With Alfonso Peccatiello, The Macro Compass
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Alfonso Peccatiello joins the podcast to discuss his contrarian views on inflation, bond yields, and interest rates.
The guest doesn’t buy the inflation narrative entirely, believing credit creation has peaked. We are likely to see negative economic surprises and drawdowns in risk assets starting in the fourth quarter. The yield on 10-year bonds should peak at 0.5% due to a ‘Eurofication’ of the U.S. yield curve.
- Why concerns about inflation are misguided (1:54);
- The Fed is right. Inflation is transitory (6:37);
- Demand for bank loans is “terrible,” despite extremely low yields (13:54);
- Why do bond yields continue to drop? (18:16);
- The bond market is saying growth and credit creation has peaked (23:24);
- Why central banks’ digital currency experiments are potentially a game-changer (27:49);
- Background on the guest (33:04);
- The ‘four quadrant’ approach to macro investing and where we are right now (36:26);
- The Fed tightening cycle should start in late 2022 and peak around 0.75% (47:50);
- How low do we go on the 10-year this cycle? (57:00)
More Information on the Guest:
Highlights From Our YouTube Channel
Nathaniel E. Baker
I am here with Alfonso Peccatiello, known on Twitter as @MacroAlf, and he has a website substack, the macro compass, we are here because of Alfonso’s views about inflation. Now, as we all know, inflation has been a pretty big, very big buzzword here in markets recently. A lot of concerns about inflation. And, you know, commodities prices have been ticking higher. bond yields have been ticking lower, which is not a sign of inflation. But there are nevertheless a lot of concerns about inflation. It’s something that people look for in fed minutes, any fed commentary about inflation, could lead to higher interest rates and fed tapering, at least that’s concerned inflation, inflation, inflation, higher prices, higher gas prices, higher wages, these are all things that have investors on edge a little bit. So Alfonso here has a very contrarian view on this, and he is not concerned about inflation. In fact, though, he is very much about disinflation, which is different from deflation, which we’ll talk about in a little bit. But Alfonso, give me your views here of inflation and why the concerns about inflation are misguided.
Alfonso Peccatiello 1:54
Yeah, thanks for having me on the show, by the way. I really, really appreciate this. So the first thing I’m going to say here is that yes, we are going to see inflation for the next few quarters. We’re probably going to see core PCE in America around 3% for the next two to three quarters. But that’s it. We go back to structural trends, we go back to the disinflationary trend that that basically we have seen for the last 40 years since 1980s. Without we’re going back there and actually, I guess pretty soon as well in the next two to three quarters, and then you know, we’re back to our secular forces. So I believe this is all temporary and the hype around there in reflationary trades and market commentaries about inflation is way overdone. So I also think the peak in bond yields is what we have seen the cycle at 1.75% in 10 year treasuries, I think it was May, and that’s the best you’re going to see. If you’re looking for higher yields on 10 year treasuries, we’re already going down to 1.3%. But I think we’re headed lower as well, as we go into next year.
Nathaniel E. Baker 2:56
Headed even lower than 1.3. Okay.
Alfonso Peccatiello 2:59
Yeah, I guess so. So the reason why I bring this status out is because every time we have a credit in US Sugar Rush, reflation period, you hear all the bond bears and all the secular inflation guys jumping on the wagon and screaming on higher yields and higher structural inflation. But it just doesn’t work. And the reason why it doesn’t work is because we have very poor structural growth, it’s here to stay and it’s driven by stuff you can’t change. It’s horrible demographics, your your labor supply in America, that will shrink year on your basis for the next 20 years. If your labor force is x millions next year is going to be x minus y millions. So if you have less people in the working force, these guys are also going to be able to produce lesser output, assuming equal productivity, actually, productivity itself is pretty stagnant as well, in Europe, even worse than in America. But in America, it is stagnant. And it is a byproduct of capital misallocation that comes from easy, super easy policy stance from central banks. It’s a vicious circle. You have very stagnant productivity, you have horrible demographics, it’s very difficult to produce structural growth. And so what we try to do, every time we face a crisis, and we can’t produce structural growth is we overlay cyclical growth. How do we do that we we simply create money out of thin air. And here it’s not central banks creating money. It’s the government by fiscal spending and its commercial banks by lending new money into existence. Central Banks accommodate the process. They create reserves this walk these assets, they move away the bonds and they give reserves to banks. But you know, these new monies, new credit which is created and flows into people’s hand today, at the expense of, you know, future generations, simply borrowing more today actually leads to a cyclical Sugar Rush, or like reflationary impulse. And every time we have this kind of impulse, everybody jumps on and says, Well This is a regime change, it must be different this time, we’re going to see inflation at 5% for the next 10 years, but we are not. Because for every Sugar Rush, credit in US Sugar Rush, there is always a credit cliff. It’s always there. It’s coming. Now credit impulse all over the world as peaked in q4 20. It has been massive, I mean, America sprinted ridiculous amount of fiscal deficits compared to the output gap. Even in Europe, for Christ’s sake, we have done some some some fiscal stimulus, which is very rare for us over here. But it is fading the way already. effect is, it has been the money has been spent, or should I say, created by the government, it has been put in the hands of people. And actually, it’s interesting to see that 50% of Americans have not even spend this money that used it to repay for my debt, or they’ve saved with this money. So that already tells you something the private sector does not look for additional credit, it’s over leveraged, even if you try to smash them with credit, they won’t spend it. But at some point is probably this over the effect of fiscal stimulus is over. So you face the fiscal cliff, you’re over in that you’re over leveraged, you have poor structural growth capacity, the private sector doesn’t want to borrow more, and you go back to the Google Trends.
Nathaniel E. Baker 6:13
Okay, there’s a lot of stuff in there for us to unpack it, but it sounds. For starters, it sounds like you are kind of in the feds camp, that all of this inflationary effect is transitory to steal their term. So it sounds like you you buy that?
