Archive for April, 2015


April 17, 2015

David Rolley Co-Portfolio Manager, Loomis Sayles Global Bond Fund

In an era of negative bond yields, it has rarely been more challenging to make money in the world’s fixed income markets. On this week’s WEALTHTRACK, veteran Portfolio Manager, David Rolley of the Loomis Sayles Global Bond fund explains how he and his team are both protecting their portfolios and seeking outsized returns in some out of the way places.

CONSUELO MACK: This week on WEALTHTRACK, Loomis Sayles Global Bond Fund Manager David Rolley is finding more valuable plays in places like India and Brazil and tells us what other international investments are music to his ears. That’s next on Consuelo Mack WEALTHTRACK.

Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack. A recent Wall Street Journal headline put it succinctly: “New Era in Bonds: Zero Yield, or Less”. For the first time ever a country, in this case Switzerland sold a 10-year bond that gives investors a yield below 0%.

That negative yield means investors who bought the bonds when they were issued will not get all of their principal back in ten years, they will actually lose money. That’s not supposed to happen when you buy a top rated government bond. It also turns the whole borrower/lender relationship on its head. Why are investors paying Switzerland to lend the country money?

It’s a question we will discuss with this week’s veteran bond manager guest.

Another phenomenon with the potential to roil the bond markets is the relationship between supply and demand. It has changed dramatically since the financial crisis and the changes are not favorable to investors. Liquidity, the ability to trade bonds easily has deteriorated.

As you can see from this chart, dealer inventories of corporate bonds have plummeted as banks and other traditional market makers have withdrawn from the market under pressure from new laws and rules put in place after the financial crisis.

But while dealers reduce their supply the size of the market has soared as more companies issue bonds and more investors buy them. The problem is without big dealers it is getting harder to buy and sell bonds quickly, particularly in size.

These are just two of the challenges facing bond investors today. This week’s guest is more than up to the task.

He is David Rolley Co-Team Leader of Loomis Sayles’ Global-Fixed Income Group and Emerging Market Debt Group. Rolley is the Co-Portfolio Manager of several funds including the Loomis Sayles Global Bond Fund since 2000, which is a Morningstar silver medalist and the Loomis Sayles Global Equity and Income Fund which is ranked four-star by Morningstar, and which he has co-managed since 2008 with bond legend Dan Fuss.

Loomis Sayles is a long-time sponsor of WEALTHTRACK but Rolley has more than earned his spurs as a global investor for over three decades.

I began the interview by asking Rolley how hard it is to find investment opportunities around the world.

DAVE ROLLEY: Well, Consuelo, the reality is it is probably as difficult today as it has ever been, and it’s difficult for a reason. Our yields are very low. This is not, you don’t need an expert to know that interest rates are low in the United States; and they’re not just low in Europe, they’re negative in Germany, negative interest rates. This is unprecedented, and this has happened for a reason, and the reason is that our markets, the bond markets, are, you might call, collateral damage in central banks’ attempts to speed up the world economy, but they’re doing it with interest rate suppression. That’s really what quantitative ease is: they’re buying a lot of bonds that drives up the price for the short term, but it drives down the interest rates, and that’s across all the yield curve, and it’s true in the United States, it’s true in Europe, it’s true in Japan, and I think it’s increasingly true even in China.

CONSUELO MACK: Central banks are that powerful? We’ve got a global market; it’s very complex. They have that much power to determine really the level of interest rates?

DAVE ROLLEY: The answer is yes, given the growth and inflation environment that they are dealing with today. That would not be the case if, let’s say it’s 1997 and you’re central bank is Argentina, Argentina facing a rising inflation rate. In that case, their power to suppress interest rates would be very limited and they would not be able to do it. But here where the growth outlook is challenged, where most economies have excess capacity, where headline inflation rates have had one handles in the United States, I think the headline CPI …

CONSUELO MACK: That’s one percent. Right.

DAVE ROLLEY: … was actually just, the all-product CPI was actually zero where it has been negative in Europe, where it has been negative in Japan. Yes, yes, in that world, you don’t have countervailing forces and they can do what they want.

CONSUELO MACK: Right. How long do you anticipate this to continue, this kind of interest rate suppression?

DAVE ROLLEY: I think the answers are going to be different in different economies and …


DAVE ROLLEY:… the market consensus, which we agree with, is that the first to extraordinary policy will be the United States because from the crisis, we have kind of done the best and we are the closest to being healed and healthy.

CONSUELO MACK: Now, so you agree with the consensus that, in fact, that Janet Yellen and the other Fed officials are going to raise interest rates sometime this year.

DAVE ROLLEY: I think our current working guess is September.



DAVE ROLLEY: And it will be driven by the data.

CONSUELO MACK: And when they do start raising rates, is it going to be a very gradual process? And what, you know, people talk about kind of the natural rate of what interest rates should be, what the ten-year Treasury note should be, so what would be a normal rate under regular circumstances without the Fed keeping interest rates low?

