France & AI's Debt Boom: When Do Bond Buyers Push Back? | Matt King (Satori Insights) #23

Neither governments, nor hyperscalers, so the big borrowers in fixed income, are yield sensitive for now, or sufficiently yield sensitive for now. All of the underlying problems are to some extent being masked by the strong performance of equity markets and the tightness of credit spreads and some of the AI exuberance, and there is a decent case that that is overdone, and if some of that starts on winding then that just feeds back into still more pressure on the sovereign. This cycle will not be broken until the bomber kid shows his boss. Welcome to another episode of Fixing Floating. On this show we usually stain the weeds of credit, but the rates sell off in the US and the turmoil in French OATs have made macro hard to ignore for anybody running a portfolio. I usually ask guests to bring a couple of slides, not everybody at hers, but today's guests told me he thinks in slides so we won't be short of material. Matt King was a credit strategist at JPMorgan and then ran Credit Strategy at City. Today he runs the Tory Insights. Matt, welcome to the show. Thank you very much for having me. French 5 years CDS are about 80 Bips and OATs are at their widest to boon since 2011. Yet European credit spreads are still near their tights. Which market? Matt, what do you say is wrong? Not sure. There are lots of conflicting factors here. I'm not sure either is wrong, but at a minimum there's an underlying tension here. So the first thing is that credit spreads in general are driven by corporate leverage most of the time and corporate profits in particular are strong at the moment and that helps to justify for the vast majority of the market tight levels of spreads. Likewise, even in a macro sense, credit risk has moved a little bit away from corporates and towards sovereigns and that is why France is responding to nasty deficits and so. The issue though, as always in credit, is that there's a discontinuity. There's a sort of pivot point where even the corporates decide I thought you were safe, you're not safe, you're influenced by the sovereign too. And we're not quite there yet. In general, you reached that point earlier for banks than you do for non-financials but it's one of the things we learned in 2011 to 12 that eventually you get to it kind of across the board and maybe we'll go more into detail on that later. I think you also got a really good slide if you come back to the slides where it clearly shows that credit is expensive if you compare it to to the last 20 years or so. On the same end, we do see rate wall spiking as well. How do you think about that conundrum rate wall taking over where the credit spreads are super tight? Again, it's sort of the same thing. It's sort of this discontinuity that comes a point where it dominates but that point is where it ceases to just be concerned about rates and it starts being a concern about sovereigns inability to pay and sovereigns likely impact changing regulations or changing tax rates for corporates in a way that turns it into a corporate issue. And we're not quite at that point yet. We're becoming more and more worried about the sovereigns but we're just not there and maybe you can see it also with things like the VIX. So just as credit spreads are tight so the VIX is relatively low and the ratio of the rate wall relative to equity wall again is really quite elevated that there is a point where that will change but we're just not there yet. Even for France, never mind in places like the US that I'm also very worried about and where argued there's a lot less in the price. So you would say that the credit spreads are currently more derivative of the VIX than they are of the move. That's a whole separate. So yes, although actually you're touching on a whole separate thing where equity investors love to say no no it's the credit market that's much more rational and credit investors are always looking for the nice tool that says no the equity market is more liquid and maybe the VIX is a good indicator. There's a whole separate story there which we can go into if you want but but yes of the two credit is clearly much closer to the VIX than it is to the move. For many years I would argue that spreads were distorted and not reflecting relatively poor corporate fundamentals and credit and corporate leveraging up. You can't say that at the moment because corporate profits are just so high for the majority of the credit universe you really have to get down into trouble so you need to private entities and private credit and some of the sub segments before there's a genuine concern there. Firstly I'd say credit has been following its fundamentals and more so than previously inequities maybe you'd make more of a case that there's been too much exuberance. So you would say that credit is down to the the single B spectrum where it should be in terms of spread levels just if you think about where corporate profits are and what equity markets are signaling. Yes I mean if that's a little bit too benign there's a whole backstory here where for years credit spreads followed corporate leverage and then around about 2012 they diverged from corporate leverage but but yes now whether it's fundamental indicators or even things like central bank liquidity indicators. Credit to my mind looks less out of line with where it should be tight those those spreads are then equities are ex equities have displayed more exuberance and maybe the issue for both of them comes back to this this issue that the real concerns that are out there there are some credit concerns and mostly around the hyperscalers and the weight of issuance but in general the real concerns that are out there are sovereign and macro and politics. And there is a point where all of those come to dominate corporate credit concerns but we're not quite there yet and it's that that gives rise to this underlying tension of gosh my spreads are really tight but I still have this macro world where I'm where I'm worried about everything. Yeah I think down to 2008 the consumer was running really really hot and then essentially governments have been taking over now to a degree where they are on the bring some claim of of insolvency I wouldn't go that far how has this shift occurred from the consumer the corporate down to the government. So I sort of like to joke that I've spent all my career looking at bubbles not through choice but I kind of have to migrate to wherever the concern is and it's shifted steadily and it's usually where the big credit expansion is and so back in 2000 it was. Dot com and it was corporates and there were reasonably small amounts of debt and then in 07 it was cibs and then in 08 it was the broker dealers and I ended up doing lots of work on things like repo. And then over the last decade it's moved towards central banks it's moved towards the sovereign debt crisis but increasingly you see just as we moved from corporate debt to mortgages in 2007 2008 so likewise now it's governments where the massive debt amounts of borrowing are it's governments where the debt levels. To GDP are really elevated versus history it's governments where we worry about reaching a tipping point and that risk spilling over and was just a little bit alarming about it is that at each stage the quantity of debt that we're talking about gets bigger one reason 2000 and dot com was so well contained is because the amount of corporate debt was relatively small in the grand scheme of things households and