Alfonso Peccatiello 6:26
Yes, definitely. So what we’re seeing now is the perfect combination of supply bottlenecks, which are, I guess, almost a definition or something to just be there when there is a pandemic, you will have supply bottlenecks. That’s, that’s okay. I guess those supply bottlenecks, by the way, will be solved. Not all of them, but at some point they will be solved. would you expect the producer of commodities to just dialed back when he has commodity prices? Well, where we are, of course, if you shut them factories, because they can’t, you know, reopen because of the pandemic, they won’t reopen. But once the pandemic restrictions are lifted, which is happening, by the way, what do you expect the commodity producers to do with these prices, is probably gonna try and produce more, of course, to lock in this huge profit margins yesterday. So those supply bottlenecks as you basically take away, bobbitt restrictions are going to be, you know, slowly solved. The other side of the equation is the aggregate demand, which was absolutely boosted in a in a huge fashion by fiscal stimulus that here again, I’m asking a question here, the fiscal stimulus you saw in 2020 and early 2021, will you see another round or even a bigger round? Because Don’t forget, we measure inflation on the year on year basis. So in order to continue to have 4% and 5% inflation next year, you will be comparing to this year inflation basket. So then I’m asking you do you expect in q4 2021, the US government to come on to come in with a 10 trillion fiscal stimulus again, for an even larger one? No, you don’t expect that you actually expect that to expect them to roll away some of the stimulus that was there. So the aggregate demand boost is simply going to fade away. It’s just a mechanical fiscal clip for a credit cliff, we see that every single time the Trump administration went in 2018, with a pretty big fiscal stimulus and the output gap was estimated to be negative. Back then they came in a massive fiscal stimulus. Yes, we saw growth. So wage growth, we saw unemployment rate, the three and a half percent, by the way, even then core PCE went to 2%. And that was it. And then what do we see in 2019? Once this is effect fades away? Well, you see, you know, growth slowing down and the Fed being forced, again, the good old cutting cycle, this is no different absolutely no different.
Nathaniel E. Baker 8:41
Yeah, interesting points, well argued for sure. I do want to just challenge you on some of that, partly because it’s my job, and partly because I know that you like it. But the when you look at these, these things, a lot of these prices and things are cyclical and can be scaled back gas prices are a perfect example. But if you look at other things, some, it’s going to be hard to kind of put the genie back into the bottle. Wages are one example. Now wage growth hasn’t been all that dramatic yet. I think the last fed report, or I’m sorry, the last employment report then on farms payroll showed showed it in line with expectations around 3%. Still, that’s not nothing. And it’s probably more than it has been. And that’s just hourly workers. And it’s more than it has been probably in quite some time. I don’t know that for sure. But the point is that there is a lot of liquidity sloshing around the system and a lot of these prices that are being adjusted higher, aren’t just going to come down. The guy down on the corner where I get my sandwich is, you know, charging now 12 or $13, whereas 10 years ago, he was charging seven or eight. He’s not just going to, you know, adjust his prices downward. When there’s less inflation. I would suspect maybe he Well, I don’t know. But those are so what do you make of all that the wage growth, and then also the fact that this will see it kind of be seen in other parts of the economy, like you look at asset prices, real estate, too, is going gangbusters. And those are all parts where we’re one could argue that inflation is being seen and felt.
Alfonso Peccatiello 10:20
So good points, by the way, I like to be challenged. .
Nathaniel E. Baker 10:23
Yeah, I know.
Alfonso Peccatiello 10:25
So let’s talk about first sandwich guy. Right? So he’s gonna charge you more for a sandwich. All right, so this year, you’re going to see assuming the sandwiches sitting in the core PC basket, it’s not but let’s assume it is, then this year, compared to last year, you’re gonna see an increase of 10% or 5%. From that, you know, that single item in the basket, alright, then you’re saying his price is not going to be lower next year? Let’s assume his price is going to be the same next year, just the same, it’s not going to lower it, but it’s going to be the same, right? So assuming now the core PC basket is only made by that sandwich, do you know what inflation year on year is going to be next year, if the guy doesn’t move the price, it’s going to be 0%. So what people fail to understand is that in order to have increasingly higher and other than inflation, you need not only the absolute level of the inflation basket will be higher, to be high, but you also need the acceleration in this pace of change to be higher every year. Otherwise, you’re not gonna achieve year on year changes that are higher and higher as we go. It’s a bit like saying the government has done deficits for 10 trillion, then next year, they’re gonna do 10 trillion. Okay, that’s exactly the same as last year. So you need a constantly accelerating pace in order to generate your new inflation. So how do you achieve that the wage growth is one of the ways in which you know, want to start with people demanding higher wages, then they’re probably gonna try and demand higher wages down the road again. Now, the issue that I have is that people compare this period with 1970s, for example, and they say, look, you know, one of the drivers inflation in 1970s, but also that wages were going up. So the purchasing power in real terms was going up year on year, on an accelerating pace. And that, of course, drove people to spend more and therefore inflation picked up. Now, in the 70s, you had labor unions that were really, really, really powerful. And you didn’t have a scalable, huge force, which is tech. Now, nowadays, you have the opposite. You have labor unions that are less and less powerful, you have more decentralized, let’s say, wage bargaining. And then you have tech, which is scalable in the end needs, I think I read somewhere 1/10 of the employees to generate the same million of sales, then you need in the 70s, it’s pretty hard to, to think that, you know, with such a huge portion of our service economy being redirected towards that you will be able to have which bargaining power with these guys, this is not an industrial age, we’re not living in the 70s. That’s much much different today. So I would argue wage growth, yes, sure, temporarily is going to print the 3%. It has already done so by the way for a while, but it will be dialed back as well as any other cyclical deflationary hype that we’re seeing right now.
Nathaniel E. Baker 13:08
Very interesting. Okay, I guess. So no concerns about inflation, then. And you you do have some good points about the year over year prices. But if you don’t think that this the consumers are, are out there in force, and that a lot of this money is going to find its way back into the economy, do you think they’re going to continue to use it to pay down debt, and other things like that.
