Broken Market Signals Are Warning of the “End Game”
Summary
Is the bond market really warning of a U.S. debt crisis — or are investors misreading a distorted market signal? Michael Green …
Transcript
When you have a mechanism like passive investing that has grown so rapidly and so large, we need to consider the possibility that the price signals are not being driven by those facts. When a market increasingly becomes a mechanical system that is governed by regulations and rules. It no longer represents the collective wisdom of the crowds. It simply represents the extremes of the model that we have built for it. we will see volatility begin to rise exponentially. That's the warning sign that we're beginning to approach the endgame. >> Hello and welcome to Wealthy. I'm Maggie Lake. Joining me today to discuss the outlook for US markets is Michael Green, chief market strategist at Simplify. Hi Mike. Thanks so much for being with us. >> Uh it's a pleasure to be here, Maggie. Thank you for having me back. So, as usual, fantastic timing because you just wrote an open letter to the US Treasury Secretary which you posted on your Substack. Um, I'm curious what prompted that? Why did you feel the need to speak out? >> Well, the key issue is is that the work that I've done around passive is often linked to the equity markets, but we're actually finding that some of the mo the biggest distortions are now occurring in the uh fixed income markets, in particular the market for sovereign debt. We're seeing a quote unquote puzzling lack of interest in the 30-year bond as it crosses over 5%. Now, there's narratives around that, right? We're worried about inflation, the US government is going bankrupt, etc., etc. But the reality is a 5% 30-year bond should actually be attracting a significant amount of attention. People should be paying attention to it for no other reason than it candidly meets most of the obligations that people have in retirement. I had a really interesting experience this past week. I spoke to a group of institutional allocators down in uh North Carolina, Asheville, North Carolina, and highlighted that we'd seen this radical change. We've gone from basically zero on long-term interest rates to well in excess of the inflation rate, near the highest level of real rates we've ever seen in history. This is very much at odds with almost all the evidence that we have from a demographic feature of what should actually be happening and what people should be doing with their retirement planning. And I asked a simple question, has anyone changed their allocations? And literally in a room of 500 institutional allocators, not one hand went up. Nobody is actually changing their allocations. When you dig into the mechanics of what's actually happening, it really boils down to effectively an index phenomenon. The structure of passive investing in bond markets allocates just like they do with equities more capital to bonds that are trading at higher prices. When you have the period of zero interest rate issuance that we had from an extended period of time, basically from 2009 until give or take 2021, that creates conditions under which those low coupon instruments as you raise interest rates collapse in price. Many 30-year bonds or near 30-year bonds are now trading in the 50s. >> That means that far less capital is being allocated to them. They take up less weight in the index and they receive less interest even as they would meet the vast majority of retirement obligations that people are facing. And so this was really what I highlighted for Secretary Bessins in the open letter was that what we were seeing was not a market judgment on that 30-year bond, but rather a mechanical byproduct of how we choose to allocate our investments under government mandate. uh the regulatory framework is distinctly skewed towards bias towards passive vehicles and it unfortunately is creating the outcomes that we're now interpreting as the imminent collapse of you know the US government because it can no longer afford its entitlements etc. None of that is actually true. So we are watching people miss an incredible opportunity that in my analysis is increasingly being driven by how we invest not the thoughtful application of logic or um understanding of financial markets. That that's that's that's huge and a really important distinction because I think the narratives you just talked about, you know, the inflation uh debt load we can't handle anymore. Um are really persistent right now and we do feel like people are voting with their feet. That's what I hear from loads of really experienced people. They're making a judgment. They're saying, "I'm not willing to take on the risk that the US now uh sort of presents uh as a as a government that can't afford the debt anymore. You're going to have to pay me a higher risk premium to take your debt." You're saying that's BS. That's actually not really what's going on. >> I don't think that's what's going on. I'm certain that many people believe that. Unfortunately, I think that becomes a function of the market presents what we think of as truth. And when you have a mechanism like passive investing that has grown so rapidly and so large both as a portion of the equity market and now as a portion of the fixed income market we need to consider the possibility that the price signals that we're receiving are not being driven by those facts right or those assertions which I would argue are not facts. We can actually afford to service our debt. We can afford to do things but because we think we can't we're actually making bad choices. So, but I I I want to dig into that a little bit, but when you talk about meeting the needs of retirement, I think this is really important because the other super super popular narrative is that 6040 is dead. You should not look for to bonds to diversify. They're sort of, you know, um because of the the the whole issue with uh the devaluing the dollar and alling the dollar, collapse of the dollar, collapse of US ability to financ >> you shouldn't hold bonds. That's the that's the message retirees are hearing or people who are trying to plan their portfolio including a lot of the people that that we talked to. Why do you say that this uh the 30-year at 5% or over 5% meets the needs of retirement? What is it doing? What is it providing that that people are misunderstanding? >> Well, what it's providing is current income ultimately in a uh asset protected manner. If you buy a 30-year bond with a 5% yield, you will receive that 5% yield for the next 30 years and you're actually ultimately going to have the principal left over. So whether that's devalued by inflation or not is actually somewhat irrelevant. You're dead at that point. When you think about a historical withdrawal rate from a 401k and the target of 4%, that 5% alone allows you to get there with none of the equity risk, etc. Now, the great irony, as you're pointing out, is not only are people saying 6040 is dead, there was a Wall Street Journal editorial that just was released, I believe it was the end of last week, saying the new model should be a 9010, meaning you should have 90% in equities and 10% in bonds. This is ironic because the exact same analysis on the equity market would ultimately suggest that that we're looking at forward expected returns that are below 2%. And so people are scrambling to buy a 2% expected return asset and foregoing a 5% return far less volatile far more stable asset that ultimately protects your portfolio allows you to meet the objectives of a 401k and that 4% withdrawal rule and nobody's taking advantage of it for the very simple reason that we're not seeing the price action support that narrator. Uh this is I mean people it feels like a cold water on your face based on what most of us have have been drilled into us over the last you know year or so I think. So is the government bond market it first of all is this a US phenomenon or do you think that this is happening sort of globally and is it mean that the government bond market's not functioning properly right now? >> It it means exactly the latter part of it and it is happening globally. That was one of the components that I highlighted within my piece is that we're increasingly starting to see the narrative that this is a global phenomenon. UK rates are selling off. Australia, which has a debt to GDP of around 25%, is seeing its rates follow the same pattern. Japan is seeing its rates sell off with far worse quote unquote fundamentals than the United States has. They're all behaving identically. that suggests that there has to be something that is a broader mechanism rather than the specifics of the US government or the US dollar that is really behind this and when you dig into it you discover that it is indeed a mechanical process of how we've chosen to allocate our capital. That's so interesting and explains. I just was speaking to someone who's a more of a technician, Mike. Um when we saw that big move in yields, I think it was not this past Friday, but the the week before. And when he was looking at the chart, he just saw huge gaps that you would not see normally, just an absence of buyers and and really dysfunctional. And it really concerned him. And he said, "This is just you don't see this normally. Something's not right." And I think you're filling in the part of what's not right for people who've been watching the behavior of the market when you say um by the way if you're not watch if you don't in addition to following Mike uh and simplifies work on simplify I suggest that you uh follow his substack. Yes, I give a fig because this is where you're laying out a lot of this stuff as well. Um and in it at one point you said if you needed I'll explain it like you do to a golden retriever one of the AI prompts and I was like yes please. Um but if when you're talking about now the prices are because of what's happened um 65 cents or 55 cents on the dollar. I think that's what you were referenced before. So the prices are low on those bonds. Um people hear that and think then then you know that that is the market saying that they're not worth as much or why would I want something? um or what does that what what kind of dynamic is that creating and what and because you offered a lot of explanations to the Treasury Secretary as a way out? What what should we understand about that and why has that become a persistent problem now especially among institutions? >> Well, there's two separate components to so when a bond is issued is issued with a coupon. So bonds that were issued in 2021, for example, would have been issued with typically a quarter percentage or a half percentage coupon associated with it. When you raise interest rates, when interest rates rise, the market has to accommodate that through an arbitrage phenomenon where that bond that has the exact same credit risk is treated on an equivalent yield basis to the newly issued paper that matches that maturity. So, a 30-year bond that was issued in 2021 should have, and there's not really a 25-year issue, but if there were a 25-year issue, it should be trading at the exact same price as a coupon that was issued this year with a give or take 5% yield. When you adjust for that relationship, you have to lower the price of the bond. It doesn't reflect a credit assessment. It's not the same phenomenon that we would see within a high yield bond that is trading at a distress price. It's simply a reflection of the forward expected return matching the current coupon to that lower coupon issue. The reason that that creates a real problem in the banking system in particular is the phenomenon that was tied to Silicon Valley Bank. So when uh banks bought mortgages or they bought long duration uh US government debt in the early part of the 2020s that paper has now fallen far below the levels that they acquired it at. It was issued at par. It's now fallen to between 55 and 75 cents. That creates a loss that if banks were to realize that would actually impair their capital base and prevent, excuse me, and prevent them from being able to lend or actually even function. They would be in violation of Basil regulations. Their reaction to that