mortgages it's a much bigger number governments if you get to it we are the hint of that in 2011 2012. They take everything out with them and would hopefully we don't get to that but historically it's concerning. What would you say is the key driver of government debt growth. Clearly there are a number of things to do with aging populations and what have you and the need genuine need to step in and act as a circuit breaker in 2008 for fear of. If we don't have defaults feeding on themselves however over time I think you can come up with an argument that we've kind of become addicted to government rescues and central bank rescues and each time as the quantity of debt gets bigger so the so if anything you can make an argument especially for the central banks the gap between there being a problem and then the rescue coming has got steadily shorter each time so I remember all the way back to. LTCM and it took five weeks between before they were really coming up with lots of easing and aggressively good as you injection and then when it was Lehman in 2008 was about three weeks until we started getting things like the top and then with guilt not so long ago it was about five days and then with SVB was just a weekend before they were immediately coming up with a bank rescue package and I don't think you know SVB in particular yes you can make a case that say. Deposit flight is easier now and therefore they were right to step in but it still wasn't was obviously systemic as say the the sovereigns would be and I think you also see this more broadly it's kind of it's young cause joke about well we all know what to do it's just that we have no idea how we're going to get reelected once we've done it and so likewise I do despair a little bit today with so many steps I mean terrorists sort of the most obvious one but where things that risk being counterproductive. to product. from a long-term debt sustainability and ultimately economic welfare perspective, nobody's got the guts to do them. And instead, you do, you just manage the short-term crisis we've seen in the UK with the government repeatedly trying to help people and being at the end of the moment that you saw it in France as well with the efforts to raise the retirement age. The moment you try and do the right thing for the long-term, some special interest group cries, that they've been wronged, and then the government's end up backtracking. And unfortunately, what that sort of suggests is that this cycle will not be broken until the bond market shows who's boss, and it's the bond market who's boss unless it ends in revolution and devolved and run away inflation. I think you have mentioned in another interview that usually you look at what drives price or what are the underlying drivers. It seems that liquidity and central bank liquidity, which has been the primary driver of returns in the past, is not the main driver anymore. What has replaced central bank liquidity or general liquidity as the main driver for returns? Exuberance, especially in equities, and did buying a momentum chasing, and especially when it comes to the US, I've just written a piece about this. It's actually a little bit circular, but it's basically repo and financial leverage, but let me go a bit more slowly through some of the moving parts. It's funny, you say it used to be the markets were driven by central bank liquidity. Now, I think markets used to be driven by interest rates and fundamentals, and private sector borrowing, and you and me deciding whether or not to borrow and build a new factory and hire people based on the level of interest rates, because that was when interest rates had a large impact. And then what sort of happened is round about 2012, yes, all my favorite fundamental relationships broke down. Interest rates themselves didn't seem to be doing much, and what we got used to, from 2012 through until about 24 or so, was liquidity, not driven by 11 of rates, but driven by central banks, and I look at this in terms of the numbers. You can literally show that the changes in money creation or credit creation used to be driven organically, and then increasingly just quantitatively were driven by central banks and reserves going up and down in different jurisdictions over an extended period. Fiscal was some of it too, but it was the central bank liquidity that just overwhelmingly explained, especially credit spreads, but even things like equities for a long time. Since 2024, yes, this has changed, most obviously for equities to a much lesser extent for high yield and barely at all for investment grade. And what you see in this more recent period is basically, even as the central banks have finally been draining liquidity, and there are a number of technicalities there, equities have carried on making new highs. The story is to say, "Oh, that's just about the AI, and it's just about the profit's explosion," and that does come into it, but I think that there's another story which shows up. I like to say I look at two things. I look at how much money is being created, or how much credit is being created, and where the money is then going, and everything breaks down between the two of them. To say that at the moment, especially in the US, and to some extent more broadly, it's not the amounts of credit creation which are extraordinary by historical standards. Even if we add in governments, and especially if we exclude governments, the hyperscale is a starting to borrow a lot, but they're just starting. Instead, what's extraordinary is the inflows to credit funds, to equity funds, equity funds in particular via ETFs. The exuberance or willingness to take risk is just off the charts, and in particular what's been a bit alarming is the way that everyone has been educated to buy dips, and educated that the central bank will step in if necessary, and it's in the US in particular that all of that shows up most strongly. Would you say, or put differently, where's the money then coming from if it's flowing into equities or into funds in general? If we're not careful, I need a different set of slides because we get deep into the weeds, which actually I like doing, of money creation, and you start doing these asset liability tables and things. But generally I would say, where money creation is always a bit like, or the process of borrowing is a little bit like magic, it's closer to being self-funded than people imagine, because as somebody borrows you add assets and liabilities to the system, and while there is confidence and credibility, everything goes up including asset values with it, but if you run it in reverse, then everything goes down. So at the moment, and I think that credit creation process is much more important than people recognize, the at the moment that credit creation process has been happening overwhelmingly from the fiscal side, especially in the US, there is beginning to be a smaller contribution from things like bank loans and from corporate borrowing. But in general, I'd still say the pace of corporate borrowing has been reasonably muted, it's been the fiscal side, it doesn't create deposits, but it's flowed very directly into the massive expansion of US money market fund assets, and then I've just written about this, but two or three things then happen. There's been an unusual willingness of US investors to rotate away from cash and into risk, especially in the form of equity fund inflows, be the money market funds have helped fund the US deficit directly, but then see this whole thing with the basis trade and the