JACK FARLEY: Today, Raoul interviews James Aitken, a macro insider known for his analysis of FX markets. James talks to Raoul about the different choke points he's seeing in the dollar funding markets and how these strains are affecting the bond market worldwide. You see, forex and bonds, they could seem like entirely different baskets, but they're actually intertwined in extremely interesting and important ways. Today, Raoul and James go over that relationship in great detail. They really give you a masterclass of the interplay between currency risk and credit risk. It's a great conversation. It's a long conversation, and I think that you're going to enjoy it.
RAOUL PAL: James, good to get you on. I really, really wanted to chat to you because you and I have known each other for quite a long time now and your understanding of the complexities of the juxtaposition between macro, politics and the plumbing is unparalleled. You're very well known as the insider's insider. I just thought with so much going on, you are the person who really wants to reach out to, just to get really an understanding of what is really going on, and where do we think this is all going and just to get your personal opinions on some of this.
JAMES AITKEN: It was very good to see you all, boy, and thank you very much for having me on. I'm very grateful to you and your subscribers for their time. Before we get into markets, Raoul, I just like to give as our American friends would say, the most enormous shout out to anybody and everybody who's been affected by COVID-19. Our thoughts go out to families who may have loved ones in hospital or have lost loved ones, and thoughts of course, go out to all the heroes on the front line, medicine working in ICUs nonstop.
Also, our thoughts, of course, go out to individuals who are trying to keep their family portfolios on an even keel, and of course, all those small businessmen and businesswomen who're imagining what the next six to nine months or 12 months looks like for their business. It's a very humbling time for us all, isn't it? I think that was a very generous introduction. I appreciate it, I'm just [indiscernible] who's deserved.
RAOUL PAL: Give people a bit of background about yourself as well, just so they can catch up.
JAMES AITKEN: No, I won't take the subscribers through a whole lamentable sell side career. I should be grateful for that. Things got pretty interesting for me in 2002, when I started working for a company called AIG, and I was in the trading arm of that and then it got taken over by Joe Cassano in AIG Financial Products. One might say that for the four years after that, I had a front row seat at the circus, and I thought I knew a tiny bit about economics and markets and then I became an employee of AIG Financial Products and I realized there was a whole financial universe out there about which I knew absolutely nothing.
The irony, perhaps tragedy of AIG Financial Products is that while it was obviously opaque to the rest of the world, internally, it was transparent. I was able to walk 10 feet maybe 15 feet across the dealing room and Curzon Street in Mayfair, which you obviously know so well that building, and ask people what are you doing with this subprime CDO? What are you insuring? Talk to me about collateral balance sheets and everything else, and I managed to stay out of trouble there for a period of time, left to join UBS in August 2006, work with some fantastic people there, Raoul, and some of whom you know.
UBS, I'll be ever grateful to them, let me loose on their client base and policymakers around the world. I was sitting on a foreign exchange sales pit, but basically doing everything and that was a very interesting time because from August 2006 onwards, I was trying to say to people, here's this thing called subprime. Here's what happens if house prices flatline, level and go down, here's structured credit, here's what's under the plumbing of the financial system. If A, B and C happen, we're in for a torrid time. Then through 2007 and 2008, I got to work with some fascinating people. I got to work with all sorts of institutional investors around the world. I was very, very lucky firstly, to have a job during that period when many of our friends were being laid off, and work with these people but also help people not lose money, which was critical, and help some people who you and I know well make a fortune.
On the back of all of that, my client said in early 2009, you don't need a bank. Go work for yourself, we'll back you. As you may recall, back in '04, working for yourself is one of the most terrifying things you do, but happily 11 and a half years on with the backing of some fantastically loyal clients around the world, I'm still here, still plugging away and, Raoul, just to finish, I'm still trying to be less wrong.
RAOUL PAL: That's all we try and do. Talk me through the situation we're in now from your top down perspective, and just we'll dig in as we go just to see what comes out that's interesting.
JAMES AITKEN: Yeah, let's think about the highest level, we have a double supply shock. We have the obvious disruption, which let's not forget has barely begun and COVID-19 combined with this oil dispute, which we'll get into our shim later, between food and Prince MBS. We also have on top of that, a nascent demand shock because everyone's going into hibernation and hunkering down and not spending or consuming. The last thing you want to throw on top of all of that is a financial crisis, hence the extraordinary actions that central banks are taking all around the world to prevent the financial system crumbling upon itself.
Just to be clear, double supply shock. Obviously, the economic jolt from COVID-19 combined with the oil fight, throttle on the other side of that and nascent demand shock as we all hunker down. The number one priority of central bankers everywhere is to ensure that the financial system as best they can determine, remains on an even keel and does not crumble on itself.
RAOUL PAL: Now, talking to the financial system, clearly a lot of what they're doing, there's an alphabet soup of stuff of which nobody understands. It feels like they're papering over a load of cracks. They're trying to get the system working. Because I've never seen the Treasury market really fail as much as it did. It got itself in quite a bit of a mess. What do you think the current problems are and how are they addressing them?
