HARLEY BASSMAN: Good day, everyone. My name is Harley Bassman. And today, I'll be a guest interviewer on behalf of Real Vision. I've had an episodic macroeconomic commentary as the Convexity Maven. And I currently manage a hedge fund of one, me. Prior to this, I spent 35 years on Wall Street, where my claim to fame is I created the MOVE index and the VIX, which is the VIX for bonds.
I have been invited to be an expert inquisitor to draw out the thoughts of our guest, Eric Dolan. Eric is the Executive Director and Senior Economist at the CME Group. He's responsible for generating economic analysis on global financial markets by identifying emerging trends, and evaluating economic factors, and forecasting their impact on the CME Group, the company's business strategy, and upon those who trade in its various markets.
Prior to joining the CME Group, Eric gained more than 15 years' experience in the financial services industry working for investment banks and hedge funds, both in the United States and France. Eric holds a bachelor's degree in economics and political science from St Mary's College in Maryland, and a master's in statistics from Columbia University in New York. He's also a CFA.
Eric, where to start, ay, yi, yi. I'm not going to put you on the spot, but we are speaking slightly before the Fed releases their statement. So, I'm not going to ask you to predict the outcome, but from 30,000 feet, how do you think the Fed's policies since the start of the pandemic have impacted the markets? And maybe more broadly, since the financial crisis in '09?
ERIK NORLAND: Well, thank you so much for agreeing to do this. It's just a tremendous pleasure to talk with you, Harley, especially given your incredibly long experience in the real trenches of options trading. Yeah, I think the Federal Reserve has a bigger impact on options markets than many people realize.
I think that when people think of options, they often think of it in terms of volatility spiking in response to short-term price changes, or kind of drifting downwards as markets calm down. But I think central bank liquidity plays a really key role in all of this.
And in particular, since March, since the COVID crisis kind of got to its acute phase in the financial sense, the central banks, including the Federal Reserve, but also its peers around the world, the ECB, the Bank of Japan, Bank of England, et cetera, they have really tried to keep a lid on market volatility. But I think they've been more successful in some areas than others.
They have gotten volatility on short-term interest rates, obviously, to come down to exceedingly low levels. You see that in futures, on the euro dollar. You see it a five-year government bond futures as well. You even see it as far up as 10 years. And you also see it in the currency markets too.
The currency markets were very disjointed for a while in March, when there was a sort of incipient dollar funding crisis. The central banks got together and provided massive swap lines, really kind of clamped down on that volatility. So, when you look at the major exchange rates, the implied volatilities are now mostly down to where they were pre-pandemic.
Where they have had less success, however, are things in areas that they have less control over, so, very long-term interest rates. For example, you look at 30-year US treasuries, applied volatilities are obviously way down from their peak levels in March. But they're significantly above where they were trading, say, 12 months ago, pre-pandemic.
You also mentioned the VIX earlier on. If you look at the options on the NASDAQ, the S&P, or the Russell 2000, they're also obviously way off their highs, but there's trading at significantly higher volatilities than they were, say 12 months ago, or especially two, or three, four years ago.
And you also see that, lastly, in gold and silver. I think that the central bank's creation of liquidity, the Federal Reserve doing $3 trillion of QE in a three-month period of time, between March and May, that sent the NASDAQ flying. It sent gold and silver flying. Silver went up 155% between March and August. Gold went up 40%. The NASDAQ, as we know, had a huge rally.
It kind of petered out in early September. And I think that made options traders really nervous. I think that option traders looked at these movements, and kind of thought to themselves, OK, this could either go a lot further to the upside, in which case, maybe call options need to be more expensive. Or it can all snap back and go the other way, which makes put options also, I think, really expensive on those kinds of assets.
HARLEY BASSMAN: It occurs to me, and I hadn't really thought about this too much before, but I don't want to get into the weeds out of the gate here, but I will. Do you think the impact, the repression of volatility, which is certainly plan B or plan A of what the Fed wants to do-- it is part of their policy to reduce volatility, for lots of reasons-- but do you think the primary driver is taking rates down and compressing the curve? Or is the greater impact the selection of securities they use?
So, buying mortgage securities, which have an embedded optionality, by buying those, they reduce, they compress the optionality component, which is in the market, by buying credit securities or other things like that. Because a credit bond's nothing more than a treasury and a default swap. So, by buying those-- which is more important, the level of rate, the shape of the curve, or the securities selection of what they're doing to create the oppression?
ERIK NORLAND: Yeah, I think it all matters. I think that, in a sense, the Federal Reserve has a pretty easy time repressing volatility at the short end of the interest rate curve. Not only through setting interest rates at zero, but also due to their forward guidance. They can simply tell the market that we're not going to raise interest rates any time soon.
The Federal Reserve has essentially signalled to the market that they're very unlikely to raise interest rates any time in the next, say, two or three years, maybe even longer. And I think the market kind of understands this in a deeper way now than they did, say, at the end of the global financial crisis.
