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Treasury Bond Strategist Translates The Repo Market Insanity – Rebel Capitalist Show Ep. 23!

Rebel Capitalist Show

George Goncalves 

George Goncalves is a bond strategist with more than 20 years of experience in the subject, and who is capable of translating the last week's repo insanity.

March 12th, 2020 was one of the most volatile days of the U.S. stock market.

The Fed committed to $1.5 trillion in repo market operations, and people have been speaking about a treasury market disruption.

George, in this interview, helps us connect all the points and talks about the repo market, the differences between the two treasury bonds there are, the liquidity problem, the Fed's tools, and the possible consequences to their actions.

George Gammon: All right guys, it gives me a great deal of pleasure to bring someone to The Rebel Capitalist Show that I just saw an epic thread of his yesterday on Twitter regarding everything that's going on in the repo market with collateral, the bonds.

He's a bond strategist. He's been in this business for 20 years, his name is George Goncalves, and he's right here, right now on short notice.

So George, thanks for being on The Rebel Capitalist Show.

George Goncalves: Great to be here, George.

George Goncalves story and experience as a bond strategist

George Gammon: All right. So just quickly for my viewers who might not know your background, can you fill them in on your story and how much experience you have in the business?

George Goncalves: Yeah, absolutely.

So I started out the late 1990s, really at the start of this liquidity bubble that we've been living in through the last 20 years where you've seen multiple iterations of The Fed producing new programs or easing to keep interest rates going lower and lower.

Each time the tank looks like it's going to run dry, but really they always find… to pull a rabbit out of the hat.

But it started out in the late '90s on the buy side, moved over to the sell-side.

And basically I was there for about 20 years working my way up through various research departments at all the largest banks that you could name and talking to investors from US, all the way to anywhere out in Europe, through Asia.

So really a pleasure to have that experience and being able to collect a lot of knowledge across different investor types, from central banks to hedge funds to large real money, and of course, working at a bank and a dealer myself.

George Gammon: So I'm curious what your day to day looks like.

What does a bond strategist do?

George Goncalves: I think we start our day like everyone else, looking at all the key economic data.

This past week notwithstanding, which has felt like more like a year than it has felt like a week, or a month, I should say.

Everyone has their own style and techniques.

I'm more of what you would consider a macro fixed income strategist that really bottoms up understanding of the plumbing of the system, understanding how trades get executed, coming up with trade ideas yourself, and spending time communicating those views with traders as well as clients.

Really just the flip side of what an equity analyst would be or an equity strategist, it's the bond version.

The repo market

George Gammon: Got it. So going back to yesterday, and that was Thursday, March… what was that, the 12th?

What on earth happened?

From a layman… I'm just checking my Twitter feed in the morning.

Usually, I look at the repo stats that they post on the New York Fed's website, and I saw that they did about a hundred billion overnight and then they did another hundred in term repos.

But there was a lot that didn't get accepted.

So oversubscribed by, if my memory serves me right, $74 billion, something like that.

I thought, okay, well this is a big deal.

And then actually on Twitter, I said, “This just feels like the fireworks that we saw back in 2008.”

But then no more than two or three hours later, I see on my Twitter feed from guys like you that The Fed upped it to $500 billion, another term repo they were doing that day.

Then they added another $500 for this morning and another $500, and it just keeps going up and up until the end of the day, they had $1.5 trillion.

I remember seeing Steve Leaseman… And this was before it was up to 1.5, it was only at a trillion then.

I almost felt bad for the guy. I always give him a hard time on my videos, but he was sweating and he was announcing that they went up to a trillion.

It was just such a crazy event that you could see the stress in his face and you could hear it in his voice.

But what on earth happened yesterday?

George Goncalves: To be honest, if you think about the actual numbers and it starts with like sound really big, it's really trying to drive home a message.

Trying to control the narrative, to be honest, to put this idea that we're creating a firewall, we're producing as much liquidity as necessary.

But if you look at the actual stats and what we've seen in the last two-term operations, they've been fractions of what people could have taken down.

So the repo programs being larger there, if, over the course of the next couple of weeks, there's a really a pile-up of collateral on the dealer side, then they could take advantage of those larger numbers.

They don't have to oversubscribe, so to speak.

But I think that was really just optics.

The Fed is virtually buying time.