DAVE ROLLEY: That’s a good question. And we have a lot of history of interest rates, and if you look at the history over time, you’ll notice that there are certain relationships that reappear over and over again. One of them is that most of the time, the inflation-adjusted interest rate, the real interest rate if you want to call it that, looks something like the real growth rate.




DAVE ROLLEY: Of GDP. Why would that be? If you think about it, the simplest way is that there is an arbitrage: if you can grow faster than what it costs you to borrow, you ought to borrow the money because that’s what you can get on your investment. But if it costs you too much to borrow and you’re not growing that fast, borrow less because you can only get what the GDP is going to produce.


DAVE ROLLEY: That’s not true company-by-company, but when you add everything together, it kind of holds, and what you see is you see GDP trends correlating with real interest rate trends, not just over time but across countries. So Japan was slow-growing and it had a really low inflation rate, it had a really low yield for a long time. High-growing countries tend to have higher interest rates over a really long time. So if you wanted to pick one metric, one rubric that most economists would agree with most of the time, the real growth rate should look like the real trend, real yield in the bond market.

CONSUELO MACK: So our rates right now in the U.S., for instance, are far below, right, the real growth rate?

DAVE ROLLEY: Oh, yes. Oh, yes. We’ve got two-handled growth. So you might think that, add one-and-a-half percent on inflation, you might think that fair value for the ten-year Treasury might be three-and-a-half percent. Well, it’s been a long time since we’ve seen three-and-a-half percent on the ten-year Treasury. And quite frankly, most people would now put fair value at something between two-fifty and two-and-three-quarters, maybe three percent max. That’s all pretty much what anybody expects until we have a different world.


CONSUELO MACK: How do you manage, let’s just start with the U.S., so number one, your view of the value of the U.S. Treasury market and value of the U.S. bond markets, for instance, what is your assessment? Very rich?

DAVE ROLLEY: I think …

CONSUELO MACK: Fairly valued?

DAVE ROLLEY: … our short version of that is that when we look at all of the markets, we see the equity markets as fully valued and we see the high-quality bond markets as overvalued, and that was overvalued for a reason. It has to do with excess central bank liquidity that will go on for a while, but as that liquidity is gradually withdrawn, our bias is to expect high-quality interest rates to rise a bit. That means you have to worry about capital losses. So the longer the maturity of your bond, the bigger your risk exposure to capital loss is, you know?


DAVE ROLLEY: If a 30-year bond sells off, it’s a lot more painful than if a two-year bond sells off. So what we have been doing is we have been deemphasizing Treasuries except for liquidity reserves; that’s your buying power you keep on the side. When something else gets alarmingly cheap somewhere else, you need to have something to buy it with, and we don’t lever portfolios. So we always keep a little cash around if we want to go shopping. But we have then been looking at essentially mid-quality credit, and that means we look at asset- based securities and we look at corporate bonds. When we look at corporate bonds, we tend to like triple-B, which means they are investment grade but not the best, so they …

CONSUELO MACK: So the lowest tier of investment grade.

DAVE ROLLEY: … lowest tier of investment grade.


DAVE ROLLEY: And we like the highest tiers of the high-yield market. We don’t want to go down to a triple-C market most of the time because that really requires a very strongly- growing economy for those guys to grow into what is probably a very challenging capital structure. Now, you’ve asked about the U.S. corporate market, and quite frankly, most investors now would break that market into two parts and that would be oil names and everyone else.

CONSUELO MACK: Right, and explain that, that very important demarcation in the markets right now, not always the case but right now.

DAVE ROLLEY: It has to do with the fact that the price of oil has fallen by half, and the businesses that work at $100 oils may not work so well at $50 oil, particularly if you’ve borrowed a lot of money to invest in an oil services business or to drill a new field. And in those kinds of businesses, they can be very, very sensitive to the oil price; it’s the difference between a cash flow that’s positive and losing money every day.

CONSUELO MACK: And energy bonds are a large chunk, right, of the high-yield bond market?

DAVE ROLLEY: I believe they’re something north of 15 percent, in the range of 15 percent of the entire high-yield market was energy-lending. And so many of these folks are, they’re not quite wildcatters, but nonetheless, there was a lot of optimism about the drilling prospects that they’re following up, but there’s a lot of leverage.

CONSUELO MACK: Therefore, because the entire high-yield sector has been hurt by the decline in oil prices and the perception that therefore, all of the energy bonds could be vulnerable to default or whatever. So tell me how you’re assessing the high-yield sector and opportunities.