was to put this entire class of bonds into what's called the hold to maturity category. That allows them to avoid recognizing the loss. They're basically saying, "Look, we're going to hold this for 25 years, and in 25 years, we're going to get our par back in the principal payment." But that suddenly means that you've got basically illquid and inactive capital within the banking system. That's what caused the distress for Silicon Valley Bank. Once you've put something into hold to maturity, when you receive requests from depositors to provide you with their with their funds back, you have to source that liquidity from somewhere. If you touch that hold to maturity category, you impair the entire portfolio and create conditions where you have to recognize that loss. And so banks will do almost anything to avoid doing that. The solution under Silicon Valley Bank was to create a lending facility from the US government where you could borrow, obtain liquidity. They would treat the instrument as if it was still par in that hold to maturity framework and you could obtain liquidity against it. But that liquidity is being sourced at an expensive price and it's costing you significantly more to borrow under that framework given the level of current level of interest rates than you're receiving on those assets. It's impairing bank profitability and reducing their willingness to lend to anything other than the most pristine credits. The US government, of course, being one of those. My proposal is very straightforward that the government should effectively reissue 30-year bonds and exchange the 65 cent market value for an equivalent market value of current coupon bonds. That does two things. one, it actually significantly liquefies those portfolios. It creates conditions under which banks can again begin tapping that credit, that capital and recognizing that maybe they don't want to actually just lend to the US government. Maybe they want to lend to the private sector. >> The second thing that it does is it actually raises the current income going into banks and that actually facilitates balance sheet repair as well. The last thing that it does is it actually reduces the quantity of US government debt outstanding and that actually is obviously a benefit as well. It helps to address this narrative of whether or not the US government is overly indebted. This would ultimately this proposal would lower that indebtedness by about threequarters of a percentage point. It's not going to change the world. It's not going to change anyone's total assessment of the financial stability of the United States, but it certainly helps. And more importantly, it gets the credit mechanism functioning on the banking system again with far less government intervention. >> Would would it also help to deal is this is this related to the passive who keep buying the uh the higher price bonds? Would it also address that or are these two problems two separate problems? >> Well, the the conditions are created in part because of the lack of the passive bid. So, when you think about a dollar going in, I use the thought experiment, my Substack of a super simple bond index. Imagine there's only two bonds in the universe. There's a two-year bond and a 30-year bond. And at stage zero, they're 50/50 in terms of index construction. If the Federal Reserve lowers interest rates, that 30-year bond is going to rally sharply. It's going to rise quite a bit in price because the market has to do the opposite of what it did when it discounted them to 65 cents. it has to make them per pursu equivalent to a new issue coupon that's at a lower rate. Um that actually would skew the index towards longer duration bonds. And this is the condition that we saw basically from 2009 until give or take 2022 in which the bond indices became longer and longer duration as the Fed would cut interest rates with the expectation that this was providing some form of stimulus. it would cause those longdated bonds to rise in price. That increase in price skews the index towards them. It's why the index had such extraordinary duration sensitivity going into the 22 rate hikes that caused the catastrophic losses. The duration exposure of the index had risen by roughly 35% over the period from 2009 until give or take 2020. When the Fed then hikes interest rates, the opposite happens. The index becomes underweight, the long duration bonds, and overweight the front of the curve. In my analysis of what a passive bond index represents today, it's about 35% underweight, the duration component of it. That means when a dollar goes into a passive bond index, it's buying more of the front end and it's ignoring the back end. relatively ignoring the back end. That means the pricing is less um efficient. It means that the demand is less and it's created among other things the extraordinary rise of what's called the basis trade which is effectively hedge funds recognizing that there is a mispricing that is occurring out here. They are shorting treasury bond futures, buying the off therun issues that offer very similar total yields, but are being ignored and therefore they can pick up between 10 and 20 basis points of additional return. They capitalize on that 10 to 20 basis points by lever leveraging themselves 50 to one so that you end up creating a return of 10% quote unquote risk-free. That's not risk- free to the system. It's an extraordinary amount of leverage that's sitting out there. It exposes the US government >> to disruptions in the bond market when credit financing is called into question. >> And that's exactly what we're trying to address with this type of proposal. Reduce the opportunity for the arbitrage that exists in the basis trade. create a functioning credit market and treasury market in which people can honestly look at it and say, "Okay, I'm buying a par bond that pays me 5% that allows me to achieve my retirement objectives, and I stop doing a lot of really silly stuff like engaging in strategies that are designed to create excess return by taking on significant additional risk." >> Yeah. And I I think it's really important to lay that out because I mean you're you're deep in the math and you have spent years, you know, you understand the ins and out in the bond market. One of the things that I've seen happening and it's sort of everywhere is that there's a lot happening with flows and with mechanics related to markets that most of us don't have that kind of in-depth knowledge about. And what's being layered on that in the world of finit and wherever is this sort of narratives and morality about what's happening that suit the purpose of people posting them like the you know imminent decline of the US. Um which doesn't mean that there aren't serious problems but then you hear what you just laid out and you're like wait a minute there's something else that's happening that's moving this around. not um it's not because people are making a distinction necessarily. Um and then you have that repercussion that people are avoiding a a whole asset class because of that. So that that's wild stuff. Okay. So Kevin Walsh is a new Fed chair. You wrote the letter to Scott Bessant, but Kevin Walsh is is coming in as a Fed chair. We understand that he would like the private markets to function more and do the do the work and not be so reliant on the central bank. What are your expectations? Do you think that he understands what's happening that he would be open to trying to address some of these imbalances that you talk about? >> Well, first I think he absolutely would and one of the benefits of the proposal is is that it exposes the narrative that we don't need much higher rates that rates are not stimulative. This is one of the really critical things I think for people to understand. If you remember Maggie, in 2022 the narrative was now we've got real interest rates, therefore value is going to outperform, right? Sanity will return to the stock market. >> Instead, as I predicted, we've seen the exact opposite. We went right back to what we were doing before. Again, this is a mechanical property of a passive dominated market. The structure of the indices are such that they reward with more marginal capital prices that go higher that in equities manifests itself in a rising stock market. In the case of bond markets, as I highlighted, it can create either neglect or enthusiasm for the longdated securities. Unfortunately, where we sit right now, people are regularly running around and saying rates need to go much higher in order to quell the speculation or to attract people back to the 30-year bond. The math and the mechanics that I've laid out highlight that that's not the case. It is a structural feature of the market that can be addressed proactively, but it has to be done through the Treasury. The Treasury is responsible for issuance and retiring of US government debt. There could be an opportunity to involve the Fed through something that's called yield curve control. But candidly, that's a really inelegant, blunt tool that doesn't address the primary issue here. >> We need to at some point move to reforming the way that we invest. We need to move away from passive. >> So you you just said you spent uh the last decade talking about reforming the the way we invest. >> Yeah. So I mean it's been basically a decade since I've identified these issues. I started with the equity market. It's expanded into the fixed income market. It's become increasingly apparent that unfortunately I was correct in my analysis of what is actually going on. The academic literature is exploding around this. I collaborated with on this letter with some of the academics I've worked with in the past. In particular, Valentine Hedad had a 2019 paper in which he laid out some of these components basically the duration targets that are that exist within the institutional world etc. and how those can be influenced by um changing character of coupon issuance. He had not connected it to passive investing but now acknowledges that that is indeed what we are actually seeing. So we know that this is correct. It's just a question of do we choose to address it. It does have to be addressed through the Treasury. It does create the additional benefit of allowing the Fed to lower interest rates without perpetuating the narrative that this is, you know, yet another bailout, that the US government is captured by fiscal dominance, etc. None of those statements are true as of yet. They could become true. And I want to emphasize that if we don't address many of these issues, we will ultimately find ourselves under these conditions. But the the narrative for why it's occurring is not actually why it's happening. So it is really important that we start to address this. In terms of interest rates itself, I think it's really important for people to recognize how depressed the interest rate sectors of the economy are. The auto sales are running way below population adjusted levels. That's a financed vehicle. Many forms of appliances are seeing incredibly depressed demand. Again, financed vehicles. If you consider the housing market, you're facing two pinchers that are hitting there. One is the much higher level of mortgage rates makes it uneconomic for people to sell their existing home, cash in that 2.75% mortgage that they secured in 2020 or 2021 and move to a new location because the downgrade in house size that you would have as you retire is actually potentially going to increase your payment in today's world. >> And so there's an unwillingness of sellers and at the same time the ability to build new product is impaired by those much higher financing rates. And as a result, we're seeing the lowest turnover we've ever seen in history for the US housing markets. They've lost their dynamism. And unfortunately, that is a byproduct of interest rates being higher than they should be. I want to be clear. I don't think we should have zero interest rates. Although I think if we continue down this path, we will ultimately be forced to go there again. >> And so I really think that's actually critical people to understand. This is not a morality or a bailing out of the banking system. The banking system