Episode 52: PJ Pierre & Zed Francis – Are any banks solvent?

In this episode, I have the privilege of engaging in a captivating conversation with two distinguished guests.

First, we have PJ Pierre, the Vice President of Trading and Portfolio Management at Denali Asset Management. Joining us alongside PJ is Zed Francis, the esteemed co-founder and Chief Investment Officer (CIO) of Convexitas.

Topics: 

  • Are any banks solvent?
  • Insure all deposits?
  • Start a bank?
  • Debt Ceiling Trades?
  • Jubilee, reset, revolt…choose wisely and more!

I hope you enjoyed this conversation with PJ & Zed as much as I did!

 

Listening options:

Have comments about the show, or ideas for things you’d like Taylor and Jason to discuss in future episodes? We’d love to hear from you at info@mutinyfund.com.

Download Transcript

Transcript Episode 52:

Taylor Pearson:

Hello and welcome. This is the Mutiny Investing Podcast. This podcast features long form conversations on topics relating to investing, markets, risk, volatility, and complex systems.

Disclaimer:

This podcast is provided for informational purposes only and should not be relied upon as legal, business, investment, or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect opinions of Mutiny Fund, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed to not make specific trade recommendations nor reference past or potential profits. Listeners are reminded that managed features, commodity trading, forex trading, and other alternative investments are complex and carry a risk of substantial losses. As such, they’re not suitable for all investors, and you should not rely on any of the information as a substitute for the exercise of your own skill and judgment in making a decision on the appropriateness of such investments. Visit mutinyfund.com/disclaimer for more information.

Jason Buck:

All right, we’re going to do a three-way conversation today. I have Zed Francis from Convexitas and PJ Pierre from Denali right away. Gentlemen, let’s plug away at the top. Zed, we’ll start with you. Where can the people find you?

Zed Francis:

Jason’s made fun of me from pastimes for using full… What do you even call it? Address, but convexitas.com. I’ll leave the WW out for you this time around, but yeah, convexitas.com, best way to see what we’re doing, writing about, talking about. Do a little bit of stuff on LinkedIn here or there, but that’s the story.

Jason Buck:

PJ, where can everybody find you or not find you specifically is what you’d vote for?

PJ Pierre:

Yeah, I’m probably not going to be that easy to find, but I mean, PJ Pierre on LinkedIn and also I’m on Twitter, but I don’t really post that much, so that’s at Tatiana Pierre at Twitter.

Jason Buck:

Well, this is my favorite part is I think a good podcaster, if you’re looking to maximize your podcast and get more eyeballs is you try to get people that are big on Twitter or Fintwit or social media. So I was really smart in getting both of you that don’t post to Twitter, or don’t even hang out there at all and barely even lurk on Twitter. So that was really smart of me to really boost the ratings of the show. We were joking about many things before we got on, but I didn’t have a theme or practice other than I think both you guys understand credit and all those sorts of things a lot better than I do. So I just thought I’d get the three of us together. But maybe a jumping off point will be PJ, recently I was just doing a podcast with Toby Carlisle and you rightly called me out because unconsciously or flippantly, I referenced fractional reserve banking and so you texted me like, “You’re an idiot.” And so I appreciated that. But maybe-

PJ Pierre:

I actually said we can’t be friends anymore.

Jason Buck:

That’s right. So you were right in calling me out and I will give the caveat though, for any of you that want to get into podcasting or whatever, just know if you podcast, you are going to say so many stupid things that even if you listen back, you’d argue with yourself because you got three things going on in your mind. So you say a lot of stupid things on autopilot, but that doesn’t exonerate me. So first, let’s correct me with fractional reserve banking is a myth that gets perpetuated. So you could talk about price and equity and maybe give us a jumping off point there.

PJ Pierre:

So is that me?

Jason Buck:

Yeah, you’re the one that called me out. It’s your turn.

PJ Pierre:

Right. Well, you were talking about the dynamics that took down SVB, I think, and I think you made an astute point that people don’t really understand banking and particularly the people who are under the age of 40 who might have some misconceptions about banking. But the dynamic of fractional reserve banking isn’t anachronism from the fixed exchange gold standard days when we actually did have fractional reserve banking and all sorts of bank credits were horizontal, endogenous money structures built on the vertical money, which would then be gold bullion at the time. So in this current iteration of modern banking, loans create deposits and by definition, any required reserves. And I think I made the comment when we were going back and forth that it’s always about price, not quantity on a floating FX system, which is where the distinction actually becomes important.

Jason Buck:

So that’s a good starting point. By the way, Zed, always feel free to jump in. You don’t need to wait for me or anything. So part of that though, when we were texting, I said, “Well to initially start a bank bank, you have to put up equity.” And so to me, that’s a form of fractional reserve, based on the equity, not on the reserve. So it’s fractional equity. You can only lend a certain amount of what you have in that equity.

PJ Pierre:

Absolutely.

Jason Buck:

But maybe flesh out a little bit better, what do you mean by price?

PJ Pierre:

Well, what I mean by price is that bank lending isn’t reserve constrained, so it’s always just about the price of funding more than it is a stock of funds that you could then lend from. So anytime a bank could make a loan on favorable terms where the rate of return on a loan is going to be attractive enough for the embedded risk that they model in the loan on top of whatever spread they want for their margin of error and their models and the spread between their actual cost of funding, the loan gets made. So in that situation, that’s where the monitorists in the ’80s found that they really couldn’t target the money aggregates that they wanted to because by limiting the amount of reserves in the system, didn’t necessarily limit the amount of credit that was created. And it’s just one of those situations where, because that system is an endogenous system, it doesn’t really require anything external.

Jason Buck:

Zed, is there anything you disagree with what we’ve said so far or nuance or anything like that?

Zed Francis:

No, I think more in agreement, just adding onto it, that operating a bank is, you’re just creating a spread. So it’s like, we’re going to issue a loan with some sort of credit spread over what’s determined to be risk fee rate, whether it’s floating, using fed funds/SOFR, or whether it’s a fixed thing that’s priced off of treasuries, what’s in that spread? And ultimately, what’s in the credit spread portion, I would probably call the piece of the loan where the bank’s actually not really making a ton of money. They have a little bit of underwriting costs in there, they have credit risk of the institution, but that piece is pretty efficient and to be super boring, bank loans are a little bit more, we’ll call it, semi-private markets, not fully private, but semi-private markets versus listed fixed income instruments.

But if you were to operate long investment grade credit, completely interest rate hedge, historically, the 40 odd years of that indices, the excess return from owning credit versus just owning treasuries, there was key rate duration match, is essentially zero. So in the publicly traded markets you’re like, “I am taking on excess risk owning credit versus just treasuries and my returns are essentially excess returns.” That’s pretty similar for ag. You get a little bit better in high yield, but ultimately, the market’s actually pretty darn efficient from the pricing the credit spread reasonably correctly. So how the heck does the bank really make money?

And the answer is it’s the spread between risk free and what they get a borrow at. And what we’ve been seeing for a while now is that spread was pretty decent. You were paying deposits one basis point and as fed funds/SOFR was climbing and that expansion of spread between what they were borrowing at, against what was embedded within the overall lending facility was how, in theory, they’re making money. That’s why everybody’s like, “oh, interest rates are up, bank stocks are going to start going up,” because everybody understood they’re going to continue to be able to borrow money well below what they effectively should. And then you had some greedy participants that probably didn’t manage that spread risk appropriately. And when all of a sudden people woke up and said, “You know what? I don’t want to earn one basis plan anymore. There’s other alternatives,” then it started creating some problems.

Jason Buck:

So part of that, maybe this is a good thing about the spread and everything is with the SVB thing and what PJ was referencing, my conversation with Toby earlier was about, it was more the things I learned from SVB was how many people in their 20’s and 30’s, understandably I guess, always thought that a bank was, they just kept their secured funds there. It was like, I don’t know, a gold vault in the ground or something. And they didn’t realize that the banks lent out money. And it was just interesting to see how much young people, the way they understood banking. And then part of that too is, and this is come back to what you were just saying is, I also got to see how out here in the Bay Area in Silicon Valley, they just kept berating the banks for borrowing short and lending long. That’s stupid. And it’s like, that’s what banks do. You don’t understand banks. PJ, sorry, you wanted to jump in there?