huge expansion of repo and out to $7 trillion of repo is more than doubled since 2022. And that in turn ends up, it's almost as if the US deficit has been self-funding, and that process is starting to fray around the edges, but it's some of the caricature is, it's kind of as though, especially in the US for several years now, it's just been, it's as though the government gives you a tax cut, and then you all agree that you're going to put your tax cut into the equity market, and the equity market goes up, so there's a positive wealth effect, and it's all great. Yeah, every credit expansion looks great while it's going on, and there's an underlying vulnerability that's building up there. You just mentioned the basis trade. Is there a basis trade that important in a grand scheme of things, so is it just a big wolf, but it's not really that frightening. It's a complex, more broadly, there is a surprising degree of local stability, but there are signs that risk has been pushed into the tails, so actually it's, the numbers are terrifyingly large, but at the same time they've mostly been sort of countercyclical and self-regulating. The main risk that they point to is a liquidity shock more than a credit shock, and while it has echoes of 2008, basically everything is much better collateralized these days, and there are better monitoring of counterparty exposures, and a lot is migrated to central clearing. At the same time, the sheer scale of the numbers points to a risk and the growth of the hedge funds, and the fact that banks have access to the SRF in the US, but the non-banks do not, does create this risk of simultaneous liquidity pressure, bond sell off, and at the point where you start getting an associated equity sell off, there is scope for some of that to ripple through into the economy. Again, it's a little bit, I wouldn't say it's 2008-like, especially, but it is kind of 1998-like, and in that sense, you know, the 1998 sort of the classic example, the liquidity and the other relative value trades, eventually came good if you could hold onto them, but that's no good if you get forced out of them when the liquidity shock hits. And I think that's the broader relevance here, too, as well. What do you say that the growth of hedge funds, and especially assets on a management there, pushed those players more into doing all ever more tied relationship? Well, let's say in the past, you did a trade for, let's say, ten bips, and then you went down to five bips, and now you're doing it for two. You know what I mean? And the leverage the way down went higher if static relationships do widen, you have the higher risk of systematic breakdown. I don't think I would overstate that, and I would probably be more concerned about the correlation across strategies and the potential for herding than about the risk in and of itself. So what I mean by that is, I'd want to run away and run more numbers in order to ensure that this is the right diagnosis, but generally, I'd sort of say the opposite. So in credit, yes, we always have. Let me backtrack somewhat. When leverage started at banks, started being restricted by the regulators post 2008, I used to say, be a bit careful here, it's clearly too much leverage can create its own problems after all we had 2008. But at the same time, it was actually Kevin Walsh at the time, who made the point about the recipe for liquidity in a market is diverse, myriad investors trading in an uncorrelated way. And in this respect, I always felt that leveraged trading had the ability to create actually a relatively stable market in a way, even things like CDS markets, people would rely on mean reversion and credit versus equity. and Bonville CCDS, there was lots of trading back then and some of it used leverage, but often it was actually locally quite stable because we weren't all doing the same thing and, indeed, I was used to say credit was the asset class, where it was difficult to make a lot of money, but you could make a small amount of money very consistently and that was really advantageous. And the trouble with all of the leverage constraints, as I saw it, is that investors didn't just say, "Oh, I'm constrained or leverage or can't hit my return targets," they said, "I know. I've got a good idea. We'll go down in quality. I'll buy tier one, I'll buy other off-bench mark assets, and gradually we shifted more into possibly less levied initially, but more correlated, reaching for yield and down in quality and momentum chasing and dip-vying. And you see some of that in the equity market today with the best performing factors have not actually been the ones associated with tech. It's just been the stupid ones that buy whatever it is that's been going up, and that's been your best strategy. And again, that sort of pushes risk into the tails because there's a point where funding gets squeezed and therefore you had a problem. In general, for the obvious things like the basis trade, I am a bit alarmed at the size, but they have not demonstrated what you described as it's become less attractive to do the basis trade, so the volume has shrunk, and it's been, and even in equity financing, which is where some of the risk has been shifted, their two markets sell off, and actually the size of that trade has diminished. So there's still a vulnerability to a funding shop, but I think it's a bit more a function of the correlation of the bets that people are making than it is of just the size of the thing." That makes sense. If you turn away from from funding markets and go more into what's going on in Europe and especially in France, would you say that if you look at OIT boon spreads, is this the right thing to look at? Is this the new thermometer? All these things, there are, and I actually had somebody else ask me about this before and runs on banks and how do I build a sovereign or a macro systemic risk monitor. You always want a number of different indicators, and each of them have pros and each of them have cons, and some of them are fundamental and some of them are technical and nothing is ever perfect. Traditionally, I would always have argued that you should actually look at spreads to swaps rather than spreads to gubbies because the government swap spread was certainly in corporate space because the government swap spread was its own form of credit. Likewise, within the eurozone, there's an argument whether you're looking at CDS, sovereign CDS, or whether you're looking at at spreads to buons, or whether you're looking at outright yields. All of them end up being relevant for different things. All of them ultimately are probably moving in a nasty direction at the moment, similarly measures a term premium and so on, and yet the most important thing is probably not actually anyone quantitative indicator, and it's the more subtle indicators to do with credibility and self-reinforcing runs and politicians being held to account or failing to be held to account, which are what we would want to capture. Would you say that the impact from energy markets did put French policymakers into a weak spot, so they came from, let's say, an disadvantaged position, and now they find themselves with this budget mass and also this high budget deficit, so it's a very hard position to get out of it. But if, let's say, they returned to credibility or to seriousness, and at the same time, energy markets cooled down at some point, everything resolved back to normal. I wish. I think the problem at the moment is that voters have no appetite for seriousness, and any attempt