62: How The Biggest Bull Market Could Come Crashing Down

Economic Risks

Paul Schmelzing, a PhD candidate at Harvard, outlines the potential economic risks facing the bond market. He highlights how a combination of factors, such as inflation and bank balance sheet issues, could lead to significant losses. Schmelzing warns that these elements, which previously occurred in isolation, might now converge to create a "perfect storm" in bond markets, reminiscent of past financial crises 1.

In the second half of the 1960s, bond investors who were long US treasuries back then lost close to 40% in real terms within four years.

--- Paul Schmelzing

This scenario could result in losses similar to those seen in the late 1960s, with inflation playing a critical role 1.

   

Value at Risk Models

Value at risk (VAR) models are crucial in understanding modern bond market dynamics. Paul Schmelzing explains how these models, which set volatility cushions for banks, can trigger massive sell-offs when thresholds are breached 2. He draws parallels between the current environment and Japan's early 2000s experience, where VAR models led to significant market volatility 2.

The sort of volatility associated with those kind of VAR models that suddenly dictated a massive dumping of bonds up until the middle of 2003 hurt everybody else who was not in the maturity transformation business.

--- Paul Schmelzing

This historical context provides insight into potential future market disruptions 3.