maintains the losses. We are not changing any of those characteristics. We're simply restoring functioning to the US Treasury market in the context of what has transpired with passive investing and how we choose to allocate capital. The second thing is is the narrative that interest rates need to be much higher is just empirically false. Like we actually know that the level of interest rates are quite restrictive. Unfortunately, we look at the stock market soaring and we say this is evidence of extraordinary speculation. Clearly, we need higher interest rates to combat this. Again, just not true. It's just not true. When a market increasingly becomes a mechanical system that is governed by regulations and rules, it no longer represents the collective wisdom of the crowds. >> It simply represents the extremes of the model that we have built for it. >> That's that's a really really great and succinct way for all for us to understand this. And from having talked to you about passive for years, it's sort of like a Frankenstein that just continues to to charge along and and is sort of disrupting what we would what we understood to be the system. What about inflation? That's the other thing we hear all the time right now. We see all you know prices rising across the board in all these different levels. Do do you think that is a persistent threat? And it's not just the war. We know that's that's creating. We hear we hear people talk about, you know, changing geopolitics, resource nationalism. There are a lot of explanations around why this might be more persistent inflation. It doesn't seem like that's something you're worried about. Or do you think that interest rates aren't the right way to deal with it? >> Well, I think it's a combination of factors. So, one, interest rates are a very blunt tool. um you are basically using a central planner approach to manage a market economy by trying to set the price of money for a particular group. Um the second component in terms of inflation is that the underlying characteristics of the economy are actually quite deflationary. >> The population pressures that existed in the 60s7s and into the 1980s have largely been replaced by falling populations and declining labor forces. That means that the underlying um interest rate has to be set lower for the very simple reason that you don't have anywhere near the demand to maintain capital investment. If you think about what productivity or inflation captures in a purely fundamental sense, part of what you're trying to recognize is that you have a production possibilities frontier. It's an economic term that basically is the combination of labor and capital that produces the greatest possible outcome. When you have a rapidly growing labor force, you need to add capital at a rapid rate in order to maintain that capital labor ratio that allows you to preserve your location on the production possibilities frontier. That means that the demand for capital i.e. interest rates will be high. That was the 1960s and 1970s for us. When you move into an environment in which population growth is slowing and turning negative, that means that the capital labor ratio is actually going to rise even in the absence of investment. That means there's less demand for capital than there otherwise would be. And interest rates should be lower. Unfortunately, that's not the phenomenon that we're experiencing. And again, I tie it to the way we've chosen to invest and the way we've chosen to behave as a society. There are two separate phenomenon that are intersecting. The first is in the 1970s we shifted from defined benefit plans which created retirement as a stream of income in which you effectively received an annuity. You worked for any number of years you contributed into your retirement that turned into a stream of income that replaced the income that you received in your retire in in your that you received when you worked in your retirement. that uh approach actually allows you to socialize and spread out the risks of unknown longevity. >> The 1960s and 1970s we encountered the downside risks of that in the private market primarily because we'd seen a fairly significant rise in expected in life expectancy that meant the people that contributed into the system were likely to take withdrawals for a longer period of time. We chose to remove that liability from corporations. We retained it on the public sector, by the way, which is one of the reasons people look at public sector employees and say, "What are you complaining about? You've got a pension. You don't have to worry about this stuff." >> Um, when we chose to go to define contribution, it actually has a very perverse effect because you don't know how long you're going to live and I don't know how long I'm going to live. We all have to save assets and accumulate assets for the worstcase possible outcome. We're not replacing income. We're now hoarding assets with the expectation that we'll be able to sell those assets in the future to be able to fund our retirement. That actually creates a dramatic outward shift, rightward shift in the aggregate demand for financial assets and is largely responsible for the financialization that we've seen in our economy. Your working life basically exists to stockpile financial assets that you hope will last through your retirement. It's no longer about replacing income. It's about having enough that you think you're going to survive. How much is enough? It's got to be more than I already have. Right? >> So, this is actually creating the social um disruption where the boomer generation is accumulating and hoarding assets that the younger generation is competing with as they're trying to begin the process of saving for their retirement. That's one of the phenomenon that we've created. It was a misapplication of um theoretical finance and a misunderstanding of actuarial behavior that we're just now coming to terms with. There's a phenomenal paper that was released earlier this year, gentleman's name is co-imbra cobr in which he evaluates this shift from defined contribution to defined benefit or to from defined benefit to defined contribution. And what he finds is exactly what I articulated. A dramatic increase in demand for financial assets, a surge in the price of those financial assets which shows up as a much lower cost of equity which is the forward expected return from equity investments and perversely a much higher cost of financing the government. To put some parameters on that under a defined under a defined benefit plan the cost of equity would average about 7%. under defied contribution that falls to between 1 and a half and 3%. So a fantastic increase in the valuation of equities. At the same time the cost of financing the government more than doubles. And so by virtue of how we've chosen to build our retirement systems by making every individual responsible rather than acknowledging that we exist as a collective who have a social responsibility to make sure that people are taken care of in their old age and converting those claims into an income stream. We've instead moved into an asset porting environment. The second phenomenon is a byproduct of that. Once you decide you're going to force everyone to invest on their own, the vast majority of people aren't investors. They don't have that experience base. They aren't capable of analyzing the individual securities and selecting appropriate investment methodologies. As a result, we chose a shorthand approach, the index and the passive index at that which was not selected because it was academically robust as as um uh Rob Arnot wrote back in 2005. I believe it was the primary reason we chose market cap waiting for our passive index construction was because it was easy to implement. Unlike almost any other allocation mechanism, it doesn't require you to continually rebalance the portfolio. The market theoretically does it for you, right? If something goes up in price, you now own more of it. If something goes down in price, you now own less of it. That was that unfortunately morphed into an idea that this was the most academically robust and thoughtful way to invest. But it's not at all true. We're talking about a subset of assets. We're talking about publicly traded equities in the United States. That means you're ignoring the privately held companies. Many institutions have tried to diversify into privates for precisely this reason. It also means perversely that you're ignoring the entrepreneurial ventures and the human capital that exists for the vast majority of individuals. The local owner of the Bedadega receives no benefit from these from the flow of these retirement assets. In fact, they now have a com a competing asset for their own entrepreneurial ventures that says, "Hey, guess what? You can get a fantastic return on a tax advantage basis if you allocate your savings to the S&P 500. If you decide to put it into your bodega, you don't get those benefits." And as a result, we're seeing a collapse in entrepreneurship in the country. >> That's empirically borne out. So we have decided to do this to ourselves by virtue of trying to follow effectively a model of the economy that bears no resemblance to the actual economy itself >> and is creating in the meantime all these distortions which now have gotten to the point where they're really affecting the system. The good news here Mike is that the it sounds like once you understand the problem presumably if you want to reform it you can fix it. Is there and you I know you've been making suggestions uh across all of these issues. Is there any appetite to look at this like why would we not want to address this since it's creating what are now becoming dangerous imbalances? >> Well, unfortunately it is creating dangerous imbalances and we do have to address it but it's not a painless process. among other things that would require the government to say, "Hey, um, those equity values that you guys are all counting on for your retirement, we're going to put them at risk by changing the rules." There's no appetite for that whatsoever, right? Likewise, uh deciding that you're going to target the US corporate bond the US bond market in this fashion creates some very unhappy players who are extraordinarily wealthy and wellconed on the basis trade in the hedge fund world. It's clearly something that would not be well received by Citadel um or Exodus Point. These are firms that you know have significant influence certainly more than I do as an individual. Um, and they are understandably resistant to their bread and butter being taken away from them. Um, there's a lot of resistance to this, you know, and the irony is is as I was driving up to Philadelphia where I'm sitting in the middle of a construction zone, as we were talking about before, you know, I I caught a headline that Vanguard is increasingly targeting the high fees in fixed income investing. In other words, they're making a big push into the fixed income space >> to do the same thing. >> The simple rea is to do the same thing to the bond market that has happened to the equity markets. >> But in your mind, this does not end well. >> No, it's not just in my mind. So you know earlier this year I released an academic paper that I wrote in in concert with Hari Christian Krishnan and Stefon Stern in which we identify that this becomes like the XIV the trade that made me well known um has its own you know self-correcting formula that basically says at some point we will see volatility begin to rise exponentially. We're already seeing elements of that. Look at the behavior of mega cap stocks in in response to earnings reports. they display clear behavior that they are trading under reduced liquidity terms. That's the warning sign that we're beginning to approach the endgame um which we identify as around 60% passive share at that point and we're about 53 to 54% today gaining about 4%. um that the real craziness is in front of us, not behind us, >> which is I think so so worrying uh on so many levels. And and I um again, you're if if anyone listening is interested in this because it affects the individual, right? This is eventually going to become um a ballot box