PJ Pierre:

Well yeah, so when you describe the misconception, one, I think I’ll say the misconception spreads more broadly than that. I think generally, most people conceive banks as taking in some sort of raw material deposits that they then manufacture loans with. So in the basic concept of manufacturing or producing something. And that misconception continues to be propagated currently even with the fall of SVB and First Republic and these other regional banks. Whereas, like Zed just mentioned when he was talking about the way banks make money and it’s all about the spread.

And so, that’s the dynamic. That dovetails into what I was saying about it’s about price not quantity. It’s in the fact that when the deposits started leaving regional banks, the belief is that the regional banks have less raw material from which to manufacture loans with. And my argument is that well no, the deposits are a residual of past lending, not the raw materials that are used to make new loans or future lending. And so, what would happen is if the banks can attract funding, whether it be from a customer deposit, whether it be from interbank lending or a loan at the discount window, if the bank can attract funding and make a loan at a attractive enough spread, the loan gets made if they have the capital to do so.

With what you were mentioning with, that, in a sense, the bank lending is fractional, I think that’s correct, but it’s a dynamic of terms. Whereas every bank has to have a certain amount of loss capital as per their regulators to backstop their balance sheet. So simple numbers, if that capital requirements 10%, a bank with a million dollars in capital could have a 10 million balance sheet. Those numbers are rarely that easy to comprehend. Typically, it’s tier 1 capital is 4.3, blah blah blah, and it breaks down and there’s an average capital requirement that’s probably somewhere around 6%, I think in a banking system today. Zed might actually have a better number than that than me. I mean, it’s usually somewhere below 10.

I think if you understand that it’s about price, not quantity, it’s easier for you to look at what drives an actual banking collapse like SVB. And I would make the argument that every bank, no matter how it’s managed, is vulnerable to a SVB style bank run that leads to an eventual collapse if the Fed doesn’t backstop you. And by Fed I just mean the Federal Government.

Zed Francis:

Yeah, I mean, ultimately all banks have essentially a carry trade which makes them effectively long duration. They have a flattener on and they can choose to accept that risk where they can hedge out that risk. And in theory, if they’re hedging out that risk, when they potentially have the unlikely event of deposit outflows, they’re able to liquidate something on the loan side of the house at a basically, market price because they’ve removed a lot of the market factors via hedging related to their price. So if everything was still marked at par and “Hey, we got some deposit outflows.” Well, go sell some stuff at par. Well okay, we got the balance continue to be in place.

But the issue is when you know start having your loans not being tradable at par going forward below par and you have the compounding effect of outflows. There’s nothing to liquidate. And we saw the stairstep. SVB, they liquidated things in the fall, they liquidated some more things in January and they kept tagging what they could sell close-ish to par. Most of the stuff was low 90s, but they understood, we must start reducing both sides to try to keep this thing going and then they ran out of acceptable things that they could liquidate at fair price to keep them alive. That’s why I’m almost surprised today the PacWest, seemingly people are happy that they were able to liquidate a handful of assets and everybody’s fruit initial commentary was like, “This is at better pricing than I would’ve thought.” And you’re like, “Well everybody cherry picked what they sold here.” You’re telling me, the 3 billion or the 100 billion they got, and you’re like, “Oh man, that’s a decent price.” You’re like, “No, that’s the best stuff.” What’s remaining might not look so great.

PJ Pierre:

Well right, and I think you make a good point there and it elaborates further on the point I was hoping to make and maybe not making well that it’s axiomatic to the banking system that unless a bank holds only assets that it could always sell at par, it’s always potentially vulnerable to a bank run. So then what does that mean? I mean, the only asset that you could always sell at par would be settlement balances. It would just be reserves. So you’re not in business if you just have reserves. So as soon as you make a loan, as soon as you have any sort of balance sheet asset that potentially has market risk, whether that risk is credit risk or whether that risk is just duration risk, “risk free assets” still have duration risk.

Jason Buck:

Go ahead, sorry.

PJ Pierre:

Well right, so when you actually zoom out, you realize that it’s the system designed to where any bank that gets a run, potentially just has to shut it’s door unless there’s someone back there with an unlimited supply of liquidity to make sure that the banking system is good on those runs. And that’s supposed to be why we have a lender of last resort to stop bank runs.

Zed Francis:

Yeah, it’s one of those where it’s like, it was, call it a year ago, it should have been easy. You’re paying, we’ll call it, just zero on deposits and we’re receiving, we’ll call it, floating debt. SOFR of, call it, 3%. So a bank should have said, “All I’m trying to do is lock in that 300 basis points.” And that’s achievable to do. And the risk that you’re hedging there is one thing, but then you also have to do it in liquid items because if all of a sudden what you’re paying for deposits goes from zero to 300 basis points, your spread’s gone and you should unwind the entire freight, ultimately. So step one, that’s one path of doing it is just trying to lock in that 300 basis points of your current cost of financing that’s below essentially, the risk-free rate that you’re allowed to earn plus a spread. What most of them did instead was just throw a lot of things into their hold-to-maturity side of the world, which becomes problematic when you actually need liquidity.

Jason Buck:

So there’s two questions I have in there. And by the way, because Zed brought up PacWest, I just want to let everybody know we are recording this on May 22nd, 2023, just a timestamp, the PacWest part of the commentary and the SVB part, as we know, it takes forever to find out even where all the bodies were buried at SVB and what actually went on. Even years later, we might not have a full picture. But part of it, I think, my two questions are from what both of you’re saying is that, one, like you’re saying, there’s a certain amount of fiction within banking. If we had to run in all banks, they’re all essentially going to have a problem selling assets at par, so there’s always an issue there, but allegedly SBV didn’t hedge their interest rate risk, but even with hedged interest rate risk, when they still had an issue maybe selling everything at par.

And almost like, Zed, what you were saying, the second part of that question is, this comes out, I think of the analogy of you and I when we had the discussion about the British LDI things that were going on, is a lot of those were in funds that weren’t liquidating on a continual basis. And so, do you think part of that is SVB or a bank can get ahead of this. They need to just start liquidating earlier. If they see interest rates rising, they need to be really adjusting their balance sheet to accommodate for interest rate rising? Is that fair? So the two questions are, would hedging interest rate matter other than you just have to hedge your interest rates and they should have if they didn’t? And then two, is it the continuous nature of it? Unless there’s a run on all banks, then you’re just trying to front run everybody outside of the exits, right?

Zed Francis:

Yeah, I mean, my view is you should always be hedging 100% of your interest rate risk. That’s not how the machine works. The machine works that you get to borrow well below the risk free rate and you get a lend at the risk free rate plus a spread. So why am I taking any sort of curve or duration risk in interest rates? So my argument is you should always be hedging 100% of that, but you’re always going to have some assets that you’re going to say that, the main risk here is not necessarily interest rates. It’s in the spread side of the house or more like illiquidity premium or something like that. And yeah, you’re allowed to utilize that, hold-to-maturity bucket for a portion of those assets that should be in that vein. But if you’re lending to a AA institution at SOFR plus 125 basis points, that shouldn’t be in your hold-to-maturity bucket. That should be nice, vanilla, we’re locking in a spread, we’re hedging out the interest rate, let risk move on to the next loan.

Jason Buck:

PJ, you wanted to jump in on part of that?