DAVE ROLLEY: Consuelo, you’re absolutely right, and you’ve actually pointed at two different opportunities and they’re both investable; and they both represent value but they’re different values and they have different kinds of risks associated with them. The first is the oil sector itself, and because almost all of the oil names have been driven lower, you can then look through them and say, well, who are the survivors here and at what price? And you can stress-test these companies and say, well, what do they look like at $30 oil? What do they look like at $50 oil? And if you think oil is going back to $65 in a year or two, you can look at those.


DAVE ROLLEY: And we look across those names and we found some companies that we think are survivors. I won’t mention the names on the show, but that is an interesting area. And furthermore, there’s another way to get paid there. It is that if all of your oil reserves have been marked down by 50 percent in value, there are other very powerful oil companies, household names, your Exxons, your Chevrons of this world, that might find acquisitions to be a way to rebuild reserves. I don’t know …

CONSUELO MACK: For themselves, exactly.

DAVE ROLLEY: … exactly.

CONSUELO MACK: So they can get them cheap.

DAVE ROLLEY: I don’t know if you know, but all of the biggest oil majors, and no one’s worried about their credit risk, what people are worried about is their long-term business risk. All of them, their biggest business challenge is replacing their existing reserves, and they have been awfully good at that for a long time, but it becomes increasingly difficult over time. If they can make an acquisition and replace reserves with a company that they are buying that they think might be at a substantial discount to its long-term value, that’s probably a good business bet.

CONSUELO MACK: So therefore, there’s a stock opportunity there as well.

DAVE ROLLEY: What happens is that the equity guys could get paid a whole lot of money, but the bond guys who buy their bonds at a discount because they’re borderline triple-B or high-yield, going from double-B to single-B because of this price pain, you might wake up and discover that you’re owned by Exxon and, wow, suddenly you have an A-rated security, and that’s not a bad day.

CONSUELO MACK: Sure it isn’t, right.

DAVE ROLLEY: We won’t make as much money as the equity folks, but a re-rating of the ownership of a bond can represent 10 to 25 price points of capital gain the day the transaction might be announced.

CONSUELO MACK: Wow. That’s pretty impressive.

DAVE ROLLEY: It’s a good day for fixed income.


DAVE ROLLEY: You’ve mentioned something else though, and I think this is actually almost as interesting in terms of making money. You talked about the effect of oil price weakness on the entire high-yield market. It was 15 percent of the indexes. Some people sold high-yield ETFs. Some people reduced positions in high-yield mutual funds. That put pressure on the whole high-yield market. So now you can find better values for securities just because they had the same rating as the energy names. They’ve been sold, but they have no oil exposure whatsoever. They could be in the health care business, and we’re taping this at a medical library, so that seems like a reasonable industry to think about, and some of those names have become more valuable as well. And so, we have increased our high-yield exposure across all of our portfolios not just in energy names, but certainly with a bit of an energy concentration.

CONSUELO MACK: Let me ask you about something that you mentioned earlier, which is that in some countries, for instance, Germany, that we are seeing negative interest rates, which in my experience on Wall Street, I’ve never been in an environment where we’ve had negative interest rates.

DAVE ROLLEY: Across Europe, a number of the North European bond markets, not just the German bond market, have negative yields. Now, I asked a very senior European economist who was visiting our offices recently, why would a European investor buy a German bond with a negative yield? And his answer was very simple: it was, “Because they’re afraid it might get more negative.” I said, “Well, I guess that’s what you might call a momentum strategy, not a value strategy.” And he said, “We call these technical markets.” And we had a long conversation about why people like buying negative yield in securities, and it has to do with maybe they can’t buy anything else, and that’s either because they are a central bank and the Euro forms part of their reserves.

CONSUELO MACK: Right. So they have to hold these.

DAVE ROLLEY: And they have to own some.


DAVE ROLLEY: But they’re not probably increasing their share. Maybe they’re a bank or an insurance company where they want to own government bonds because it doesn’t have a capital charge against the investment, whereas if they owned common stock in any of a dozen high-performance European companies, they would have to allocate equity against their equity position, their own, they have to have a less-leveraged company because people see stocks as risky.


DAVE ROLLEY: That’s what the regulators have said. Well, I tend to think that a well- performing company’s equity is less risky than a negative-yielding bond because with a negative-yielding bond, I am certain that I have permanent loss of capital. I’m pretty sure of that. And the other stock, it might actually grow. So it’s not clear that what the regulators are doing makes sense, but those are the laws and that is how they have to allocate portfolios. So what we have is we have trapped capital, and the trapped capital is stuck in some negative- yielding securities. That doesn’t mean we have to jump into that box with them.

CONSUELO MACK: Right. And so therefore, at Loomis, Sayles, you are not jumping into that negative interest rate box.

DAVE ROLLEY: No, no, no. We think that makes no sense whatsoever.

CONSUELO MACK: Right, what’s your assessment of the opportunities in emerging markets?