Alfonso Peccatiello 13:31
So one indication of that is to look at bank lending, because it shut the government and you want to bring money and it’s lost people with checks, you can, and then it’s up to them what they do, but the demand for endogenous structural credit. So bank loan demand, that tells you a lot. So if you look at the demand from the private sector for bank loans, despite extremely low yield, it’s terrible. It’s terrible, because these people are already over leveraged, they don’t see an outlet for productive investments, they just don’t see that neither corporates nor households actually see that. So they’re shrinking demand, and actually depends on lending lending anyway, because for them, it doesn’t make too much sense. I mean, return on equity on these loans are terrible regulation and the capital you have to attach to these loans is pretty high, and the loan yields are pretty low. So from from a bank perspective, doesn’t make much sense to land, but also the demand side for credit is pretty low. And when that happens, it tells you that the private sector is over leveraged. And I mean, an example again, as we discussed before, is that the US printed large amounts of money and 50% of that was not used to actually you know, consume, what was rather used to pay down that debt already tells you something, I mean, the private sector is over leveraged. And by the way, the public sector cannot print money to pay back their that they need cash flows. I mean, a corporate cannot bring money, they need cash flows to service that that household needs cash flow to serve that service mortgage, if they think they’re over leveraged, and they know that prospects have you know, Rosy growth of their cash flows down the road. They’re not going to borrow more.
Nathaniel E. Baker 14:58
Hmm interesting and the higher prices that we’re going to see that we’re seeing. And again, not all of them will be adjusted downwards. But that’s not going to take a hit into household spending and curtail any anything like that.
Alfonso Peccatiello 15:12
Well, I mean, I guess some of the sticky, some of the prices are going up, price increases are going to be sticky, that’s okay. Some other price increases might be dialed back. And what that means is that actually, this is in again, in a PC basket. This is deflationary year on year, I mean, you reduce prices, so a certain proportion of the PC basket is going to turn negative next year. So simply on this basis on a base effect basis, let’s say it’s very hard to foresee medium term inflation at 4 to 5%.
You asked the question before, which we didn’t touch upon, which is real estate. And that is a little bit different. Because I think the objective of the government’s out here is to keep a real interest rates lower than real GDP growth. So what this does is effectively it inflates away your debt burden. So you refinance at the real interest rates in America today, which is negative, which is amazing, right? And then, on an inflation adjusted basis, you’re effectively inflating away your debt, you pay a nominal rate of 1% refinance, then inflation is one and a half percent. So on a real debt burden level, you’re actually reducing your debt burden, right? What this does on the consumer side is exactly the opposite. So people that are putting their money in a bank account or buying risk free assets like treasuries today, they’re seeing their purchasing power reduce over time, because they get 1% in nominal yields. But then inflation is one and a half percent. So in real purchasing power terms, they literally lost money. And I think it is basically a stealth way to let’s call it default, rather than in nominal terms in real terms. So what you’re doing is you are basically by a financial repression, punishing Savers, and consumers in order to make sure that you can inflate the way you’re over levered your your, you know, your your debt burden, basically. And yeah, this basically forced people to find alternatives, they will find ways to invest their money, which is not in risk free assets, or on a bank account. And real estate is one of the ways right, can you borrow yourself today, at mildly positive real interest rates, or maybe let’s say in Europe, you borrow at 2%, for 30 years, you expect inflation to be 1%, or one and a half percent. So in real terms, you’re borrowing at 0.5%. And then you’re putting this money in bricks and land, which is scarce by definition. And people would prefer that rather than, you know, being charged by definition, negative real interest rates as a sum of 0% nominal yields on a bank account, if you’re lucky, in Europe, you’re going to negative nominal interest rates on bank accounts, inflation rate, and some sort of a wealth tax that you have to add on top as well. So people are looking for alternatives. And that makes sense,
Nathaniel E. Baker 17:55
right. So then what is driving all of this money into bonds? and you said it like you’re not getting returns on these things? I mean, the risk free rate is very low. Indeed, the ten-year is 1.3%. And, you know, temporary or transitory or not, you have inflation, the price, the purchasing power of your dollars, or euros or your yen today is not the same as what’s what is going to be 10 years from now. Why would anybody and then you have assets that are attractive real estate, even stocks, right? Why would anybody put their money into bonds? And why the bond yields continue to fall?
Alfonso Peccatiello 18:35
Yeah, so the answer to the first question is that there are so many institutional investors out there, they don’t have a choice. The reason why they don’t have a choice is regulation. But regulation forces you effectively to be fixed income investor, if you’re a pension fund, for example, you have certain rules to adhere to, and one of it is that you’re you must be liquid. And you must have some sort of a fixed return on your asset side, although now you counter this the return you’re supposed to service on the liability side, by regulation, you’re forced to invest in fixed income. If you’re an insurance company, that’s the same if you’re a bank Treasury, that’s the same. So I call institutional investors regulatory driven price staplers. They don’t even price what price makers
Nathaniel E. Baker 19:16
price takers. Okay, okay. Sure.
Alfonso Peccatiello 19:19
They’re not price setters, their price takers. I mean, they have to be invested in bonds. And they can ever lower portions of their liquidity buffers invest in bonds, if they prefer to have cash instead, but guess what? Cash is yielding even lower than your 10 year bonds. So, you know, by definition, some of these guys will have to buy, then there is the move the asset class cohort,
Nathaniel E. Baker 19:40
hang on a second. But the same thing can be said for stocks. They also have a fixed allocation that they have to do to stocks or stocks don’t keep going up, especially now. And so it’s not like, Is it the fixed income allocation different where they have to? Because it, you know, it just doesn’t seem to make sense?
Alfonso Peccatiello 19:58
Well, the fixed income bar is more regulatory driven than your stock allocation. So there is more regulation that binds you really to invest in fixed income, I would say. And then the other thing is that for the last 40 years, let’s not forget that fixed income has performed incredibly well. And it also acted as a diversifier against your risk assets in the portfolio. Now, I would argue that the payoff of your bonds today that should act as a, you know, counter balancing effect against your risk assets, it’s pretty poor. Because in real terms, you pay a premium to be invested negative real interest rates, effectively, that’s a premium second option premium, and then the option payoff out of this bond investment, it’s actually pretty poor. It’s not convex. I mean, there isn’t a nominal lower bound at some point at which his bond yields probably can go lower than that anymore. And therefore your payoff is not that bad. So from from a diversifier point of view, if you want to call it like that they’re less attractive, but from a regulatory standpoint, tons of people out there are forced to be invested in this asset class.
Nathaniel E. Baker 21:00
Interesting. So what caused them the spike up in yields to 1.75, or whatever the high was a couple months ago, and if memory serves at the same time, stocks were selling off too what happened there.