PJ Pierre:

Yeah, I mean, I think that’s pretty fair. What I would say is, I believe that, I mean, as per the regulations, banks, they’re only allowed to have a certain amount of liquidity mismatch. The regulators learned that during the savings and loans crisis, that, as you said Jason, banks borrow short, lend long, there’s a chance that they could have issues being able to provide for a certain amount of deposits basically being withdrawn from their balance sheet. And the regulators basically impose certain stress tests to make sure that if rates were to go up 5% in 12 months or all sorts of different things within these stress tests to say, you meet the right amount of robustness, I guess, for these dynamic variables in the system that can change and cause you to have issues with liquidity.

And SVB, I would assume, was in compliance with those regulations. And if they weren’t, then the question is why were the regulators allowing them to do so? I mean, my mentor used to run a small bank here in Florida and regulators aren’t nice guys. They’re like IRS agents. They come in and if you’re not in compliance, they talk about removing management, changing management. You have a certain amount of time to comply or otherwise you go into conservatorship or receivership. When you have FDIC insured deposits, they’re pretty strict on these parameters that they impose on banks. Now, SVB had a very small amount of insured deposits. And to add on the question you were asking, there was a lot of things that SVB could have done and chose not to do that could have probably given themselves more of a chance at surviving. You have non-insured deposits, when people want to move that money, there’s no contractual obligation that they have to be able to move that money in a day.

Jason Buck:

So do you think we’re going to see some more, potential, if we had more runs on banks that we would freeze bank accounts Argentina style?

PJ Pierre:

So you can’t freeze FDIC deposit, those have to be liquid and on demand. But anything that’s not insured, it’s a term deposit with the bank. There’s a chance that you may not get your money as quickly as you would like to have it. Now SVB avoided doing so and they just made good on those withdrawals as if they were all FDIC insured, but they didn’t necessarily have the obligation to do that.

Jason Buck:

Zed, do you think we should ensure all deposits after this?

Zed Francis:

No.

Jason Buck:

I know you had personal feelings about SVB. You were texting me while it was going on, but I’m just saying going back to the idea of everybody under 40 had a certain understanding of banks or misunderstanding of banks. So do you think in future for businesses, et cetera, we should ensure deposits or you think businesses should have to run a treasury direct account or what do you think about that?

Zed Francis:

Yeah, I think, at some level it’s the responsibility of the firm, individual, something along those lines to assume some of the risk that they’re taking themselves rather than putting that onto the public.

Jason Buck:

PJ, what are your thoughts?

PJ Pierre:

Yeah, I mean, so this is going to be the first place where I think me and Zed are going to be in stark disagreement, and that’s because I just don’t believe that the liability side of the bank balance sheet is the place to impose market discipline. So for instance, like you said, if we start a bank, we’re going to start it with a certain amount of capital. That’s on the asset side of our balance sheet. Our customer deposits are on the liability side of the balance sheet. It doesn’t really serve public purpose to punish banks by having them try to compete for those liabilities. Because at the end of the day, the only people who actually really truly get hurt are the depositors. So if you believe that there’s some benefit to having non-insured deposits in the payment system, then it would mean that you believe that there’s some benefit that’s derived from individual depositors deciding which banks should attract their deposits.

I mean, I would argue that that’s just an untenable situation. I mean to ask mom and pop to analyze SVB’s balance sheet and decide whether or not they should deposit money there when they have a government bank charter where the government’s telling you that, hey, these guys meet all the regulatory requirements to become a bank, which are pretty stringent.

Zed Francis:

Yeah, I mean, I think the exact line in the sand can be debated. 250 grand might not be the right number, but I think somebody with a billion dollars should have some responsibility that their stuff is not insured by the rest of us.

PJ Pierre:

Yeah, I mean, it’s means testing and I think intuitively, it makes sense for us to have means testing. Like you said, someone with a billion dollars probably doesn’t need the public backstopping their deposits. But you could look at it from the other side of the coin too. It’s like saying, well, someone with a billion dollars shouldn’t have access to the public school system for their children. I mean, the point is, if children should be educated, children should be educated. And I don’t really think it serves public purpose to have that, to impose that means test, but it’s arguable and people have different-

Zed Francis:

Yeah, it’s just super negatively asymmetric. So a lot of people supporting the risk of an individual in a pretty aggressive way.

Jason Buck:

How would you think about that gray area’s of, let’s just say I’m running an Ecom business with five to 10 million in turnover and I’m just using the bank just to move that money in and out of whatever. The likelihood that I’m going to adjust for their balance sheet or use treasury direct or anything for my cash needs, is pretty minimal. So what do you do in that scenario?

Zed Francis:

Well, I mean, that’s just a lot of really lazy CFOs. I mean, it is beyond easy to set up auto sweeps across everything these days. The negative for bank runs is it’s easy to move money really fast. The positive is I can automate this entire thing to have literally zero risk beyond 250 grand at any single account. And on top of that, which is again, lazy CFO, you were earning 0% in the bank account where you could be earning substantially more in another instrument. So it’s irresponsible two ways. You were taking this unnecessarily jump risk and you are earning less money than you should have.

PJ Pierre:

Well, so that’s where I think I’ve pushed back a little bit, some more at Zed because to your point, what we’re basically saying is if you’re a responsible CFO, you’ll jump through enough hoops that all of your money’s FDIC insured.

Zed Francis:

For a smaller business that has a benign treasury department where you’re only really carrying a couple million bucks of cash, 10 plus million dollars. It is your responsibility. It’s pretty easy to do to set up auto sweeps.

Jason Buck:

For PJ, I’m probably going to front run you. Like you were saying, if you’re sweeping and you’re algorithmically going below FDIC in multiple banks, why not just ensure the whole thing?

PJ Pierre:

Why not just insure the whole thing? So what we’re saying is if you take-

Zed Francis:

I’m not even necessarily saying between multiple banks. You need a minimum liquidity amount of some variety that will sit in 1, 2, 5 bank accounts at multiple different banks, potentially. But you should be having a treasury function and sweeping that money out of those banks into other type of vehicles that are going to allow you to earn more money on that unencumbered cash for business operations while you’re waiting to utilize that for operations. So it’s your responsibility to be acknowledging the jump risk of a potential bank collapse, but it’s almost even more you responsibility to make sure you’re earning as much as possible on your cash before it’s needed for business operations.

PJ Pierre:

Yeah, I mean but, so what we’re describing is we’re describing a situation where if you jump through the right hoops, then you could have unlimited deposit insurance. I mean, we’re basically telling the individual, if you put all the money in one pocket, a fraction of it’s insured. If you divide the money amongst all your pockets, then all of it’s insured. And I don’t really know how it serves public purpose to impose that market discipline on the system. That introduces frictions, costs, all sorts of things that don’t necessarily add any real benefit.

Zed Francis:

I think SVB is a prime example of this, because as you say, it was very deminimis amount of their overall deposits were actually insured. And if people were responsible and were spreading this money around, then it would’ve been a known quantity that they were on par in comparison to other banks with the amount of their deposits were insured.

And as you say, if the regulator would’ve actually been doing their job because they would’ve seen the amount of risk on their plate for operating that bank. And what really ended up happening here was the regulators were lazy because they’re just like, “Well, we got this bank over here, but it’s only a handful billion of FDIC insured deposits, so I don’t care about that. On the rung of things that I need to pay attention to, it’s towards the bottom because from my seat as a regulator, it’s got the least amount of risk in it. It has no FDIC insured deposits. So my job is to protect the FDIC and so I’m going to pay attention to the banks that have a significant amount of FDIC insured deposits.” And by happenstance everybody said, “Forget it, we’re going to change the rules for one or two people.”

PJ Pierre:

Yeah, I mean, I think in practice, what you said is true because the Fed has left the FDIC to handle most bank regulations where the Fed actually has a regulatory and supervisory role to play in banking as well, which it tends to not do these days as they focus on modeling interest rate expectations and things like that. So yeah, I would agree that the regulators that were visiting SVB were probably mostly focused on their FDIC insured deposits and found those to be deminimis. But I think that still doesn’t explain the dynamic that we saw play out in that situation.