at seriousness causes the incumbent to be thrown out. And voters likewise are tempted by easy solutions, and sooner or later they're going to learn they can't have that, especially because the easy solutions make the longer term arithmetic worse. So yes, undoubtedly Iran and all prices have made everything worse, and yes, whether it's France or the UK for that matter, governments that have kind of consistently hoped on growth bailing them out are suddenly finding that they're in a tight spot and needing to pay attention to the bond market. At the same time, actually for France in particular, I'm not sure you can really make that accusation. I would argue that the Macron government has, or the various Macron prime ministers and governments, have sort of tried to do the right thing with modest pension reforms and so on, and instead, and basically have had to backtrack because they've run into such severe opposition as they're doing a little bit at the moment with the schools. There is a broader problem in France in particular that it hasn't come close to running a surplus in decades, and therefore, again, you kind of question, maybe that's why the population has come to think that they can get away with it, but at the same time, I certainly don't think you can blame it just on oil prices. Can we already think about a kind of end game, or how would you think about the way forward? I am hoping that this is a play in multiple parts, and I'm kind of hoping that I may no longer be alive when we eventually, if there is an end game, a history mostly tells you worrying things on this front. I think though we can conceivably sort of speculate about what's in the next act, and the problem as I see it at the moment is that neither governments nor hyperscalers, so the big borrowers in fixed income are yield sensitive for now, or sufficiently yield sensitive for now. That is happening at the same time as the buyers are increasingly price sensitive. The pension funds and the insurers and the central banks for that matter that used to constitute a large part of the demand have been replaced. In France's case, it's by foreigners holding more than half the debt, and in the US it's a little bit more complicated, but the new buyers have a choice, and as a result they demand a higher yield, and that tension then compounds with things like rising interest payments to the point where eventually the government does become price sensitive, but it needs to get to the point where you remember the prior crisis, which in the UK we kind of do with Liz Trasse, Italy kind of does every retail investor knows about lost bread. In France we haven't reached that point yet, and actually one of the differences between French and Italian debt is the strength of the retail bid in Italy, and maybe that's one way in which France could eventually come out of this, but it still feels like we get more pressure first. In addition, all of the underlying problems are to some extent being masked by the strong performance of equity markets, and the tightness of credit spreads and some of the AI exuberance, and there is a decent case that that is overdone, and if some of that starts on winding, then that just feeds back into more pressure on the sovereign. If you're looking for more credit related content, check out fixandfloating.com, and now back to the show. You have mentioned that there are pretty much no yield-insensitive bias as we get in the past. One very large buy in the past was Japan, right? How much of this yield pick-up across the globe has to do with Japanese investors selling foreign bonds? So one conversation I had was somebody telling me that Japan was selling some of their US holdings, but then stepped away and started to turn towards French government debt and started selling those instead. So how would you characterize the role of Japan? I would not want to overstate that story. It is one of the moving parts, and it's difficult just to quantify these things because it becomes about the marginal buyer and the price sensitivity of the buyer, and not just the total scale of the buying. But while yes, Japan has been a large buyer of actually French debt in particular, but also US Treasuries and agencies. A, everyone always worries about this, and actually a lot of what the Japanese do is not physical selling. It's just reinvesting elsewhere. And B, you just look at the numbers, and we're talking tens of billions, we're not talking hundreds of billions, it's just not big enough to tip the scales plausibly even allowing for the price sensitivity argument. I think you could probably make a stronger case that the rise in JGB yields predates the rise in French yields and in US yields, and the rise in term premium in Japan, albeit from very low levels, again, predates the rise in term premium elsewhere. And in that sense, the drawing attention to the problem and creating a backdrop where people begin to worry about sort of repatriation. That becomes more relevant and takes on an outsized importance. but the actual scale of the foreign bid from Japan and then moving home, I think there are other larger moving parts than just that. So you would say that real rates rising in Japan and as a consequence, real rates rising across the globe and then after that, the second guessing of investors had actually a bigger impact than the actual selling. Yes, and I wouldn't blame the real yield rise just on Japan. Clearly there are other factors like the hyperscalers desire to borrow which are super important there too, but yes, the actual flows themselves, they're just not big enough. I like to joke that I know I'm old because for the vast majority of my career, a few hundred billion was a lot of money. And these days you don't even get out of bed unless we're talking trillions and the deficits are in trillions and the hyperscaler borrowing is in trillions and the repo is in trillions and the Japanese flows, especially the active selling and active buyer, that's tens of billions at most. Unless we put it in yen. [LAUGHS] That makes sense. How would you attribute, because you're just talking about real rates, how would you attribute this very significant rise in real rates? The bullish version people like to tell is don't worry, it's just growth. I don't think that's right. There's an element of that, but that's not right. Traditionally, actually, with sharp rises in real rates, that's bad for credit and it's bad for equities, especially when it happens rapidly. Growth does feed into it, but I don't think it's just that. The relationships I find most persuasive over the long term are ones where the change in technically natural rates or neutral rates, kind of a smooth real rate, are associated with changes in the private sector's desire to borrow. And for me, over multiple decades from 1980, through until the mid-2000s, what we saw was a drop in the private sector's desire to borrow, what everybody wanted to be was Apple. It was designed in California, but somebody else does the dirty business of making it. Somebody else needs the financing, and usually it was China. And that was what the equity market rewarded. What has changed, and that was what led to these drops in natural rates across the board. What's changing now is not only governments, suddenly designing that they need to be borrowing more for infrastructure and defense and everything else, but also simultaneously, the hyperscalers and others dependent on them, wanting the bricks and water, wanting to diversify away from China and start doing onshoreing