At the end of the global financial crisis in 2009, the Fed tried to communicate that, but the markets weren't as willing to believe it then as they are today. But when the Fed put rates at zero, or close to zero, anyway, in December 2008, they left them there for seven years. And so, this time, I think the market remembers that experience. And it says to itself, the Federal Reserve really can just put interest rates down there, and just leave them there for like half a decade or more.
And so, I think that really helps to clamp down on that volatility. Because you rightly point out, the Federal Reserve isn't just setting interest rates at zero. They're also doing QE. Some of that involved buying treasuries. The Federal Reserve has never explicitly said that they're doing yield curve control. They've kind of avoided that language. But nevertheless, buying large quantities of 5's, 10's, even 30-year bonds, does put a cap on where those bond yields can go to on the upside. And I think does help to suppress the volatility.
And then lastly, i think maybe the most interesting point is the Federal Reserve buying mortgages, but also buying corporate bond ETFs, which as you rightly point out have these options embedded in them. And so, when the Federal Reserve goes in there and starts purchasing these bonds, it's almost like they're buying options off the market, or actually writing insurance to the market, if you will.
And by doing that, they really have helped to keep corporate bond spreads very, very narrow. If you look, for example, at Credit Suisse or Barclays indices of spreads versus US treasuries for corporate bonds, those went from about 4% or 5% over treasuries, all the way up to a peak of maybe 10% over treasuries. T And now, they're trading at 3.67 over treasuries.
So, the Federal Reserve has completely suppressed credit risk-- or not credit risk, I should say, but credit spreads, rather. Credit risk is still there, but they've kind of repressed the pricing of credit risk, if you will, in those markets. And I think that that's very much a product of that aspect of their QE, where they're not just buying treasuries, they're also buying mortgages. And they also did some corporate bond ETFs.
HARLEY BASSMAN: Let's put your talents as an economist and as a market valuation person to test over here. Once upon a time-- actually, I would argue still, the best predictor of a recession is the yield curve. And every time it happens-- I remember before this, in '08 and in 2000, each time the curve flattened, everyone said, it's different this time. And, of course, it's never different this time.
And once again, we had a yield curve flatten and invert before this. And we had the recession, but it was COVID that I suppose drove it. Is that actually the case that it was a COVID that pushed us into recession? Or even without COVID, would the signal from the yield curve been correct?
ERIK NORLAND: That's a great question. That's one I think about for a long time. And so, you're right, the yield curve did invert. It inverted actually quite a long time ago. It started to invert really around the end of 2018. And it kind of stayed very flat or slightly inverted for much of 2019. So, to my mind, at the time it was signaling a coming economic downturn.
I spend a lot of time studying yield curves. And I'm fascinated with them, because they're not only a good predictor for the United States, but I looked at-- I can't remember exactly how many, I think 20 or 26 different currencies around the world. And they correlate positively to economic growth across every single currency to varying degrees. Some of them are not so good, like they're not such a great indicator.
And the Japanese yen, which is an interesting point, but generally speaking, if you look at even countries like Brazil, Colombia, Mexico, South Africa, Russia, China, they correlate quite accurately variations in the pace of economic growth. And so, I think we were heading for a pretty steep slowdown. And between 2018 and 2019, the economy slowed from a 3% to a 2% growth rate. I think we were probably heading towards a very, very slow pace of growth in 2020 or 2021. In part, because I think the Fed in 2018 and 2019 over tightened.
Now, that's not to say that the economic downturn that we had this year was primarily because of that tightening. And I think it was unquestionably primarily because of the lockdowns related to COVID, which was a sort of massive external shock, almost like-- almost like a meteorite striking the planet. And so, that produced, I think, a much deeper economic downturn than we ever would have had based on the yield curve alone.
But what I think is kind of a little disconcerting with the yield curve right now, not just in the US, but in many countries, is that it's not very steep. If you look back to past economic recoveries, if you look back to, say, 1992, or to 2003, for example, or to 2009 and 2010, the yield curve was really steep. Back then, you would have maybe 400 to 500 basis points difference between three months and 30 year.
Now, that difference is like 150 basis points or 160 basis points, generously. And so, the yield curve is pointing to potentially a very soft economic recovery. And I'll just make one last point on this, which is the yield curve's not alone in pointing this out.
There's also futures on dividends. Which I know is sort of an arcane thing. They were launched about six years, ago at the end of 20-- beginning of 2015. And there's dividend index futures also. So that the market thinks the dividends in nominal terms will be the same or lower in 2030 than they are today. So, it's not just the yield curve. It's also the dividends forward curve that suggests that the market believes implicitly that we're in for some very soft economic growth.