Whereas, you have a situation where you pass your stress test, so the regulator looks at your situation and says… I mean, you look at this, if this was a fire inspection. The fire inspector shows up and looks at your building and says, “All right, everything meets code. This building is stamped safe. Then the fire marshal does some sort of drill, which is like the Fed hiking rates that causes your building to catch on fire. And then that same fire marshal refuses to hand you a fire extinguisher because you should be responsible for protecting your facility.

I mean, these banks, I mean, if you look at SVB in particular, their assets were all tier one assets. I mean, they were treasuries. They were treasury securities, and these assets were deemed to be money good until the Fed took a course of action that made those things trade out of discount to par. You could make the argument that if there was ever a time for the Fed to do QE, it’s in a situation where it’s raising interest rates so quickly that it’s forcing money good assets to become distressed, for lack of a better term.

Zed Francis:

I mean, you can frictionly less hedge 100% of your interest rate risk, both duration and curve, everything along those lines. And as a institution that your entire infrastructure of why you exist is essentially to, as you say, figure out the right price to lend money and then source the funds to go ahead and lend that money and capture that spread, it is irresponsible for all those institutions to blame movements and interest rates on any of their failures because that’s their responsibility to hedge out the risks associated with operating their business. And again, their business should be focused on capturing a spread. It should not be taking duration bets. It should not be taking massive curve bets.

PJ Pierre:

But by definition, if the entire banking system hedged out all its inflation risk, the cost of that hedge is going to be the cost of all the interest risk, it would just eat up all the spread.

Zed Francis:

You’re just locking in your spread. No, you’re just blocking in the spread.

PJ Pierre:

Well, right, but you’re locking in that spread by putting that risk upon somebody else. So if the whole system is doing this, then it just becomes a cost of collecting that risk premium over time. You’re, in essence, eliminating the return system wide if all of the risk is hedged out.

Jason Buck:

You’re saying there’s no arbitrage condition that if you fully hedged, then if everybody fully hedged, then there’s no spread.

PJ Pierre:

Right.

Zed Francis:

No, but the spread is the fact that their cost of financing when they’re financing via deposits is generally substantially less than the risk free rate. And that’s not necessarily an arbitrage, but that’s the spread. That’s the spread you should be locking in.

PJ Pierre:

It’s substantially less than the risk free rate when you introduce duration, if it’s overnight rates in that regard, yeah. So in essence, you’re describing a situation where the banking system would just be long reserve deposits at the Fed, earning interest on excess reserves,

Zed Francis:

Yeah, which the big banks did for a long time because they didn’t see a lot of loans that were lovely to be in banking. So they’re like, JP Morgan’s going to continue to pay you one basis point and just earn their five over there. They don’t even have to bother hedging, like you said.

PJ Pierre:

So I think this is good though. So it explains the point that I was making though. Whereas when you impose these sorts of conditions, we’re describing a situation where we’re incentivizing that banks just don’t make loans, they just earn interest on excess reserves at the Fed. How does that serve the economy? How does that serve public purpose?

Zed Francis:

I agree. You’d rather have that potential capital being pushed through the machine rather than taxpayers just paying JP Morgan and not having us get paid as depositors at those institutions. Completely agree with you there, but that’s just different than the responsibility of operating a bank where you’re entire livelihood should be capturing a spread and not taking directional risk. And try to do that as many times as you can.

PJ Pierre:

So a bank will model what they think the duration of their liabilities are and then model what their duration of their funding is, and then through their risk metrics determine where they want to be on that spectrum. Whereas the regulator caps how much liquidity mismatch you’re allowed to have with what they consider safe, in a safe range. And then you exist within that spectrum. You’re describing a situation where there’s zero liquidity mismatch and you’re just fully hedged.

Zed Francis:

Which I think you should be at target. It’s not exactly fully achievable, but that should be a target, and it’s so easy to do is the part too. I could take-

PJ Pierre:

I think it becomes a fallacy of composition though. I could easily hedge when hedging is affordable because others aren’t hedging. If everyone’s hedging, hedging goes to just the price of the risk and then you’re not really hedged,

Zed Francis:

No.

PJ Pierre:

Because an aggregate the risk, it’s a musical chair situation. An aggregate, you can’t get the risk out of the system. You can just transfer the risk from me to you.

Zed Francis:

But again, it’s not a risk transfer, it’s locking in the spread between what you’re paying depositors and what the system is saying the risk free rate is. That is how you’re making money.

PJ Pierre:

You’re locking that in with what?

Zed Francis:

I’m going to key rate duration hedge my entire loan portfolio to basically make it look like I only have spot risk. So then I all of a sudden have a portfolio where I’m earning spot risk free rate across the spread. We can argue whether there’s actually any spread or not, but I’m earning that and I’m borrowing to support that risk at whatever deposits.

PJ Pierre:

And you’re doing that with swaps?

Zed Francis:

A blend. It’s going to more depend what my loan portfolio looks like. If most things are pegged off of SOFR, I’m probably going to be using more treasury type derivatives just because I don’t want to take swap treasury spaces first.

PJ Pierre:

You don’t test this risk.

Zed Francis:

Really, the only times it-

PJ Pierre:

And who’s selling you this hedge?

Zed Francis:

I can trade a billion DV1 like water. That’s fine.

PJ Pierre:

I mean, I know it’s doable. I’m just as we work it out, as you think it through, what I’m trying to ascertain is who are you transferring the risk to when you do this?

Jason Buck:

It’s also theory and practice, right PJ? I think you’re saying too, in essence, if we all hedge that way, that’s going to be a no arbitrage position, but that doesn’t happen in practice. So what Zed saying is, if he was running his own bank, this is how he would hedge that risk. And then you’re saying, because everybody’s not doing it, therefore it allows that condition to take place.

Zed Francis:

My only edge is I have a piece of paper and only a limited amount of people have this piece of paper that allowed me to borrow money below what everybody else would pay. That’s my edge of operating this bank is I get to borrow money from depositors below everybody else.

PJ Pierre:

And where does that edge come from? Where does that edge come from?

Zed Francis:

That we only approve a handful of banking licenses.

PJ Pierre:

The thing that the banking license gives you is the banking license gives you a-

Zed Francis:

And to be clear, this is a bad business. There’s only, whatever we’re down to, technically what? 14,000 banks, something like that?

Jason Buck:

No, we’re down to 4,000 from 14-

Zed Francis:

4,000, sorry. Yes, a decent amount of people have this piece of paper. They give them that edge to be able to borrow money less than everybody else, but it’s still a really not very good business.

Jason Buck:

Well, that’s going to give me a great transition in a second, but PJ, I’ll let you finish. What were you saying the banking license allows you to do basically?

PJ Pierre:

So what the banking license allows you to do is enter into a 90/10 or a 95/5 public-private partnership where if the capital requirement is 5%, that means that someone else is putting up that other 95%, otherwise it’s a insolvent system from inception. And that other person who’s putting up that five is the government. That’s the whole point of the FDIC insured, the Federal Reserve as a lender of last resort on the side of the banking system. And so what happens is, it’s not that banks are necessarily borrowing for less than anyone else, it’s that banks create their own liability when they lend. So they’re issuing their own liability out of thin air. And that’s what that charter gives them the right to do. Well, I should rephrase that. The charter gives them the right to do that in a way that we all accept that liability because we all could issue IOU’s out of thin air.

Zed Francis:

Yeah, and it’s just the levers they can pull on to finance that liability they generate is a blend of the different facilities overnight window. They can issue bonds themselves or they have this unique one where they can pay depositors no money.

Jason Buck:

While PJ thinks about it, I’ll transition us. So where we’re headed to is a great way where I’ve pinged you guys with some questions, but we’ll flesh it out a little bit more. But before I get to, I got to have an interlude real quick. We go to TreasuryDirect and everything. Do you guys do it as well? That website absolutely sucks and it’s only gotten worse as more people are sharing.

Zed Francis:

No, it’s true.

PJ Pierre:

Yeah, it sucks.