or at least have multiple, and consciousness of choke points and supply chains. And that has transformed the private sector's desire to borrow. That, for me, is the overwhelmingly important factor. What is also beginning to creep in is a rise in term premium. As far as I can see, that rise in term premium has not been nearly as much, especially in the US, as would be warranted. We are still, despite the large rise, we're still significantly below where term premium were in the 1990s, and the fiscal situation is massively worse than it was in the 1990s. If you go back to France for a second and just think about what happened during the last time we had a kind of sovereign debt crisis, back in the days banks were trading much wider than sovereigns. In this case, sovereigns are even trading through the banks. Your banks have perceived much more safe. What would you say is the main attribution? And would you say, at a later act as we have defined before, banks could trade at some point wider than the sovereign again? The rule, my former colleague Hans Lorenz, did a lovely piece on this back in 2011, 2012. The, again, it's about the discontinuity. The most of what you see is a change in the correlation. So it's not that corporates can't trade through the sovereign. It's not that banks can't trade through the sovereign. That's generally harder. But even then, if the bank is sufficiently internationally diversified, there are times when they trade through the sovereign. However, at low sovereign CDS spread levels, certainly below 120 basis points was the trigger at the time. The corporates were able to trade off their own fundamentals, especially in Iowa, but even in investment grade. The trigger that you see at around 120 basis points is that the suddenly the corporate, and especially the bank, becomes more correlated with the sovereign CDS, because banks in particular are just too vulnerable to through their government bond holdings or to deposit flight out of the country, as we saw in 2011. And it's that that makes it, which makes them a correlated, but also be harder for them to trade tight to the sovereign than is the case for the corporate. Corporates in some respect look like a safe haven, but what we saw there too is at some point, they get dragged up in it as well. And you're beginning to see a little bit of that already with French equities underperforming. It hasn't quite affected the bonds yet. And again, that's because we haven't reached the traditional point where you get this kink in the curve, probably at around 120 basis points or so of sovereign CDS rather than 80. You just mentioned this continuity, where everything is fine until it isn't. I mean, with banks, it makes a lot of sense, where, as you said, deposit flight and also sovereign bond holdings on the balance sheet. What's the driver for corporate? Is it that gross as suddenly slowing down or what is the key driver for corporate than aggressively selling off at some point? I'd almost say that scope for discontinuities isn't that the defining feature of credit itself as an asset class? It's all about confidence. You're fine when you've got confidence and then suddenly you're not when the confidence isn't there and people try and quantify it, but it's always hard. I also like to, I remember with my northern rock deposits that I had back in 2008, I was there looking at the CDS widening and saying, oh, but it's an online account. It's all going to be okay. I was fine the night before. And then the morning after I could still log in, but actually it just sort of you type in your password and then it froze and it's like, oh, God, this is what a modern day background looks like. Anyhow, for corporates for non-financials, it's a bit different, but the vulnerability is still there and your growth is a little bit of it and it's the first place that they get caught up. But it's mostly, it gets more extreme. When sovereigns get into difficulty, they do change taxes. They do change laws. They do resort to sudden nationalizations and it's those sorts of, as we might get with tennis water in the UK and it's not just about there, but it's not just about the corporates being in difficulty. It's the sovereign getting into difficulty and say, I need to clutch everything. We get the most extreme, but unfortunately, still relevant example is wars. No, sorry, we need to appropriate all of your assets for the war effort. And as part of that, I'm seizing your factories and I'm not giving any compensation to either equity holders or bondholders. - That was very well put. Any chance we're gonna see something like that towards the end of the decade in France. But do you think that's all still very, very further out? - I hope we don't get war, either in France, more or more broadly on any time scale. And mostly I would anticipate more scares with the bond market, but there are several things that are, rather than outright cataclysm, but there are several things that are concerning. One of these is obviously the direction of the politics and the tendency towards populism and the tendency towards blaming migrants or facile solutions and not dealing with the real underlying problems like pension ages, for example, in France's case. Another, and again, that mostly points to, at some point you have a scare and then eventually a government is brought back into line. Likewise, people need to realize that the ECB can't come to the defense of a country just because it's following the wrong policies and the bond market is rightly punishing it. The schemes are not set up to do that. And you'd need a very, very large, if anything, it would rescue everybody else, rather than the country that was pursuing irresponsible policies. However, a, I mean, wars are always difficult to predict, but also one of my favorite frameworks for coping with this slightly dystopian period is the one that Ray Dalio uses based on hundreds or thousands of years of history. And the way I'd summarize it is, he just kind of looks at the numbers and he says, look, your warning signs historically speaking of capital controls and defaults and runaway inflation and wars and things are number one, high levels of debt, big tick, number two, high levels of inequality, big tick, number three, high levels of polarization politically, very big tick, and number four, the decline of the all-great power and the rise of a new great power. And that's what we've got at the moment. And France is neither of those, but is kind of squeezed in the middle as Trump, but it's more pressure on Europe, including through Russia. And that just interacts with all the quantitative vulnerabilities to do with having a high debt load. What is debt or leverage? It's a sensitivity to asset prices. And the risk is that that interaction develops in a nasty environment. direction. So I hope it doesn't come to all of that. But as we elect ever more extreme governments, and as the debt numbers become more extreme, you can see it in France. We're made not sure. It's oh, maybe we should just have the, you know, convert to zero coupon petrol. So you could possibly come object to that. And no, that's how runs start. When you suddenly find that your central bank has no capital, we touched upon yield insensitive sellers of debt now quite a bit. One type hyper scaler, so we haven't touched upon. It seems that they are extremely insensitive to overall yield levels, but also the spread level. It seems that the projects they are financing are still very attractive in a return on investment