get efficiently priced, and that's a
Speaker 1: problem because markets are not anticipating this like extremely important
Speaker 1: risk factor, arguably the most important risk factor fundamentally. But
Speaker 1: it's convenient in the sense that you can extract from
Speaker 1: markets um this kind of baseline, time preference and other
Speaker 1: fact in other variables that that lets you put that
Speaker 1: price on carbon ultimately to to to get a sense
Speaker 1: of what the cost benefit looks like, because to get
Speaker 1: a cost benefit you need to have with and without
Speaker 1: like they could do a cost benefit. It's what I
Speaker 1: need to know is what's the world like without climate change,
Speaker 1: and what's the world like with climate change? And how
Speaker 1: do I mitigate that impact? And because climate change is
Speaker 1: an indogenous process to the real world, but but arguably
Speaker 1: in an exogenous process to the market perspective on the
Speaker 1: real world, you can kind of do that somewhat efficiently. So,
Speaker 1: I mean you mentioned the time preference of investors. There,
Speaker 1: can we talk a little bit more about that, because
Speaker 1: the point that you're making about yields is that we're
Speaker 1: basically talking about the time value of money, and so
Speaker 1: they're going to factor into any big action that you
Speaker 1: actually undertake to fight climate change because it costs money,
Speaker 1: and you have to make that calculation as an investor
Speaker 1: how much your money is worth going into a climate
Speaker 1: change initiative versus something else. So how are you thinking
Speaker 1: about the discount rate and like how much does that
Speaker 1: traditionally factor into cost benefit analyses for climate change? Yea,
Speaker 1: So maybe just taking a step back, like why are
Speaker 1: we discounting these impacts at all? Climate change costs? I
Speaker 1: think the numbers like a quadrillion dollars over the next
Speaker 1: hundred years. Why are we not just using that? Why?
Speaker 1: Why why are we using this discounting effect? And from
Speaker 1: a from a first principal standpoint, interest rates reflect time
Speaker 1: preference in the sense that I can use my hundred
Speaker 1: dollars today to go buy something, or I can use
Speaker 1: it in a year, and if I'm going to delay
Speaker 1: that consumption by a year. Then there's some value to
Speaker 1: me in that right. There there's some there's some there's
Speaker 1: some cost um in giving up that year of access
Speaker 1: to my money, and so that's the interest rate I'm
Speaker 1: going to charge for it. So if interest rates to
Speaker 1: one percent, it means that the time preference reflects a
Speaker 1: one percent annualized cost to delay in can some ship uh,
Speaker 1: interest rates are observable, like we have many interest rate
Speaker 1: driven instruments. Treasury bonds are are kind of a good
Speaker 1: example of that. There's also a rich and deep derivatives
Speaker 1: market which is tied to other interest rates, and we
Speaker 1: can use that to infer time preference in that sense.
Speaker 1: So let's say we have an observation of time preference UM,
Speaker 1: and we've soolidated that into some running rate of interest
Speaker 1: two percent three adjusted for inflation, because most of these
Speaker 1: estimates are done in inflation adjusted terms UM. So then
Speaker 1: what we can do is say, well, climate change is
Speaker 1: going to cost a certain amount of money every year
Speaker 1: for the next hundred years. Because that money in the
Speaker 1: future is worth less or we're gonn actually talk about
Speaker 1: it probably after this but potentially more, but it's worth
Speaker 1: a different amount in the future. Than it is today,
Speaker 1: than the discounted future value of those damages is what
Speaker 1: I should be willing to pay today to avoid them.
Speaker 1: And so that's the social cost of carbon, which is
Speaker 1: an incremental metric ton of carbon dioxide. What is the
Speaker 1: economic impact into the future, and what is the discounted
Speaker 1: value of that damage today? And if I'm thinking in
Speaker 1: terms of pure economics, the moral angles is important but
Speaker 1: not necessarily part of that analysis, then I should be
Speaker 1: willing to pay up to that discounted amount to to
Speaker 1: avoid negative outcomes. I guess put a different way. We
Speaker 1: usually talk about the time value money as how much
Speaker 1: is the money worth to me today versus in a year?
Speaker 1: But you can also think of it equivalently as how
Speaker 1: much is it worked to me to avoid a loss
Speaker 1: in a year versus today? Those are it's it's symmetric
Speaker 1: in that respect. So what is thinking about this framework
Speaker 1: get you? Like? Okay, so you work through this, you
Speaker 1: like calculate the theoretical damages do this sort of this
Speaker 1: time value analysis? Where does it get you? And what
Speaker 1: does it tell you in terms of carbon pricing or
Speaker 1: connecting it to uh to your specialty like rates? Like
Speaker 1: where does what does the analysis say, yeah, I think
Speaker 1: it's important to keep in mind that models are flawed.
Speaker 1: These models are very flawed, But we have to make
Speaker 1: a decision. We don't have the option to not make
Speaker 1: a call on this because climate change is going to
Speaker 1: happen one way or the other and we need to
Speaker 1: take some steps to mitigate it. But we're lots of
Speaker 1: steps to mitigate it. But if we're unwilling to de industrialize,
Speaker 1: which is kind of the the ultimate and only complete solution,
Speaker 1: then we need to come up with what we're willing
Speaker 1: to do, and so this analysis is an attempt to
Speaker 1: do that, and we're basically making our best guests as
Speaker 1: to how much we should we should be willing to
Speaker 1: spend to avoid damage down the line. And it's convenient
Speaker 1: as a framework UM in two ways. One is it's
Speaker 1: it really does get you to policy, right. It gets
Speaker 1: you to a set of policies that the cost of
Speaker 1: which is immediate, that you can at least justify on
Speaker 1: the basis of some framework. Right. We need to come
Speaker 1: up with a reason why it's worth spending a trillion
Speaker 1: dollars today, um, because everyone who is contributing those tax
Speaker 1: always want to know why a trillion? Why not to
Speaker 1: why not half? Where did this number come from? Um
Speaker 1: flawed though those models maybe they get us to that
Speaker 1: and two is at least from a more near term standpoint.
Speaker 1: From an observers standpoint, we get a sense of how
Speaker 1: the government is likely to react, so we're not what
Speaker 1: we're focused a little bit on the policy making process,
Speaker 1: but there's also the more near term impact on how
Speaker 1: government policy evolves. And to the extent that this framework,
Speaker 1: this approach is central to the government's policy making process.