issue because everyone feels I mean, we've talked about this. Everyone or the average person feels like they're not doing well. We know that and and this puts some real sort of understanding on the dynamics that are creating a situation where a young person who's 26 is feeling like the system's not working for them and angry and you can sort of you know put that across many different demographics. Um, if we circle back to to to the issue about the bond market here, you wrote in your piece, you wrote, "As of midmay 2026, you'll have the opportunity to sell your other financial assets and buy 30-year US treasuries at a level of income replacement unmatched except for the four years of of vulkar rates. For all the distress, you actually see a really unique opportunity here if people were to buy bonds." >> Yeah. I mean, the the simple reality is is most corporations have done this with their defined benefit plans. They have quote unquote defeased them by taking advantage of higher rates to effectively inoculate themselves against the risk that these portfolios would not meet their return objectives. The American public has the same opportunity. We're actually looking at a situation where the accumulated stockpile of financial assets at the interest rate that is being offered by the US Treasury would provide more income replacement to the US public than at any time in history since the four years around Vulkar when we had 15% rates. That's an extraordinary observation. And the crazy part is nobody's doing anything about it. And does that is is am I oversimplifying it to when you say sell other financial assets? You mean reduce equity and increase your exposure to bonds? >> That is the implication. Now the reality unfortunately is is everybody decided to do it. >> We'd have a stock market crash. >> That you'd have a stock market crash and you wouldn't be able to finance it. So part of what I'm actually trying to do is highlight people move first. >> Right. Actually, Secretary of the Treasury Scott Bessant um gave me probably one of the single best lines in terms of portfolio management I've ever heard, which was if you're going to panic, panic first. That is, you know, I'm not recommending that people panic. I'm recommending that they do the calculations themselves. The real yields that are being offered approaching 3% and the 30-year tips, for example, offer you just an extraordinary opportunity to take stress out of your life and to sleep better and to worry less. If you're really concerned that the US government is just going to flat out lie to you about inflation, which all the evidence is they are not, I want to be really clear. There are private sector, private firms that provide inflation analysis. True inflation would be a great example of that. They have no incentive to understate inflation. Yet they are telling you that the US government is overstating inflation. That is unfortunately what almost every economic analysis of inflation has shown over time. Now the perverse calculations that are done by the BLS, Bureau of Labor Statistics for CPI do understate inflation for many at the lower income levels. their the ability to substitute the ability to introduce new technologies etc is not deflationary. It tends to be inflationary. That's an unfortunate misrepresentation and we need to acknowledge that that the tools and dashboards that we're providing to our politicians and our elected officials and appointed officials for that matter are often deeply flawed in their construction, concealing many of the details that are creating things like the affordability crisis that I've written on and that you just highlighted. Again, do the diagnostic on it. What is an affordability crisis really about? We can't afford homes. Why? Because the boomers are hoarding the existing homes. They're unwilling to downsize. Why? Because interest rates are high enough that if they do so, they're going to end up with negative cash flow uh implications on it, particularly against a fixed income uh retirement. That's a terrifying prospect. They'd much rather keep their existing home that they've already paid for and they'd rather lobby for uh property tax exemption, which means they don't get penalized when the prices rise. >> Yeah. >> So, you're proposals everywhere, by the way. >> Everywhere. Absolutely correct. Right. So, what we're actually trying to do is put bandages on gaping open wounds that we actually have the ability to address. But the simple reality is we don't want to do it because there's too many interested parties that are pushing back in the opposite direction. I want to be really clear as an asset manager. I'd love to manage your assets. If you decide to go Treasury direct, you don't have to pay an asset management fee at all. >> Wow. >> Right. You you can literally avoid the entire process. Take me out of the equation. Do the math. figure it out and I guarantee you're going to come to the same conclusion unless you allow yourself to be consumed by fear. And if you are consumed by fear that the core stature of the United States is that the US government is incentivized to lie to you for any number of reasons, right? And there are reasons why they can lie to you and why they would choose to lie to you. But the idea that there's this giant conspiracy to misrepresent all of this data as compared to what I would broadly term incompetence um is just wrong. It's just wrong and it's sad to watch. >> Yeah. And and um not only uh incompetence but um maybe a lack of visionary leadership. Um that in spades in Washington right now in my opinion. Um I think in a lot of people's opinion. Real quick as we as we wrap up here, we're going to link your piece. By the way, it's really important for people to read the whole thing um because you lay out the math which is I think so different from a lot of other people who are just sort of posting ideas on on social media um and in forums. There's all the math behind this folks. But um how do commodities fit into this picture at all? How are you thinking about commodities? >> Well, I've written some pieces on this and I think it is important to distinguish between different types of commodities. Um there's what I call human food and machine food. um energy commodities are very much machine food. We're moving to a world in which there is a far greater fraction of our power production that is going to things like data centers etc. I don't think that's going to change although I do think that we will discover that there are extraordinary breakthroughs on efficiency within those data centers that mean many of the forecasts that people are making are overstated. Um but the simple reality is is that energy can be consumed both by humans to stay warm or to light their homes and by machines to do calculations as we increasingly rely on the machines to do the calculations for us effectively functioning uh almost as cyborgs where we are outsourcing many of our skills and capabilities to machines that can do it faster and in many ways better than we can ourselves. that creates demand for the energy infrastructure and in particular I'd highlight areas like nuclear which will ultimately emerge from this. Um on the human side the simple reality is is we're now recognizing that the population forecasts that were made for the the global population to hit 9 billion are flawed and in fact we're actually looking at a situation where it's entirely plausible the global population peaks around 2035. Human food by definition benefits from the same productivity and technological advances we have. In fact, agricultural technology and productivity has been among the highest of any sector. >> And so we actually are facing a world in which our primary concern is not an absence or a shortage of food, although that certainly exists in some regions of the world. We do have to be cognizant of that. Um, but what we're really facing actually is a surplus. And so we're actually weirdly looking at a world in which innovations and I I hate to bring this up because I know it's going to be a lightning rod, but you know when you think about something like lab grown beef or lab grown chicken or pork, etc. replacement for proteins, those are impossibly efficient relative to cattle, right? It takes 16 units of human consumption grain to produce the equivalent in beef. A lab can do that for a fraction of that because you're not wasting all the energy in the mobility of the cattle. You're not doing all this stuff. It's it's lab grown, right? It's out of a petri dish. It will ultimately be biologically identical. It will probably be better. And I understand that makes me sound like a Frankenstein and a technoutopian, etc. But the simple reality is the stuff that you're consuming today in many ways has been modified in the same way. the the um gene modification of agriculture that has existed over 10,000 years has always been about improving the conversion of energy into food products. Um we're just going to continue that process. And if we're doing that against reduced population, I find it really hard to get super excited about commodities. Particularly when I consider that our largest commodity, corn, is very inelegantly used for energy production in a manner that we know has negative return on investment. It just suggests that there's, you know, far more capacity on the agricultural side than we're giving evidence to. This is not a forecast for what's going to happen to the price of wheat in the next six months or the next two years for that matter, but it is a simple reflection of the reality that commodities represent less and less of our purchasing basket. We are increasingly removed from it. When you buy a box of frosted flakes, you're paying about a penny for maybe it's actually about two pennies for the corn content. you're paying about three cents for the sugar content and you're paying about $1.95 for the marketing and logistics. Um the commodity prices are are I would argue largely irrelevant and unfortunately this is part of where morality tends to kick itself in. You highlighted that many people are trying to introduce morality to that. One of the more interesting responses that I got to my proposal was yes this would work. Yes, this would make things better, but we really need to push the system to collapse. I don't want it to get bailed out yet again. And and your response to that has just got to be like, what? What are you talking about? Like, you want people to die. You want people to have terrible lives. You want to create a social revolution in which millions of people are potentially killed. Like, how's that mor, you know, how is that moral? >> Like, when we can fix a very weird place. >> I I think it's Yeah, I think it is a strange place when people are like that. But to be honest with you, I remember um right before the great financial crisis, people saying sort of like, you know, let Lehman fail, let those bankers get and then the wheels came off and it was horrible for 10 years and and you didn't hear any of those people a after that say like let's blow it up. I mean, that's just I think irresponsible, but it creates that sense of fear, Mike. I think that um is so pervasive right now as you point out and is really making it difficult for people as they're trying to figure out what to do with their future. One of the things I so appreciate catching up with you on is um that you are laying it out and you are backing it up with facts and you are giving people at least some information to make more educated decisions or demand other actions from their elected leaders or people who are in positions of power. Um I think information is power and and you've been doing such an amazing job of that. Um and this is another example. I mean, I think we're all going to go back and re rest restack this and watch it a bunch of times to try to figure out, do we really understand what's happening with bonds um and challenge maybe what we're being told to think about asset allocation versus what we should be doing. So, as usual, amazing to catch up with you. Thank you so much for your time. >> Thank you, Margie. >> Appreciate it. Take care, everybody. We'll see you soon.