And then on top of that, they also shifted the QE with [inaudible 00:05:02] out of T-bills, which if they had not done that, considering all the money that's flowing into money markets, they would start competing with the money markets for actual collateral themselves.

The fed finally got the message, and is something I've been writing about for a while now, they had to shift out the curve.

People thought, “Well if they do that, they're going to acknowledge that they're doing QE.”

It's like, well they're doing QE anyway, so let's just make it for real, move out the curve, and don't leave such a heavy footprint in the T-bill market in the short term securities, which…

People have been either raising cash, liquidating out of equities.

Your first port of call is the money markets, and they don't have enough short term securities to buy like they used to.

So it was a smart move by the fed, but they're basically in this kind of throwing the kitchen sink at it attitude.

And look, it's starting to work in terms of clearing out some of the kinks in the treasury market.

But I think some of those preventative, some of it was just optics to say, “Look, we got this under control. We're doing a really heavy load of repo.”

I think that's not where the problems lie.

The problems will lie with credit and other markets, which we can get into if you're interested.

But the treasuries themselves are starting to also price in ways which were very atypical of how the treasury market usually operates, and that's really sacrosanct for them.

That's like the key thing for them, to keep super liquid.

The difference between the on-the-run and off-the-run treasuries

George Gammon: Are those credit spreads between the… I think you talked about that, and I actually texted you last night about that. Very fascinating.

I didn't even know that there was a difference between the two types of treasuries.

We've got the on-the-run and off the run treasuries.

I guarantee you 99% of my audience has no clue that there's actually a difference between the two.

Can you explain that a little bit further?

George Goncalves: It's almost like parallel universes, you have these two bond markets in a different dimension, but they're all coexisting.

There's a series of now six on-the-runs and soon to be seven on-the-runs when they introduce 20-year treasuries, most likely in May.

But there are these points on the curve which are the main tenors, the main maturity points on the curve, which people use to connect the dots and make a yield curve.

Those are the benchmark on-the-run securities which are issued most mostly every month and some are issued on a quarterly basis and then reopened as an old version of the new one.

These on-the-runs treasuries are where most of the trading activity gets done for hedging, for macro bets on where you think rates are heading, how the curve is going to move.

You use the on-the-runs because they're deepest, most liquid ones that are actively trading every single day.

Whereas the off-the-run securities are still treasuries.

George Gammon: They're the same maturity.

George Goncalves: They can be the same maturity, different coupons, potentially, different interest rate levels, but over time their prices will adjust for that.

But they're literally another parallel yield curve that's overlapped with these benchmark securities, and they trade around them.

It's almost like there's a solar system, the on-the-run 10-year year treasury is the sun, and then all around it's like 10 and a half and nine and a half.

Those securities that are around it are less liquid than the on-the-run.

George Gammon: All right.

So that's why all of the entities that are often in the repo market, they put a premium on the on-the-run treasuries because of that liquidity and they're just trading it back and forth with one another as opposed to something that's far more illiquid where it's just sitting on the portfolio of some 75-year-old guy in Florida.

George Goncalves: Or a pension that's multi-billion dollar pension or the Central Bank globally or a bank portfolio in New York or in Chicago.

It really doesn't matter.

Those securities are there because there's more deep value and usually offer slightly higher rates, which over time helps from a compounding standpoint.

George Gammon: For sure.

George Goncalves: They're still treasuries, we don't want to put them on a separate plane altogether, but they're not the active trading.

So when you see on TV that the 10-year treasury is moving up and down X amount of basis points, it is the on-the-run that's moving.

The off-the-run could be actually moving more.

George Gammon: Okay. Okay, I got it.

So whenever we see this on CNBC or Bloomberg, it's the on-the-run interest rate they're referring to.

George Goncalves: Yep.

George Gammon: Okay. Got it.

Generally, what's the spread between the two? Historically, is there an average?

George Goncalves: It depends because just like the yield curve will give you different yield spreads between the two-year and the 10-year, if it's a steeper curve, you have a different spread.

When the curves are very flat, the spreads compress.

So we're talking about very few basis points, a couple of basis points here or there.

But when markets are operating and functioning properly, where there's a lot of liquidity in the system, when there are relative value investors that say:

“Hey, if this thing gets out of line and it goes to four or five basis points higher than the same security but just different treatment towards it, people will come in and soup them up and try to compress that spread.”