Jason Buck:

We need something better. Maybe an entrepreneur needs to work on that, on the TreasuryDirect side. Speaking of entrepreneurs, I mean, coming out of GFC in 2007, 2008, I spent a lot of time looking at banks and thinking about what would it look like to start my own bank. I looked at credit unions, et cetera, of how could you ensure all deposits or not take too much risk so you didn’t have that bank run or you treated it almost like we treat gold vaults. And obviously, it’s exceedingly difficult to do, but there’s two reasons to do it, but they’re competing like, Zed, you’re saying. This is a terrible business. But then also what PJ is talking about too is you have this capital ratio so you can create loans out a whole cloth. So you have these two things that are competing against each other to make it a good business and a bad business.

And so how would you guys go about it? Because I texted PJ, I was like, “You want to start a bank?” He was like, “Hell no.” But it does make sense if you think about Andy Beal and some of these other more private style banks is it gives them almost infinite capital that all the buffet acolytes want and access to government on that capital ratio. And PJ’s shaking his head already, so maybe he wants to jump in first of why or why you would not want to start a bank.

PJ Pierre:

Well it doesn’t give you infinite capital because your capital-

Jason Buck:

Ratio, yeah.

PJ Pierre:

Yeah, you have your capital ratio. So if a bank wants to expand its balance sheet beyond its capital requirement, you just have to raise more capital.

Jason Buck:

But I was saying like you’re saying with the public-private partnership is, let’s say that capital reserves 10%, the government’s lending you 9% out of 10% for you to go out and make money off of.

PJ Pierre:

Yes.

Jason Buck:

Which is a great thing, but then-

PJ Pierre:

But the government’s also telling you what you’re allowed to do to make money.

Zed Francis:

And there’s a lot of fixed cost.

PJ Pierre:

A lot of your best ideas, the government just tells you, “No, you can’t do that.”

Zed Francis:

You rather be In insurance. Insurance is much better than banking.

PJ Pierre:

Yeah, insurance is much better. Agreed.

Jason Buck:

No, that’s most of Zed and I’s conversations as well. But part of it though, so there’s two things. One, obviously the government at current state, whatever, is never going to allow me to reach a burner style to go out and lend to entrepreneurs at the bank or the interest rates are going to be onerous. But so let’s flip it around though. What if I wanted just a stable bank that was basically a vault for my cash so to speak? And I know you’re going to have umbridge with all those words I just used PJ, but the idea is what if you were just long deposits with the Fed? Would that be a way to run a bank that where you can maybe cover the cost in the technological age of running the banks or maybe people only spend $20 to $50 a month for your banking costs for them to have essentially, insured deposits.

PJ Pierre:

So to the degree that you can start a bank, attract lots of customer deposits, pay them a much lower rate than what you’re earning on your excess reserves deposited at the Fed, then yeah, you’re describing exactly what Zeds been pining about here. They’re going to make a lot of money in that sense. Now, there are circumstances where that’s not the case and it’s risky. I think I told you the story before, Jason, that back when Warren Mosler was working at a small regional bank at the start of his career in the ’70s, Congress passed the law that said that the banks had to pay their depositors 5.5% on deposits or lose your bank charter. And at the time, the going rate in money markets was only paying 5%. So to run a bank you had a net negative carrier of 50 basis points and it was just a fixed cost of doing the business as Zed mentioned. Whereas you just had to figure out a way to overcome that during the course of business. Otherwise you’re just going to lose 50 basis points.

And at the time, what Warren Mosler did was he took their deposits and deposited it with their competitor and earned a 5.5%. But which is going back to what I was saying before where the whole system can’t do that obviously because that’s just a fallacy of composition. But to the degree that you could out compete someone else and saddle them with your deposits. I mean, you could find yourself in a situation where you’re not able to have that cheat source of funding.

Jason Buck:

Part of that though Zed, what do you think? I think people in Silicon Valley have said that they would be willing to pay a cost instead of making money off deposits as long as their deposits were insured. If they have millions of dollars in there when they’re running their, say, their business treasury account. So do you think that’s possible to cover the cost of the bank? People may need to pay $100 a month just for the service like we do for a gold vault. You’re paying for the vault, the security, the technology, and it comes at a cost, not as you should make money off of it.

Zed Francis:

But I think the number is a lot bigger than that.

Jason Buck:

More than $100 a month, I take it?

Zed Francis:

If you have to pay a point and a half under your deposits, I think people’s tunes will change. This is isn’t cheap SAS Netflix subscription stuff.

PJ Pierre:

Well yeah, because even those are a situation where someone else is paying the cost of that. When that SAS company is burning investor capital to provide you cheap services.

Zed Francis:

If you want to be actually insured, it costs a lot of money.

Jason Buck:

I want to- Go ahead, Sorry.

PJ Pierre:

I think you make a good point there though Jason, to the fact of when we think of risk-free rates as being positive, a lot of the same types who were very upset that with ZIRP and zero rate policy for the risk free rate, are also a lot of the same types of people who are, I would say, sympathetic to the hard money view of things. But if you look at a gold standard situation, I mean the risk-free rate on gold is negative as you’re mentioning. I mean there’s a negative cost of carry.

Jason Buck:

But too, almost it ties also back into Zeds point earlier, if somebody has a billion dollars in cash, we don’t want to ensure that. To me, for the most part, as an idiot, what I see treasuries in aggregate is just a place to park enormous amount of capital. So if China, \]et cetera want to put trillions of dollars into some sort of vehicle, then they’re going to use US treasuries. Well, I think they should have a negative interest rate. There should be a cost of holding that capital in a safe manner, but maybe I’m an idiot.

PJ Pierre:

I’m somewhat sympathetic to that view.

Zed Francis:

I saw there’s still negative term premium, Jason.

Jason Buck:

I hate talking about topical things, but I do want to talk about debt ceiling just as a jumping off point for a conversation. But before we get there, almost a little speed wrap-

Zed Francis:

Oh, Jason, Jason, I really thought you were going to go with Jimmy freaking Butler. That is the important thing of the day.

Jason Buck:

Unfortunately, yeah.

Zed Francis:

Jimmy Buckets is a guy.

Jason Buck:

Jimmy Buckets, man.

Zed Francis:

That that’s the topic of du jour, not debt ceiling.

Jason Buck:

PJ, are you a heat fan or no?

PJ Pierre:

I am.

Jason Buck:

And we were talking about the Brightline before we got on. You could take the Brightline down to the stadium. There’s many times I’ve been on the Brightline where people are going… You can walk right from the Brightline station in Miami to, well it used to be American Airlines arena, then FTX or is that going to change anyways?

PJ Pierre:

Yeah, I think the FTX sign might’ve been taken down already.

Jason Buck:

Yeah. I appreciate you trying to transition us away, but I’m going to keep coming back to it, but in the speed round though, before we get there, I’m just curious, what are your guys’ takes? Because people are talking about again, does an inverted yield curve matter? Is that important at all? This is just a speed round question.

PJ Pierre:

Yes.

Jason Buck:

And I should say… Okay, you say yes, but let me start with, correct me if I’m wrong, the original paper was the 90 day and the tenure, but people always quote the two and the 10 or the two and the five and people use all sorts of different instruments to now quote it. But isn’t it technically in the paper it was the 90 day and the tenure and most people don’t try to replicate the 90 day.

PJ Pierre:

Does an inverted curve matter for what? Would be my question.

Jason Buck:

Well one, I have a problem with anybody who goes, “Well, it predicts a recession in the coming years.” It’s almost like staying transitory or something. You’re not giving me a date. Does this really matter? And then my point is pre 1980, the yield curve didn’t predict anything. It was less statistically significant. So is this time different? How long does this keep going on? And if everybody starts attenuating their portfolios to the inverted yield curve, does it change in real time?