DAVE ROLLEY: I think they’re interesting and they’re going to get more interesting. And that’s true on both a fundamental basis and a cash flow or investor positioning basis. Let me talk about some fundamental markets that we kind of like but which it’s hard to invest in. India is, I think, an improving story. India is not an oil exporter; they don’t depend on the price of iron ore.

CONSUELO MACK: Like China does. Right.

DAVE ROLLEY: They depend on essentially whether governance in India gets better. The Indians are very entrepreneurial; they have good businesses. They have a massive domestic economy; there’s over a billion people there. This is a huge economy that could grow very rapidly with relatively moderate changes. We have a world-class central banker who is relatively new in the job and has just a host of good ideas that he is in the process of implementing. So I think Indian financial markets have responded positively to that. We have the new administration, and while they, I don’t think they can do everything they want to in 100 days, they are committed to growth, and I think that they’re going to find their way to get it. So in that world, your best ideas are probably equity ideas, but where you can find rising improving Indian companies that issue bonds outside of India, that’s a very interesting investment for us.

CONSUELO MACK: Oh, interesting.

DAVE ROLLEY: And we hold those positions. And in many cases, we’ve already seen credit upgrades in the names that we own, so that’s worked very well.

CONSUELO MACK: So these are, Indian companies that are issuing bonds.

DAVE ROLLEY: … Indian companies issuing dollar-pay bonds …

CONSUELO MACK: Dollar-pay bonds.

DAVE ROLLEY: … in global markets.


DAVE ROLLEY: There are some offshore Indian rupee securities, and we use those from time to time, and we can buy the Indian currency outright through the forward markets and we do some of that as well. But I would say for most investors most of the time right now, the equity story is the most obvious form of access and might have the highest return.

CONSUELO MACK: So in the Global Equity and Income fund, Loomis, Sayles Global Equity and Income Fund, of which you are a co-manager, so Indian securities are an area, and I know …

DAVE ROLLEY: Yes we do own…

CONSUELO MACK: …and I know you are very careful about specific Indian securities, so it’s very important what you’re buying …

© 2015 MackTrack. All Rights Reserved Page 9 of 10


CONSUELO MACK: | WEALTHTRACK Transcript 4/17/2015 – Program #1143

DAVE ROLLEY: But yes, India is …

CONSUELO MACK: … that that’s an area of opportunity for you.

DAVE ROLLEY: … yes, India is an important country in the portfolio now.

CONSUELO MACK: Loomis, Sayles Global Equity and Income Fund, my understanding is that you have a maximum position in that fund in equities …


CONSUELO MACK: … right now.

DAVE ROLLEY: Yes, we’re at our equity limit.

CONSUELO MACK: Yes. So explain why you are at your equity limit.

DAVE ROLLEY: Because we think that ultimately, when we look at the stocks that we hold name-by-name, we think their horizon return will be not just positive but could very possibly represent double-digit returns. And you look at the bond opportunity, and, well, there is just a lot of pain ahead probably. You have very low yields that will at some point renormalize. You do not renormalize without a loss of capital, re-pricing that security down. So if we own it at 100 cents on the dollar today, we’re going to own it at 92 cents on the dollar the day after tomorrow in many parts of the bond market, and that’s an eight percent loss. And if you’re only getting paid one or two percent in terms of your coupon income, that’s a tough investment to justify. Now, we are finding value, but the opportunity set is still bigger on the equity side than it is on the fixed income side because you don’t want to build an entire portfolio out of energy, distressed metals, and Brazilian securities. That’s not diversified enough.

CONSUELO MACK: Yes. But in a global bond portfolio, or even in the international bond portfolio, you have to be invested in bonds.


CONSUELO MACK: So what’s your bread-and-butter investment in a bond portfolio?

DAVE ROLLEY: The core structure, you know, we wake up every day, the global team sort of sits together, and in this kind of interest rate environment, very low yields, a relatively strong dollar, our first job is to do no harm. We are overweight dollars, but it’s a risk- controlled overweight. We have very little in terms of European high-quality securities because I don’t like negative yields. We are looking selectively across the entire opportunity set of over, I think, 1000 investable companies around the world to find companies that can.


April 10, 2015


Watch the related WEALTHTRACK episode.


April 10, 2015

Few investors have the prescience of this week’s Financial Thought Leader guest. Long before the 2008/2009 financial crisis he identified the powerful and destructive rise of what he called the “Shadow Banking System”, the unregulated institutions funding the housing and credit bubble.  He also coined the phrase “Minsky Moment”, after the economist Hyman Minsky’s theory that financial stability ultimately leads to financial instability, as people and institutions take on more risk. That is exactly what happened.