It's like a relative value.

George Gammon: There's an arbitrage deal.

George Goncalves: There's an arbitrage deal. Exactly.

George Gammon: Okay.

So I was looking at a chart today on one of the feds websites, and it went back to 2008, when we had the issue with Bear Stearns and Lehman.

They had what I think is the spread between those two for the 10-year, and it showed that it got up to almost 60 basis points.

George Goncalves: That's right.

George Gammon: Wow. So what did that spread get up to yesterday?

Was it close to the 60?

I read one report, I think on MarketWatch, that said that it actually got up to 50, but I just… I couldn't believe that.

George Goncalves: When there are times of the duress, those spreads can gap out tremendously, because what you are basically paying for, without going into specific levels, is you're renting balance sheets.

You're renting the ability to park that security somewhere, and it's going to have to probably sit there for a longer period than the on-the-run, which you can get rid of in a heartbeat.

So when there's periods of either duress or balance sheet becomes very scarce, you're renting that balance sheet, and it comes with a more implied cost.

You see that in futures… Futures also don't have an inherent footprint on balance sheets.

They're a derivative of a treasury and those… what, it's called the basis was also widening to levels of those sorts.

So when we get to periods like this, you can see a real differentiation between treasuries on-the-runs versus off-the-runs.

It's a great thing you went back and looked at that.

The last real-time that we had something like this was during the financial crisis, where it starts to really blow out.

And The Fed then came in and of course, did QE, and now we're so used to QEs.

George Gammon: Like, we're nonchalant. Don't worry about it. Another trillion? No, no, no problem.

So with the issue that we had yesterday and the lack of liquidity that we've obviously been having since… on the short end, since September 17th and it's just blown up now…

I talk to Jeff Snyder every once in a while and I follow him on Twitter.

George Goncalves: He's great.

Is the liquidity problem a matter of cash or collateral?

George Gammon: Yeah, he's incredible.

His view on this is that it's more of a collateral issue than a cash issue.

In the video today, I went over it. Liquidity has two components to it. It's not just cash.

People see that and just get fixated on it.

But if there's no collateral in the system, it doesn't matter how many quadrillions of dollars are sitting in reserves at the fed, it's not going to get out into the repo market.

So do you have a view?

I think per your tweet thread last night, you've got a similar view to Jeff, but I don't want to put words in your mouth.

George Goncalves: I agree with a lot of concepts that Jeff has put out as well as others that have great command in this sector.

The thing that I try to do is straddle the middle, which is, it depends on who you're talking to.

For the large major banks, it probably is more of like a collateral thing.

For the smaller banks that are really more liquidity deprived, as the liquidity haves and have nots, it's more about actual access to the cash, and I think really having the ability to have those LCR ratios stay high.

So I think it's… The banking system is not one uniform entity, there are different degrees of needs, and I think that the larger banks as a collateral story.

Also, there's something that others have mentioned too, is that there's a connection back to the global dollar phenomenon.

And how… We really have a US dollar-based in the US, we have a Eurodollar which has been around for decades, and we have an Asia dollar.

Those three dollars kind of are like a Venn diagram, they overlap with each other depending on trading hours and also depending on what has been issued in overseas markets.

Sometimes there's a collateral scarcity in the dollar markets out overseas, which then forces some major shifts.

We started to see a little bit of that yesterday too.

The Eurodollar FX basis started to widen yesterday, which showed that there was a demand dollar.

Even today, the way the dollar was trading, it was looking as if there's…

Beyond the balance sheet renting part, which was one component, there is a global dimension, which is a need for dollars.

And I think that's starting to pop up today too, which is why The Fed's tools are not fully exhausted.

They're going to probably do more next week if we can get into that.

But the repo is really a domestic issue.

Of course, the foreign banks that are part of the primary dealer network can use it, but it's more for the domestic… it's more for treasuries and mortgages.

If we're going to have a problem in our fixed income markets, it's not going to be just there, it's going to eventually reverberate into credit and high yield as we're seeing with spreads.

So I think The Fed's going to do something much more creative.

George Gammon: So the real quick takeaway to summarize for the viewers so that they can follow this here.

There could be a collateral issue with maybe the bigger players, but for the smaller players in repo, it might be more of a regulation issue with the liquidity coverage ratio or maybe basil three.