Speaker 1: It lets us kind of think like they think and
Speaker 1: come up with a sense of what the likely range
Speaker 1: of outcomes is. And the Biden administration has been very
Speaker 1: clear that the social cost of carbon is the single
Speaker 1: most important number in their climate change agenda. So you know,
Speaker 1: we should we should get a better sense of how
Speaker 1: to how to get behind a value of that and
Speaker 1: what the right set of assumptions are than rather than
Speaker 1: sort of necessarily arguing about the utility of that number
Speaker 1: relative to other numbers. The last thing I'd say is
Speaker 1: this discounting effect. Um it is possible. It's kind of
Speaker 1: two approaches to this. What we've focused on here is
Speaker 1: a market driven discount rate, which is really measuring pure
Speaker 1: time preference, and and that's extracted from in this case
Speaker 1: derivative markets, but you can get it from treasuries or
Speaker 1: other places. UM. That's been pretty standard practice for a
Speaker 1: very long time. A common critique of that approach is
Speaker 1: that it prioritizes the sort of talked about it a
Speaker 1: second ago, you know, the current generation's individual perceptions of
Speaker 1: time preference, rather than societal aggregate UM intergenerational perceptions of
Speaker 1: time preference. And it's explicitly a moral because it's just
Speaker 1: a number extracted from markets. And so what you can
Speaker 1: do is you can use that discount rate and you
Speaker 1: can take a more prescriptive approach and normative approach, where
Speaker 1: you argue for what the right discount rate should be,
Speaker 1: incorporating factors like like inequality betweenations and within nations, incorporating
Speaker 1: the interaction between different countries. You can incorporate the risk
Speaker 1: of extinction. People have done that, UM, and so you
Speaker 1: can use that to quantify again the right number, and
Speaker 1: and that becomes in some sense the thing you argue about.
Speaker 1: So there, on the one hand, there is the modeling process,
Speaker 1: which has its own uncertainties and legitimate critiques of that
Speaker 1: but we have to come up with something. And on
Speaker 1: the other you can sort of say, well, well, the
Speaker 1: market saying the discount rate should be one percent, but
Speaker 1: I think it should be negative ten percent because I'm
Speaker 1: highly risk averse when it comes to these things, and
Speaker 1: you can make a normative case for that, and therefore
Speaker 1: it's worth spending more money than than than another discount
Speaker 1: RaSE but potentially imply so it sort of consolidates that
Speaker 1: whole argument to a single number, which is convenient. It's reductive,
Speaker 1: but it's it's convenient for for having this conversation. So
Speaker 1: is the implication here that whatever you decide as the
Speaker 1: discount factor is going to be like as much, it's
Speaker 1: going to be as important as an input into your
Speaker 1: model as your climate change projections and things like that. Like,
Speaker 1: is the discount factor perhaps an underappreciated input into our
Speaker 1: models of climate change and cost benefit analysis? Yeah, it's
Speaker 1: massively important because of the long time frames involved. So
Speaker 1: if you have a one percent annualized discount factor and
Speaker 1: you compound that over a hundred years, you're talking about
Speaker 1: a very large effect. The the thing that I think
Speaker 1: we wanted to highlight in this which is in the
Speaker 1: past there was this debate, which is, normative discount factors
Speaker 1: tend to result in lower numbers, market based discount factors
Speaker 1: at the time tended to result in higher numbers. So
Speaker 1: if you go back to two thousand seven, when the
Speaker 1: Stern report came out, the real rate of interest over
Speaker 1: thirty years was something like three And because you're compounding
Speaker 1: this over long periods, I forget the precise arithmetic is
Speaker 1: but you know, a hundred dollars in in fifty years
Speaker 1: at a three percent discount rate, is is worth a
Speaker 1: couple of bucks? Like it? It has a very strong
Speaker 1: effect on the present value of those damages. And if
Speaker 1: you move that to a one percent discount of factor,
Speaker 1: all of a sudden you've got twice as much present
Speaker 1: valure damages or three times as much of a hundred years.
Speaker 1: So the debate was usually that markets are applying a
Speaker 1: higher discount rate then many economists and philosophers, frankly I
Speaker 1: thought was appropriate to the problem. And for all the
Speaker 1: reasons I mentioned. What's happened since then is the long
Speaker 1: term real rate of interest has come down a lot,
Speaker 1: and that's secular stagnation. That's to some extent an endogenous effect.
Speaker 1: In that there could be some climate risk priced into
Speaker 1: that secular stagnation expectation. But the important observation is that
Speaker 1: this argument over whether or not normative discount factors, which
Speaker 1: are relatively low. I think one percent is the is
Speaker 1: the mean of some surveys of economists. Now the real
Speaker 1: rate of interest over fifty years is negative half percent
Speaker 1: or something like that. Like the market versus normative approach
Speaker 1: has flipped in that markets are pricing negative time preference
Speaker 1: over long periods. And when you flip from a negative
Speaker 1: from a positive interest rate to a negative interest rate,
Speaker 1: all of a sudden time inflates the value damages rather
Speaker 1: than discounting them. So discounting is really not the right
Speaker 1: word in a world of negative real rates. And so
Speaker 1: now when when when we look at a hundred years,
Speaker 1: that hundred dollars of of of nominal damage is worth
Speaker 1: three hundred dollars, and so it really it changes the
Speaker 1: way you think about the time distance to these effects.
Speaker 1: So I mean, is the simple is the simple upshot?
Speaker 1: Then that in a period of ultra low real interest rates,
Speaker 1: then setting us that climate people look at a period
Speaker 1: of ultra low interest rates and also a period of
Speaker 1: uh secular stagnation, and they say, Okay, well, then this
Speaker 1: is like a natural period for the government to spend
Speaker 1: a lot of money, invest a lot in research. Generally,
Speaker 1: perhaps um introduce such a sort of spending impulse and
Speaker 1: capital expenditure impulse to break us out of this secular stagnation.
Speaker 1: Is the implication then that that just also applies even
Speaker 1: more so when thinking about addressing the climate threat in
Speaker 1: this economic environment. Yeah, it means that the self corrective
Speaker 1: elements of economic growth just doesn't really apply. So if
Speaker 1: we have negative real interest rates over long periods of time,
Speaker 1: that means that we have basically an expectation of negative
Speaker 1: real growth rates in in equilibrium over long periods of time.
Speaker 1: And so you can sort of like the narrative version
Speaker 1: of this argument is climate change is going to cause
Speaker 1: a lot of damage, but the but the cure is
Speaker 1: worse than the disease, and we're going to spend too
Speaker 1: much money today and do too much economic damage today. Um,
Speaker 1: so we're better off growing our way out of these
Speaker 1: issues like that. That would be one line of argument,
Speaker 1: which is we want to let the economy grow because
Speaker 1: it will we will all be better off over the
Speaker 1: long run. Even in the context of climate change related damage.
Speaker 1: If we allow for for unfettered economic growth and and
Speaker 1: the secular stagnation hypothesis and the consistency of markets with
Speaker 1: that expectation says that's just not true anymore, Like you're
Speaker 1: better off fixing problems today because the longer you wait,
Speaker 1: the bigger the problem is going to be. And um,
Speaker 1: that was not true ten years ago, at least an expectation. Now.
Speaker 1: Secular stagnation, I should say, has been around for a
Speaker 1: long time as a concept. It originates from the late thirties.