This week’s WEALTHTRACK guest is legendary bond trader, Federal Reserve watcher and economist, Paul McCulley who spent many years in the top ranks of bond giant PIMCO. What financial forces does he see gathering now?   Continue Reading »


April 10, 2015


Few investors have the prescience of this week’s Financial Thought Leader guest. Long before the 2008/2009 financial crisis he identified the powerful and destructive rise of what he called the “Shadow Banking System”, the unregulated institutions funding the housing and credit bubble. He also coined the phrase “Minsky Moment”, after the economist Hyman Minsky’s theory that financial stability ultimately leads to financial instability, as people and institutions take on more risk. That is exactly what happened. This week’s WEALTHTRACK guest is legendary bond trader, Federal Reserve watcher and economist, Paul McCulley who spent many years in the top ranks of bond giant PIMCO. What financial forces does he see gathering now?

Paul McCulley Economist & Fed Expert


CONSUELO MACK: This week on WEALTHTRACK, globe trotting economist, Fed watcher and Great Investor Paul McCulley gives us the big picture view of the world’s economies and markets and what it means for your portfolio, next on Consuelo Mack WEALTHTRACK.

Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack.

Few investors have the prescience of this week’s Financial Thought Leader guest, which is why we have asked him to come back to WEALTHTRACK and give us an update on his views of the state of the financial world and markets. We will also ask him to make a few portfolio suggestions!

He is Paul McCulley, former Senior Partner at PIMCO. Founding Member of its Investment Policy Committee along with firm founder Bill Gross, Author of the influential monthly “Global Central Bank Focus”, and Manager of PIMCO’s huge short term trading desk where he oversaw an estimated $400 billion dollars in assets.

McCulley retired from PIMCO in 2010 to write, think, speak and otherwise lead a more balanced life, which he did until last year, when he was lured back to PIMCO for a few months as Chief Economist by his former boss and close friend, Bill Gross before Gross abruptly left the firm for another. We’ll discuss McCulley’s decisions in our extra session on our website

I mentioned McCulley’s prescience. Long before the 2008/2009 financial crisis he identified the powerful and destructive rise of what he called the “Shadow Banking System”, the unregulated institutions feeding the housing and credit bubble. And he coined the phrase “Minsky Moment”, after economist Hyman Minsky’s theory that financial stability, as this country had during the Alan Greenspan era, ultimately leads to financial instability as people and institutions take on more and more risk. Well of course, that is exactly what happened.

We asked McCulley what forces he sees building in the economy now?

It’s a fascinating question, because the whole mosaic of Minsky I can talk about for hours, and we don’t have hours. The “Minsky Moment” is the culmination of excesses where you have a sudden stop in the markets, and you have a massive recession. And technically speaking, what you’re doing is you’re ushering in something called a ‘liquidity trap.’ Which is that your central bank takes interest rates to zero, but nothing much happens. Because the private sector is checked into the Nurse Ratchet center for balance sheet rehabilitation. So it’s not the price of debt; the private sector has got too much of it. So they’re delevering. So the central bank, quite appropriately, goes to zero, but nothing much happens because you’ve got delevering. And that is known technically as a ‘liquidity trap.’

CONSUELO MACK: And so where are we in the liquidity trap? Then are we out of it?

PAUL MCCULLEY: Well, fortunately America is on the cusp of exiting.


PAUL MCCULLEY: And actually it’s been an amazing journey over the last six years, because as you note, we have been stably at zero for short-term interest rates for the last six years.


PAUL MCCULLEY: And that’s not the textbook answer to getting out of a liquidity trap. Conceptually, what you should do is you could go to zero, but you should have the government do the opposite of what the private sector is doing.

CONSUELO MACK: So it should stimulate, the government should stimulate.

PAUL MCCULLEY: The government should borrow. If the private sector is delivering, the government sector should lever up. Now, other people would derisively call that ‘deficit spending.’

CONSUELO MACK: Right, it’s a Keynesian…

PAUL MCCULLEY: Keynesian. So you’ve got all sorts of back…

CONSUELO MACK: John Maynard Keynes, right.

PAUL MCCULLEY: We did some of it the first couple of years, and then the Tea Party captured the Republican Party and we had austerity. Which is not just boneheaded; it’s stupid. When you’re in a liquidity trap and the private sector is in self-imposed austerity, the last thing the government should do is join them. But we did. Which meant that all the burden was on the Fed and they got us out of the liquidity trap. That can work, but actually has some saddle benefits or liabilities, that are not particularly attractive.

CONSUELO MACK: So let’s talk about those, one of the things it’s created is that as we all look for returns on our money, we’ve got to go to other markets, because we can’t get them in our savings, we can’t get them in the fixed income markets, right? So there’s this asset inflation that everybody talks about.

PAUL MCCULLEY: Yes, effectively getting out of a liquidity trap with monetary policy alone, with actually fiscal policy going the opposite direction, requires inflating asset prices.

CONSUELO MACK: Right, so stocks, bonds, and what, real estate.

PAUL MCCULLEY: And real estate are the big three.


CONSUELO MACK: So those are the three major ones, yes.