Zed Francis:

I was going to say, the only reason it matters is there’s a lot of product that’s been built that essentially is a carry trade. And so, are they overnight funding? Is it three months? Is it two years? Who the heck knows what’s the most important point on the front end? But that’s why it matters is people are taking leverage by borrowing short to buy risk assets that obviously have duration to them. And what matters more is the move, that’s going from steep to flat to inverted. And then when do people have to refinance the carry portion of that position? So that’s why it matters, in my view, is it’s just a financing thing and when they have to reset financing, doesn’t make sense to continue to hold all those long duration risk assets at that current cost of financing and maintain that carry trade position or not.

Jason Buck:

So you think that automatically will lead to a recession, the unwinding to those carry trades?

Zed Francis:

No. No. I think it’s probably more asset price based than necessarily “real economy.” And if it doesn’t just the “wealth effect,” if things don’t take too much. It’s not automatic. It’s going to be 80%.

PJ Pierre:

To me, and I think what you’re alluding to is, does it matter as a recession indicator? Is that what you’re asking Jason?

Jason Buck:

Yeah, that’s probably fair. Well, yeah, it’s more like one, is the mechanics that Zed was just talking about, but me, it’s more like financial media just using this one. They just love when this happens because then they all go crazy with their bearish rage on news cycles and then just say that a recessions imminent, but you just don’t know when. So that’s unhelpful for a trader.

PJ Pierre:

Right, so I mean, what I would say is the yield curve is a recession indicator in the sense that it tells you that the market is forecasting a recession and so it’s, the market believes there’s going to be a recession. Do with that what you will.

Jason Buck:

Well, it’d be interesting to see if it works in a rising rates environment too. Like I was saying, all the research on it’s only since 1980. They time windowed how often it’s been predictive. So I don’t know.

PJ Pierre:

Well, yeah-

Zed Francis:

Not only that… Go ahead, PJ.

PJ Pierre:

No, I was going to say, I often say that the yield curve has predicted 17 of the last four recessions.

Jason Buck:

Just like Robert Kiosaki and then what’s Dr. Doom? Sorry, Zed, what were you going to say?

PJ Pierre:

Yeah, all those guys.

Zed Francis:

Yeah, I’m more just like the shift in the yield curve has a potential of creating force selling because it makes it less interesting to borrow money to buy things. And I think potentially, decent amount of that carry trade style of investment has actually been done more so on the private side rather than the public side of tradable assets over the last 10 years. And so it probably is mattering, they just have a longer leash than forced liquidation of, I don’t know, some commingle product that’s all trading listed instruments that, it’s a forced unwind. It’s a little bit different on that sense.

PJ Pierre:

The two go hand in hand too, where I think you’re right, the yield curve can cause some forced selling, but oftentimes, it’s forced selling that cause causes a yield curve to invert.

Jason Buck:

So thinking about this debt ceiling thing. One, like I said, this stuff drives crazy. I don’t really enjoy talking about it, so to speak, but there’s been some interesting mechanics underneath the hood, at least. In general. I think the debt ceiling stuff to me is the world is full of sound and fury, the end signifying nothing. They typically raise the debt ceiling. So there’s a lot of probably just political posturing in Kabuki theater, except that, I’m sure you guys deal with this too, as people that trade derivatives with our FCMs and et cetera. I’ve been getting calls and emails saying even rolling T-bills, 90 day T-bills, they’re nervous about the duration even of your 90 day T-bills. When is that window going to come into effect with what’s going on? What if there is a government shutdown? So you’re dealing with that side, which is crazy.

The other one is, you see people that wanted to buy CDS against the US dollar. Government and everything were like, you’re going to get paid in Euros and if it collapses, how do you think you’re going to get paid out? How is that going to work? The other piece to that though is, Zed, you and I were texting a few weeks ago how commercial real estate lending was basically drying up. And I would assume part of that’s they just want to wait and see what’s going to happen with the debt ceiling. But I really don’t have a specific question other than just laying those things out. So whichever one of you wants to jump in first to have any thoughts or feelings about debt ceiling or if this stuff matters. Zed, I know you and I have been texting about it quite a bit about a lot of credit drying up where people are just, it seems like, in a wait and see mode. Is that fair?

Zed Francis:

I don’t know. I think the market is not really thinking there’s a lot of risk here. I would say there’s not a dramatic amount of… The prices aren’t telling me that people are very worried about it, but it’s more… Go ahead, PJ.

PJ Pierre:

There’s not a ton being discounted.

Zed Francis:

Yeah.

PJ Pierre:

Debt ceiling, Interesting. So whenever I have discussions about the debt ceiling with anyone, one of the things I say is that I agree with your point where typically the debt ceiling is a non-issue. It typically always gets raised. The thing that makes a debt ceiling somewhat interesting to me though is the fact that it’s a situation where the politicians play chicken with this deadline. And it’s a situation where I think it’s like you’re playing with water balloons or what you think are water balloons, but it turns out it’s actually a mini nuke.

And I say that because I don’t think too many people actually realize how bad it really would be to actually smack that debt limit and what that looks like. I think most people model it with what we saw with the government shutdowns. But it’s very different and it’s a much more dynamic situation than the government shutdowns. With the government shutdowns, you basically furlough workers and you defer payments and you basically use some accounting tricks to avoid what would be termed the technical default. Actually hitting the debt ceiling just creates this pro-cyclical race to the bottom where the government is forced to immediately cut spending, which then means less income in the economy, which then means less tax receipts, which then means the government has to cut spending further, less income, less tax receipts. I mean you could get a 50% reduction in GDP in two weeks.

Zed Francis:

What I think’s most interesting because the question is does it cause everybody to dig in to their side of the trenches harder or not? And what I’m getting to is there’s a ton of money that comes in on June 15th, and so even if you run out June 5th, everybody knows we’re back open in 10 days. And so does having that knowledge base that, “We went over the line but we’re all the way back in 10 days,” cause people to dig in further and not get things resolved because everybody views it as it’s just a silly bridge. They can technically not pay people and then pay them on the 15th and be like, “Don’t worry about it.” I don’t know what side of it’s on.

PJ Pierre:

I think there’s a lot of that kind of stuff that leads to it. I mean, I just think that if we actually failed to raise the debt limit, I think the politicians would quickly realize… To me, it’s like the bombing of Pearl Harbor where you immediately realize, maybe this was way worse than I thought it would be.

Zed Francis:

Yeah, I mean, it’s 10 different questions. If you get to again, just making up a date, but you get to June 5th and you’re like, “Technically we’re there.” And Yellens can basically say, “We’re going to do some things to last 10 more days.” Or she can say, “We’re not going to do those things to last 10 more days.” And which one is a more politically digestible decision? My whole thing is I do think the 15th because everybody now acknowledges the amount of tax receipts that come in on the 15th that, unless one side really caves from extreme fear that we’re probably going to push through that event because everybody doesn’t view it as a long-term problem. It’s like, “Ah, yeah, it’s a week of silliness and then we got money again.”

Jason Buck:

There’s a couple questions around there, but I’ll take a quick side tangent because PJ, Pearl Harbor and everything, I was listening actually to Founder’s podcast this morning on my walk and it was about Sol Price, the founder of Costco. He was living in San Diego as a lawyer and after Pearl Harbor, he was working with his lawyer during the day and then working for the defense department at the night. But what I didn’t know was post world Pearl Harbor, they blacked out San Diego and a lot of West Coast cities. So at night, how do you get around with no lights? You got to drive. How do you navigate that? And I just think how people now think they make so many sacrifices and they blacked out the entire city for months on end and you’re trying to get to these night jobs to help out the government. That’s just an insane proposition when you think about even navigating San Diego. But that’s neither here nor there.

So we’re talking about debt ceiling though. Zed, how do you think about what is the appropriate amount of debt for the US? Is this a Malthusian number, as a global hegemon, is there a number? Everybody likes to argue about it’s too much or it’s not, how do you even know what’s too much? How do you think about it? How do you conceptualize it?

Zed Francis:

Yeah, I mean, I don’t think there’s a number in the sand or anything about what’s too much. I personally think the problem is future liabilities, not necessarily the ones that we’ve already got on the books, but all the promises we’ve made with various programs in the future.