Speaker 1: So basically after every major every major recession, there's been
Speaker 1: this wave of secular stagnation prognosticating It kind of reminds
Speaker 1: me of the you know, the kids today, like all
Speaker 1: these kids in their phones, like they're never going to
Speaker 1: learn how to read. Um. But it turns out that
Speaker 1: in the midsu there are a bunch of people who
Speaker 1: are because of the printing press now would learn how
Speaker 1: to write books have I hand anymore. So there's always
Speaker 1: like this this handwringing in the in the in the
Speaker 1: in the presence of change. But this time might actually
Speaker 1: be different. And Larry Summers is obviously sort of associated
Speaker 1: with this argument. Um. But the combination of demographics um,
Speaker 1: the digital transformation, a global savings glad, the rise of
Speaker 1: Asia like all of these, all the globalization trend which
Speaker 1: is still in place. Um. You know, all of these
Speaker 1: things point to lower at least directionally real growth rates
Speaker 1: over time. And and that just means again directionally the
Speaker 1: cost of waiting, the cost of an action is higher.
Speaker 1: And we're using markets because they do a pretty good
Speaker 1: job of finding stuff like that, Like markets are better
Speaker 1: at identifying regime change um than than we are individually.
Speaker 1: And you can see that just because you know the
Speaker 1: secular stagnation hypothesis and the implications for long term interest rates,
Speaker 1: like the growth rates that that's been reflected to some
Speaker 1: extent in surveys of economists, for example. But the transition
Speaker 1: has been very gradual, whereas markets kind of price this
Speaker 1: in in two thousand eight and have largely stayed in
Speaker 1: that range. So um, you know, markets have done a
Speaker 1: decent job at least at a high level of never
Speaker 1: mind the next ten fifteen basis points. You know, categorically
Speaker 1: they're going to be done a good job of spotting
Speaker 1: the shift in the way the world grows and if
Speaker 1: we're shifting to a load of negative growth environment in
Speaker 1: the lead up to the really damaging impact economically of
Speaker 1: climate change. UM, there's a much greater incentive to act now,
Speaker 1: and that's reflected in in the in the social cost
Speaker 1: of carbon like if when you when you calculate even
Speaker 1: taking damages in in sort of local um nominal terms
Speaker 1: as as a given, like let's not argue about how
Speaker 1: we're calculating the dollar value of those damages. That's the
Speaker 1: separate conversation. Even if you take that as a given,
Speaker 1: just the way the environment and expectations have evolved means
Speaker 1: the social cost has gone up six seven times of
Speaker 1: the past ten years, and that really changes your cost benefit.
Speaker 1: That changes the way which you should be willing to
Speaker 1: spend to avoid it. So on that note, I mean
Speaker 1: I was reading a City group note by UM one
Speaker 1: of their strategists recently, Matt King, and apparently City has
Speaker 1: been having a bunch of client calls with Larry Summers,
Speaker 1: and Matt King was strongly UM suggesting that Larry Summers
Speaker 1: had sort of backed off the secular stagnation idea because
Speaker 1: of the recent backup in yields, which seems like I
Speaker 1: don't know a bit of a knee jerk reaction, but
Speaker 1: I'm curious this idea that secular stechnation has multiplied the
Speaker 1: cost of climate change in action. How well does that
Speaker 1: stand up to the recent changes in the treasury market,
Speaker 1: the volatility that we've seen, and UM, the increase in yields. Yeah,
Speaker 1: so most of the move in yields has been an
Speaker 1: inflation expectations. So we're really focused for this purpose on
Speaker 1: the real rate of interest, and over thirty to fifty years,
Speaker 1: the real rate of interest is still negative at least
Speaker 1: if and there's some argument here I should I use
Speaker 1: treasury rate, shall use tips? Shall I use derivative markets?
Speaker 1: And what we do here is we look at expectations
Speaker 1: for the federal funds rate the FEDS target rate over
Speaker 1: fifty years, for example, UM and adjust that for inflation expectations.
Speaker 1: And the reason we do that is UM. When you're
Speaker 1: dealing with securities, and we talked about this back last March,
Speaker 1: securities have sort of different treatment under different circumstances. It's
Speaker 1: harder to hold a bond than a derivative, especially for
Speaker 1: a bank, so you're sort of baking in some of
Speaker 1: these nuances of balancie costs and things, but derivatives specifically
Speaker 1: are UM are sort of an easier proxy. And so
Speaker 1: when we look at fifty year o I S swap rates,
Speaker 1: which is just expectations again for the federal funds rate
Speaker 1: over the next fifty years, it's still negative adjusted for
Speaker 1: inflation expectations. So UM, directionally, you know, it maybe maybe
Speaker 1: more like four or five times over the past ten
Speaker 1: years now rather than six or seven the volatility and
Speaker 1: the social cost of carbon using market discount rates is
Speaker 1: potentially a critique that makes sense, but but directionally it's
Speaker 1: still negative. So markets are pricing in negative real growth
Speaker 1: rates over very long periods of time. UM. The other
Speaker 1: thing that I think is important to keep in mind
Speaker 1: is because we're talking about fifty hundred years UM, the
Speaker 1: bond market stops at a thirty year instrument, but these
Speaker 1: risks go out much further, and derivatives conveniently trade fifty
Speaker 1: sixty in some cases a hundred years out, and the
Speaker 1: discount rate actually starts to decline after that thirty year
Speaker 1: point UM. And there's some technical reasons for that. UM.
Speaker 1: There's a market flow driven reasons for that, but the
Speaker 1: discount rate over sixty years is less than the discount
Speaker 1: rate over thirty years by this measure, for example, So
Speaker 1: you know there is this You can interpret that as
Speaker 1: graaight risk of of negative real growth rates over longer
Speaker 1: horizons and be sort of consistent with the demographic outlook.
Speaker 1: So that means and that's also consistent with more normative arguments,
Speaker 1: which say, I should to balance the scales like these
Speaker 1: market interest rates are set by the current generation and
Speaker 1: the next generation doesn't get a say so I should
Speaker 1: give them. Uh, I should give the current generation a
Speaker 1: haircut when I think about discount rates, and so over
Speaker 1: sixty years, where I'm spanning a bunch of generations, that
Speaker 1: discount rate should be naturally lower because it's just scoping
Speaker 1: in many more people, many most of which haven't been
Speaker 1: born yet, and so they should get a little bit
Speaker 1: of a leg up in the relative value of their utility.
Speaker 1: And and that naturally emerges from a from a market
Speaker 1: based approach. Um, it's kind of part of bond math.