perspective. What are you of use in turn of this type of seller of debt? I think you just put it extremely well. I think the biggest moving part is not the credit side, but the equity side in the expectation of future profits. And I guess it's like the classic. And as such, you kind of expect the spreads to continue widening it to put pressure on until the equity market cracks. And we're not there yet. This is visible in the classic way that credit investors and equity investors like to think about leverage. The equity investors say, oh, it's the debt to equity ratio. Look, look, it looks absolutely fine because I've got these elevated equity valuations. So I can take on more and more debt, both on balance sheet and increasing the off balance sheet in terms of commitments and so on, which start dwarfing the on balance sheet numbers. And as a result, that process of sort of broader money creation or credit creation helps drive up the equity valuations and make everything appear okay. But we see the free cash flow going to zero and negative. We get more and more alarmed about it on the credit side. And eventually it comes to the point where the equity market takes notice. And when that happens, of course, suddenly you look at all of the debt that was issued and you realize it's not as sustainable as you thought previously. And the slight frustration is clearly if we try and look at debt to EBITAR and we try and look at debt to free cash flow in order to get our heads around this. But especially when you have lots of off balance sheet commitments and it's dependent on a highly uncertain and amazing new technology, it gets difficult to do that accurately. And yet as we're there at any bubble, if you say I don't want anything to do with it, I'm sitting on the sidelines, you've just gone to performing. Maybe there's more of a problem for the equity investors than it is for us in credit. But I still think that's the way that all of these cycles tend to work. Yeah, really good observation. But even then, I mean, if you think about let's say hyperscalers stop issuing and you have bought a lot of long and let's say Google or a matter, you're going to outperform, right? Because real rates just going to go down a spread is going to come in because everybody's just assuming that spread's going to widen or there's more issues coming. So not necessarily. But I think you touched upon another very important point that we are just looking at this moving target, right? Nobody knows how much, how much issuance is going to come over the next couple of years. Do you have a fewer mental model? How you think about the expected borrowing of the hyperscalers or everything AI related? The problem is it's different from the mental model we would have used in the past precisely because the technology and the equity moves are so transformational. Traditionally, corporate borrowing is sensitive to spreads and yields. It's, I mean, to some extent, it depends on economic prospects. But when spreads get wide enough and yields go up enough, corporates rein in their issuance. What's different about the hyperscalers is that, as you say, as the spreads and the yields have gone up, they haven't cared and they've, if anything, been not been shy of issuing even a discount to secondary. At the moment, the concern is greater in CDS than it is in cash bonds, but that just kind of points to more issuance putting more pressure on. In terms of magnitudes, it depends on who you ask. Consensus is like trillion dollars of further issuance by 2028, but then if you look at a Pock AI, then you start coming up with two trillion dollar type numbers. And I think the easiest way to think about it is, you know, even as, of course, as they're simultaneously saying, well, humanity might not exist with the, you know, in 2030. And so the easiest way to think about it is just that the likelihood is that the weight of enormous issuance in what Silicon Valley perceives as a winner takes all environment is going to continue until something breaks. And there's something breaking is likely to be the confidence on the equity market side, and, and we're getting closer to that point, but we're still not quite there yet. And most likely, it will be some combination of equity factors, the combination from China, the fact that already the models are amazingly powerful, but I'm not sure I need your new and latest model, unless I'm really working in cybersecurity or defense to do everything I need to. And or maybe it's just economic prospects when finally we move from AI doing amazing things to hang on if it's doing such amazing things, I'm not sure I need my workforce anymore. I do think we get to some of those, at which point we say, oh my god, goodness, I've got way too much debt. It's a little bit like the dot-com phenomenon in that, in that respect. But we're just not there yet. And, and, but the real difference, as I say, is they're not displaying the cyclicality, precisely because that's the other way of thinking about it. It's that in a normally speaking, it's lower quality credits getting into trouble, whether it's in mortgages in 2008 or whatever, that puts pressure on the on the cycle. Part of what's what allows credit to prolong cycles, but especially at the moment is when the main sources of borrowing are actually quite high quality credits, the sovereign or Google, that's when you say, okay, I shut down a little bit of the pressure to the rest of the market through shareweight officials, but it prolongs everything. And we're just not there yet. And that's in turn, and it's partly why their sensitivity is so different from what we're used to. Would you also say that sensitivity between equity and credit is less pronounced? I mean, usually, if you think about a credit which is decently levied, you would assume that, let's say, if equity is going down, you have a certain delta where credit is selling off, right? But in the case of the hyperscalers, leverage is at a so low level. So you would need to level them up to quite aggressive degree until this credit equity relationship starts really to bite. You know, what's your opinion there? And that just sounds to me that, as you said before, we are just not there. We need much more issuance or much more debt incurrence until we reach a certain point. So basically, yes, this is where I would invoke the debt equity clock or the credit clock that I used to make more use of when it was fundamentals that were more obviously driving markets. And usually you can think in terms of companies going through regular phases of leveraging and de-leveraging. And initially, it's got kind of organic growth with profits growing faster than debt. And then, at some point, as the profit growth naturally slows, then they resort to things like sharebibex and M&A to keep everything going until the bubble bursts. And that's what we saw in '97 to 2000. And that's what we saw to a lesser extent in cycles thereafter. But then just recently, it's all kind of changed, whether it's the central banks intervening through enormous amounts of liquidity, or whether it's the sovereign's dominating the corporates, or whether it's just now with the enormous scale of the hyperscaler profits or the tech sector profits, free cash flow has disappeared. The profits themselves haven't disappeared. And yes, conventionally, you'd say it's just as though we're still at a really early stage of the cycle. And there are signs that've been doing things like cutting the sharebibex in order to keep some semblance of control. But