Broken Market Signals Are Warning of the “End Game”
Summary
Is the bond market really warning of a U.S. debt crisis — or are investors misreading a distorted market signal? Michael Green …Transcript
When you have a mechanism like passive investing that has grown so rapidly and so large, we need to consider the possibility that the price signals are not being driven by those facts. When a market increasingly becomes a mechanical system that is governed by regulations and rules. It no longer represents the collective wisdom of the crowds. It simply represents the extremes of the model that we have built for it. we will see volatility begin to rise exponentially. That's the warning sign that we're beginning to approach the endgame. >> Hello and welcome to Wealthy. I'm Maggie Lake. Joining me today to discuss the outlook for US markets is Michael Green, chief market strategist at Simplify. Hi Mike. Thanks so much for being with us. >> Uh it's a pleasure to be here, Maggie. Thank you for having me back. So, as usual, fantastic timing because you just wrote an open letter to the US Treasury Secretary which you posted on your Substack. Um, I'm curious what prompted that? Why did you feel the need to speak out? >> Well, the key issue is is that the work that I've done around passive is often linked to the equity markets, but we're actually finding that some of the mo the biggest distortions are now occurring in the uh fixed income markets, in particular the market for sovereign debt. We're seeing a quote unquote puzzling lack of interest in the 30-year bond as it crosses over 5%. Now, there's narratives around that, right? We're worried about inflation, the US government is going bankrupt, etc., etc. But the reality is a 5% 30-year bond should actually be attracting a significant amount of attention. People should be paying attention to it for no other reason than it candidly meets most of the obligations that people have in retirement. I had a really interesting experience this past week. I spoke to a group of institutional allocators down in uh North Carolina, Asheville, North Carolina, and highlighted that we'd seen this radical change. We've gone from basically zero on long-term interest rates to well in excess of the inflation rate, near the highest level of real rates we've ever seen in history. This is very much at odds with almost all the evidence that we have from a demographic feature of what should actually be happening and what people should be doing with their retirement planning. And I asked a simple question, has anyone changed their allocations? And literally in a room of 500 institutional allocators, not one hand went up. Nobody is actually changing their allocations. When you dig into the mechanics of what's actually happening, it really boils down to effectively an index phenomenon. The structure of passive investing in bond markets allocates just like they do with equities more capital to bonds that are trading at higher prices. When you have the period of zero interest rate issuance that we had from an extended period of time, basically from 2009 until give or take 2021, that creates conditions under which those low coupon instruments as you raise interest rates collapse in price. Many 30-year bonds or near 30-year bonds are now trading in the 50s. >> That means that far less capital is being allocated to them. They take up less weight in the index and they receive less interest even as they would meet the vast majority of retirement obligations that people are facing. And so this was really what I highlighted for Secretary Bessins in the open letter was that what we were seeing was not a market judgment on that 30-year bond, but rather a mechanical byproduct of how we choose to allocate our investments under government mandate. uh the regulatory framework is distinctly skewed towards bias towards passive vehicles and it unfortunately is creating the outcomes that we're now interpreting as the imminent collapse of you know the US government because it can no longer afford its entitlements etc. None of that is actually true. So we are watching people miss an incredible opportunity that in my analysis is increasingly being driven by how we invest not the thoughtful application of logic or um understanding of financial markets. That that's that's that's huge and a really important distinction because I think the narratives you just talked about, you know, the inflation uh debt load we can't handle anymore. Um are really persistent right now and we do feel like people are voting with their feet. That's what I hear from loads of really experienced people. They're making a judgment. They're saying, "I'm not willing to take on the risk that the US now uh sort of presents uh as a as a government that can't afford the debt anymore. You're going to have to pay me a higher risk premium to take your debt." You're saying that's BS. That's actually not really what's going on. >> I don't think that's what's going on. I'm certain that many people believe that. Unfortunately, I think that becomes a function of the market presents what we think of as truth. And when you have a mechanism like passive investing that has grown so rapidly and so large both as a portion of the equity market and now as a portion of the fixed income market we need to consider the possibility that the price signals that we're receiving are not being driven by those facts right or those assertions which I would argue are not facts. We can actually afford to service our debt. We can afford to do things but because we think we can't we're actually making bad choices. So, but I I I want to dig into that a little bit, but when you talk about meeting the needs of retirement, I think this is really important because the other super super popular narrative is that 6040 is dead. You should not look for to bonds to diversify. They're sort of, you know, um because of the the the whole issue with uh the devaluing the dollar and alling the dollar, collapse of the dollar, collapse of US ability to financ >> you shouldn't hold bonds. That's the that's the message retirees are hearing or people who are trying to plan their portfolio including a lot of the people that that we talked to. Why do you say that this uh the 30-year at 5% or over 5% meets the needs of retirement? What is it doing? What is it providing that that people are misunderstanding? >> Well, what it's providing is current income ultimately in a uh asset protected manner. If you buy a 30-year bond with a 5% yield, you will receive that 5% yield for the next 30 years and you're actually ultimately going to have the principal left over. So whether that's devalued by inflation or not is actually somewhat irrelevant. You're dead at that point. When you think about a historical withdrawal rate from a 401k and the target of 4%, that 5% alone allows you to get there with none of the equity risk, etc. Now, the great irony, as you're pointing out, is not only are people saying 6040 is dead, there was a Wall Street Journal editorial that just was released, I believe it was the end of last week, saying the new model should be a 9010, meaning you should have 90% in equities and 10% in bonds. This is ironic because the exact same analysis on the equity market would ultimately suggest that that we're looking at forward expected returns that are below 2%. And so people are scrambling to buy a 2% expected return asset and foregoing a 5% return far less volatile far more stable asset that ultimately protects your portfolio allows you to meet the objectives of a 401k and that 4% withdrawal rule and nobody's taking advantage of it for the very simple reason that we're not seeing the price action support that narrator. Uh this is I mean people it feels like a cold water on your face based on what most of us have have been drilled into us over the last you know year or so I think. So is the government bond market it first of all is this a US phenomenon or do you think that this is happening sort of globally and is it mean that the government bond market's not functioning properly right now? >> It it means exactly the latter part of it and it is happening globally. That was one of the components that I highlighted within my piece is that we're increasingly starting to see the narrative that this is a global phenomenon. UK rates are selling off. Australia, which has a debt to GDP of around 25%, is seeing its rates follow the same pattern. Japan is seeing its rates sell off with far worse quote unquote fundamentals than the United States has. They're all behaving identically. that suggests that there has to be something that is a broader mechanism rather than the specifics of the US government or the US dollar that is really behind this and when you dig into it you discover that it is indeed a mechanical process of how we've chosen to allocate our capital. That's so interesting and explains. I just was speaking to someone who's a more of a technician, Mike. Um when we saw that big move in yields, I think it was not this past Friday, but the the week before. And when he was looking at the chart, he just saw huge gaps that you would not see normally, just an absence of buyers and and really dysfunctional. And it really concerned him. And he said, "This is just you don't see this normally. Something's not right." And I think you're filling in the part of what's not right for people who've been watching the behavior of the market when you say um by the way if you're not watch if you don't in addition to following Mike uh and simplifies work on simplify I suggest that you uh follow his substack. Yes, I give a fig because this is where you're laying out a lot of this stuff as well. Um and in it at one point you said if you needed I'll explain it like you do to a golden retriever one of the AI prompts and I was like yes please. Um but if when you're talking about now the prices are because of what's happened um 65 cents or 55 cents on the dollar. I think that's what you were referenced before. So the prices are low on those bonds. Um people hear that and think then then you know that that is the market saying that they're not worth as much or why would I want something? um or what does that what what kind of dynamic is that creating and what and because you offered a lot of explanations to the Treasury Secretary as a way out? What what should we understand about that and why has that become a persistent problem now especially among institutions? >> Well, there's two separate components to so when a bond is issued is issued with a coupon. So bonds that were issued in 2021, for example, would have been issued with typically a quarter percentage or a half percentage coupon associated with it. When you raise interest rates, when interest rates rise, the market has to accommodate that through an arbitrage phenomenon where that bond that has the exact same credit risk is treated on an equivalent yield basis to the newly issued paper that matches that maturity. So, a 30-year bond that was issued in 2021 should have, and there's not really a 25-year issue, but if there were a 25-year issue, it should be trading at the exact same price as a coupon that was issued this year with a give or take 5% yield. When you adjust for that relationship, you have to lower the price of the bond. It doesn't reflect a credit assessment. It's not the same phenomenon that we would see within a high yield bond that is trading at a distress price. It's simply a reflection of the forward expected return matching the current coupon to that lower coupon issue. The reason that that creates a real problem in the banking system in particular is the phenomenon that was tied to Silicon Valley Bank. So when uh banks bought mortgages or they bought long duration uh US government debt in the early part of the 2020s that paper has now fallen far below the levels that they acquired it at. It was issued at par. It's now fallen to between 55 and 75 cents. That creates a loss that if banks were to realize that would actually impair their capital base and prevent, excuse me, and prevent them from being able to lend or actually even function. They would be in violation of Basil regulations. Their reaction to that