Speaker 1: Does that extent you know, that's also consistent with with
Speaker 1: those arguments. So yeah, I think the are we in
Speaker 1: a secular stagnation world or not? Is a much more
Speaker 1: extensive conversation in certain ways. But but I think at
Speaker 1: the end of the day, like this, moving treasury rates
Speaker 1: and moving interest rates generally UM is much more notable
Speaker 1: for its speed than its magnitude and really hasn't changed
Speaker 1: the underlying narrative that we can extract from markets over
Speaker 1: long periods of time. And that's why I'm saying, basis
Speaker 1: points between friends, you know, over long periods is really
Speaker 1: not that big a deal. And if we were to
Speaker 1: be having this conversation in the mid nineties or the
Speaker 1: early eighties, we would say that's Tuesday. So you know,
Speaker 1: we we've gotten used to a very low voltility world,
Speaker 1: and the outlook really hasn't changed in a fundamental way
Speaker 1: on the basis of these moves UM, and real rates
Speaker 1: themselves only started to adjust for the past few weeks.
Speaker 1: It's really been mostly an inflation expectations outlook. So I'm
Speaker 1: still having trouble wrapping my head around something like okay
Speaker 1: because of very low real rates expectations, however you measure it,
Speaker 1: the cost of not doing anything about climate change is
Speaker 1: extremely high right now, and that part I get. But like,
Speaker 1: let's say, like we did enact a series of policies
Speaker 1: right now that really did jolt the economy out of
Speaker 1: something that we call secular stagnation, which seems possible. I mean,
Speaker 1: you know, you mentioned the increase in real rate has
Speaker 1: been very modest, but it's possible. You know. It's like,
Speaker 1: if we already get some sort of sustained fiscal stimulus
Speaker 1: and massive capital expenditures and all kinds of different things, like,
Speaker 1: it seems possible that we could have a set of
Speaker 1: policies that would jolt us out of this whatever we've
Speaker 1: been in for the last decade or longer. Does that
Speaker 1: then imply that the cost of inaction on climate like
Speaker 1: goes down? Like that's like I don't quite sort of
Speaker 1: like get that link. It seems to me it's like, Okay,
Speaker 1: there's like there's like disaster waiting for us at some
Speaker 1: point within action, and either we want to do something
Speaker 1: about it or not. But this idea, that's like, Okay,
Speaker 1: if suddenly they started roaring and companies started spending and investing,
Speaker 1: and we saw wage growth and capital expenditure the likes
Speaker 1: of which we haven't seen, what is that? How does
Speaker 1: that then imply that somehow the cost of inaction goes down?
Speaker 1: I think it depends on a couple of things. The
Speaker 1: first is is inflationary or not? Like is wage growth
Speaker 1: with driving things? And if so, then we're not looking
Speaker 1: at a at a rise in real growth rate expectations
Speaker 1: as much as we're looking for a rise in nominal
Speaker 1: grade birth rate expectations. And that means that an inflation
Speaker 1: adjusted world, which is how we do all of this analysis,
Speaker 1: it won't really show up. But you could argue that
Speaker 1: there is a set of policies, whatever they are, that
Speaker 1: quote unquote fix or help the United States transition to
Speaker 1: a more balanced economy, economy with a higher um equilibrium
Speaker 1: growth rate and and sort of mitigate the the not
Speaker 1: just the deflationary but also the sort of negative growth
Speaker 1: impulse of things like digitalization and aging populations and so forth.
Speaker 1: And so you know, the hypo I guess is like,
Speaker 1: if we can design a set of policies that boost
Speaker 1: real growth rates for a long period of time in
Speaker 1: a fundamental way, restructuring the economy is such that we
Speaker 1: get sustained higher real growth rates, Like, should that change
Speaker 1: the way we think about climate change? Especially because in
Speaker 1: doing so we've we've probably not necessarily made the problem worse. Right,
Speaker 1: economic growth in carbon emissions or somewhat correlated. You certainly
Speaker 1: learned that last year, you know. I think there's a
Speaker 1: version of this where the boom you're describing is the
Speaker 1: conversion of the carbon economy to a to a zero
Speaker 1: mission economy. And so in that context, the cost of
Speaker 1: climate change would be going down because you would be mitigating.
Speaker 1: And so the two things are kind of the same. Um.
Speaker 1: But if you, for example, were to to imagine a
Speaker 1: scenario where all fossil fuel restrictions were lifted and we
Speaker 1: were just prioritizing growth at all costs, independent of the
Speaker 1: impact on the climate, the economic opportunity cost of inaction
Speaker 1: would go down. But that's where the normative arguments come in.
Speaker 1: So that would be uh, something that people wouldn't want
Speaker 1: for other reasons than economics. I think what's convenient right now,
Speaker 1: especially from a policy making standpoint, is the normative and
Speaker 1: descriptive arguments kind of line up in the sense that
Speaker 1: the economics, um, the economics motivate action, the moral imperative
Speaker 1: motivates action, and so the two things are saying the
Speaker 1: same thing. Um, what you'd run into in the scenario
Speaker 1: you describe as is a conflict more along the lines
Speaker 1: of what was true twenty years ago, and you know,
Speaker 1: how the world would behave under the circumstances is kind
Speaker 1: of hard to say, Um, but that's that's an opportunity
Speaker 1: for less economically motivated arguments for climate change action to
Speaker 1: take place. And you know, I guess that it sort
Speaker 1: of brings in the non linear and existential nature of
Speaker 1: the risk and so like how much is survival worth
Speaker 1: to you? Right? It's sort of like what's the value?
Speaker 1: What's the dollar value of the survival of modern civilization?
Speaker 1: I don't think it's just one times global GDP UM.
Speaker 1: So there's you know, the run into this issue where
Speaker 1: economics is probably not the right framework to be thinking
Speaker 1: about that. But from a policy making standpoint, um, the
Speaker 1: amount you should be willing to spend in a world
Speaker 1: of higher growth rates to mitigate the economic impact in
Speaker 1: isolation of climate change would presumably go down. Um. But
Speaker 1: but the there are lots of things we do as
Speaker 1: a country that are not necessarily economic purely economically motivate. Right.
Speaker 1: I guess in the long run, world dead and the
Speaker 1: discount rate doesn't exist. UM. I want to talk a
Speaker 1: little bit more about um. The Treasury market volatility, because
Speaker 1: that's been such a big topic for well anyone in
Speaker 1: markets recently, and it comes into the debate on secularis
Speaker 1: technician and the connection to climate change like we were
Speaker 1: talking about earlier, but more broadly, this is something that
Speaker 1: you've obviously been watching for a long time, and we
Speaker 1: had you on in the aftermath of the big March
Speaker 1: sell off in US treasuries last year. I'm curious, what
Speaker 1: did you observe in the most recent a bout of
Speaker 1: volatility and do you think there's a sort of underlying
Speaker 1: connective tissue between these different dramatic events that we keep
Speaker 1: seeing in the treasury market. So, you know, we had
Speaker 1: the most recent one, we had the sell off, we
Speaker 1: had repo madness. The year before, we had the big
Speaker 1: flash well it wasn't really a flash crash, but flash
Speaker 1: swing in treasury yields a few years before that. Do
Speaker 1: you think there's a sort of underlying cause between all
Speaker 1: of those different events? So what's interesting about this event
Speaker 1: is I think it's in in a weird way, this
Speaker 1: is the healthiest and most like permissible or or least
Speaker 1: worrying version of about a volatility and treasure markets that
Speaker 1: we've had in tenure. And the reason I say that
Speaker 1: is each of the events you just described had some
Speaker 1: underlying weirdness to it that seemed to conflict with the
Speaker 1: intuition of how things are supposed to go. So. Um,
Speaker 1: When when treasuries rallied thirty basis points in an hour,
Speaker 1: that's inherently weird. UM When cash features basis positions that
Speaker 1: the relationship between treasury futures and the cash bonds that
Speaker 1: are deliverable into them completely diverse, like they did in March,
Speaker 1: that's weird. When you have a complete collapse in market
Speaker 1: depth that persists for a long period of time, We've
Speaker 1: had that several on several occasions over the past ten years. Um,
Speaker 1: you know, mark the inability of of dealers and others
Speaker 1: to make markets in a very liquid and safe fast up,
Speaker 1: that's weird. We haven't seen really any of that here.