Alfonso Peccatiello 21:12
So of course, you have the temporary reflationary trade, which always happens, so many that it has happened as well on the Trump I mean, we saw 10 year yields at 3%. Back then, right. So you it’s a combination of two things. It’s a repricing of the Federal Reserve hiking cycle down the road. And it’s also repricing of premium. So term premium is this weird component, which basically represents the premium but a long term bond investor wants to go home for all the long term bonds rather than rolling bills effectively. So instead of if I want to own fixed income for the next 30 years, I have two options, I can buy three month bills and roll them for the next 30 years, every time they expire, when I could just buy today a 30 year bond, right? Like I can do both, hey, buy a 30 year bond today, I’m exposed to certain duration risk and interest rate risk. So I want to be rewarded also for that, in theory, I want to be rewarded for the structural growth, we’re able to generate the prime inflation were able to generate and some sort of the ratio, right. So when yields were going up, and the Federal Reserve was, was saying, look, we are in a deflationary period. But we don’t really care, we’re gonna be doing flexible, average inflation targeting, we’re gonna let inflation overshoot. Because you know, we have undershoot for so long that we don’t, we don’t see the problem with inflation running higher than 2%. For a while. It also basically puts more term premium required by investors to buy these long term bonds. Because the distribution of probabilities of future events 10 years 20 or 30 years down the road starts to become much more scattered. You don’t know whether the Federal Reserve is playing with fire, if their stance is too aggressive, regarding, you know, letting inflation overshoot. And as you effectively secretly see this inflation coming, you start demanding higher yields higher term premium to buy these long term bonds, right? It’s exactly the opposite what’s happening today, people are smelling in the bond market that the peak of the growth impulse and the credit impulse is behind us. So when that happens, you’re probably slowing down on the growth trajectory. And at the same time, you have the Federal Reserve that is telling you, well, actually, we saw inflation printing a couple of times three to 4%, we’re not that sure we’re gonna let it overshoot for so long, we’d rather start up thing we’d rather start tapering and even discuss and I can say, so what that does, it actually makes the future distribution of probabilities for long term nominal growth down the road, much less scattered, because, you know, the Federal Reserve will act, if something starts to move, you know, too much into the overheating territory, which means long term, you are more secure that the trend is, you know, more confined within a certain band, and therefore, the term premium you demand for buying this bond is lower, and that helps pushing the 30 year bond yield down, which is exactly what’s happening today.
Nathaniel E. Baker 24:01
What would you need to see from the Fed to kind of change your outlook here and to change your equation? I mean, one thing about the Fed is that they’ve showed in the pain past cycles, that they’ve kind of kept their foot on the gas a little bit too long. You know, I remember the early 2000s. The Greenspan fed. And then, I guess, the Bernanke, I guess, Bernanke, he came in and started raising pretty much may not anyway, doesn’t matter. But the point is that they kept rates at zero for way too long, which kept the which led to the real estate bubble to come even more inflated. And they’ve done that a couple of times, one could argue they did it in 99. And then, you know, so what is what do you make of that argument that the Fed, the attic could be talking a lot about raising about hiking, but once the market shows freaks out, for whatever reason, they will stick to their kind of growth at all costs mantra, and keep printing longer than they need to.
Alfonso Peccatiello 24:57
Yeah, it’s a good question. There are two ways to start off The rebalance imbalances in the system, one of it is a pretty large wealth destruction up front. So you need all these accesses to be cleaned out, you need the current generation to be usually punished for the excesses that we have accumulated in monetary policy but also in how much credit we have taken on board over the last 40 years. And I’m always wondering which elected official is ever going to be wanted to be recorded in the in the history books as the guy that, you know, effectively wiped out one or two generational wealth, because that’s what’s actually required. I mean, to bring back the SMP to some reasonable valuations, you will need to drop over about 50 to 60% at least. And the SMP is always used as the barometer. But if you look at the word wealth is distributed all over the world. Global real estate accounts for 57% of the global market cap portfolio. So if you if you measure the market cap will be just a puzzle over the world. Real estate is at 57% of all the global wealth. So if real estate starts to reprice, and it’s an asset, which is inherently leveraged because of mortgages, obviously, if that starts to reprice, it’s a complete mayhem. I mean, he there’s a there’s implications for the labor market for the consumers for families, you you’ll have to see an employment rate going up. I mean, it’s a major restructuring, unprecedented. That’s one way. And you know, if it happens, by coincidence, or by accident, like the pandemic was probably one of these potential accidents, then at least people could blame an external agent. But which elected official is to go for for this solution, you know, by his own choice, no one wins. Yeah. So then the alternative solution is to basically make sure that we go for financial repression. And as we are overleveraged, we try to punish savers and consumers with negative real interest rates. And, you know, we hope to inflate away some debt. But these negative real interest rates bring other sorts of bubbly phenomenon, like real estate prices going through the roof. And investors start to look for any any risk assets that can reach on because they don’t want to be charged two or 3% of the real basis every year and lose the purchasing power. So it’s not a good situation, to be in to be honest.
Nathaniel E. Baker 27:14
But yet, it kind of describes every single business cycle of last 30 years, doesn’t it. And we had an O eight, a big meltdown in real estate. And we saw, you know, the what happened it was it was indeed very ugly, but then the Fed just came in and started printing money. Again,
Alfonso Peccatiello 27:29
if I would have to really call something a game changer would ever look at the Central Bank digital currency experiment. So the reason why I pay attention to this is that, at the moment, central banks cannot lend money, they can swap existing assets for bank reserves. So they go to a pension fund, and they say, You bought the bond a year ago, here’s my QE, I’m actually going to create reserves, and I’m going to take this bond away from you. And you’re going to be stuck with this reserves. And you’ll have to deposit these reserves in the banking system. And you’ll have to start chasing, again for new assets to buy. Right, that’s, that’s what the central bank can do today. That’s what they do, the central bank cannot lend money cannot reach the real economy straight away immediately. The agent, which is the real economy straight away immediately is the commercial that commercial bank can lend to you when we can then go away and spend this money, right. So with central bank, digital currency, theoretically, if you bring them to the extreme, you could have a central bank that actually circumvents the commercial banking sector, and allows me or you have an account at the Fed or the ECB or the whatever it will be. And in this account, you can you can transact, but you can also basically get credit, the credit line out of discount. So that would be a game changer. That would be a central bank that reaches straightaway the real economy and can extend or contract credit, basically their own will, without having to convince or, you know, sort of negotiate terms of these lending conditions with commercial banks that are free to lend out or not lend out, that can be a game changer,
Nathaniel E. Baker 29:04
a game changer for good or for bad.