was to put this entire class of bonds into what's called the hold to maturity category. That allows them to avoid recognizing the loss. They're basically saying, "Look, we're going to hold this for 25 years, and in 25 years, we're going to get our par back in the principal payment." But that suddenly means that you've got basically illquid and inactive capital within the banking system. That's what caused the distress for Silicon Valley Bank. Once you've put something into hold to maturity, when you receive requests from depositors to provide you with their with their funds back, you have to source that liquidity from somewhere. If you touch that hold to maturity category, you impair the entire portfolio and create conditions where you have to recognize that loss. And so banks will do almost anything to avoid doing that. The solution under Silicon Valley Bank was to create a lending facility from the US government where you could borrow, obtain liquidity. They would treat the instrument as if it was still par in that hold to maturity framework and you could obtain liquidity against it. But that liquidity is being sourced at an expensive price and it's costing you significantly more to borrow under that framework given the level of current level of interest rates than you're receiving on those assets. It's impairing bank profitability and reducing their willingness to lend to anything other than the most pristine credits. The US government, of course, being one of those. My proposal is very straightforward that the government should effectively reissue 30-year bonds and exchange the 65 cent market value for an equivalent market value of current coupon bonds. That does two things. one, it actually significantly liquefies those portfolios. It creates conditions under which banks can again begin tapping that credit, that capital and recognizing that maybe they don't want to actually just lend to the US government. Maybe they want to lend to the private sector. >> The second thing that it does is it actually raises the current income going into banks and that actually facilitates balance sheet repair as well. The last thing that it does is it actually reduces the quantity of US government debt outstanding and that actually is obviously a benefit as well. It helps to address this narrative of whether or not the US government is overly indebted. This would ultimately this proposal would lower that indebtedness by about threequarters of a percentage point. It's not going to change the world. It's not going to change anyone's total assessment of the financial stability of the United States, but it certainly helps. And more importantly, it gets the credit mechanism functioning on the banking system again with far less government intervention. >> Would would it also help to deal is this is this related to the passive who keep buying the uh the higher price bonds? Would it also address that or are these two problems two separate problems? >> Well, the the conditions are created in part because of the lack of the passive bid. So, when you think about a dollar going in, I use the thought experiment, my Substack of a super simple bond index. Imagine there's only two bonds in the universe. There's a two-year bond and a 30-year bond. And at stage zero, they're 50/50 in terms of index construction. If the Federal Reserve lowers interest rates, that 30-year bond is going to rally sharply. It's going to rise quite a bit in price because the market has to do the opposite of what it did when it discounted them to 65 cents. it has to make them per pursu equivalent to a new issue coupon that's at a lower rate. Um that actually would skew the index towards longer duration bonds. And this is the condition that we saw basically from 2009 until give or take 2022 in which the bond indices became longer and longer duration as the Fed would cut interest rates with the expectation that this was providing some form of stimulus. it would cause those longdated bonds to rise in price. That increase in price skews the index towards them. It's why the index had such extraordinary duration sensitivity going into the 22 rate hikes that caused the catastrophic losses. The duration exposure of the index had risen by roughly 35% over the period from 2009 until give or take 2020. When the Fed then hikes interest rates, the opposite happens. The index becomes underweight, the long duration bonds, and overweight the front of the curve. In my analysis of what a passive bond index represents today, it's about 35% underweight, the duration component of it. That means when a dollar goes into a passive bond index, it's buying more of the front end and it's ignoring the back end. relatively ignoring the back end. That means the pricing is less um efficient. It means that the demand is less and it's created among other things the extraordinary rise of what's called the basis trade which is effectively hedge funds recognizing that there is a mispricing that is occurring out here. They are shorting treasury bond futures, buying the off therun issues that offer very similar total yields, but are being ignored and therefore they can pick up between 10 and 20 basis points of additional return. They capitalize on that 10 to 20 basis points by lever leveraging themselves 50 to one so that you end up creating a return of 10% quote unquote risk-free. That's not risk- free to the system. It's an extraordinary amount of leverage that's sitting out there. It exposes the US government >> to disruptions in the bond market when credit financing is called into question. >> And that's exactly what we're trying to address with this type of proposal. Reduce the opportunity for the arbitrage that exists in the basis trade. create a functioning credit market and treasury market in which people can honestly look at it and say, "Okay, I'm buying a par bond that pays me 5% that allows me to achieve my retirement objectives, and I stop doing a lot of really silly stuff like engaging in strategies that are designed to create excess return by taking on significant additional risk." >> Yeah. And I I think it's really important to lay that out because I mean you're you're deep in the math and you have spent years, you know, you understand the ins and out in the bond market. One of the things that I've seen happening and it's sort of everywhere is that there's a lot happening with flows and with mechanics related to markets that most of us don't have that kind of in-depth knowledge about. And what's being layered on that in the world of finit and wherever is this sort of narratives and morality about what's happening that suit the purpose of people posting them like the you know imminent decline of the US. Um which doesn't mean that there aren't serious problems but then you hear what you just laid out and you're like wait a minute there's something else that's happening that's moving this around. not um it's not because people are making a distinction necessarily. Um and then you have that repercussion that people are avoiding a a whole asset class because of that. So that that's wild stuff. Okay. So Kevin Walsh is a new Fed chair. You wrote the letter to Scott Bessant, but Kevin Walsh is is coming in as a Fed chair. We understand that he would like the private markets to function more and do the do the work and not be so reliant on the central bank. What are your expectations? Do you think that he understands what's happening that he would be open to trying to address some of these imbalances that you talk about? >> Well, first I think he absolutely would and one of the benefits of the proposal is is that it exposes the narrative that we don't need much higher rates that rates are not stimulative. This is one of the really critical things I think for people to understand. If you remember Maggie, in 2022 the narrative was now we've got real interest rates, therefore value is going to outperform, right? Sanity will return to the stock market. >> Instead, as I predicted, we've seen the exact opposite. We went right back to what we were doing before. Again, this is a mechanical property of a passive dominated market. The structure of the indices are such that they reward with more marginal capital prices that go higher that in equities manifests itself in a rising stock market. In the case of bond markets, as I highlighted, it can create either neglect or enthusiasm for the longdated securities. Unfortunately, where we sit right now, people are regularly running around and saying rates need to go much higher in order to quell the speculation or to attract people back to the 30-year bond. The math and the mechanics that I've laid out highlight that that's not the case. It is a structural feature of the market that can be addressed proactively, but it has to be done through the Treasury. The Treasury is responsible for issuance and retiring of US government debt. There could be an opportunity to involve the Fed through something that's called yield curve control. But candidly, that's a really inelegant, blunt tool that doesn't address the primary issue here. >> We need to at some point move to reforming the way that we invest. We need to move away from passive. >> So you you just said you spent uh the last decade talking about reforming the the way we invest. >> Yeah. So I mean it's been basically a decade since I've identified these issues. I started with the equity market. It's expanded into the fixed income market. It's become increasingly apparent that unfortunately I was correct in my analysis of what is actually going on. The academic literature is exploding around this. I collaborated with on this letter with some of the academics I've worked with in the past. In particular, Valentine Hedad had a 2019 paper in which he laid out some of these components basically the duration targets that are that exist within the institutional world etc. and how those can be influenced by um changing character of coupon issuance. He had not connected it to passive investing but now acknowledges that that is indeed what we are actually seeing. So we know that this is correct. It's just a question of do we choose to address it. It does have to be addressed through the Treasury. It does create the additional benefit of allowing the Fed to lower interest rates without perpetuating the narrative that this is, you know, yet another bailout, that the US government is captured by fiscal dominance, etc. None of those statements are true as of yet. They could become true. And I want to emphasize that if we don't address many of these issues, we will ultimately find ourselves under these conditions. But the the narrative for why it's occurring is not actually why it's happening. So it is really important that we start to address this. In terms of interest rates itself, I think it's really important for people to recognize how depressed the interest rate sectors of the economy are. The auto sales are running way below population adjusted levels. That's a financed vehicle. Many forms of appliances are seeing incredibly depressed demand. Again, financed vehicles. If you consider the housing market, you're facing two pinchers that are hitting there. One is the much higher level of mortgage rates makes it uneconomic for people to sell their existing home, cash in that 2.75% mortgage that they secured in 2020 or 2021 and move to a new location because the downgrade in house size that you would have as you retire is actually potentially going to increase your payment in today's world. >> And so there's an unwillingness of sellers and at the same time the ability to build new product is impaired by those much higher financing rates. And as a result, we're seeing the lowest turnover we've ever seen in history for the US housing markets. They've lost their dynamism. And unfortunately, that is a byproduct of interest rates being higher than they should be. I want to be clear. I don't think we should have zero interest rates. Although I think if we continue down this path, we will ultimately be forced to go there again. >> And so I really think that's actually critical people to understand. This is not a morality or a bailing out of the banking system. The banking system