Pimco's McCulley Discusses 10-Years, The Yield Curve, The Shadow Economy, Minsky Journeys And The Deflation Beast

Some interesting observations from Pimco's Paul McCulley, who seems hell bent on destroying the premise of financial prudence, and instead joins the Fed in its "All In" endorsement to speculators and savers.

I cringe when I hear men like Kansas City Fed President Tom Hoenig muse that the Fed will ultimately need to get the Fed funds rate back up to a 3.5-4.5% zone. I deeply respect Mr. Hoenig, both as an economist and as a man, but I just don't see why the Taylor Rule of the Forward Minsky Journey should apply to the Reverse Minsky Journey.


Simply put, the 2% real Fed funds rate constant in the Taylor Rule should, in my view, be considered toast. In a world of deleveraging and hoarding cash it makes absolutely no sense to reward holders of cash with an after-tax real rate of return.

Too bad the baby boomers are coming: remember: this will be the first year that that baby boom generation starts retiring after hitting 65 (explains why Social Security is now officially net outflowing). After 2008, most of the boomers got destroyed and lost a major portion of their net wealth by holding stocks. Good luck expecting that they will rush right back into equities.

McCulley on 10-Year interest rate and curve shape expectations:

And for 10-year Treasuries? Six years ago, I assumed potential real GDP growth be 3-3.5%. In a world facing a prolonged, even if a less nefarious Reverse Minsky Journey, I think 2-2.5% is a more plausible estimate, which should be the anchor for private 10 year yields, defined as the real swap rate. In turn, assuming swap spreads hold near flat [they are currently negative, as are 7 Year swap spreads today], as at present, this implies a 4-4.5% fair value range for both nominal 10-year swaps and Treasuries. But this will only be the case when the market can credibly discount that the Fed will have the economic justification of an at-target (2%) inflation rate and an at-NAIRU (5%) unemployment to lift the nominal Fed funds rate to its 2.5% "neutral" nominal level. 


Would such a curve, flatter than at present, but still reasonably steep, beget speculative excess via leverage, as was the case in the mid-2000's? I don't think so because policymakers have learned that regulation of leverage is not an evil, but a missing virtue that now becomes an imperative. The shadow banking system will, I believe strongly, be a small shadow of itself for a long, long time. This, while I am sure I will be wrong about many things in the years ahead, I have few fears that unbridled, unregulated leverage will again be the dog that bites me.

Is that so? Where in current financial reform is there a curb on exploding shadow leverage? Where in the Dodd bill is more prudence cast to the same banking stupidity that blew up the system the last time around when the curve was so flat that bankers had to leverage 50x to make money on it? While we are confident Mr. McCulley is simply talking his, and Pimco's $1 trillion bond book, for which aggressive rate increases would be devastating, we find lots of faults with his blind hope in the suppression of banker greed, which ultimately, using various financially-innovative mechanisms, is the reason why we had a systemic implosion of unprecedented proportions. Alas, we are confident in one thing: Paul is right in that the Fed will keep rates at zero for a long time. And when the flattening begins, the same stupidity that caused the $600 trillion shadow banking system to develop, will reappear. Where will we stop this time? One quadrillion? Quintillion? Coupled with a vastly higher hyperinflationary threat, the result of that final Forward Minsky Journey, in the parlance of the Pimco executive, will be not only very aptly named, but promptly achieved. Only this time it will not be the "debt deflation monster" of the private sector that forces the destruction of the system, but the public one. We are already seeing its wondrous impact on the Eurozone. We eagerly await as its full force is felt, soon, on US soil.

Full McCulley speech.


McCulley March 25