PJ Pierre:

Entitlements.

Zed Francis:

Exactly. A blend of entitlements and other things that we’ve essentially, already committed to providing into the future. And that’s probably what causes problems at some point. I don’t know when. What the number? Who the heck knows. But it’s just were running out of the ability to actually provide those services, forget necessarily the money, just having enough human capital along with money capital to provide all those services that we promised. It seems like we’re going to have some sort of impasse. I don’t know if that’s 5 years, 10 years, 40 years, but that’s what worries me more than necessarily a specific number of the amount of debt that we got.

Jason Buck:

PJ, how do you think about what’s the appropriate percentage of debt to GP or any of that stuff? Do you think it even matters?

PJ Pierre:

Yeah, I don’t think in the terms of debt to GDP matters because I think I’ve said it to you before that economics, particularly macroeconomics is the art or the science of confusing stocks with flows. Whereas the debt is a stock and GDP is a flow. So the two don’t really have that much importance in relating the two numbers together. What I do think, and I’m in agreement with Zed, whereas I think the bigger concern is productive capacity. Whether or not we have the ability to provide the necessary goods and services that are entitlements imply are necessary.

And I think the thing that’s interesting about that is most of the debt related concerns, I think, actually tend to make me fear that we’re going to have a worse situation that way because what happens is we end up not investing in making the necessary capital investments today that will improve our productive capacity to be able to then provide those necessary goods and services in the future, which is investing in our infrastructure, investing in education, and doing all these sorts of things that are going to make us basically more productive. Because I think at the end of the day, it’s the real resources that matter, not the entries on the Fed’s balance sheet

Zed Francis:

It forces things towards payments rather than investment.

PJ Pierre:

Exactly. Well yeah, and we do that in so many different places. So if you see your children as an expense instead of an investment, the way you interact with allocating resources towards them is going to be very different. I mean, if you see children as an investment, then you’re going to want to give them good education. You’re going to want to allocate lots of resources towards that investment. If this is an expense, you’re going to want to minimize cost and you get two very different outcomes depending on just that simple framing.

Zed Francis:

And the amount of debt you have makes those decisions harder rather than easier without a doubt.

Jason Buck:

Well two questions around that. One is, as a trader, do you like these debt ceiling negotiations. Everything says it gives you some more maybe volatility in the market or volatility compresses while we wait to see what happens? Or would you rather you just can’t wait for this to pass and get back to your regular trading schedule? Let me start with Zed on that.

Zed Francis:

I very much dislike having any either fiscal or monetary stuff involved in my day-to-day trading activities. Because I have no edge. I just have no edge. I have no idea what they’re actually going to do. And whatever they do, how does it matter? If I knew exactly what they were going to do, how do I think markets are going to move? My conviction on that is pretty darn low too. So I prefer not having them involved.

Jason Buck:

PJ, how do you think about the trading around it?

PJ Pierre:

Yeah, I mean, I tend to agree wholeheartedly. I think there’s very little edge in deciding whether or not Congress is going to pull the right lever in time to avoid these kinds of things. And it’s one of those situations where even if you get the trade, when they do the wrong thing, you got bigger problems to worry about typically anyways.

Jason Buck:

And like you said, figuring out the cascade of consequences, even if you knew exactly what was going to happen with perfect foresight is positioning, paradox, all those things happen to usually put the trade against you anyway.

PJ Pierre:

Positioning, counterparty risk. Yeah, I might have the right trade on with the wrong counterparty who they can’t pay me anyways so who cares?

Jason Buck:

Or everybody’s pre positioned for that move or whatever or not positioned, so it just violently lurches the other way. One of the things though-

Zed Francis:

[inaudible 01:08:05] you’re like, “Okay, right now it’s pricing and a benign amount of risk over the next handful of weeks.” And you’re like, “Oh, they decided the June 15th date is all that matters so they’re going to do a two week bridge.” You’re like, “Ah geez, they didn’t actually solve anything but it killed off my training because I was focused on the last next three weeks.” You’re like that, “That’s not very fun.”

Jason Buck:

Also, similar analogies is, it was a Q4 of 2020, the Trump election and everything, there was that kink in the vol curve anyway. So even though you want to maybe be long… You’re paying so much for it doesn’t really matter because of the event risk. And then you and I talked about in Q4 of this just last year, is everything was around like FOMC meetings. It was just one day intraday vol, so it’s very difficult to trade around these event horizons. Is that a fair way to look at it?

Zed Francis:

Yeah, I try to have risk lower on those days. Because again, in general, markets are tending to price something and it’s something that I don’t have any edge in.

Jason Buck:

PJ, do you have edge that you want to talk about publicly around these events?

PJ Pierre:

No.

Jason Buck:

This will transition, I think, in an interesting way for the last topic of conversation. So speaking of trading, figuring out what’s going on in the world and trying to be predictive of macro events, recently Hugh Hendry and Russell Clark were on a podcast. They’re looking at the same things, but they get two completely different conclusions than what the trade is. And right now, Hugh Hendry, at this date and time, and I don’t want to speak for him, is basically long TLT. He thinks everybody else’s positioned on the other side. He thinks that long TLT is going to be the move and it’s already gotten beaten up too much. So he said he thinks everybody’s missing that.

On the flip side, Russell Clark says, now we’re about to go through a secular inflationary period, so Russell Clark’s trade is short TLT, long gold. So they’re looking at similar things and drawing the exact opposite conclusions. And so everybody’s now talking about structural or cyclical inflation. Is this a paradigm shift? I’m just curious to how you guys think about those things playing out, how you position your book. Does it matter? And I’m not sure if any anybody’s right. How can we know if it’s transitory or secular while we’re trading it? You only know in hindsight. How could you possibly know that? And maybe, I don’t know who wants to jump on that grenade first.

Zed Francis:

Go for it, PJ.

PJ Pierre:

Well I mean, I don’t know how you’d know. I don’t believe I ever know anything about the markets. It’s always about probabilities for me. But I mean, I’m sympathetic to the argument that we may be seeing… Jason’s doing this to me on purpose. He knows I’m hesitant to use the term inflation when talking about these sorts of things. So I think I’m sympathetic to the idea that we’re likely in an environment with more price pressures than we’ve been accustomed to over the last 30 years. I think some of that stuff is just by definition and it’s nothing particularly insightful, but I think everyone has been talking about these things like reassuring of supply chains and adding redundancies. So we’re generally moving from a very specialized, very efficient globalized economy to one that’s going to be more regional. So there’s going to be a lot of global redundancies, which just means things are probably just going to cost more.

And also, we’re coming out of an environment where the Fed was, in essence, eating lots of vol and a lot of that vol needs to get priced back in the markets, which is another friction, another form of inefficiency that just makes capital allocation less or it makes it harder to allocate capital and feel comfortable about your risk. So then you have to build in more of a margin for error. So that means the cost of capital goes up, all these kinds of things. So all these things are just inputted into the price level. And then by definition, higher rates. If you look at forward pricing channels, higher rates also feeds into higher prices. If you’re a home builder, you’re going to pay more money on your debt, so you’re going to have to charge a little bit more for your homes, so on and so on and so forth.

So I’m very sympathetic to that view. The only reason why I’m a bit cautious about just putting on a bunch of secular inflation type bets is that you never know what you don’t know in that regard. Oftentimes, deflationary pressures come from something that no one really anticipated, whether it be some sort of innovation, whether it’s going to be AI, whether it’s going to be additive manufacturing, who knows? So I don’t think it’s the type of thing that there’s going to be a ton of edge in trying to monetize. Everyone’s aware of it. Everyone has a flavor of their opinion of it, and I don’t see any clear asymmetric bets that I think are going to definitely pay out.

Jason Buck:

Ugh Hendry’s argument about his long TLT trade is positioning. He thinks that everybody’s positions on the other side of that trade.