yes, it's normally you would expect a significant, to be able to push things significantly further and even have a complete decorrelation between credit spreads and equities as we have between 1997 and 2000, where the spread's widened out. And the equity market carried on rallying even as you were leveraging up your balance sheet. And it's only when eventually the equity market realized that that's unsustainable, that then you get the bubble bursting and credit and equity selling off together. So maybe you could say that the hyperscalers are a bit closer to six o'clock, insofar as we're starting to see, but mostly you look at the correlations, I was running some debt equity charts earlier today. And mostly they're actually moving, they're still moving broadly moving together. It's just then more an issue of the names like Call Weave or others, which are having much more aggressive financial policies. Everything ends up being interconnected. It is certainly names like Call Weave that are at the cutting line. But at the same time, Just as the equity guys rightly say, "Oh, there isn't an equity bubble based on PEs. If there is one, it's in earnings." Yes, but those earnings themselves sort of somewhat circular, or even as the earnings have broadened out beyond the tech sector to the rest of the market, that's because of the extraordinary amounts of spending from the hyperscalers and the building of the data centers and everything that have caused other segments of the economy to do well and generated these earnings. And so there's lots of stuff that, that's my, for me, the way I summarise everything, is the risk hasn't disappeared, it's been pushed into the tails. And it's sort of, it feels, it's a bit like in credit that we've abandoned the Covenant, so nothing defaults. But at the same time, when we get the defaults, the recovery rates are really low. It's kind of the same thing, call we've was a bit more exposed, but actually the factors driving the cycle as a whole that could take all we've down, but would cause a significant widening and lots of other things as well. And they're all quite extreme, even if they can get more extreme still. Is it fair to say that, let's say, the default probability is still quite low, but if defaults come, the recovery rates are just very low. It's that how you think about it in broad terms, as you say, risk is getting pushed into the tails. Yes, although if anything, I almost think that it understates it. So we've seen that to date with individual corporate defaults, it's sorted, some of it follows, especially for things like software companies where, where the value of the company is no longer in the bricks and mortar, but in the employees and they can leave. And especially when you then have additional sources of financing bit, but when the default is postponed, eventually when you get to it, the recovery rates end up being low. But again, in a sense, I think that's too positive. I think you need to look at adjusted measures of defaults taking into account the LMEs as some of the rating agencies are increasingly doing. And those LMEs, even when they are supposedly voluntary, often those involved significant losses of value for credit investors already now, I did a presentation a year or so ago, pointing to the deterioration in upgrade, downgrade ratios for high yield relative to investment grade. And I suspect what it actually is, is it's private equity owned companies. It used to be that when the company had lots of debt, you could guarantee that they were going to try and come back to investment grade and know now, the moment there's an improvement in profits, it's, oh, we're going to do the dividend recap. And if we over-done it, then we're going to do the LMEs and move the assets somewhere else or whatever the mechanism is. So I think, in a sense, that understates it, but it is symptomatic of this pushing risk into the tails. And to some extent, that is where I do come back to things like the central bank liquidity. We often think in terms of a sort of cliff between things priced at power and then things priced at recovery. And what you get in an environment of abundant liquidity, which we had for a decade or more, investors were forced to buy things against the better judgment of the analyst who said it's expensive. We mustn't do it. And the portfolio manager said, I've had another inflow. I've got to put the money somewhere. What that gives you is stuff that should have been defaulting priced at power. And then when you do get the default, yeah, the cliff is all the steeper. But isn't it still the case if we spare our tripleses? It seems that everything is super tied, whereas tripleses trade massively wider. It seems that the case, whereas you have this part of the market where everything is pricing more or less towards recovery, but in the rest of the market, people really need to put money to work. Yes to a point. So when we look at the publicly quoted numbers, as far as the data are available, as far as I can see, while there is this enormous cliff with tripleses, it's not just a cliff, as was the case historically in spreads, where spreads are clearly mispriced, it's that there is a parallel cliff in fundamentals at about the triple sea level. You go down and double B profits are really good too, and single B profits are really good too. And yes, at some point you start to worry about the adjusted EBITDA or whatever it is. But in general, for the liquid names, it's that equity problem, it's if there's a bubble, it's a bubble in earnings and not just in markets being distorted. The caveat around that is, is the adjusted EBITDA, is especially the private markets where it gets difficult to analyze all of this stuff, where the incentives are overwhelmingly to do the refinancings, to keep everything going, to the continuation vehicle, if necessary, and there you see investors gradually getting more nervous and the requests for outflows from some of the private credit vehicles and the BDCs and so on. And yet there too, whereas it might have been systemic and say caused a run in the past, I don't see that happening now, because there's actually quite a good protection there, which is that these funds have put up gates, and you can't get your money out, and therefore that could get to the point where you put your money out of the liquid fund because you can't pull it out of the illiquid fund, but we're not there yet. And so that allows those problems to be worked through, but it does leave you with the lingering feeling as this really marked correctly, and most likely it isn't, but we may not discover that until earnings themselves take a broader hit. But would you say that even if the earnings side is taking a dive, is this directly translating into issues in private credit, as I'm just assuming that the relationship between Borough and London is very tightly knit, and nobody is really interested in, you know, the truth coming out, just if I may say so, and everybody's more interested in just continuing to lend and just continuing to show that everything is going right. And otherwise it's very tough for me to understand if triple C-spreads are so wide and a certain sub-segment of private credit should mirror pretty closely what's going on in public credit. Why isn't, you know, like they are more restructuring activity as there is in public credit? From part I think it's because you can't pull your money. The moment that everything gets re-financed, well we've postponed the problem for another three years or whatever it