maintains the losses. We are not changing any of those characteristics. We're simply restoring functioning to the US Treasury market in the context of what has transpired with passive investing and how we choose to allocate capital. The second thing is is the narrative that interest rates need to be much higher is just empirically false. Like we actually know that the level of interest rates are quite restrictive. Unfortunately, we look at the stock market soaring and we say this is evidence of extraordinary speculation. Clearly, we need higher interest rates to combat this. Again, just not true. It's just not true. When a market increasingly becomes a mechanical system that is governed by regulations and rules, it no longer represents the collective wisdom of the crowds. >> It simply represents the extremes of the model that we have built for it. >> That's that's a really really great and succinct way for all for us to understand this. And from having talked to you about passive for years, it's sort of like a Frankenstein that just continues to to charge along and and is sort of disrupting what we would what we understood to be the system. What about inflation? That's the other thing we hear all the time right now. We see all you know prices rising across the board in all these different levels. Do do you think that is a persistent threat? And it's not just the war. We know that's that's creating. We hear we hear people talk about, you know, changing geopolitics, resource nationalism. There are a lot of explanations around why this might be more persistent inflation. It doesn't seem like that's something you're worried about. Or do you think that interest rates aren't the right way to deal with it? >> Well, I think it's a combination of factors. So, one, interest rates are a very blunt tool. um you are basically using a central planner approach to manage a market economy by trying to set the price of money for a particular group. Um the second component in terms of inflation is that the underlying characteristics of the economy are actually quite deflationary. >> The population pressures that existed in the 60s7s and into the 1980s have largely been replaced by falling populations and declining labor forces. That means that the underlying um interest rate has to be set lower for the very simple reason that you don't have anywhere near the demand to maintain capital investment. If you think about what productivity or inflation captures in a purely fundamental sense, part of what you're trying to recognize is that you have a production possibilities frontier. It's an economic term that basically is the combination of labor and capital that produces the greatest possible outcome. When you have a rapidly growing labor force, you need to add capital at a rapid rate in order to maintain that capital labor ratio that allows you to preserve your location on the production possibilities frontier. That means that the demand for capital i.e. interest rates will be high. That was the 1960s and 1970s for us. When you move into an environment in which population growth is slowing and turning negative, that means that the capital labor ratio is actually going to rise even in the absence of investment. That means there's less demand for capital than there otherwise would be. And interest rates should be lower. Unfortunately, that's not the phenomenon that we're experiencing. And again, I tie it to the way we've chosen to invest and the way we've chosen to behave as a society. There are two separate phenomenon that are intersecting. The first is in the 1970s we shifted from defined benefit plans which created retirement as a stream of income in which you effectively received an annuity. You worked for any number of years you contributed into your retirement that turned into a stream of income that replaced the income that you received in your retire in in your that you received when you worked in your retirement. that uh approach actually allows you to socialize and spread out the risks of unknown longevity. >> The 1960s and 1970s we encountered the downside risks of that in the private market primarily because we'd seen a fairly significant rise in expected in life expectancy that meant the people that contributed into the system were likely to take withdrawals for a longer period of time. We chose to remove that liability from corporations. We retained it on the public sector, by the way, which is one of the reasons people look at public sector employees and say, "What are you complaining about? You've got a pension. You don't have to worry about this stuff." >> Um, when we chose to go to define contribution, it actually has a very perverse effect because you don't know how long you're going to live and I don't know how long I'm going to live. We all have to save assets and accumulate assets for the worstcase possible outcome. We're not replacing income. We're now hoarding assets with the expectation that we'll be able to sell those assets in the future to be able to fund our retirement. That actually creates a dramatic outward shift, rightward shift in the aggregate demand for financial assets and is largely responsible for the financialization that we've seen in our economy. Your working life basically exists to stockpile financial assets that you hope will last through your retirement. It's no longer about replacing income. It's about having enough that you think you're going to survive. How much is enough? It's got to be more than I already have. Right? >> So, this is actually creating the social um disruption where the boomer generation is accumulating and hoarding assets that the younger generation is competing with as they're trying to begin the process of saving for their retirement. That's one of the phenomenon that we've created. It was a misapplication of um theoretical finance and a misunderstanding of actuarial behavior that we're just now coming to terms with. There's a phenomenal paper that was released earlier this year, gentleman's name is co-imbra cobr in which he evaluates this shift from defined contribution to defined benefit or to from defined benefit to defined contribution. And what he finds is exactly what I articulated. A dramatic increase in demand for financial assets, a surge in the price of those financial assets which shows up as a much lower cost of equity which is the forward expected return from equity investments and perversely a much higher cost of financing the government. To put some parameters on that under a defined under a defined benefit plan the cost of equity would average about 7%. under defied contribution that falls to between 1 and a half and 3%. So a fantastic increase in the valuation of equities. At the same time the cost of financing the government more than doubles. And so by virtue of how we've chosen to build our retirement systems by making every individual responsible rather than acknowledging that we exist as a collective who have a social responsibility to make sure that people are taken care of in their old age and converting those claims into an income stream. We've instead moved into an asset porting environment. The second phenomenon is a byproduct of that. Once you decide you're going to force everyone to invest on their own, the vast majority of people aren't investors. They don't have that experience base. They aren't capable of analyzing the individual securities and selecting appropriate investment methodologies. As a result, we chose a shorthand approach, the index and the passive index at that which was not selected because it was academically robust as as um uh Rob Arnot wrote back in 2005. I believe it was the primary reason we chose market cap waiting for our passive index construction was because it was easy to implement. Unlike almost any other allocation mechanism, it doesn't require you to continually rebalance the portfolio. The market theoretically does it for you, right? If something goes up in price, you now own more of it. If something goes down in price, you now own less of it. That was that unfortunately morphed into an idea that this was the most academically robust and thoughtful way to invest. But it's not at all true. We're talking about a subset of assets. We're talking about publicly traded equities in the United States. That means you're ignoring the privately held companies. Many institutions have tried to diversify into privates for precisely this reason. It also means perversely that you're ignoring the entrepreneurial ventures and the human capital that exists for the vast majority of individuals. The local owner of the Bedadega receives no benefit from these from the flow of these retirement assets. In fact, they now have a com a competing asset for their own entrepreneurial ventures that says, "Hey, guess what? You can get a fantastic return on a tax advantage basis if you allocate your savings to the S&P 500. If you decide to put it into your bodega, you don't get those benefits." And as a result, we're seeing a collapse in entrepreneurship in the country. >> That's empirically borne out. So we have decided to do this to ourselves by virtue of trying to follow effectively a model of the economy that bears no resemblance to the actual economy itself >> and is creating in the meantime all these distortions which now have gotten to the point where they're really affecting the system. The good news here Mike is that the it sounds like once you understand the problem presumably if you want to reform it you can fix it. Is there and you I know you've been making suggestions uh across all of these issues. Is there any appetite to look at this like why would we not want to address this since it's creating what are now becoming dangerous imbalances? >> Well, unfortunately it is creating dangerous imbalances and we do have to address it but it's not a painless process. among other things that would require the government to say, "Hey, um, those equity values that you guys are all counting on for your retirement, we're going to put them at risk by changing the rules." There's no appetite for that whatsoever, right? Likewise, uh deciding that you're going to target the US corporate bond the US bond market in this fashion creates some very unhappy players who are extraordinarily wealthy and wellconed on the basis trade in the hedge fund world. It's clearly something that would not be well received by Citadel um or Exodus Point. These are firms that you know have significant influence certainly more than I do as an individual. Um, and they are understandably resistant to their bread and butter being taken away from them. Um, there's a lot of resistance to this, you know, and the irony is is as I was driving up to Philadelphia where I'm sitting in the middle of a construction zone, as we were talking about before, you know, I I caught a headline that Vanguard is increasingly targeting the high fees in fixed income investing. In other words, they're making a big push into the fixed income space >> to do the same thing. >> The simple rea is to do the same thing to the bond market that has happened to the equity markets. >> But in your mind, this does not end well. >> No, it's not just in my mind. So you know earlier this year I released an academic paper that I wrote in in concert with Hari Christian Krishnan and Stefon Stern in which we identify that this becomes like the XIV the trade that made me well known um has its own you know self-correcting formula that basically says at some point we will see volatility begin to rise exponentially. We're already seeing elements of that. Look at the behavior of mega cap stocks in in response to earnings reports. they display clear behavior that they are trading under reduced liquidity terms. That's the warning sign that we're beginning to approach the endgame um which we identify as around 60% passive share at that point and we're about 53 to 54% today gaining about 4%. um that the real craziness is in front of us, not behind us, >> which is I think so so worrying uh on so many levels. And and I um again, you're if if anyone listening is interested in this because it affects the individual, right? This is eventually going to become um a ballot