Alfonso Peccatiello 29:07
That’s a good question. Yeah, that would be a game changer in terms of probabilities to generate inflation, okay. Because you will have a central bank that is able to reach the real economy straightaway, doesn’t need an intermediary credit to reach the real economy straightaway. But, you know, is this is this really going to solve the problem longer, long term? I mean, if you are an aging population, that is unproductive, how are we going to produce structural growth? I mean, we can borrow more and more we can we can become more and more over leveraged. But, you know, this is not a structural effect. It’s just a bigger bandaid. That’s what it is. But it would be a game changer in terms of how do you need to price the distribution around inflation. So that change we would, you know, force me to reconsider my disinflation stance because now you have all of a sudden, central bank’s able to reach the real economy straight away.
Nathaniel E. Baker 30:00
Failing that you are still in a disinflationary camp, you still don’t think that the Fed and central banks can produce the inflation that is, yeah, that scares people.
Alfonso Peccatiello 30:11
No, I mean, and again, I stay in that camp, simply because I see an over leveraged private sector, it’s massively over leveraged private debt to GDP in America is 165%. And when you think of that, you can think of the government able to just borrow again and print its own currency. I mean, the private sector is a currency user, not the currency printer, to the private sector needs the real cash flows, and these guys are over leveraged, and, and that leads them to have less credit demand. And as they have less credit, demand their appetite for credit going forward, these guys are not gonna, you know, borrow to go into productive investments, they’re just gonna try to save more or to pay down their debt. And when you have these dynamics coupled with tech, coupled with aging demographics coupled with horrible productivity, I just can’t see any long term aggregate demand push. I mean, to generate inflation long term, it’s one thing to have supply bottlenecks to generate short term inflation. Long term inflation comes from sustained boost to aggregate demand over the long term, medium to long term. And given the conditions I’ve just described, I can see where this strong and sustainable push to aggregate demand is going to come from.
Nathaniel E. Baker 31:21
Fair enough. All right, Alfonso . Let’s take a short break, I want to come back and I want to give our sponsors a chance to be heard. And also come back and ask me some more questions about if we could about assets, in particular, what this might mean for investors. But let’s first take a short break. If you’re a premium subscriber, don’t touch the dial, you’re not going to get the break. And to sign up to be a premium subscriber. Go to contrarianpod.substack.com and sign up.
Okay, welcome back. Everybody here with Alfonso Peccatiello known as the macro alf on Twitter, and the macro kompass. He has his little set substack subscription there, which by the way, I recommend signing up for a phone. So this is the section of the show where we ask our guests about themselves personally, how they came to this stage of their life as investors or economists or whatever it is that they are. And so yeah, so curious about your your path. And how you got where you are today. You mentioned your earlier offline that you’re in the south of Italy, where it’s quite hot, as it is here in the northeastern us, which is July, I guess, to be expected, but anyway, yeah, take it away. Tell us about more about you.
Alfonso Peccatiello 32:37
thanks for the chance. So basically, well, I’m Italian. But that’s I guess you’ve already gotten that by accent in the last 20 minutes or so. But I actually live in the Netherlands, which is a small, small country, north of Europe.
Nathaniel E. Baker 32:52
Yes. different country from Italy? Yes.
Alfonso Peccatiello 32:55
Yes, very much. And so the way the reason why I got into this business was that I was very curious when I was 14, 15. My mother is a treasurer, very small bank, the south of Italy. And we were having lunch at school breaks. And she was always this computer on on this on this lunch table. And she was looking at charts. And I’m like, What the hell is that? And she says, Yeah, this is a b2b future, which is, you know, it’s like a domestic government bond future from Italy, and she was trading that for for the Treasury over bank. And I was very fascinated by this chart going up and down. I wanted to understand what was driving and what that means, why it’s going up, why it’s going down. And you know, what, what actually does this represent? And so she started explaining a bit and I started reading some books. And at some point, I realized I really liked that. I was like, connecting the dots on a macro very, very broad macro sense, like, what’s driving was his unemployment rate going up or down the average shrinking labor force or an expanding labor for so what does it do to government bonds and to equities and then to credits and to other stuff. So connecting the dots was the part of the like the most and finance and broad macro seem to actually defeat that appetite for knowledge and connecting the dots very well. So then I went to university studied it macro and did some quantitative finance course with option price and stuff like that. And then started in finance, basically, in in Treasury, managing fixed income book. And you know, it has been a nice journey, especially when you become more institutional investor, you’re able to see things from a different lens, but you still wear your hat of a broad macro top down analyst, you’re able to see what’s going on, but you also have a better understanding of how much regulation is impacting decisions out there. And you know how these real money investors, as they’re called in jargon, so insurance, pension funds, banks, etc, move their capital and take their investment decisions, which sometimes As I should say, pretty funny and unexpected, but you learned that in the desert in a good journey.
Nathaniel E. Baker 35:08
Very interesting. And so you’re in the Netherlands, I hail from Italy. And now what are you okay, so let’s talk some now about the about the outlook for economies. And for we can talk about bonds or other asset prices. Obviously, the understanding is that neither of us are offering investment advice here, and should not be viewed as investment advice. So we have what is your your kind of top down view of economy and markets right now.
Alfonso Peccatiello 35:34
So before we jump into that, just make a small disclaimer, I think to yours. I’m here just representing myself, I do not speak on behalf of my employer, my views do not necessarily represent my employer’s view, this is just me talking about my private account investments basically, and what I would do, which doesn’t mean you have to do the same. Got it. So talking about economies and asset classes. So the way I look at the world now is that I think the market is smelling that the credit impulse is actually baked into for 20. If you run the numbers, it does speak into 420.