JAMES AITKEN: It's like LTCM meets October in '97 inside 48 hours, that's what it looked like in the Treasury market. At the most basic level, you cannot hope to have a functioning financial system if there are no functioning risk free curves for people to price assets or hedge assets. That's why last September, if we go one step back, was so important. People went on and on about the repo conniption, and about Fed reserves and all these kinds of things, which was broadly correct, but not specifically correct.
The events of last September were a tremendous wake-up call for anyone doing RV fixed income, because we almost lost the bond market. Let's think about a very simple example to help subscribers think about what actually happened in March in the Treasury market. Now, we won't go into the precise reasons but for most of the past five years, Raoul, there's been a very nice little basis trade available to RV fixed income managers. You'd go long Treasury cash bonds, and you sell the equivalent number of futures against them, it's a positive carry trade, or at least was, let's say, for simplicity around seven basis points.
You would lever that to the hill and that requires obviously a lot of Treasury repo to be available to go long the bond, and it also requires a lot of liquidity in Treasury futures. Most of all, it assumes that your cost of financing is predictable and stable, which of course for about 48 hours last September, it was not, and we narrowly avoided last September, a very substantial nasty unwinding of all sorts of Treasury basis positions, and we live to fight another day.
Fast forward to March, who would have imagined that the Fed cutting 50 basis points out of the blue, their first cut would have been the event that derailed all these relative value positions in the Treasury market because without getting too technical, if JC repo rates or let's just say repo rates are sticky, and the Fed cuts out of the blue by 50 basis points, then obviously, overnight index swaps and other short term measures of dollar borrowing come down a lot.
That, ironically, is what blew up a lot of these RV fixed income trades that spilled over into the Treasury market just to finish the point, at a time when, let's just call him a principled man, was trying to unwind his risk imparity position, or risk disparity, and it all just fed on itself, throw a sprinkling of foreign reserves sellers of treasuries, and is it any wonder that constrained primary dealers and others found it very, very difficult to price and distribute liquidity around the world's ultimate risk free curve, which promulgated the most astonishing intervention from the Fed, which is ongoing?
You recall many years ago, we all would have been blown away by the Fed buying 60 to 80 billion of treasuries a month. Well, they've been doing 50 billion to 80 billion a day, and it's barely keeping the bond market on an even keel. Look, what do we have? This basic, let's not forget, Raoul, this applies to so many things we've seen over the past two months. It's not just Treasury basis trades. It's not just credit, we went into this exogenous shock with everything priced for perfection. We'd had 10 years of leverage upon leverage, roll down carry, short volatility, illiquidity and duration all boxed up on itself, we came into 2020 and all of these heroes were saying cash is trash at precisely the wrong moment.
Of course, you cannot vote to unwind 10 years of cumulative risk and leverage and everything else in about two months but suffice to say, we have removed an enormous layer of excess over the past couple of months and the very best news for the financial system is thanks to these extraordinary central bank actions, we once again have a basically functioning financial system and we have basically functioning risk free curves and the Treasury curve, but I very much doubt any central bank's going to be able to step out of this for a long time to come.
RAOUL PAL: Part of the issue here is that the free market regulation of the Treasury market switched from banks to private counterparties, who don't get direct access to Fed liquidity, and therefore, there's a link in the chain which is what blew up essentially was their access to the same price capital as the banks would get.
JAMES AITKEN: Yes, that's one way of thinking about it for sure. There were a number of smaller broker dealers that emerged over the past several years who did nothing but repo. Obviously, it's been a difficult time for those fellows, and I feel sorry for them. I would say at best, those folks were marginal players and marginal providers of liquidity. A lot of the repo provision was still via the primary dealers, and we've all looked at the data or examined the data on JP Morgan and to a lesser degree, Wells Fargo and we can see who had the biggest reserve deposits at the New York Fed so we can imagine who the top players were.
I just say, Raoul, that it was still pretty much the banks we know, the famous household names that were providing repo liquidity, but I suspect your question is thinking through the chain or following the money trail. It's one thing for JP Morgan's broker dealer to finance Treasury positions and provide financing to their hedge fund customers and others. It's another thing altogether to downstream dollar repo liquidity around the world or through Japanese banks, and I'm taking a couple of steps ahead here but bear with me.
When I think about dollar liquidity choke points in the system and where things get stuck, and where repos sometimes doesn't work or gets congested, I think first and foremost of the Japanese banks. I think if I remember correctly, you've written a bit or talked a bit about Japanese banks, and how important dollar liquidity is to both sides of their balance sheets. If I think about the past month, critical thing was ensuring that the Japanese financial system more so than any other financial system had an adequate stock of dollar financing, whether it be secured or unsecured to tie their financial system over. To me, I'm spending a lot of time looking at Japanese banks and thinking about their ability to upstream and downstream dollars around the world.