PAUL MCCULLEY: But just remember, a “Minsky Moment” is because you have too much debt relative to income and asset values. I mean, the housing sector you ended up with a notion of the debt’s higher than the value of a house, called an ‘underwater mortgage.’ So a debt problem is not just an absolute debt issue. It’s debt relative to assets. So if you want to get out of a debt problem, either you can write down the debt or you can drive up the price of the asset.

CONSUELO MACK: So that’s what we’ve done, that’s the path.

PAUL MCCULLEY: We’ve driven up the price of the asset, which actually internally delevers the system, because everybody’s asset-to-debt ration improves, because capital gains on asset prices don’t have an offsetting liability. They’re the free lunch in the game. So it sounds all delightful.

CONSUELO MACK: It does. So what’s the problem?

PAUL MCCULLEY: The problem is that it is undemocratic, and doesn’t pass a smell test of social justice. Because if the way you get out of the soup is to drive up asset prices, that’s going to benefit the people who…

CONSUELO MACK: Have assets, right.

PAUL MCCULLEY: … have assets. Poor people don’t have assets.


PAUL MCCULLEY: Middle-class people have assets, and particularly their 401(k) and their house. But the people who really have lots of assets and particularly stock? Are rich people. So getting out of a liquidity trap, which is wonderful to do; no criticism of Ben Bernanke whatsoever. It beats the hell out of the alternative, which is a depression. But if you’re going to get out of this way, it will … the way he had to do it … I stress he had to do it this way; it wasn’t a choice, he had to do it … you will end up, when you get out of the liquidity trap having a more unequal, unjust society than when you went into it. It is quite bluntly a form of trickle-down. And trickle-down doesn’t pass my progressive sense of social justice, but it does work.

CONSUELO MACK: Right, and it doesn’t pass Janet Yellen’s sense of social justice either.

PAUL MCCULLEY: No it doesn’t. CONSUELO MACK: Because she is a progressive.

PAUL MCCULLEY: Yes, she is.

CONSUELO MACK: I mean, she admits it, and so here we are, we’re looking at the employment. And the unemployment rate has come down. So where are we, as far as the employment situation, and the economy going still subpar growth for a post-World War II economy? How are we getting out of that? What’s the outcome going to be there, Paul?

PAUL MCCULLEY: We’re getting out of the liquidity trap, but we’re not getting out of the economy that’s still not performing up to its potential.


PAUL MCCULLEY: And we’re not easily getting out of the economy that has got the most unequal income distribution and wealth distribution of our lifetime. And it’s a huge concern of Janet Yellen’s. And the easy answer is to ignore Wall Street’s cries about the notion that we’re going to have an inflation problem if wages move up. I mean, I spent so much of my career literally on Wall Street, south of here, this whole notion of, you know, if the labor market is high, then the Fed’s behind the curve and I need to tighten up and throw somebody out of work.

CONSUELO MACK: But we’re so far from the labor market being hot.

PAUL MCCULLEY: We’re so far from that, and Janet’s perspective is very straightforward. If the average Joe gets a raise in America that’s above inflation, that’s called a solution, not a problem.

CONSUELO MACK: Yes, and that’s a low bar now, because inflation is below, well, two percent, by whatever measures.

PAUL MCCULLEY: Exactly. Exactly.

CONSUELO MACK: So aren’t we kind of getting there, though? So aren’t we starting to see?

PAUL MCCULLEY: We’re getting there very incrementally, but it’s a wonderful thing. It’s not a problem. And actually this phrase that I’ve been around all of my life from Wall Street, of ‘wage inflation,’ as it’s just mean, nasty, ‘we’ve got wage inflation.’ Excuse me, we never talk about profit inflation. Wage inflation, no. We’re going to see the Fed underwrite, under Chair Yellen, an increase in the return to labor. An increase in the return to labor.

CONSUELO MACK: So do you think that Janet Yellen and the Fed can do that alone? I mean, are we on our way there?

PAUL MCCULLEY: Actually I think that they now have the phrase, and I think Bill Dudley actually put into the lexicon the phrase: ‘let the labor market run hot.’


CONSUELO MACK: The president of the New York Fed.

PAUL MCCULLEY: Yes. And so they’re going to let the labor market run hot, which means that we’re going to have a four percent, as the first number on our unemployment rate, I think. Perhaps we could go to the low fours percent.

CONSUELO MACK: Before what?

PAUL MCCULLEY: Before the Fed would consider it to be a problem. Now, there are a couple of implications as we think in terms of markets. Just because the Fed’s willing to let the unemployment rate go to the low fours, which is a principal populous I say hallelujah to …

CONSUELO MACK: And this is a whole new target for them. It used to be, I remember when unemployment reaches six percent.

PAUL MCCULLEY: Six percent.

CONSUELO MACK: Right, then we’re going to start raising rates.

