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Peter Higgins 00:18
Hello, and welcome to this Investing Matters Podcast. My name is Peter Higgins, you can find me at Conkers3 on Twitter.
And today I have the huge privilege of speaking with Brian Pellegrini, the Founder and Senior Analyst at Intertemporal Economics and he's all the way over there in the US. Where are you today, Brian?
Brian Pellegrini 00:41
I’m in Westchester, just north of New York City.
Peter Higgins 00:44
Thank you very much for joining us from Westchester in New York City. Thank you very much.
Now, Brian, I will start this conversation if I may, with you talking about your educational past your professional qualifications, including where you attain them, please?
Brian Pellegrini 00:59
Well, so I was a Computer Science Major at Columbia engineering school.
Back just after the wheel was invented, I worked on Wall Street for a little while after that.
And then I attended the Masters of Science Finance Program at Northeastern University while I was at Connolly Insight, and I was getting my CFA so CFA, you have down periods, right.
So every six months, where you just like sitting twiddling your thumbs and CFA is very, it's, it's awesome.
It covers a lot of stuff, but it's very pen and paper, right? There's not a whole lot of application, it's all checking the knowledge.
And so I wanted to kind of round that up.
And then in 2014, I attended the Executive MBA program at Columbia Business School. While I was also at Connolly Insight, I got a lot done while I was at Connolly insight. And that rounds it out.
Peter Higgins 02:09
Cool. Thank you. I wanted to just go back a little bit and talk to us about that period of time you had on Wall Street, what you did, what your experiences were, what was going on in the markets at the time?
Brian Pellegrini 02:21
Sure, sure, so it was a really interesting time I started in January of 2007, at Morgan Stanley working in the asset backed securities group.
And so I saw the very peak to the very trough of the asset backed securities boom.
And I got to learn a lot about how the shadow banking system worked and how it was important to a bubble economy and maintaining that bubble.
And so you know, I didn't realize how historically important it was at the time when I first started. But it certainly became pretty apparent as things started to break.
And so I worked there for two and a half years. And then the great decimation happened in structured finance, and everybody got laid off. And I was privileged to spend a year as a bartender, and bar manager at a bar in Manhattan, Bar Nine, which was a lot of fun. I learned a lot there about people. So it was a good little break.
Peter Higgins 03:36
Fantastic. Now, thank you for sharing that. I think it's brilliant that we learned a little bit more about the nuances of the market, some of the things that's happened, some of your experiences because of the layoffs as well. And the experience of dealing with these volatile markets, which would seem to come around in cycles, don't they? I want to talk now, if I may, about your first job and journey into economics, which doesn't move on to that bit and where it all started for you really?
Brian Pellegrini 04:01
Well, so I started off, I knew I wanted to work in financial services.
I didn't really I had been interested in economics in college, but I didn't really see a professional application for it at the time, right?
It just lack of knowledge, other than being a professor or some sort of researcher in that, you know, pure research role.
And so I worked briefly in the client service department at Bridgewater Associates way back before even Morgan Stanley.
And that's where I discovered the role of the strategist, I had no knowledge or skills that they were interested in, in research.
So I was advised that I needed to go and get those.
And that that prompted my journey onto Wall Street. And so after, after the bar, I've worked for a little while as an investment banker at a boutique investment bank with small cap technology firms.
And I was looking for an economics research role at that time. And I came across on the Columbia job board a posting for a little company with almost no information on his website Connolly Insight, but it was macroeconomics research, and I was like, well, what the heck right, like let's go for it.
So I applied. And you know, I had been while I was at the bar, I was helping an Emerging Markets analyst start up his own boutique research firm, an economics research firm, as an internship, sort of, you know, just to sort of learn the ropes a little bit and so the business manager at Connolly Insight, Camila was I mentioned that and she was like, Would you leave your banking job to work with Paul at his boutique firm and I was like I leave this place in a second for him like and so she was like, well, that's interesting because that sounds a lot like what we have here Connolly Insight and so I met with Bernard and Dino his partner at the time, it was great because we just talk shop the whole time.
I was pretty sure I had gotten the job because I never got any questions about like, what's your boss say is the worst thing about you or anything any of those typical interview questions.
And Bernard really liked that I was thoughtful about the questions and that he actually asked me a question that I had no idea the answer to. But he liked that I didn't just give some bs answer and that I sat and thought about it.
And he was like, don’t worry, you're not going to know. And it was, you know, at the time, in the end, China were roughly in the same place economically in terms of development.