Speaker 1: And what we've seen is shift in expectations that happens
Speaker 1: all the time from a very low base because there
Speaker 1: was a lot of pessimism early on about the long
Speaker 1: term health of of the economy and the long term
Speaker 1: impacts of COVID. I think it's it's easy to forget now,
Speaker 1: but back last April May, the vaccine prognosis was eighteen
Speaker 1: months at best, and even that's kind of aggressive, right,
Speaker 1: and and and then we and even then, if the
Speaker 1: vaccine six efficacy, that's a great vaccine. And what we
Speaker 1: got instead was efficacy in November and two of them
Speaker 1: and and now how you know, three approved and more coming. So, um,
Speaker 1: we were doing two million shots a day, not one
Speaker 1: million shots to day. I remember when when Biden said
Speaker 1: we want a hundred million people, a hundred million shots
Speaker 1: in a hundred days. Everyone said, well, that's kind of ambitious.
Speaker 1: And now we're gonna we did in sixty um. So
Speaker 1: like there has been truly a shift in the outlook. Um.
Speaker 1: And when you had a massive deflationary shock that was
Speaker 1: expected to persist for eighteen to twenty four months and
Speaker 1: it turned out it's only going to persist for six
Speaker 1: to twelve, there's gonna be a bigger vision and inflation expectations,
Speaker 1: and that's what you saw initially. So the most of
Speaker 1: the move and treasury yields has been on the inflation
Speaker 1: expectations side, even the real rates have started to catch up. Um.
Speaker 1: There has been some positioning effect, but you don't see
Speaker 1: the same sort of I think negative convexity or forced
Speaker 1: hedging is often blamed for a lot of these things,
Speaker 1: and there's certainly been some of that, but um, that's
Speaker 1: all anecdotal, and and the price action suggests that this
Speaker 1: was really changes in in fundamental exposures, not forced activity
Speaker 1: by seeing mortgage headers or there's some c t A effect,
Speaker 1: But you know, you're not seeing the sort of persistent
Speaker 1: relationships and weird relationships between different assets and asset classes
Speaker 1: that you would expect if it was one of these
Speaker 1: sort of forced liquidation or other sort of chasing your
Speaker 1: tail type of events. And the last thing I say,
Speaker 1: which I was frankly somewhat surprised to see, is even
Speaker 1: though we had a twenty basis point move in treasuries
Speaker 1: on a few weeks ago, that the high frequency community
Speaker 1: has been persistently making markets through this volatility, and um,
Speaker 1: that's pretty unusual. Usually they drop off a lot more
Speaker 1: aggressively when ball picks up, and it's a sign of
Speaker 1: a much more healthy market microstructure then we saw, especially
Speaker 1: last March. And so, like I guess, my reaction all
Speaker 1: of this is a bit of a not a yawn,
Speaker 1: but I'm certainly not as worried as I think the
Speaker 1: headline price action would suggest, because when you when you
Speaker 1: revise your expectations dramatically, you should see dramatic changes in prices.
Speaker 1: The question is have we overshot or otherwise exacerbated that
Speaker 1: repricing or are we broadly consistent with the moving fundamental expectations.
Speaker 1: And I think the ladder is mostly true. You know,
Speaker 1: we can point to occasional bouts of of that sort
Speaker 1: of like position squeezes and so forth. Like one of
Speaker 1: the things we were we were watching is there was
Speaker 1: a lot of carry trading that built up over this
Speaker 1: loan for long environment. And when when that happens and
Speaker 1: things start to move and those positions get pressured, you
Speaker 1: usually see the biggest reaction in the highest carry positions.
Speaker 1: So the most attractive carry trades tend to be the
Speaker 1: ones that do the poorest when things start to really reprice.
Speaker 1: And you definitely saw that at times. That's why, for example,
Speaker 1: five your treasures moved the most across the curve on
Speaker 1: that one big day a few weeks ago. But that's
Speaker 1: not a fundamental thing. That's a position squeeze. But you know,
Speaker 1: at the end of the day, that's a day or
Speaker 1: two here there. Um I don't even mean to be
Speaker 1: too sangue about it, because you know, at some point
Speaker 1: everybody's a convex the heager, meaning like we are. There's
Speaker 1: a there's a large community of levere holders who are
Speaker 1: very p and L sensitive, and a lot of them
Speaker 1: were long durations, so you know, you rates back up enough,
Speaker 1: and if if the levered community is chasing that from
Speaker 1: a positioning standpoint, it can end up exacerbating things. But
Speaker 1: but that only goes so far, and I think at
Speaker 1: this point price action is just a lot healthier then
Speaker 1: then say the Tampa tantrum, or certainly March, or after
Speaker 1: the US downgrade, or the European sovereign deet crisis, all
Speaker 1: of these more existential and seeming events like this is
Speaker 1: much more benign in a lot of ways. What, um so,
Speaker 1: I should just note here we are recording this mark.
Speaker 1: It's actually a day before a federal reserve decision, so
Speaker 1: you know, listeners should note that. I'm curious about something
Speaker 1: you mentioned. Looking at the frequency market maker community and
Speaker 1: there ongoing making of such markets even during the worst
Speaker 1: of the volatility a few weeks ago. What are the
Speaker 1: specific data points that you look like when you talk
Speaker 1: about treasury market micro structure, such that we're beyond just
Speaker 1: looking at price, but how well the price is actually working?
Speaker 1: What are the things that tell an observer that, yes,
Speaker 1: price society was very volatile and historic level, but actually
Speaker 1: it still looks like a just a functioning market. Yees.
Speaker 1: So we don't have all the information because a lot
Speaker 1: of these systems obscure information in various ways to protect privacy,
Speaker 1: So there's anonymity concerns and so forth. But um, when
Speaker 1: we think about the treasury market in particular, Um, there's
Speaker 1: kind of two categories of trading. The first is what
Speaker 1: you would call in the old world voice trading or
Speaker 1: dealer to client trading, where uh say, a large central
Speaker 1: bank has a few billion dollars worth of treasuries to
Speaker 1: move and they call up their dealer and they say,
Speaker 1: I'd like to sell you, you know, two billion triple
Speaker 1: old fives, and dealer says, okay, I'll pay you this
Speaker 1: many basis points for from the hot run and markets
Speaker 1: this wide, and they agree in a price. It's it's
Speaker 1: very like it's a much more familiar kind of human
Speaker 1: interaction kind of thing, and it happens in very chunky fashion.
