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.

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