box issue because everyone feels I mean, we've talked about this. Everyone or the average person feels like they're not doing well. We know that and and this puts some real sort of understanding on the dynamics that are creating a situation where a young person who's 26 is feeling like the system's not working for them and angry and you can sort of you know put that across many different demographics. Um, if we circle back to to to the issue about the bond market here, you wrote in your piece, you wrote, "As of midmay 2026, you'll have the opportunity to sell your other financial assets and buy 30-year US treasuries at a level of income replacement unmatched except for the four years of of vulkar rates. For all the distress, you actually see a really unique opportunity here if people were to buy bonds." >> Yeah. I mean, the the simple reality is is most corporations have done this with their defined benefit plans. They have quote unquote defeased them by taking advantage of higher rates to effectively inoculate themselves against the risk that these portfolios would not meet their return objectives. The American public has the same opportunity. We're actually looking at a situation where the accumulated stockpile of financial assets at the interest rate that is being offered by the US Treasury would provide more income replacement to the US public than at any time in history since the four years around Vulkar when we had 15% rates. That's an extraordinary observation. And the crazy part is nobody's doing anything about it. And does that is is am I oversimplifying it to when you say sell other financial assets? You mean reduce equity and increase your exposure to bonds? >> That is the implication. Now the reality unfortunately is is everybody decided to do it. >> We'd have a stock market crash. >> That you'd have a stock market crash and you wouldn't be able to finance it. So part of what I'm actually trying to do is highlight people move first. >> Right. Actually, Secretary of the Treasury Scott Bessant um gave me probably one of the single best lines in terms of portfolio management I've ever heard, which was if you're going to panic, panic first. That is, you know, I'm not recommending that people panic. I'm recommending that they do the calculations themselves. The real yields that are being offered approaching 3% and the 30-year tips, for example, offer you just an extraordinary opportunity to take stress out of your life and to sleep better and to worry less. If you're really concerned that the US government is just going to flat out lie to you about inflation, which all the evidence is they are not, I want to be really clear. There are private sector, private firms that provide inflation analysis. True inflation would be a great example of that. They have no incentive to understate inflation. Yet they are telling you that the US government is overstating inflation. That is unfortunately what almost every economic analysis of inflation has shown over time. Now the perverse calculations that are done by the BLS, Bureau of Labor Statistics for CPI do understate inflation for many at the lower income levels. their the ability to substitute the ability to introduce new technologies etc is not deflationary. It tends to be inflationary. That's an unfortunate misrepresentation and we need to acknowledge that that the tools and dashboards that we're providing to our politicians and our elected officials and appointed officials for that matter are often deeply flawed in their construction, concealing many of the details that are creating things like the affordability crisis that I've written on and that you just highlighted. Again, do the diagnostic on it. What is an affordability crisis really about? We can't afford homes. Why? Because the boomers are hoarding the existing homes. They're unwilling to downsize. Why? Because interest rates are high enough that if they do so, they're going to end up with negative cash flow uh implications on it, particularly against a fixed income uh retirement. That's a terrifying prospect. They'd much rather keep their existing home that they've already paid for and they'd rather lobby for uh property tax exemption, which means they don't get penalized when the prices rise. >> Yeah. >> So, you're proposals everywhere, by the way. >> Everywhere. Absolutely correct. Right. So, what we're actually trying to do is put bandages on gaping open wounds that we actually have the ability to address. But the simple reality is we don't want to do it because there's too many interested parties that are pushing back in the opposite direction. I want to be really clear as an asset manager. I'd love to manage your assets. If you decide to go Treasury direct, you don't have to pay an asset management fee at all. >> Wow. >> Right. You you can literally avoid the entire process. Take me out of the equation. Do the math. figure it out and I guarantee you're going to come to the same conclusion unless you allow yourself to be consumed by fear. And if you are consumed by fear that the core stature of the United States is that the US government is incentivized to lie to you for any number of reasons, right? And there are reasons why they can lie to you and why they would choose to lie to you. But the idea that there's this giant conspiracy to misrepresent all of this data as compared to what I would broadly term incompetence um is just wrong. It's just wrong and it's sad to watch. >> Yeah. And and um not only uh incompetence but um maybe a lack of visionary leadership. Um that in spades in Washington right now in my opinion. Um I think in a lot of people's opinion. Real quick as we as we wrap up here, we're going to link your piece. By the way, it's really important for people to read the whole thing um because you lay out the math which is I think so different from a lot of other people who are just sort of posting ideas on on social media um and in forums. There's all the math behind this folks. But um how do commodities fit into this picture at all? How are you thinking about commodities? >> Well, I've written some pieces on this and I think it is important to distinguish between different types of commodities. Um there's what I call human food and machine food. um energy commodities are very much machine food. We're moving to a world in which there is a far greater fraction of our power production that is going to things like data centers etc. I don't think that's going to change although I do think that we will discover that there are extraordinary breakthroughs on efficiency within those data centers that mean many of the forecasts that people are making are overstated. Um but the simple reality is is that energy can be consumed both by humans to stay warm or to light their homes and by machines to do calculations as we increasingly rely on the machines to do the calculations for us effectively functioning uh almost as cyborgs where we are outsourcing many of our skills and capabilities to machines that can do it faster and in many ways better than we can ourselves. that creates demand for the energy infrastructure and in particular I'd highlight areas like nuclear which will ultimately emerge from this. Um on the human side the simple reality is is we're now recognizing that the population forecasts that were made for the the global population to hit 9 billion are flawed and in fact we're actually looking at a situation where it's entirely plausible the global population peaks around 2035. Human food by definition benefits from the same productivity and technological advances we have. In fact, agricultural technology and productivity has been among the highest of any sector. >> And so we actually are facing a world in which our primary concern is not an absence or a shortage of food, although that certainly exists in some regions of the world. We do have to be cognizant of that. Um, but what we're really facing actually is a surplus. And so we're actually weirdly looking at a world in which innovations and I I hate to bring this up because I know it's going to be a lightning rod, but you know when you think about something like lab grown beef or lab grown chicken or pork, etc. replacement for proteins, those are impossibly efficient relative to cattle, right? It takes 16 units of human consumption grain to produce the equivalent in beef. A lab can do that for a fraction of that because you're not wasting all the energy in the mobility of the cattle. You're not doing all this stuff. It's it's lab grown, right? It's out of a petri dish. It will ultimately be biologically identical. It will probably be better. And I understand that makes me sound like a Frankenstein and a technoutopian, etc. But the simple reality is the stuff that you're consuming today in many ways has been modified in the same way. the the um gene modification of agriculture that has existed over 10,000 years has always been about improving the conversion of energy into food products. Um we're just going to continue that process. And if we're doing that against reduced population, I find it really hard to get super excited about commodities. Particularly when I consider that our largest commodity, corn, is very inelegantly used for energy production in a manner that we know has negative return on investment. It just suggests that there's, you know, far more capacity on the agricultural side than we're giving evidence to. This is not a forecast for what's going to happen to the price of wheat in the next six months or the next two years for that matter, but it is a simple reflection of the reality that commodities represent less and less of our purchasing basket. We are increasingly removed from it. When you buy a box of frosted flakes, you're paying about a penny for maybe it's actually about two pennies for the corn content. you're paying about three cents for the sugar content and you're paying about $1.95 for the marketing and logistics. Um the commodity prices are are I would argue largely irrelevant and unfortunately this is part of where morality tends to kick itself in. You highlighted that many people are trying to introduce morality to that. One of the more interesting responses that I got to my proposal was yes this would work. Yes, this would make things better, but we really need to push the system to collapse. I don't want it to get bailed out yet again. And and your response to that has just got to be like, what? What are you talking about? Like, you want people to die. You want people to have terrible lives. You want to create a social revolution in which millions of people are potentially killed. Like, how's that mor, you know, how is that moral? >> Like, when we can fix a very weird place. >> I I think it's Yeah, I think it is a strange place when people are like that. But to be honest with you, I remember um right before the great financial crisis, people saying sort of like, you know, let Lehman fail, let those bankers get and then the wheels came off and it was horrible for 10 years and and you didn't hear any of those people a after that say like let's blow it up. I mean, that's just I think irresponsible, but it creates that sense of fear, Mike. I think that um is so pervasive right now as you point out and is really making it difficult for people as they're trying to figure out what to do with their future. One of the things I so appreciate catching up with you on is um that you are laying it out and you are backing it up with facts and you are giving people at least some information to make more educated decisions or demand other actions from their elected leaders or people who are in positions of power. Um I think information is power and and you've been doing such an amazing job of that. Um and this is another example. I mean, I think we're all going to go back and re rest restack this and watch it a bunch of times to try to figure out, do we really understand what's happening with bonds um and challenge maybe what we're being told to think about asset allocation versus what we should be doing. So, as usual, amazing to catch up with you. Thank you so much for your time. >> Thank you, Margie. >> Appreciate it. Take care, everybody. We'll see you soon.