RAOUL PAL: We've talked a bit about the Fed here, what about-- and again, we'll get into that fiscal stuff in due course, but talk me through what the other central banks, the BOJ, the ECB, the PBOC, who's doing what here, and what effects is that having? Then I want to come back and talk to you a little bit about why bond yields aren't lower yet.
JAMES AITKEN: Good points. Let's start with the relatively easy one, the PBOC compared to their global peers has done nothing. It's remarkable. Here's this event that is going to be disruptive for some time to come, which you'd think in the context of the shock to the Chinese economy, the People's Bank of China would be doing something like they did in '08 or '16, and related to which you'd expect that the CCP would be stimulating as, on the extent, same extent that they did in '08 and '16. It hasn't had.
It's odd, and maybe there's some constraints there and to be clear, I don't mean the balance sheet constraints. I don't mean dollar borrowings by Chinese corporations, although we can get into that. I'm thinking more of the political narrative that Xi Jinping has created since 2017, which is this obsession, this persistent obsession with a deleveraging campaign to try to make the Chinese financial system fit for purpose, that still seems to be the dominant theme, which is remarkable.
The PBOC is a bit of a mystery to me. I don't think they're boxed in by the renminbi or the dollar borrowing by Chinese corporates, but I am surprised they're not doing a heck of a lot more. We know they're going to stimulate, but it seems quite limited and very gradual. Moving across the Sea of Japan, the Bank of Japan's all in every which way, because they have to be. They have to be.
RAOUL PAL: They just keep going.
JAMES AITKEN: Yeah, they have to, and I think my rule of thumb is that they will be buying every Japanese ETF at least until the Nikkei has regained 20,000, and that could require an awful lot of effort. The JGB market-- I think we've had this chat before. It's to call JGB's a market to give markets everywhere a bad name, the JGB market is just two numbers on screen but they're completely meaningless. They're fair play to the Bank of Japan because they are very savvy when it comes to monitoring the liquidity of their banks.
You may recall in 2016 that there was some pretty nasty spill overs of the QQE, as they call it, the Bank of Japan was doing, and you got some pretty nasty tightness in the dollar funding markets which caused some strains for Japanese banks. A former Deputy Governor of the Bank of Japan called Micaso, created a unique facility that enabled the Japanese banks not to tap the Fed of course, because that's always been there but, Raoul, to use their JGBs to pledge against dollar funding from the Bank of Japan.
The reason I flagged that, I know it sounds a bit complicated is the Japanese authorities have ample ability to liquefy their financial system in dollars and yen, but they would be hopeful that the problem goes away. The executive summary of Bank of Japan is muddle through, more of the same and things seem to be improving for them.
RAOUL PAL: Why does the TOPIX bank index looks like shit then? It basically looks like the European banks. I get what you're saying, but I just look at the chart, it says something's not right still.
JAMES AITKEN: Here's an example of what's not right. Over the past several years, the People's Bank of China and other lenders of dollars have taken advantage of the dislocation in the infamous yen/dollar cross currency basis. As we know, for most of the past several years, there has been a premium for dollars and if I have surplus dollars, I lend them via the yen/dollar cross currency basis. I lend them to, for example to Mizuho. I convert it into yen. I buy a Japanese T-bill, which gives me a synthetic US T-bill with a yield pickup.
That trade's been going on for years. The People's Bank of China and others supply the dollars to the Japanese banks. Let's stick with Mizuho. Mizuho turns around and re-lends those dollars or reinvest them in guess what? US credit. Five or six years ago, the Treasury teams of Japanese banks would re-lend those dollars into investment grade credit, or hang on, let's take more risk. Let's extend duration. Let's end up in high yield. Let's add some currency overlay on top of that, say Brazilian real just to spice things out. Job's done.
What happens if the People's Bank of China withdraws the dollars that they've lent Mizuho. Well, that whole daisy chain unwinds and for the past couple of years, if you look at the chart of Mizuho and overlay US high yield spreads at an index level, it's the same thing. It's the same thing, and I think that makes perfect sense. I ponder, Raoul, if the Japanese banks would appear to be adequately funded, I'm not worried about that. Unfortunately, they have taken a lot of their dollars, it would seem and invested in some very risky stuff at the wrong point of the cycle, and they have been punished for that.
RAOUL PAL: Particularly, if we start to see some downgrades of these BBBs, and if they're in the junk bond sector, there is-- I think we could say, a trillion dollars of BBBs get downgraded and the junk bond sector's a trillion dollars, even if my numbers are wrong by 50%, it's still impossible for the junk bond market to trade that.
JAMES AITKEN: There will be patches of indigestion I would imagine.
RAOUL PAL: The ECB, so we've already seen obviously Australia and New Zealand now QE. ECB, that's the big unknown because there seems to be this is where we start to move into the world of juxtaposition between politics, fiscal, monetary. Talk me through what you're thinking about that and then I want to come back to bond yields again, as we said.
JAMES AITKEN: Sure, sure. Raoul, the ECB, if we thought July 2012 was whatever it takes, this is whatever it takes hued, and to think