PAUL MCCULLEY: We’re going to start raising rates, to keep it from going any lower.

CONSUELO MACK: And now it’s like, you know, it’s in the fives.

PAUL MCCULLEY: We want it to go lower because we want to get the inflation rate back up to target. We’d also like to see an increase in real wages, which means we need to have wages faster than inflation. So I think the Fed’s going to underwrite that scenario.

CONSUELO MACK: And so meaning underwrite, what does that mean for policy?

PAUL MCCULLEY: Which means that once they get off of zero, it’s going to be a very tepid increase in interest rates. Everyone’s been focused on what day are they going to have liftoff? And that day’s going to be sometime this year, I think. Unless there’s some shock that I’m unaware of. And I think that would be consensus for the Fed. The big issue now is not the day of liftoff; it’s what happens after liftoff. And Chair Yellen gave a fabulous speech a week ago, well last Friday, in San Francisco, pounding the table that it’s going to be a kind and gentle trajectory for interest rates after you get off of zero. And I think that a couple of years from now, we’ll probably have short-term interest rates at somewhere between one and two percent.


PAUL MCCULLEY: Not two and three, and not three and four. So we’re going to get off of zero.

CONSUELO MACK: And why? Why is that?


PAUL MCCULLEY: It depends upon where essentially the equilibrium or neutral real short- term interest rate is. And actually there’s close alignment between Chair Yellen and Larry Summers on this whole issue. Because the “secular stagnation” thesis that Larry has popularized is the notion that it’s really hard to get to full employment unless real interest rates are very low, because our economy tends to want to save more than it does to invest. So therefore, I mean by definition in an accounting sense, they have to equal each other. But looking forward, there is a higher propensity to save than there is to invest. In order to get savings and investment to equal each other at full employment, you have to have an exceedingly low real interest rate, and the “secular stagnation” thesis of Larry is actually it needs to be negative.

CONSUELO MACK: Interest rates need.

PAUL MCCULLEY: In real terms.

CONSUELO MACK: In real terms, right. Ex inflation, right. There are a lot of things that are positive about having low interest rates, correct?

PAUL MCCULLEY: There are a lot of positive things about low rates.

CONSUELO MACK: Except for savers. When you get very low return.

PAUL MCCULLEY: Well, a particular type of savers. But it’s not just people who are getting low short-term interest rates. This is a very wonky subject, but has profound implications.

CONSUELO MACK: Right, and that’s what I’m trying to figure it out.

PAUL MCCULLEY: For everybody. And I’ll tell you the two implications right up-front. Number one is the existing level for bond prices and stock prices, the ten-year where it is. And it’s not just a yield, it’s a price. And the stock market, where it is, which is a price and a yield and a PE multiple. Existing valuations for bonds and stocks only make sense if John Taylor is wrong.

CONSUELO MACK: And when you say John Taylor is wrong, that is?

PAUL MCCULLEY: That four percent is not where the Fed’s going. That two percent is more likely to be the terminal point.

CONSUELO MACK: For the Fed funds rate.

PAUL MCCULLEY: For the Fed funds rate. And you put a term structure on that, which implies that the ten-year should be somewhere between two and three, which is where it is right now. So essentially the marketplace has already discounted zero real Fed funds rate, as the “new neutral”. Therefore, it’s priced into the markets. Which means that bonds and stocks are not in a bubble. If you were to work through the math and say: No, John Taylor’s right, when the Fed starts tightening, it’s going to keep tightening until you get four percent? The stock and bond markets are both in bubbles. You can make no rational case for a two percent ten-year with a four percent overnight rate. And if you can’t make a case for the two-and-a- half percent zone for the ten-year, you can’t make a case for the PE multiple on stocks. So the great news for the average investor who’s been involved in this market is that he’s not playing a bubble.

CONSUELO MACK: If you’re right. If you’re right about interest rates.

PAUL MCCULLEY: Right. And if I am wrong, it’s not a matter of my ego. If someone thinks I’m wrong, they should sell every stock and bond they own and get long canned green peas and small firearms, because all hell is going to break loose. We’re going to go back into liquidity trap, as the Fed force-marched us up to four percent short-term interest rates. It’s just I don’t think it’s going to happen, but if you think it’s going to happen, and then you shouldn’t be anywhere close to stocks and bonds right now. If you buy into the consensus in the market, which is essentially zero real, then the good news is you’re not in a bubble. The bad news is you have a rich asset class that have low yields going forward.

CONSUELO MACK: And this is in the bond market.

PAUL MCCULLEY: And the stock market.

CONSUELO MACK: And the stock market.

PAUL MCCULLEY: And the stock market.

CONSUELO MACK: It’s so rich, so what’s rich?

PAUL MCCULLEY: Well, it’s not so much that it’s …

CONSUELO MACK: Fully valued, overvalued?

PAUL MCCULLEY: It’s fully valued relative to the cash alternative.