I think I saw Jim Bianco texting or tweeting this morning about how he was talking to some of the banks saying that they'd love to take a piece of that trillion or 1.5 trillion that's been issued.

We didn't even talk about that, but a very small portion of what they committed to the Fed actually got used by the entities in the repo market.

So I think the first one, the first 500, only had 17 billion of demand.

Bianco was saying from the people that he's talking to, it's more of a regulatory issue.

That they'd love the money, but because of… I think it was the LCR, they just…

I'm not able to connect those dots because I'm not an insider, but that's what his point was.

So that would be step number one.

Then we're taking it to the… Well, actually do you have any… Am I getting it right there?

George Goncalves: I think you're basically getting it right.

George Gammon: Okay.

George Goncalves: Look, the larger banks are obviously really watching their LCRs, because they're actually there to uphold those regulatory requirements.

It's that the smaller players, if they take on additional repo, it starts to really alter some of their other financial ratios, so they really can't take advantage of it.

Because they have some capital, they may have to put up against it as well, and, they might also not have all the collateral either, and there might be some collateral hoarding that's happening.

There are so many different dimensions, it depends on the entity that you are.

George Gammon: Right.

George Goncalves: I think that that's why the repo tool itself… From The Fed's point of view, you can produce really large numbers.

Unless there's a piling up of treasuries and mortgages over the next couple of weeks that would even reach 500 or a trillion.

No one's going to really fully use those programs.

That's the bottom line from my point of view, which means that it was more optics, trying to say, “Hey, we got this covered.”

It was almost like an unlimited credit line has been given towards a repo function.

George Gammon: So it's more psychology than it was liquidity potentially.

George Goncalves: A hundred percent, because it's not being used as you've displayed and there's just not enough collateral to even meet that target.

It wouldn't happen.

The Federal Reserve tools

George Gammon: So you also mentioned that you think The Fed has some more tools at their disposal.

Just from an amateur like me, the only thing I see is just dropping interest rates or printing money to do quantitative easing or whatever they want to call it.

What other tools do they have at their disposal?

George Goncalves: Well, I think we can go back and hark back to the 2008 experience.

I might change some of the names that they use when they describe these tools, but they're going to basically serve the same purposes.

The first and foremost one is still the discount window, which they could just say, “Look, bring everything you want to the window and we're going to provide you cash on the other side.

We're going to really relax some of the haircuts or the constraints of what kind reduction in actual cash you get back for every single dollar of what you bring to the window.

We're just going to relax some of those constraints because we're in uncharted territory with what's happening for corporate America, small businesses.”

They did that in the 1930s.

They basically said, “Just bring it to the window and we will…”

If you have money, good entity and you have a good business model, there were actual credit departments scattered through all the regional feds which were going through and saying, “Hey, that's an actual viable company.”

That sort of activity was being done in the 1930s.

The fiscal window is a very powerful tool that they'll try to take away the stigma of using it.

George Gammon: I was just going to say that's what Jeff talked to me about quite extensively, that it's just almost a moot issue now because of that stigma.

I call it the walk of shame in my videos. But I don't know if that's your opinion on it.

George Goncalves: Well, is it relevant now when we're dealing with something that's a really random unknown?

I think people will look the other way.

If you're doing something because there's an airline industry or travel or something's happening, what's really being disrupted, they need the cash flow, it's a viable business, they'll be here in three months, but you don't want to run them out of business because there's no cash flow coming in.

I think there are ways around that, and I think that that could change. Again, that's also another optics narrative story-spinning.

So the fiscal window is one, but they can get even more specific and bring out the alphabet soup of programs, which they had, the discount window is for the banks.

But the dealers are probably going to be the places where a lot of these corporate bonds, If they start to be sold for whatever reasons, they can start ending up on the dealer's balance sheets and they could launch what is an equivalent of a discount window.

For the dealers, it was called the primary dealer credit facility, the PDCF. That might come back.

If you go back and look at the history, basically a lot of different kinds of collateral was being posted during a way that…

Pretty much almost everything was being posted.

I think even equities at some point were being posted.

So I think that is a very powerful tool, and that's still domestic and banks related.

Then there's the overseas stuff, which you can go into, which is dollar swap lines and things like that.

George Gammon: Okay.

