The Pythagorean Theorem of Financial Repression featuring Steve Sexauer Managing Director of CIO Multi Asset US Allianze Global Investors
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July 2014
Viewpoints
CIO Outlook
The Pythagorean Theorem of Financial Repression CIO Multi Asset US Steve Sexauer uses a well-known mathematical formula to shed much-needed light on the Fed’s unprecedented balance-sheet expansion. While there are multiple options for where the economy goes from here, investors should remain patient and diversified as they wait for the Fed to make the right policy changes.
Key Takeaways Stephen Sexauer Managing Director CIO Multi Asset US
◾U nderstanding the Fed’s thinking and its implications for investors is a major challenge: We have never been here before, and there is no shortage of opinions. ◾ F actoring in theories from highly respected analysts, three options stand out: recession, below-trend growth or escape-velocity growth. ◾ T he Fed won’t stop financial repression until it gets the economy it wants, but the Bullard distance equation shows we are closer than almost anybody thinks. ◾W ith interest rates at all-time lows, real rates negative and credit spreads tight, bonds can be as risky as equities, which are fully valued almost everywhere. ◾ T he best investment strategy is staying near the benchmark, keeping risk low and leaning toward high quality while avoiding high-risk/low-liquidity strategies.
James Bullard, president of the Federal Reserve Bank of St. Louis, collapsed the four trillion dollars of never-seenbefore central bank monetary expansion and extended zero interest rate policy (ZIRP) in the US into one of the oldest and most well-known equations in human history: the Pythagorean theorem.1 Bullard’s equation is parsimony at its finest. Maybe we can use it to navigate the move to more normal times. Here is President Bullard’s equation: The measure of how far the Fed is from its dual-mandate goals of price stability and employment is d = √ (u — u* )2 + (p — p*)2. The “u” is the current unemployment rate and u* is the goal; “p” is the current inflation rate and p* is the inflation goal; and “d” is the calculated overall distance from the Fed’s dual goals. Graphically, it looks like Exhibit 1, and could be taken straight out of any high-school geometry text book.
Exhibit 1: President James Bullard’s equation distance shrinks as the Fed’s goals are met distance from point p to point u = d = √ (u — u* )2 + (p — p*)2 p d p*
u*
Much ink has been spilled trying to understand the thinking behind the Fed’s balance-sheet expansion and, more importantly, how this thinking translates to the everyday lives of income-starved savers, especially retirees; to forecasts of future inflation,
1. Bullard, James B. 2014. “How Far is the FOMC from its Goals?” Speech at the Tennessee Bankers Association, Palm Beach, FL. (June 9, 2014).
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u
continued
used for long-range saving and spending decisions; and to the ever-expanding valuations of stocks and bonds. The tough reality is we don’t know. We have never been here before. But there is no shortage of opinions. The last Federal Reserve chairman, Ben Bernanke, is reported to have recently said, at a series of private dinners, that the Federal funds rate will never again see 4% in his lifetime. Is he saying the Fed won’t hit its inflation goal for a long time, or that the 2008 crisis has knocked the US off its 100-year trend of 2% per year productivity growth for decades to come, or both? The current Fed Chair, Janet Yellen, sees a large bloc of discouraged workers (not officially counted as unemployed but also not working) that monetary policy can bring back into the ranks of working Americans. She sees more “noise” than signal in the data. It is hard 12to see how Yellen will implement a rules-based policy if she doesn’t believe the data. Her policies are more likely to be judgment-based. 10Jim Grant, the astute and sharp-tongued analyst who has long written Grant’s Interest Rate Observer, sees the emergence of 8Fed-caused bubble No. 3, with No. 1 being the “Greenspan Put” (which resulted in the tech bubble and collapse) and No. 2 being 6the housing bubble that Bernanke regarded as “contained,” but which ended in the global financial crisis.