PJ Pierre:

Yeah, well if that’s true, then I’d be sympathetic with that view. I’d definitely like to be on the other side of the vote, in the crown.

Jason Buck:

There’s a couple things there. One, I’m glad you brought up term structure because we all deal with commodities and I’ve never understood that. As soon as you raise rates, you’re embedding that in the term structure of commodities, so you’re just generally increasing prices automatically. And anybody that’s trying to hedge commodity exposure or even end users. But Zed, I’ll say it maybe another way, is how do you think about, PJ’s hinting at there, what do we want to call it, nearshoring, friendshoring, I heard a called recently, those likely create regional inflationary dynamics and does labor ever get its hands around to having any ability to have some pricing power? And then when they have contributing factors, let’s say, of China coming back online that’s allegedly disinflationary or like GPT and LLMs and AI coming online that’s allegedly disinflationary, how do you even sort through those forces?

Zed Francis:

As a kickoff, I agree with PJ that where things are currently priced doesn’t seem like there’s significant amount of edge on either side of that position. So it’s like, ah, cool, we can pontificate about what we think 10 years from now is going to look like and we’ll never remember that in 2033. But in terms of running a portfolio, we’re down the middle of the field in terms of likely outcomes. So not really on my radar for what we should care about day to day in terms of running the portfolio. I’d say one little different take maybe on inflation, I think if you just said super benign, there’s fixed costs and variable costs and what’s in what bucket and how much in what bucket, who the heck knows? But variable costs, as you said, labor and onshoring and all that kind of stuff is, that’s probably a driving component there, but most of your fixed costs are likely driven by things that are blase, hard asset based.

And I think a lot of the inflation that we’ve experienced in the last two and a half years is, and it might not be the right word, but we didn’t allow a reset in fixed costs from a staff recession, whatever the heck you want to call happened the first two quarters of 2022. And so, we’ve had fixed costs be maintained higher probably than they likely potentially should have been, which is provided that floor to what we’ve seen over the last handful of years. And so I think the real question for inflation, deflation and all that stuff is do we actually get a fixed cost reset? And the most likely driver of fixed cost reset would be a decent default cycle. If you’re just the super vanilla, “Okay, I’m running a business, I’m paying rent. Sadly, I didn’t get a big bonus on rents falling over the last interchange because nobody defaulted on their building that they were leasing to me.” But maybe next time that’s different, you could actually get that fixed cost reset to some event and that would be deflationary if that actually takes place.

PJ Pierre:

That’s actually an interesting insight, and I would agree with that.

Jason Buck:

You’re saying a debt deflationary spiral basically that we have to actually-

Zed Francis:

It’s not even necessarily a spiral, it’s just-

PJ Pierre:

It could a one-off reset. It doesn’t have to be a spiral.

Zed Francis:

I have to earn X amount in cash flows if I’m carrying an asset at a 100 million dollars. If all of a sudden the assets only worth 50 million dollars, the amount of cash flows I need to support that asset are very, very different, thus the people that are paying me those cash flows to support their 50 million valuation are going to receive some of that benefit.

Jason Buck:

As PJ said, a one time reset or you’re saying the right downs, it actually pairs nicely to my final question, almost related to that is are we talking semantics or I just can’t see, and maybe I’m just not creative enough, that all of this humans being humans leads to some sort of jubilee. Now if you call that a one time reset to take the right down or whatever, that would be a form of jubilee to me. But humans being humans, our optimism and our debt load and our debt burden, it seemed like it always increases until we have some sort of reset. Am I completely wrong on that or is there-

Zed Francis:

I’m a big distress guy and I think that’s healthy to have that reset take place because the survivors on the backend, again, are going to have better operating businesses because they’re going to be able to participate in the newly created environment post that reset. We definitely are fighting any reset hard. I think governments and humanity always fights a reset really hard, and so it’s going to be some one off event that probably has us wander down that path, but predicted, I don’t think there’s a way to do that.

PJ Pierre:

Yeah, I think it’s interesting because those debt jubilees typically happen in situations where there was a monarch who had absolute power and would, based on their understanding of the system, decide that the debt burden’s too high, it’s causing stagnation, so we’re going to reset the debts. So the [inaudible 01:19:41] would scream and moan, but it didn’t matter. The king said, so the king said. I mean, the king gave you your title anyways, so you’re going to collect less economic rents moving forward post the reset. I think in this environment with the amount of political capture that capital has now, I would agree with Zed that I think we would fight any sort of a reset. I mean, if you look at what’s going on right now, you could frame it in a way and maybe it’s unfair, but the Fed is fighting inflation by raising rates rapidly, which causes the treasury to pay higher interest rate returns on outstanding debt, which means that the Fed policy basically means more money for those who have money in proportion of how much they have.

So we had this situation where, the narrative was that the Fed caused too much income inequality by keeping rates at zero. Now the Fed is also causing income inequality by causing there to be a higher government transfer payment from the government sector to those who already have money in proportion to how much they have. So we’re in this situation where it seems to always end up on the capital side of the equation as opposed to the labor side of things. And I don’t know, sometimes when you don’t get that debt jubilee, sometimes it ends in revolution, which I don’t think we want to see.

Jason Buck:

Which is just another form of jubilee, eventually. That’s one I think about often. Zed, what are your thoughts on the raising of rates essentially becomes universal basic income for savers. Do you have any thoughts on that or pushback?

Zed Francis:

Well, I mean, up until two months ago, they weren’t receiving any of that. So there’s a lot of moving pieces associated with higher rates resulting in folks actually getting distributions on their savings. Again, if you’re still at JP Morgan, you ain’t getting anything.

PJ Pierre:

By that I mean specifically those who own sovereign debt.

Zed Francis:

Right, no, we’re walking up the ladder. This is your half a million dollar retiree.

PJ Pierre:

You’re absolutely right though. If you have money deposit with JP Morgan, you’re not getting that, but JP Morgan sure is.

Jason Buck:

And then PJ, you reminded me the monarchies were they’re usually the ones that they created the jubilees because allegedly, that’s why the Rothschild’s even created bonds or government bonds because they got tired dealing with the whims of Monarchs. And then they also wanted to release some of that money from the landed gentry. So they allegedly created government bonds to trade. I don’t know how true that is, but that’s one of the historical reference points I always find is interesting.

I want to thank you both for coming on to just have a chat. I actually had, like I said, I didn’t have any questions. I actually have a bunch more, so we could always set it up for future conversations to be had, but I look forward to Zed, seeing you tomorrow at EQ Derivatives Global in Las Vegas. And then next week I’ll actually be seeing PJ at the collective in Lake Tahoe at the Edgewood Resort. So I’ll get to see you both in person soon, which is always exciting for me. But at the end here.

Zed Francis:

I’m jealous. I would definitely take Tahoe over Vegas.

Jason Buck:

What are you talking about? That’s crazy talk, Zed. Let’s plug away again, Zed. Where can people find you?

Zed Francis:

Best visit us convexitas.com and you can see myself and Devin Anderson and Brian Wysocki on LinkedIn for the Convexitas Group.

Jason Buck:

PJ?

PJ Pierre:

PJ Pierre on LinkedIn and @TatianaPierre on Twitter.

Jason Buck:

Thanks gentlemen, appreciate it.

Taylor Pearson:

Thanks for listening. If you enjoyed today’s show, we’d appreciate it if you would share this show with friends and leave us a review on iTunes as it helps more listeners find the show and join our amazing community. To those of you who already shared or left a review, thank you very sincerely. It does mean a lot to us. If you’d like more information about Mutiny Fund, you can go to mutinyfund.com. For any thoughts on how we can improve this show or questions about anything we’ve talked about here on the podcast today, drop us a message via email. I’m taylor@mutinyfund.com. And Jason is jason@mutinyfund.com, or you can reach us on Twitter. I’m @TaylorPearsonMe, and Jason is @JasonMutiny. To hear about new episodes or get our monthly newsletter with reading recommendations, sign up at mutinyfund.com/newsletter.

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