So just so I'm clear, so let's just say the corporate bonds right now, no one wants those because they're collapsing.

They don't want to catch a falling knife.

No one in the repo market wants those as collateral.

But you're saying that The Fed in '08 or prior to that, set up a mechanism where the primary dealers could buy that collateral that no one wanted and they could pretty much do a repost swap with The Fed so that collateral goes under the Fed's balance sheet.

And The Fed doesn't have a profit and loss so they don't have to worry about how bad that collateral is.

Then the reserves just get replenished in the account for the broker-dealers.

Am I following that?

George Goncalves: That's a hundred percent. They all work the same.

All these programs, it doesn't matter what ends up happening, in the T accounting mechanism, The Fed will just absorb it.

They'll absorb and they'll deposit reserves in your account.

At some point, once things either settle down, the transaction is reversed, and then dealers are able to then either move into the warehousing business if they want to hold that paper or sell it back into the markets when things calm down.

So that's a powerful tool if we get to that point.

And then there's maybe one more before the dollar swaps, the commercial paper facility.

There was also, at one point, actual US corporations were able to issue short term credit, basically through The Fed's balance sheet.

It basically expands The Fed's balance sheet, and they were able to get source cash that way as well.

George Gammon: Okay.

So before we get into the Eurodollar stuff, before 2008, if you look at a chart of the excess reserves in the system, you're looking at less than $10 billion, 10 billion with a B.

Now you've got 1.5 trillion. I haven't looked at it lately, I'd assume it's even higher with what The Fed's been doing with their balance sheet.

But you were in this business back then. So how did the repo market get funded with less than 10 billion when it requires over 1.5 trillion in excess reserves now?

George Goncalves: Well, there was just a lot more leverage on the street.

The dealers were able to actually take on more turns of leverage and warehouse all that paper. By the way, the market was a lot smaller.

We've solved, in essence, a credit crisis from away with more debt, so now the debt is even larger.

The corporate bond market has more than doubled, the treasury market has tripled or more.

We have so much more paper now in the system that you need The Fed as like this counterbalance to keep all this liquidity flowing through the system.

The potential unintended consequences of the Federal Reserve's actions

George Gammon: Yeah, the plumbing to keep it going.

So it sounds like they've got a lot of tools, but the first thing that comes into my mind are, what are the potential unintended consequences of this?

Going back to 2008, they started quantitative easing.

Bernanke said, “Oh no problem. Don't worry about it. It's just temporary.”

It seems like everything is just temporary, whether it's the income taxes or quantitative easing, every temporary thing they do turns into something permanent.

Even back in repo September 17th. Remember “nothing to see here, it's just temporary.”

Now, all of a sudden, they're doing 1.5 trillion in repos.

You know this so much better than I do.

What are the unintended consequences that might result of them using more tools than they're already using right now?

George Goncalves: Well, the QE is the most powerful one of all of them because it's a permanent execution of adding reserves and they stay there.

Whereas these other facilities, in theory, should go back down.

You're a hundred percent right though, the repo solution that was put in place kept growing and growing from September.

Well, we're just going to start with this size. Oh, that's not large enough.

They kept getting bigger and bigger and now they've created this dependency factor in order to keep it ongoing.

This is not just The Fed's doing, by the way.

There is a lot of treasuries being produced because of our deficit financing.

So someone has to buy those securities, the dealers are obligated, and you're creating…

At moments, you need a relief valve, and that relief valve is what the repo market or repo facilities from The Fed are allowing to do.

That's one side of things.

But to all these… If we get a worst-case scenario tied back to an economy that's going into recession because of coronavirus or whatever…

It was already sliding for other macro reasons.

If we're at a point where we're going to have to even double our debt or deficits per year from 1 trillion to 2 trillion, that's just a lot of securities that someone has to buy.

So The Fed, even today's actions, if you… maybe got lost in all the shuffle in all the news, because there's been so many new announcements it's hard to keep track.

But as we started the conversation, they went 60 billion T-bills to now buying treasuries across the curve, not just T-bills.

They did 37 billion on a Friday, almost half of what they're supposed to do for the full month in one day.

George Gammon: I didn't realize that. Wow. Just to put that into context, how much was QE1, every month?

George Goncalves: Depends on the mortgage versus treasuries.

The treasury one was 30 billion per month initially, and just purely treasuries and then QE2 was 75, I think per month.