4 Two long-standing and highly respected analysts of the U.S. economy, Stephanie Pomboy of MacroMavens and Nancy Lazar of 2Conerstone Macro, look at the same data, yet they see the opposite outcomes. Pomboy sees an economy, and markets, surviving 0mostly on the fumes of the Fed’s quantitative easing (QE) and ZIRP. 1960sees the economy 1965 1970 1980driven by1985 Lazar accelerating to 1975 escape velocity, an energy and manufacturing renaissance of epic proportions. These dramatic forecasts can’t both be right. In the middle is David Rosenberg, an equally respected analyst, who expects renewed
growth but is concerned about wage and inflation pressures, and a Fed way behind the curve—shades of the stagflation horrors of the 1970s. So where are we? What do we do? There are at least three possible paths. The first is a continuation of the current condition of belowtrend growth and low goods and services inflation. (Asset inflation is another matter). Second is the Stephanie Pomboy forecast of growth so slow it’s really a recession, bringing with it much lower profits and interest rates and renewed fears —at the Fed at least— of a debt-deflation collapse. The third is Nancy Lazar’s accelerating growth, bringing more profits, higher rates and most likely the end of both QE and ZIRP. We can use the Bullard distance, or Pythagorean distance, to help us gauge where we are and, even more important, how the Fed sees the world. In his recent talk, Professor Bullard plotted the path of his Pythagorean distance over the last 45 years. The plot is shown in Exhibit 2 and refers to the distance d from Exhibit 1 as the “square root of objective function value.” This distance represents the amount of trouble the Fed needs to resolve. As the exhibit shows, we have been farther from the goal 75% of the time, and closer to it 25% of the time. Exhibit 2 tells us two things: 1. We may be much closer to the end of QE and ZIRP than the markets think. While many observers see financial repression extending for many years into the future, the Bullard graph suggests they are in for a shock. 1990 1995 2000 2005 2010 2. If the Bullard equation is correct, then the odds are high we moving from our current malaise of below-trend growth toward acceleration to escape velocity. Despite the terrible -2.9% print in GDP (stated as an annual rate) in the first quarter of 2014, recession-deflation appears to be a really low-probability event.
Exhibit 2: Square root of objective function value since 1960 10 9 8 7 6 5 4 3
Average since 1960
2 1 0 1960
1965
1970
Source: Federal Reserve Bank of St. Louis.
1975
1980
1985
1990
1995
2000
2005
2010
The key insight is that the Fed will not stop financial repression until it gets more or less the economy that it wants. Stated as an abstraction, this goal is hard to grasp and see. In addition, the data are measured with “noise,” as Yellen cautions. The Bullard equation makes the Fed’s goal easy to see, grasp and measure: financial repression will stop when u and p approach u* and p* very closely. This is not a statement that the Fed is moving toward a more moderate stance; rather, it’s the reverse. The Fed isn’t changing its strategy until it gets what it wants, and Bullard lets us measure its progress toward that. The measurement shows we are close, closer than almost anybody thinks. The investment outlook takeaways are these: With interest rates at all-time lows and with real interest rates negative—and credit spreads very tight—bonds can be as risky as equities. Equities are fully valued everywhere except for a few pockets of deep value. The best investment strategy is staying near the benchmark, keeping risk low and leaning toward high quality while avoiding high-risk/ low-liquidity strategies. These principles point to holding high-quality and/or high-dividend stocks, short-duration high-yield bonds, higher-income mortgagebacked securities and a few contrarian equity ideas such as investing in Russia, Korea and Spain. Patience remains a virtue: If and when
bond yields rise and equity valuations normalize, investment prospects will be better. But as John Maynard Keynes suggested, when the facts change, we change our minds. When new evidence tells us which path we are on—recession, below-trend growth or escape-velocity growth—we will change our portfolios accordingly. We hope that the Fed, too, will decide, to do something different when the facts warrant it. Until then, patience and prudent diversification are the rules of the day.
Stephen Sexauer Managing Director, CIO Multi Asset US Mr. Sexauer is a portfolio manager, a managing director and CIO Multi Asset US with Allianz Global Investors, which he joined in 2003. He has overall responsibility for all US multiasset investment functions. Mr. Sexauer has 30 years of investment-industry experience. He was previously a portfolio manager at Morgan Stanley Investment Management. Before that, he was at Salomon Brothers and worked in economic consulting at Merrill Lynch Economics and Wharton Econometrics. Mr. Sexauer has a B.S. in economics from the University of Illinois and an M.B.A. with concentrations in economics and statistics from the Booth School of Business at the University of Chicago.
A Word About Risk: Equities have tended to be volatile, and unlike bonds do not offer a fixed rate of return. Dividend-paying stocks are not guaranteed to continue to pay dividends. US Government bonds and Treasury bills are guaranteed by the US Government and, if held to maturity, offer a fixed rate of return and fixed principal value. Bond prices will normally decline as interest rates rise. Foreign markets may be more volatile, less liquid, less transparent and subject to less oversight, and values may fluctuate with currency exchange rates; these risks may be greater in emerging markets. Diversification does not ensure a profit or protect against a loss. Past performance is no guarantee of future results. The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation. Economic data in this presentation are derived from internal research, publicly available statistics published by Bloomberg, the US Federal Reserve, OFHEO, the US Department of Commerce, and the International Monetary Fund. Š2014 Allianz Global Investors Distributors LLC, 1633 Broadway, New York, NY 10019-7585, us.allianzgi.com
COMM-022-0914 | AGI-2014-07-14-10023
Presentation by James Bullard, President and CEO of the Federal Reserve Bank of St. Louis: How Far is the FOMC from Its Goal http://bit.ly/1ypuUp9
Presentation by Charles Evans, President and CEO of the Federal Reserve Bank of Chicago: Monetary Policy Strategies & Accountability http://bit.ly/1B3U6NV
Submit a Question: To submit a question for Q&A, please email alichtenstein@interdependence.org
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