is, we've agreed to waive the covenant that there was if there even was one in the first place, oh no default, which in turn prevents things broadening. That said, even I have a separate chart where, in the past, private equity stock prices and BDCs and software in particular on the equity side have been highly correlated. It's kind of interesting at the moment, even as software equities are rallying back again, actually BDCs are under pressure, actually private equity stock prices are under pressure, and although the outflows have slowed down or the requests for outflows have slowed down, it's not really obvious that those have gone away. And I think that maybe there's a parallel here with the whole sort of equity market narrowing, it may at re-broaden them, we may keep things going for a while, but gradually investors are realizing that on one asset after another, the amazing returns that they were hoping for were not risk-free, came with a risk that had been pushed into the tails, and you're just getting this slight fraying of, oh we're not getting the returns that we thought, and that is troubling given the other elements of the macro backdrop. It's just really hard to say when or if they actually blow up. You say this should end when a rotation turns to exit, and so far inflows have proven remarkably sticky. What would you need to see to change your mind? Outflows, that's easy. The traditionally, the level of rates does several things. It affects the fundamentals, but it also affects where investors choose to rotate their money. And the whole reason or part of the reason that you reduce rates sharply when there's a crisis is to encourage investors out of cash and into taking risk, and one of the ways that tightening works is investors pull their money from risk assets, and so it's one thing to be piling into credit and equities when you can make zero on your bank account, but it's quite another when you can get four or five percent on your bank account or in your money market fund. What's remarkable in this cycle is that rates and real rates have risen to the point where historically, people would have said, actually, it's at this level of spreads, and at this level of equity valuations or macro uncertainty, I'm just not sure I want to to the same extent. And well, I think we're starting to get elements of that in credit as the, but even then it's not been that strong with the weaker returns on how you'll this year and with the duration impact, but mostly we haven't seen it, and especially in equities we haven't seen it. There's a little bit of a dip the last few weeks, but mostly that looks as though it might be recent. stabilizing and just rotating again. I think there's partly because people have learnt to buy the dips, but it's those outflows feeding on themselves, as people say, actually, and then making the fundamentals worse, and then making people say, actually, cash is all more attracted given that. That's what's been missing this time round, and the higher rates go, the greater is the likelihood we get to that point, but we're just not there. So you're saying that years in general would need to rise even further to attract money out of credit and out of equities. Do you have a third in target, or when do you think that could happen? I heard this term, DGen, people have been so degenerate that they, just as you said, keep buying the dip and don't really care about what fundamentals are underlying drivers. Or do you think that these DGens are so strong and other market behavior have just altered market behavior to such a degree that it's just very tough to lead eventually to outflows and market crackdown? I didn't know the term DGen before. Tim B. I'm good, coined it. I heard it in the interview, yeah. The versions I prefer and that I have used over a very long period are the ball and the ball. No, gently, and it comes back, no, just a bit harder, and it falls out. Or the brick on a piece of elastic, you pull and pull and pull and pull and nothing happens, and then suddenly it comes and hits you in the face. And that, I think, is my, in a sense, my greatest concern about, yes, the dip buying the momentum chasing environment that central banks have created since 2012 through repeated rescues and through, continuing adding liquidity even when markets were fairly valued, it's that now they need to push harder. Now they are more constrained than coming to the rescue because of the pressure of inflation. And even though to date it hasn't really bitten, on most of my metrics, that sort of correction looks overdue. And if it, and that in turn just creates the need for them to do more later with the risk that it bites, harder when we get to it. It's amazing how few weeks we have had without flows from especially equities and then to a lesser extent bond funds. Just over even the last decade occasion, you get them and then they restabilize. And that shouldn't be happening normally, normally, especially at these interest rates, you should have more outflows. And then that creates a nice natural slow pressure. - There makes total difference. How can investors express a trade or do you have a certain tendency how people can position themselves at the moment? - This is a whole topic in his own right. A lot depends on your own individual situation. Mostly, I think you're looking for sources of cheap convexity. I mean, you kind of always look at the sources of cheap convexity. It's difficult because, frankly, one of the other things that distresses me about the macro environment is responsible investors everywhere are going out of business. They're the ones who've been punished. If you've been looking at the macro environment and kind of worrying about things, you've had to perform versus the guy that just closed his eyes and not only went into the S&P, but bought whatever had been going up the most. It's the momentum chasing that's been rewarded and, literally, I see this in my client base, they're either moving from traditional active investing towards some negative or passive in private and they're just squeezed and value investing in particular became deeply unfashionable. So, in that sense, it's hard to just kind of put on your tail-risk edges and you do need to do the clever trade positioning for our term premium. What you do need to be in credit versus equities, probably short credit versus equities is maybe one way to do it, but that's not really a hedge. Or you do need to look for the thing that would move more in response to the sovereign widening and there are ways that you can sometimes do that using options or using cash allocations or using assets like gold, which have historically provided a degree of protection, but it's kind of difficult precisely because it's the discontinuity and especially if, like most professional investors, you're not only trying to protect against the downturn, you're also trying not to underperform against the continued upturn where the assets get pulled from you because you were too responsible and you didn't just close your eyes and take on lots of risk. - If listeners want to be responsible and up their research, where can people find you? - I'm at cetoriancites.com. I'm on Bloomberg and you can ping me on IB anytime you like. I'm occasionally on LinkedIn as well. - Matt, thank you so much for coming at a show that was a really great conversation. I enjoyed it a lot. And also thanks to everybody for listening to Fix and Floating. If you enjoyed this episode, please subscribe and follow us and see you next time.