CONSUELO MACK: Okay, right. Stocks and bonds are fully valued relative to what you can get in cash.

PAUL MCCULLEY: Cash, both now, which is zero, obviously.

CONSUELO MACK: Right, nothing.

PAUL MCCULLEY: But the forward curve says the Fed’s going to go to two. So stocks and bonds are valued fairly to current and expected short-term interest rates, but current and expected short-term interest rates are very, very low, relative to history.

CONSUELO MACK: Right, at least recent history.

PAUL MCCULLEY: So therefore, I think the news to our generation, we’re really talking about the Baby Boomers that are really sort of what the hell’s going on here? I’m on the cusp of retiring, and what are expected returns going forward? And expected returns are going to be mid-single-digits at best for stocks, I think, going forward. And less for bonds. Simply because the starting point is a very lofty valuation. And a very simple answer to that when people ask me: what’s the return going to be in the 10-year Treasury over the next ten years? It’s very simple, it has a coupon on it.

CONSUELO MACK: So you’re going to get the coupon, essentially.

PAUL MCCULLEY: You’re going to get the coupon, and the coupon’s real. And the biggest danger right now in the marketplace is people haven’t accepted that going forward returns will be the coupon. Because for the last five years, they’ve gotten capital gains when we’ve moved from five coupons to low coupons. And the core reality of people in investing is they don’t read the disclaimer that past returns are not indicative of future returns. Human beings tend to drive through the rearview mirror in investment returns. And that’s just how they work.

CONSUELO MACK: What do we do as investors?

PAUL MCCULLEY: Fascinating question because …

CONSUELO MACK: I want to make money.

PAUL MCCULLEY: You want to make …

CONSUELO MACK: What do I do to make money?

PAUL MCCULLEY: You want to make money. And you don’t get to go to heaven twice for the same good deed.

CONSUELO MACK: Right, don’t expect.

PAUL MCCULLEY: Don’t expect …


PAUL MCCULLEY: … future returns in the United States. You think in terms of who is in a liquidity trap now. And it’s Europe. And they’re not going to escape the liquidity trap for a very, very long period of time. Therefore, the revaluation of assets in Europe is in the early stages, relative to the United States. Because we’re talking about the Fed getting off of zero here in 2015. And if you ask Mario Draghi when do you think you’ll ever get off of zero? He will look at you with a very odd look. He just went to QE, and it’s open-ended QE.

CONSUELO MACK: Right, quantitative easing, right.

PAUL MCCULLEY: And so therefore, European stocks in local terms have dramatically outperformed U.S. stocks this year. So this is a theme that I’ve been articulating for over a year, out on the hustings, I had this part-time job at PIMCO last year that I do a lot of speaking, is European stocks hedged into dollars, is the short answer to your question, is you need to play the revaluation game on the back of a ultra-uber easy monetary policy outside the United States. Japan is giving you an opportunity, but I think the best opportunity is in Europe. And I think the bull market in European equities and European real estate has got a long way to run. European bond markets less so. But the equity market and the real estate market in Europe are incredibly attractive relative to the United States. And relative to the forward-looking monetary conditions.

CONSUELO MACK: And dollar hedge, do not buy in local currency in Europe. So to explain.

PAUL MCCULLEY: The United States, the U.S. dollar is in a secular bull market.

CONSUELO MACK: Right, secular bull market; that’s a long-term bull market.

PAUL MCCULLEY: Long-term bull market. So therefore, if you’re going to be protected exposure in Europe, you simply want to hedge it back into dollars. You want European equity exposure; you do not want a euro exposure.

CONSUELO MACK: One investment for a long-term diversified portfolio, what would you have all of us own some of? As specific as you can be.

PAUL MCCULLEY: As specific. Actually I like European equities and real estate hedged into dollars, intensely. And it’s performed really, really well for the last year. So trying to be a value investor in dislocated and distressed assets in Europe is my favorite thing right now. And it’s not just right now, but over the next three, five years. Because I don’t think you’ll be having the ECB hike interest rates in the next five years. Whereas I think Janet and company could be hiking interest rates in the next five months.

CONSUELO MACK: But not by a lot. And that’s the …

PAUL MCCULLEY: Not by a lot. But the act of hiking is huge. And I look at the act of hiking interest rates, just simply to act is declaring victory. A valedictory for the central bank that they got us out of the liquidity trap, because the defining characteristic of a liquidity trap is you’re pinned against zero. So just getting off of zero is a huge, huge deal.


April 10, 2015
Legendary bond trader, Federal Reserve watcher and economist, Paul McCulley spent many years in the top ranks of bond giant PIMCO before retiring in 2010 in search of a work/life balance. He returned to PIMCO as Chief Economist for a few months in 2014. We asked him about his latest departure, his current interests, and his plans for the future.

Watch the related WEALTHTRACK episode.

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