Speaker 1: We don't see that really. Um. There is some reporting
Speaker 1: of that to regulators, but uh, and certainly if you
Speaker 1: work at a broker dealer, you you can you hear
Speaker 1: about generically transactions like that, UM, but there's no systematic
Speaker 1: source of data that's available to public that lets us
Speaker 1: track that activity. But what's useful is that you know, no,
Speaker 1: no single dealer is going to want to hold two
Speaker 1: billion worth of triple old fives. So what tends to
Speaker 1: happen is that transaction gets broken up into pieces and
Speaker 1: and socialized across the dealer community through a variety of transactions,
Speaker 1: some through the futures markets, some through cash markets. But
Speaker 1: there are these inter dealer brokers that facilitate the distribution
Speaker 1: of that risk across the dealer community. And you know
Speaker 1: how that happens in detail is sort of a much
Speaker 1: more technical conversation, but sufficed to say, the risks broken
Speaker 1: up and distributed, and we can observe much more granular
Speaker 1: and rich data on that process. So UM, that's useful
Speaker 1: in the sense that the liquidity of the inter dealer
Speaker 1: market will determine the liquidity those dealers can offer to
Speaker 1: their clients, because your ability to to get out of
Speaker 1: risk is going to be directly related to your willingness
Speaker 1: to put on risk and how much you willing to
Speaker 1: charge for that. So so we we do spend a
Speaker 1: lot of time looking at those transactions. And what we
Speaker 1: have is basically every order in the inter dealer broker
Speaker 1: market going back fifteen years, you know, buy sell, change
Speaker 1: the price, change the amount, change the level you cancel
Speaker 1: the order. We we have all that. It's basically just
Speaker 1: a debug output. It's been Piper context file and we
Speaker 1: can we can sift through that and try to make
Speaker 1: as much use of it as we can. And one
Speaker 1: of the things that we've done, as we said, how
Speaker 1: quickly did this order react to anything else that happened
Speaker 1: in the market, Because we don't know who's placing it,
Speaker 1: but we know some fraction of the participants in that
Speaker 1: inter dealing market are so called high frequency, So how
Speaker 1: fast was this thing? And we find that about of
Speaker 1: orders now are reacting very quickly to something else that happened,
Speaker 1: and we know that's very likely to be high frequency
Speaker 1: because when we plot up a histogram, if we look
Speaker 1: at the distribution of timing of those events, there's a
Speaker 1: very strong peak at eight mili The seconds and and
Speaker 1: the questions, what's what's significant about eight milli seconds, Well,
Speaker 1: that's the time it takes for an email to get
Speaker 1: from New York to Chicago. So that's people checking the
Speaker 1: checking the pit, coming back to New York, trading the
Speaker 1: cash market. So you can see these little features that
Speaker 1: are indicative of what you think you're seeing because we
Speaker 1: again don't know who's trading. We just know that they're trading.
Speaker 1: High frequency is one of those things that like relies
Speaker 1: on on strong and resilient market infrast market micro structure
Speaker 1: to be profitable, and that's the liquidity that's on the
Speaker 1: screen until you need it and then it's all. And
Speaker 1: so when we track that, you know that goes from
Speaker 1: the market. The market under periods of real stress. This
Speaker 1: past few weeks, it really hasn't dipped that much. It's
Speaker 1: gone down to maybe, but it stayed pretty resilient. And
Speaker 1: that means that your on screen liquidity, what you see
Speaker 1: in the market is available to transact, is really there
Speaker 1: and that has not always been true, and so like
Speaker 1: that's a sign of healthy market infrastruction. So we've been
Speaker 1: focused on treasury market micro structure and the plumbing of
Speaker 1: the actual system. But if we look at it from
Speaker 1: a more macro perspective, I'm wondering, at what point do
Speaker 1: you see the rise and yields or I don't want
Speaker 1: to see, say, treasury market um dysfunction because you know,
Speaker 1: as you put it, the recent bout of volatility wasn't
Speaker 1: nearly as bad as we've seen in some previous UM instances.
Speaker 1: But at what point do the current events in the
Speaker 1: treasury market become a problem for the FED or at
Speaker 1: least something that it feels it has to push back against.
Speaker 1: So I think that the memory of last March is
Speaker 1: that not just that rates were moving a lot, but
Speaker 1: that price discovery was broken. So you know, something that
Speaker 1: was issued three months earlier than another bond that were
Speaker 1: functionally the same instrument with the same credit, we're trading
Speaker 1: at very different prices. And that's only if you thought
Speaker 1: the price you could get was really the price. And
Speaker 1: so the FED is not specifically concerned with rates rising,
Speaker 1: and especially if it's inflation expectations moving up, I think
Speaker 1: that's that's a sign of healthy recovery UM. Their concern
Speaker 1: from when we talk about market functioning we're not talking
Speaker 1: about volatility in isolation. We're talking about price discovery really,
Speaker 1: and the questions, can markets assign realistic prices to securities
Speaker 1: in a realistic period of time and it really and
Speaker 1: a decent enough size to facilitate the broader functioning of
Speaker 1: the market. Are they introducing sort of the risk of
Speaker 1: a market failure in which there just is not enough
Speaker 1: intermediation capacity two to keep things flowing. Um, So you know,
Speaker 1: that's that's more that's much more existential, that's much more concerning. UM.
Speaker 1: There's not a real sign that that's imminent in any respect.
Speaker 1: Right now, you see some some dispersion in the pricing
Speaker 1: of securities, but we think that's more attributable to the
Speaker 1: details of how banks invest with their portfolio and potential
Speaker 1: regulatory changes, which are important. But like what to have
Speaker 1: an event like last March, you need two things. You
Speaker 1: need an underlying vulner ability and you need an event
Speaker 1: of sufficient magnitude of shock that's big enough kind of
Speaker 1: exposed and widen that crack. And so the COVID shock
Speaker 1: in the context of balance she constraints on bank market making,
Speaker 1: was precisely that. So the risk had been there all
Speaker 1: along it just took a big enough shock to expose
Speaker 1: it and widen it and turn it into something much more,
Speaker 1: much more concerning. Now, I think, on the one hand,
Speaker 1: we don't really have that vulnerability, although we'll see what
Speaker 1: happens with with the regulatory outlook. We're likely to get
Speaker 1: some color on that or some clarity on that pretty soon.