George Gammon: So they did 50% of what they were doing in official QE, they did it in just one day.

Wow. I had no idea. Where do they go for the rest of the month? Are they just tapped out?

George Goncalves: This is where it gets really interesting, and that's why I bring up these big numbers around, the deficits are a trillion and could go easily to 2 trillion in a recession.

60 billion really is a down payment.

We can easily get to 150 billion per month on the QE program, close to, what is it, 1.8 trillion per year?

It's completely doable and it's something that might happen if we're really faced with a really sharp downturn.

Largely, I believe what they're saying is true, because we discussed the price action in the on-the-runs and off-the-runs.

There has been very little activity and very widening of bid offers, so the price that people are willing to accept versus selling them and buying.

There has been market depth, or how much actual transactions are taking place have been falling all week long.

This massive rally in the rates market, that first saw rates get cut in half and then now they've doubled again in a matter of a week, has damaged the landscape in the bond market.

And has left all these off-the-runs almost like orphanage treasuries that are out there, and The Fed had to mop it up and clean them up.

George Gammon: Wow.

George Goncalves: So I think that's what they did today.

They did like a cleanup operation to take out a lot of these securities.

That was a smart thing to do, but you're right, now they've gone through almost half of their allotment for the month.

So what are they going to do for the rest of the month?

They might have to increase the QE program.

George Gammon: It just seems like there is such a big difference between doing what's “right” right now compared to what would be right for the long term.

A lot of times those are two completely different types of action.

But if they're doing even more of this quantitative easing, which based on their definition means they're keeping it on their balance sheet for an extended period of time…

But how do they unwind their balance sheet?

And if they can't unwind their balance sheet, aren't they just monetizing the debt and going to that kind of banana republic mode or?

What do you think?

George Goncalves: I'm not fully there yet on the banana republic mode.

The US is still the dominant power, we still have the largest military and we have the dollar.

Those are two powerful forces that I think people are not going to mess with us on those fronts.

The Fed is really just executing that mission and that objective.

So I think that's really… What they're doing so far now is market functioning type stuff, and that's something that is part of their mandate.

So that's something I'm not really against.

But I am much more sympathetic to the idea of laissez-faire.

Business people should figure out how much risk they should take and they should manage those risks and not always have to get bailed out.

I'm a hundred percent behind that view. But we're just too far in.

When you have the balance sheet as large as you do and you have a vested interest in this continuing to operate in this manner…

So there are 20% of GDP. Other central banks around the world are actually even larger relative to the size of their economies.

So The Fed has scope to easily… I've joked around about it, they could double their balance sheet and it would work.

It would still work. At 8 trillion, it would still work. It starts to impact the functioning of the money markets.

That's a whole other topic that we could get into.

But they can easily double their balance sheet, and the unintended consequences will be, does that money then become inert?

Does it sit in the system and just fulfill obligations for regulatory needs or does it ever get re-monetized and go back into the economy and create inflation?

George Gammon: To be very clear for the viewers who aren't totally following the conversation, The Fed can print and create as many reserves as they want.

It could print quadrillion reserves.

The reserve accounts are basically the bank accounts that the primary dealer banks have with The Fed.

In order for those reserves, that new money that's been printed, if you want to look at it that way, to get into the real economy, the primary dealer or the bank that's under The Fed's umbrella that has that reserve account has to take some sort of action.

They have to create an additional deposit in the real economy by either buying a financial asset or creating a loan that increases the money supply.

So your point is, yeah, they could take it to 20 trillion, 30 trillion.

But the big question becomes, do those reserves get from The Fed's balance sheet somehow out into the real economy in the form of new deposits?

Increasing the money supply, we get an uptick in velocity, and then you're off to the races as far as the inflation genie.

Then we got real big problems because then the 10-year is going up, and if the 10-year goes up to a certain level, that's going to severely negatively impact the economy.

But that's a whole other interview. George, and I appreciate your time.

Thank you so much for being here.

For any of my viewers who want to find out more about you, where can they go?

George Goncalves: For the moment, just at @bondstrategist, on Twitter.

I'm working on a business plan, a business model, and I'll see where I take it from there.

George Gammon: Okay, fantastic. Thank you again for your time.

I cannot wait to do it again.

George Goncalves: Appreciate it. Thanks, George.