Growth expectations and earnings expectations are through the roof. It is the basically the inherited job, the reflation trade of q1 21, where everybody got very excited about the growth prospects. This year, we’re gonna have a massive growth in the US. But the average Bloomberg expectation economist expectation for us nominal GDP growth this year is 10%. year on year 2021 versus 2020, an earnings surprise to be 40 44%, higher compared to last year. So you might want to argue from an expectation perspective, most of the good news is actually priced in what’s not fully priced in and maybe the market is starting to smell this now. With lower long end bond yields with secret ghosts actually taken a little bit of a beating with certain commodities also down 40 to 50%. From there maybe take lumber as an example. And with cyclical stock sectors doing much worse than the secular growth sectors is that, you know, this expectation might be disappointed later this year, you know, the effect of the credit impulse fading away and the Federal Reserve coming in and wanting to tighten the bait with other central banks than being free to follow, which wants the Federal Reserve starts and you are maybe the European Central Bank, you can start thinking about tightening your own monetary policy without being afraid of Euro dollar going to 140, because the Federal Reserve has already started. So you know, at that point, you will have a little bit of a cycle of central bank’s tightening their monetary policy, which is understandable, I would say. But that happens maybe at the moment when real hard data is starting to disappoint a little bit, as we go into the end of the year, you saw the ASM data yesterday, they were already disappointing, a tiny bit compared to expectation in the market to create a bit of a growth scare. So in my macro compass publication on substack, which is called the macro compass, inspired by this this four quadrant approach that I have to market investing, right? We have, you know, we’re basically in this quadrant, moved on the y axis and on the x axis by two components, one of it is the credit impulse. So are we literally creating credit? Or are we de leveraging? So is you know, is more money like spendable inflationary form of money flowing towards the economy or with the leveraging? So are we destroying money? are we paying back our bets effectively? So what is the cycle there? And on the other side of the of the axis, you have the central bank, monetary policy stands against expectation and in a dynamic sentence, and what I mean is that you need to look at the opposite level of accommodation, but both at the pace so effectively, what are we moving? Are we becoming more or less a commodity? And how fast are we moving against consensus, right, so those are the two the y axis and the x axis of this quadrant. And then you have four quadrants basically have this compass and then your four quadrants within the compass. And, you know, we have moved if we had moved into 121, to the part of the compass that is the most positive for high risk assets of emerging market effects, cyclical stocks, banks, all that stuff and the worst one for bonds. And that happens where you have created credit, you have pushed credit to the real economy. So earnings are going up. And there is this deflationary sentiment and you have a central bank that is still on the accommodative side. So what this does is that it steepens the yield curves, because the long term nominal growth projected goes higher as you have an accommodative central bank, the face of a growing economy, right. So and that leads money to flow into the high beta risk asset of asset classes right to emerging markets. We’re doing good and commodities were doing good and all that stuff. And now we are definitely transitioning towards the left side of the compass, the left side because I know for sure that credit creation has actually peaked in q4 last year. And it leads all asset classes and GDP growth by the way, the 12 months or eizan, eight to 12 months depending on which asset classes are you looking at so late summer to fall, you should start seeing the effect of this credit cliff, actually hitting hard data and sentiment data. This doesn’t mean necessarily that equity markets have to drop off the cliff straight away, right, it also depends from what is the reaction from the Federal Reserve and other central banks. Now, as we transition to the left side of the of the of the macro compass, you effectively have to coordinate left one, which is really, really bad. And it’s when credit creation, decelerates and central banks, you know, remain tight compared to what the market would require them to be to accommodate the process of a slowing economy. And in that case, you have all risk assets doing poorly, you have volatility going up, you have the dollar going well, which is you know, a wrecking ball for risk assets from commodities to emerging markets, that’s a pretty poor quadrant and And normally, it lasts very little, because central banks jump back in and try to ease the monetary stance again and, you know, come down the markets, or you might want to move to the other left quadrant. And the other left one reading is the secular quadrant. This is the quadrant where credit creation is produced low, we don’t do much deficits, we don’t borrow that much. We stagnate on the credit creation. So earnings are not massive, real GDP growth is between zero and 1%. Inflation is between one and 2%. You know, it’s a little bit of a secular trend of disinflation effectively. And in that quadrant, you have the tech stocks, you have yields doing well, you have credit doing well. And you have the high beta sectors of the of the asset class spectrum out there doing not that well. So you have bank stocks not doing well, em login beyond behind the M, and so on, and so forth. So basically, this is the last 10 years with some interruptions here. And so and here, I’m in the process of discovering, are we transitioning towards, you know, this quadrant, so the secular quadrant, and the price action of the last month would validate that so you had NASA doing much better than the Russell, you had emerging markets, lagging behind N word bond yields doing work very well. And you add financial stocks doing worse than their tech peers, for example. Right. So this is the typical secular trends effectively, I still think there might be a race played around that we we take a little bit of a peek at the worst quadrant, because when the Federal Reserve, assuming they just go through with their with their, you know, tightening schedule, when that coincides with bad economic surprises that would expect popping up from q4 onwards, I think that’s pretty much a toxic combination. We’re also overdue for a five to 7% reduction in risk assets, which will just be healthy, my European. So I I’d be I’d be relatively careful with your exposure to risk assets, and definitely prefer the low beta to the high beta. So the more secular trends, I’m talking about your tech stocks rather than buying in industrial commodity related stocks, or em FX, that stuff I would be, I will be rather away from and, you know, the yield curve in America supposed to flatten year and it’s already flattening. Because the Federal Reserve comes in and tries to hike rates maybe next year, then five year rates are supposed to go up. And ferrovia rates are supposed to go down reflecting structural forces, so but I wouldn’t exclude completely, the chance we’re going to see a drawdown five to 7%, in SMP somewhere in q4. And you know, the dollar also does well in that environment. Because you have all these emerging markets, which are over leveraged and they are indebted in dollar, they don’t have access to the dollar. Maybe global trade is slowing down more than people think they might think today. So these emerging markets on the last $2 exports to services know that they scramble to get dollars and then the DX y gets a bit which is typical as well when risk assets assets reprice. So the dollar the dollar bearish phases here as well, I think is misplaced.
Nathaniel E. Baker 44:05
Right? Does it take a little while though, for higher interest rates to kind of take their effect in the economy? And if you look at last, the past cycles, like you know that even the most recent one pre COVID, you had the Fed tightening from what 2015 through 2018. And 2017 was, I think, one of the best years for stocks and risk assets in you know, many years. And so it does, so Wouldn’t that kind of postpone a little bit some of the nastier quadrant that you were talking about?