Speaker 1: But more importantly, this just doesn't seem like the kind
Speaker 1: of shock that's a sufficient magnitude to drive a wedge
Speaker 1: through that vulnerability in the first place. So you just
Speaker 1: don't have the same set of weakness and you don't
Speaker 1: have the same magnitude of shock. Um. So I hate
Speaker 1: to say everything's gonna be fine, because that's their famous
Speaker 1: last words, um, But we could have a big move
Speaker 1: in rates, and I think it's important to say again,
Speaker 1: like that's happened before, it will happen again. Um. Markets
Speaker 1: re price as the view changes, as the expectations change,
Speaker 1: because the world changes, and sometimes dramatically. But so long
Speaker 1: as the market is reflecting accurately that underlying fundamental shifting expectations,
Speaker 1: there's nothing to be quote unquote concerned about, at least
Speaker 1: from a market functioning standpoint. Now, we may not like
Speaker 1: the way the world's going, and you know, inflation running
Speaker 1: away is clearly a problem that the FED would have
Speaker 1: to deal with, but that's a macroeconomic issue, that's not
Speaker 1: a markets issue. So you you did kind of allude
Speaker 1: to this, this sort of upcoming sort of regulatory questions.
Speaker 1: Of course after um, you know, in the in the
Speaker 1: wake of the crash, the market crisis whatever, um, last
Speaker 1: March um, one of the things the FED did was
Speaker 1: basically make it I guess you describe it such that
Speaker 1: the banks could hold unlimited amounts of treasuries without any
Speaker 1: sort of like penalty on their total assets. So again
Speaker 1: mention the proviso when we're recording this, we don't know
Speaker 1: exactly what we'll here by the time uh this comes out.
Speaker 1: Can you just walk us through the tension here? And
Speaker 1: it's sort of like how we should think about this
Speaker 1: question of the SLR and how big it could be regard,
Speaker 1: you know, depending on how the FED acts with extending
Speaker 1: this program. Yeah. So so sl ARE the supplementary leverage
Speaker 1: ratio is a fairly blunt regulatory instrument. So it basically
Speaker 1: says you, as a bank need to hold capital relative
Speaker 1: to the overall size of your institution, So it doesn't
Speaker 1: matter what you have. However much you have of it,
Speaker 1: make sure you have five percent in capital um at
Speaker 1: the holding company level and in six percent for your
Speaker 1: your bank operating companies. So the issue there was that
Speaker 1: back last March um there was just a ton of
Speaker 1: demand for liquidity and people have been holding treasuries as
Speaker 1: a cash surrogain, so that the thought it was treasuries
Speaker 1: are risk free, they are highly liquid, they pay a yield,
Speaker 1: so instead of just earning cash returns, I'm going to
Speaker 1: buy a five year treasury and if I need to
Speaker 1: sell it, I can sell it at low cost. And
Speaker 1: the issue is that banks facilitate that sale because the
Speaker 1: vast majority of trading happens with bank affiliated dealers, and
Speaker 1: those dealers is subject to these regulations. Um. I think
Speaker 1: it's a little bit of a misnomber to say that
Speaker 1: balance sheet constraints were strictly binding last March, meaning banks
Speaker 1: simply ran out of capacity. Um, they had plenty of capacity. Actually,
Speaker 1: it's kind of a misnomer, like the SLR was never
Speaker 1: explicitly binding last March um. So if it wasn't binding,
Speaker 1: then what was the problem. And you know, I've been
Speaker 1: out there talking about how balance shee constraints were a problem.
Speaker 1: But if they weren't strictly binding them, then where did
Speaker 1: the stress come from? And the answer is it's less
Speaker 1: about your institutional constraints and more about your local constraints.
Speaker 1: So if you're assigned a commodity and asked to distributed
Speaker 1: among different businesses, so bank has a hunt of dollars
Speaker 1: worth of balance sheet and some of it goes to
Speaker 1: the treasury desks, so it goes to the credit desks,
Speaker 1: and it goes to the equities desks, and it goes
Speaker 1: to the repo desks, and it goes to the f
Speaker 1: X desk. You have to you have to allocate this
Speaker 1: scarce commodity, but you need to make sure that at
Speaker 1: an institutional level you have enough or you don't go
Speaker 1: over budget. So that means those assignments are pretty rigid
Speaker 1: and it's hard to reallocate. So I think there's also
Speaker 1: a sense of banks are highly efficient in their use
Speaker 1: of their balance sheet, and they are uh, like we're
Speaker 1: talking about over long periods, but not necessarily over short periods,
Speaker 1: And so you can run into a situation where a
Speaker 1: treasury trading desk or repo desk, which uses a ton
Speaker 1: of balance sheet and is very volatile, and its use
Speaker 1: of balance sheet can run into local limits that are
Speaker 1: part of the business management and planet capital planning process. Um.
Speaker 1: But the institution's got plenty of excess, but they are constrained,
Speaker 1: and so they start to act like the institution is
Speaker 1: balance sheet constraint, even though it's really just a local effect.
Speaker 1: What the SLR car that's did. As they said, those
Speaker 1: treasuries don't contribute to your leverage exposure, So treasury desk
Speaker 1: used as much as you want, basically like this is
Speaker 1: not going to be a problem. Uh, you know, don't
Speaker 1: go crazy and don't and make sure you know how
Speaker 1: much you got. But like if you need balance sheet,
Speaker 1: you know your need for additional balance sheet is not
Speaker 1: going to affect my capital planning at an institutional level
Speaker 1: at least as long as these carve outs are in place,
Speaker 1: and therefore you can be much more flexible with how
Speaker 1: that desk operates and so they don't run into these constraints.
Speaker 1: Is frequently that's about mitigating market failure risk. It's not
Speaker 1: about reducing leverage constraints in real time. It's about clipping
Speaker 1: the tails of these more problematic outcomes, especially at a
Speaker 1: period of time when the trajectory was towards an acceleration
Speaker 1: in the use of balance sheet So it was the
Speaker 1: it wasn't the level, it was the path of growth
Speaker 1: and the way that that was affecting local behavior. Um.
Speaker 1: So those rules were put in place to avoid those
Speaker 1: those can to avoid those market failure risks. They've been
Speaker 1: largely effective at doing so in combination with fit purchases. Um.
Speaker 1: But they're going to expire at the end of this month,
Speaker 1: so the question is, you know, are they going to
Speaker 1: get extended, if so, for how long and what form?
Speaker 1: And they're going to be extended in a format. And
Speaker 1: there's a distinction between how the bank operating company which
Speaker 1: is the deposit taking institution, and the dealer, which is
Speaker 1: part of the holding company, how they are separately affected
Speaker 1: by these rules. Um. But but I think that this
Speaker 1: specific issue of market functioning risk is a dealer issue,
Speaker 1: which means it's a holding company issue, which means the
Speaker 1: question is, on the one hand, you know, how how
Speaker 1: is this going to be treated after March three one?
Speaker 1: And on the other how's that going to affect the
Speaker 1: way that these institutions behave internally and manage their balante
Speaker 1: exposure because because that's where the sort of real risk
Speaker 1: factors lie in practice. The issue here is that we're
Speaker 1: coming into the end of this period with less buffer
Speaker 1: at an institutional level than was true early last year.