HARLEY BASSMAN: Well, I'm going to push back on that, because I have written about that topic extensively. And you do see-- you still see an upward slope in the US and in the Nikkei which is also listed futures. But in Europe, one of the reasons you have a downward slope has to do with the creation of structured notes. And the fact that Wall Street dealers who create them, they can't take-- they can't hold risk anymore. So, they have to offload that risk, because of Dodd-Frank and everything else.
And that, I think, has put a lot of pressure on the downside of dividends in Europe, which has created some very interesting trading opportunities. But certainly, the shape of the vol structure, the dividend structure right now is not optimistic in a lot of places, where it has been in the past.
Circling back to this yield curve, do you think that-- we did have the inversion in late '18, early '19. And the standard prediction is 17-19 months from the inversion to the recession. And we got the recession in March. So, it's almost like within weeks of what it was supposed to be.
When we look at this thing 10 years from now, are we can have a Roger Maris asterisk put by this recession? Or are we going to say, you know what, something happened, and it worked?
ERIK NORLAND: Yeah, that's a great question. Truthfully, I don't the answer. I guess if you just put it into a naive computer model, and you don't have any sort of dummy variables for the COVID experience, it's going to look like it worked. And you know what, it's got a lot of evidence behind it, because it's been working for decades, and decades, and decades.
And you're right, it's-- I have spent a lot of time studying this. And the number I come up with is also 17 months on average, as the leading indicator. Now, 17 months might be slightly spurious degree of precision. You might say a year and a half, but it's about right. And so, it tends to get positively correlated about after six months, but weekly, and then very strongly correlated one to two years in the future.
And I think it's always going to be an asterisk. Because unfortunately, in economics you can't do controlled experiments. And so, I think we'll just have to be content to really never know the answers to what would have happened had COVID not struck.
But it strikes me that the Federal Reserve, even though they realized something was amiss, that's why they cut rates three times in 2019, even by March, or February-March 2020, their policy was still pretty tight. So, I think that they were getting a little behind the curve before COVID suddenly caused them to catch up with that curve and lower rates to zero in a real hurry.
HARLEY BASSMAN: Well, I'm going to-- for the record, I'm going to go give the curve full credit for this. It counts. The five year, five-year forward rate dipped below the Fed funds rate before COVID, which is also a very good signal of a recession.
And people are always asking me, like especially-- when vols get very, very low, which they did prior, they always say what's the surprise going to be? And, of course, the answer is, I don't know. If I knew, it wouldn't be a surprise. There's always a surprise that happens. It happens regularly. The Fed's going to do something.
And I guess the surprise was COVID. But then, I'm not sure it's fair to go and say-- they don't get credit for that, because the surprise. We're looking at-- are we having yield curve control right now? I think, yes, but not explicit, but out there.
Let's assume we are. How is-- would yield curve control right now, as executed in some manner, fashion, or form-- and we might hear more details about it in a few hours-- how might that be different than the yield curve control that occurred post-war, in the '50s?
ERIK NORLAND: Well, yeah, I think that the yield curve control in the 1940s was very interesting. I guess it started towards the end of our involvement in the Second World War. And the idea was that the Federal government's debt had ballooned from, I don't know, maybe 30% of GDP going into the war, up to 110%. There's just tremendous amount of debt.
The Federal government had to figure out how to finance it. And keeping a cap on long-term government bonds was part of the way in which they could do that. But getting out of yield curve control proved not to be so easy. Because once you put it in place, then if you suddenly stop it, you could see a huge upward move in long-term interest rates, which could be potentially disruptive for an economic recovery, maybe, or maybe beneficial to the recovery too. It's hard to say.
But this time around, I think the Federal Reserve, so far, has done it pretty subtly. They've, so far, and you're right, maybe in a few hours this will change, but so far, they haven't really said they're doing anything explicit. And they have been allowing the 30-year and 10-year yields to drift up slightly. I think we have 10 years up to 0.9. The 30-year is getting close to 1.7% yields.
But my fear for the Fed is they're getting themselves into a bit of a trap. I think by suppressing long-term interest rates and doing all this QE, including up to the long end of the curve, they sent the equity markets soaring to these incredible record highs, where it's price earnings ratio, other kind of valuation metrics are at quite high levels.
And so, I think in order-- if they were to suddenly stop buying long-term bonds and see those bond yields spiking higher, eventually people may start switching out of equities into bonds, in which case you could see a substantial sell off in some of these risk assets. Which in turn has the potential to damage confidence from consumers and from businesses, and to maybe derail the recovery. So, I think the Federal Reserve's gotten itself into a little bit of the trap now, where it's started to do this, but now it doesn't really know how to stop.
HARLEY BASSMAN: Is QE, in general, yield curve control, more specifically, is that good public policy?
ERIK NORLAND: It's really hard to say. My-- I've tried to analyze QE and its impact on economic growth across pretty much every economy that's tried it. And so, starting in 2009, we had the first QEs from the European Central Bank, the Bank of England, and the Federal Reserve, as well as a much larger and