Alfonso Peccatiello 44:36
Yeah, it’s also a matter of expectations, I would say so in 2016, we had the China slowdown scare if you remember right. So we repriced as well. A lot of earnings down because you know China hard landing or soft landing. Do you remember all that discussion? Yeah. I was in so on a global? Yeah, you go on a global basis. You had a little bit of a scare coming from China. It led to repricing of earnings expectations back then. And the Federal Reserve was also So much more companies and have that and slowed down a little bit. They’re there, I can cycle in 2016 to them, basically resume it again in 2017, and then in 2018. So don’t take me wrong, it can be the case that the Federal Reserve is able to tighten monetary policy and accompany recovery, in a very gentle way. That is possible. The more the economy becomes over leveraged, though, the less it is their, you know, capacity to produce long term structural cash flows. I mean, that’s what the private sector needs in order to flourish and to be able to service that that burdens. And I’m afraid that COVID actually worse in that situation. it you know, wiped out something like at the moment, 2% of the labor force in America has disappeared, like no participation rate went down from 63 and a half percent to 61 and a half percent not recovered in the last year. Basically, despite Roger reopenings, which is pretty scary, it might suggest that the part of the labor force in America has just disappeared, I mean, literally, they are not even interested in looking for a job anymore, these guys. And you know, that that actually, thence the long term ability to generate structural cash flows. And if the economy’s not able to do that, then the Federal Reserve can only tighten so much before people effectively are struggling again,
Nathaniel E. Baker 46:24
has the Fed ever been able to engineer a soft landing, I guess you could argue maybe the 2018, pre COVID things are kind of okay.
Alfonso Peccatiello 46:32
Well, the first thing I would like to point out as an answer to that question is that while the Federal Reserve themselves are telling you what the terminal rate is supposed to be, according to themselves, right, so if you go back to 2005, you will find the federal terminal rate to be four and a half percent. So the Federal Reserve felt they could hike rates in a normal hiking cycle all the way up to four and a half percent, in four and a half percent was the nominal fed fund terminal rate. So that is the rate that the economy can take literally and can function at equilibrium, when that rate remains there. So you will have not not overheating, not under heating, you will have just you know, unemployment rate that Nyaru and all these nice equilibrium models actually holding up very well. Now, this terminal rate, so it is the long term.on, the long term on the dot plot of the Fed today, it’s two and a half percent, with the Federal Reserve has actually acknowledged that the economy can bake for an hour percent long term Fed funds rate. According to them, the next hiking cycle has to stop at two and a half percent. unless something changes in the meantime and something structural changes, it means demographic turns it means productivity goes up, it means you know that stuff, but asper today, they think we can go higher than two and a half percent. Right. So that’s already something I would say the central bank acknowledging they’re facing structural forces that they can’t they can’t actually influence that much.
Nathaniel E. Baker 48:00
If it’s not all relative, I mean, couldn’t the new? Couldn’t two and a half percent just be the new four and a half percent?
Alfonso Peccatiello 48:07
Well, I guess the answer to that is yes. Because as we discussed before, if you are more and more over leveraged, then at some point, you just can’t take higher rate. So the old 4% is now two and a half percent. I would even challenge that to you by saying that if you check what the actual hiking cycle of the Federal Reserve has been, versus what they told you to they’ve been looking at the terminal rate, there’s always been way lower than the terminal rate over the net over the last 20 years. So Janet Yellen had terminal rated about three and a half percent when she was in office. And you know, the Fed funds rate never went to three and a half percent. That’s one example. Right? So now the federal funds rate is two and a half percent. I would argue that the Federal Reserve maybe manages to like a couple of times, maybe that’s at best. So we’re talking about the reference right at about maybe 0.5 or 0.75%. That
Nathaniel E. Baker 48:57
Wow, okay, that’s very low indeed. Okay. How soon do you think the Fed is gonna hike?
Alfonso Peccatiello 49:02
Well, you know, if they would, if they would have a perfect path in front of them, what would happen is that effectively, they get, you know, not much of a slowdown in our data. So they get the brutal, decently positive few quarters of our data that gives them the chance to taper their purchases from 100 and 20 billion to zero to process that normally takes about nine months, I would argue, let’s assume starting in September, and then you move to June next year, where you have zero purchases on that basis, and the economy’s still doing good. By the way, that’s that’s the assumption behind and then you wait generally for about three months. That’s what the textbook would say, to make sure that everybody knows that you’re going to telegraph the first hike and what does it look like? And then late in 2022, you actually start hiking and the bond market up until a month ago was surprising. The full 25 basis point hike by December of 2022, which is consistent with the story I’m saying it’s nice It’s very hard to imagine it gets quicker than that. It can I mean, they can taper and then maybe where they’re buying only 20 billion a month, they can do the first hike. But that will be, you know, a bit outside of textbooks, right. So the textbook is first like in, you know, September to December 2022. That’s the earliest you can get. The last bond market movers actually might doubt that probably the eurodollar futures are running. So forget about that the market doesn’t believe that anymore. But yeah, if they would, I guess they have an incentive to hike in 2022. And then to continue in 2023, as well, if they have the chance. And the reason why the incentive is there is the zero lower bound, the Federal Reserve is at the zero lower bound, which means that assuming you get another crisis next year, you never know, right, assuming it happens, how is the Federal Reserve going to react to that, from an interest rate perspective, there’s nothing left literally nothing. And I say nothing, because I don’t think the Federal Reserve can ever apply negative interest rates, or they can probably, but they really don’t want to. And it’s a geopolitical reason, the dollar is the reserve currency of the world. So people are trading in dollar, they make loans in dollars, they do not want to hold the reserve currency of the world that actually charges them in nominal terms with negative nominal rates, they already are charged in real terms, but the charge even in nominal rates, I think, might be pretty much a geopolitical bomb. So they they probably want to avoid it for as long as possible. But in order to avoid that, you need to get out of the D lower zero lower bound as soon as you can. So I guess they will try. Will they succeed? Maybe a couple of weeks. And that’s it?