Speaker 1: So banks would be entering a balance sheet constrained world,
Speaker 1: or at least a world in which SR is in
Speaker 1: principal binding with less buffer. That means more rigid internal
Speaker 1: allocations and economies a balance sheet, which means greater market
Speaker 1: functioning ris And so you know that's a scenario where
Speaker 1: in principle, if if this keeps going, you could run
Speaker 1: into world where there is a need to sell and
Speaker 1: raise liquidity on the part of the real economy, the
Speaker 1: non banks, and it would be much harder for for
Speaker 1: dealers to intermediate that under the circumstances. Again, you need
Speaker 1: a shock of sufficient magnitude to to really exacerbate that
Speaker 1: and turn that into a a real issue. But the
Speaker 1: risk is greater all outs equal if banks have less
Speaker 1: flexibility in the way that they allocate that balance sheet. Okay, well,
Speaker 1: clearly a lot going on in the treasury market um,
Speaker 1: and we do have that FED meeting coming up. We
Speaker 1: are recording before it, so it'll be interesting to see
Speaker 1: how everything shakes out. So thank you so much Josh
Speaker 1: for coming on for your fourth All Thoughts appearance, and
Speaker 1: also for connecting the world of real yields with climate change,
Speaker 1: which not many people do. Thanks Spanning of Magnitude. That
Speaker 1: was great. Thank you so much, jos Yeah, thanks very
Speaker 1: much so, Joe. I found that conversation very interesting, a
Speaker 1: little bit technical, but I do think this broad idea
Speaker 1: that the way we think about climate change, or the
Speaker 1: way we make these cost benefit calculations is tied to
Speaker 1: estimates of the time value of money the discount rate
Speaker 1: as much as our actual estimates of how climate change
Speaker 1: is proceeding and climate change damage. I think that's really
Speaker 1: interesting because I don't know, like the climate change questions
Speaker 1: seems to be framed so much in science, which you know,
Speaker 1: for obvious reasons, people talk about it from a scientific perspective,
Speaker 1: but people don't really talk about it from an economic perspective,
Speaker 1: except in a broad sense that well, you know, you
Speaker 1: have to trade off economic growth for restrictions on pollution
Speaker 1: and things like that. They don't actually get into things
Speaker 1: like interest rates, um all that much. I think. No,
Speaker 1: it's super interesting because it does feel like there is
Speaker 1: this you know, I think a lot of people would
Speaker 1: accept this premise that something like climate change, which is
Speaker 1: slow moving global in nature, affects everyone but also at
Speaker 1: very sort of like indeterminate times in the future is
Speaker 1: like a very like hard thing for like market to price.
Speaker 1: But the idea of still using market pricing concepts to
Speaker 1: try to get an estimate of the cost of inaction,
Speaker 1: which is I guess basically what we're talking about the
Speaker 1: cause to inaction is a really sort of like, um,
Speaker 1: it's a really interesting exercise. Yeah. And also just the
Speaker 1: broad point about how the last time we did a
Speaker 1: really really big climate change report was the Stern Report
Speaker 1: back in gosh, I can't even remember when that was.
Speaker 1: Was that like two thousand six or something like that.
Speaker 1: I think I think it said two okay, yeah, like
Speaker 1: and back then interest rates were completely different to what
Speaker 1: they are now, and you know, his estimate of how
Speaker 1: much that changes the calculation is just something that well
Speaker 1: I certainly hadn't thought of it before, but I guess
Speaker 1: like I still have some issue with this idea that's like, okay,
Speaker 1: like there is this like looming humanitarian catastrophe. Maybe we're
Speaker 1: already seeing aspects of it played out playing out, and
Speaker 1: it's like either we're gonna we want to do something
Speaker 1: about it or not. And so it's kind of weird
Speaker 1: still for me to wrap my head around this idea
Speaker 1: that well, that would have been you know, a certain
Speaker 1: costs in two thousand seven, but the real interest rate
Speaker 1: environment is changed from two thousand seven to two thowy one,
Speaker 1: and so now there's like a total um sort of
Speaker 1: like different cost benefit analysis. But I guess still just
Speaker 1: this idea that's like, all right, if we accept certain
Speaker 1: premises about the cost of capital, how much is it
Speaker 1: costing us to wait? Is sort of a a useful
Speaker 1: a useful frame in terms of thinking about policy. Yeah,
Speaker 1: you can see there's something distinctly awkward about, you know,
Speaker 1: telling someone we're sorry that your house is underwater from
Speaker 1: climate change. But it's because the interest rate change between
Speaker 1: the last time that we made an estimate of how
Speaker 1: much it would cost to fix this problem. And now
Speaker 1: like there's something yeah, yeah, and you hinted it that
Speaker 1: like future generations or people who aren't born yet don't
Speaker 1: get a vote. But it's like, oh, we're going to
Speaker 1: do something about climate. But the real interest real interest
Speaker 1: rates were sharply positive at the time, and things were growing,
Speaker 1: and so the time value of money discounted fifty years
Speaker 1: from now, like it wasn't really that much. It does
Speaker 1: sort of like raise some like I guess kind of awkward. Yeah,
Speaker 1: I mean, I guess Josh mentioned this, But there's the
Speaker 1: sort of financial imperative and the moral imperative as well, right,
Speaker 1: but maybe I don't know, maybe by focusing on the
Speaker 1: financial imperative, that's a way to get more people involved
Speaker 1: in the whole project, and you know, maybe the ends
Speaker 1: sort of justify the means, right, Yeah, and again like
Speaker 1: the rules are going to come from somewhere, right, Like
Speaker 1: that's sort of what I took away. It's like someone
Speaker 1: how politicians around the world addressed this, Like they're still
Speaker 1: built up things like carbon pricing or other regulations that
Speaker 1: may have some impediment to slow the economy or maybe
Speaker 1: you know, needs some uh guess of like okay, how
Speaker 1: much do we invest in X or Y? Like the
Speaker 1: rules have to come from somewhere as they're trying to
Speaker 1: get ahead of this by like thinking about how these
Speaker 1: models might get shaped as a I use future that. Yeah,
Speaker 1: absolutely all right? Um, shall we leave it there? Yeah?
Speaker 1: Leave it there? Okay. This has been another episode of
Speaker 1: the All Thoughts Podcast. I'm Tracy Alloway. You can follow
Speaker 1: me on Twitter at Tracy Alloway and I'm Joe wi
Speaker 1: Isn't Thal. You could follow me on Twitter at the Stalwart.
Speaker 1: Follow our producer Laura Carlson. She's at Laura M. Carlson.
Speaker 1: Followed the Bloomberg head of podcast, Francesco Levi at Francesco Today,
Speaker 1: and check out all of our podcasts under the handle
Speaker 1: at podcast. Thanks for listening.