Nathaniel E. Baker 51:36
Yeah. Actually, you know, I know one thing the Fed could do to think if they need you, they could always just buy stocks. Right? Remember, there’s always some speculation about that. Every in every recession, and so far, they haven’t done it, but they they’re buying ETFs right, Bond ETFs. But, you know, why not switch? Those two stocks could happen, right?
Alfonso Peccatiello 51:53
Yeah, I mean, the corporate bond ETFs. So they’re, they’re moving to things that you would it would have been unthinkable a few years ago. I mean, they needed to set up an SPV, basically, to buy that stuff, otherwise, it was against the law. So you have Bank of Japan buying equities, ETFs. And at some point, the easiest way to compress risk premium out there and to come down the market is to literally to lift equities. Once you do that, then you send and also the signal of your action is very, very strong. You know, make sure that people follow what you’re doing. But again, we’re not pushing on a string. And we are imagining the next crisis with federal funds rate, probably at 0.5%. And then the next big crisis hit, and then, you know, I don’t know for how long these authorities will be able to kick the can down the road without causing what I call a convex market reaction. So markets are very linear in nature until they’re not. And you know, when when something like that happens, then you need something in your portfolio that protects you against nonlinear market action, liquidity disappearing, you know, and in something moving as a straight line down, rather than in a linear process, you then need instruments in your portfolio that are also convex, rather than linear in their base of options do that very well. If you know how to structure them. And in the past, again, it was much easier to have a 6040 portfolio with bonds doing the work for you most of the times in the draw downs, but today, I think optionality center risk hedging strategies should be part of your macro portfolio approach.
Nathaniel E. Baker 53:29
Yeah. Yeah. Although historically, again, a lot of these risk protection things that assets didn’t work very well. But the only thing that did was Treasury Right.
Alfonso Peccatiello 53:40
Yeah. And the other thing about this, this tail hedging strategies is that they, nobody likes them, because they’re very expensive. When things are going well, you literally set aside a budget, which will make you underperform your peers that are not buying insurance when it’s cheap, right, they don’t care. So you know, in this industry as incentive schemes that force you to outperform every three months, your peer group, right. So if you spend insurance premium buying out of the money options to get the convex payoff on an instrument, and nothing happens, you lost money, right? So you can lose money for a quarter, maybe for two quarters, but then your CFO or whatever your bosses will come to you. And we’ll say, What the hell are you doing, man? So and that can cost you a job. So the incentive schemes are not great, I think for hedging strategies, but I think they might have or they should have a place in your portfolio because the classic you know, approach to equities and bonds as a risk offer instrument, I guess might be less, less relevant today than it was for the last 40 years.
Nathaniel E. Baker 54:43
Yeah, and it didn’t work you know, in during COVID. And it didn’t work in oh eight either. So from what I recall looking at some of these assets, I remember the Swiss franc sold off gold sold off everything, you know,
Alfonso Peccatiello 54:55
yeah. Because you know, you’ll become more and more over leveraged, right. So So as long as you you just want to survive. When that when that comes and in order to survive, you need to get your hands on cash and to pay your you know, to make sure you can pay your margin calls when they come. So any asset you have, especially if it is in the money and will will make you money when you sell it to gold or bonds or whatever it was, you just sell it, you have to get your hands on cash, because up until the day before COVID, eight, everybody was in si ellos in, you know, over leveraged every trade out there, and then it’s a scramble just to get the cash, you know, to make sure you can repay your margin goal. So your loans that you were having to basically found your loans.
Nathaniel E. Baker 55:32
Yeah. Alright, I’ll find your last question. How low do we go on a 10? year? What’s your time horizon? Oh, well, no, this cycle, let’s say?
Alfonso Peccatiello 55:44
Yeah. So the cycle, we might say, for over the next quarter cycle five to seven years, I’m gonna say anywhere between zero and 0.5%. So that means further, yeah, this would mean federal funds rate at 0%. Because I really think the Fed will have a hard time selling to the public negative interest rates. But then it means the term premium between zero and 10 years is effectively close to zero. So you don’t need any reward to buy a 10 year bond, because you will assume the Federal Reserve has no alternative than to keep rates at zero about forever. So basically, it’s a Europe ification. If that is an English word, or a Japanese ification of the US of the US yield curve where you add, you know, the 10 year yield is very, very close to the base rate, the front end rate because there is no no uncertainty around the policy path is just going to be zero forever. So any farm brighter than 10 year yields can be as well 0.25 to 0.5%.
Nathaniel E. Baker 56:38
What was the lowest thing on COVID? It was like what around 70, 60?
Alfonso Peccatiello 56:43
I think we saw 55 basis. So
Nathaniel E. Baker 56:46
and in 08/09?.
Alfonso Peccatiello 56:49
No, that would have been higher that that
Nathaniel E. Baker 56:53
Yeah, yeah, that makes it. So this is what you think. Okay, historically, you’re talking about a historic low if it’s below 50?
Alfonso Peccatiello 57:01
I don’t know exactly when that happens. I only know that the long term trend is very clear. So you had one deal that, you know, 5% in 2006. And now they are at the 1% one 125 one 3% today, next, next stop, which is you know, in the structure of trend all the way down with some cycles around the trend, but the trend is very clear. And I don’t see any way we can revert that in any form. So we’re going to point 5%
Nathaniel E. Baker 57:27
Interesting, interesting. Very good. Okay. That’s great. Wonderful. Well, thank you so much for joining us. Maybe in closing, tell our listeners how they can find out more about you. I mentioned your Twitter and your substack. I’ll put that in the show notes as well. Macro alphas the Twitter at macro ma si r o l f, you took the German abbreviation of your name, rather than Alfonso but and the macro compass. what’s what’s the URL for this appstack.
Alfonso Peccatiello 57:55
So if you want to find me on substack, you can just go on the substack website and type the macro compass, or otherwise just go on google and type the macro compass newsletter, you will probably find me the first results. And my handle on Twitter is macro Alf, as you correctly said. It has been an absolute pleasure being on the show. Thanks for having me.
Nathaniel E. Baker 58:16
Yeah, thanks for coming on. It’s the macro compass. At dot substack. Calm is the URL. Thank you to Alfonso. Thank you all to all of you for listening. And we look forward to speaking to you again next time.
Not intended as investment advice.