But China was running a huge current account surplus, and India was running a huge current account deficit. And it was, you know, why is that right?
They're so similar in terms of their path along economic development. And the reason it's very interesting is that the one child policy, neither country has very good social security, it's all locally based.
And so because of the one child policy in China, people saved 35 cents on every dollar, because if anything bad happened to them or their kid, they would need to have the cash on hand.
Whereas in India, with a less mature banking system, and without the social security, the way people save, is by having lots of kids, and you have eight kids, one of them's going to work in Microsoft, and they'll fund your retirement. And so as a result, you have this mismatch and consumption between the two countries, even though the people are trying to effectively do the same thing. So very interesting.
But I had no idea but I, you know, I didn't just say like, well, you know, like the Wall Street thing where you just shoot off and answer and say it confidently so that you sound like you know what you're talking about, right?
So he appreciated that and that I wasn't a classically trained economist that I had learned what I had learned from personal interest in personal study, and not gone through the indoctrination process that so many people go through, where there's one way to do things.
And it's particularly prevalent in the United States, because we don't have the sort of, you know, the history of the London School of Economics of having alternative viewpoints, right, and having somebody be the devil's advocate, if you will, against whatever the current dogma is in economics.
So he appreciated that, you know, I had come so far just out of personal interest, and that he could help develop my knowledge and career further. So it was a match made in heaven.
Peter Higgins 09:26
Fantastic. Now, let's talk a bit more about the impacts of Bernard Connolly on your economics than in your journey. And also your thinking with regards to the Austrian theories of economics?
Brian Pellegrini 09:39
Sure. So, Bernard, he draws from many schools of economics, whatever is the best tool, right?
So I mean, the one thing that's great about him is he's not dogmatic in that this is the right way or that's the right way, right?
You have many different toolkits, the trick is to draw from the right toolkit at the right time. And a key aspect of Austrian theory is malinvestment.
And one of the best thinkers on that range of subjects is Friedrich Hayek, and how do you match up the market interest rate with the rate of return on capital.
And if those two things the market rate of interest, the rate of return on capital and the rate of time preference, which is the rate which makes people decide whether to borrow to consume or not, if those three rates are in line, then you can have intertemporal balance.
So consumption and investment are timed properly, so that the supply comes online at the right time as demand, and then prices will stay stable. If those things get out of alignment, then it becomes very dangerous and very difficult to get them back into alignment, because all the incentives become misaligned.
And so Bernard’s great innovation was realising the applicability of high X theories to the global economy, and especially the US economy since the mid-1990s.
And basically, that when the rate of return on investment, as it was perceived, started to increase so sharply in the 1990s, the Fed should have started raising interest rates to prevent the stock, right, but they go based on measured inflation, and was China entering the economy and with productivity gains, because of those wonderful investments.
There wasn't the inflation of goods prices in the present. But what's so important to understand about investment is that capital represents the price of goods in the future.
So if you are a saver, and you are the price of stocks goes up before you buy them, then that means the price of your future consumption, whatever they tell you inflation is 20 years later, if 20 years ago, the stock prices went up before you bought them, then that means those goods and services that you buy are that much more expensive in terms of the past money that you had purchased it with.
And so because of the way that the government measures inflation, because they can only count there's a conceptual aspect and there's an operational aspect, right?
They can only count things as they're being purchased and not 10 years from now, right?
So because they don't consider asset price inflation to be inflation, inflation got out of control in the 1990s. Right? It just wasn't anything anybody realised.
And so they started raising interest rates in 1998. And started a series of small financial crises, right?
Long-term capital management and things like that, that came to the rescue.
But eventually, what happens is the market rate of interest goes above the rate of return on capital, the Austrian natural rate.
And when that happens, that arbitrage that investors initially see where the rate of return on investment is higher than the market rate, and you say, well, I could just borrow to infinity and just keep investing it. And that'll be great, right?
But what happens is the scissor blades close slowly, but surely, the best investors work from the highest rate of return projects down, right?
And so slowly, but surely, the available investments, the rate of return on capital starts dropping, right, because the better projects are taken up. And at the same time, as the central bank is reacting to rising inflation, which does eventually rise, the market rate of interest starts going up and you get the scissor blades close.
And at that point, that arbitrage becomes negative, and you get capital liquidation.
And so the desired stock of capital goes down and you get a crash, and then they to react to the crash, because they they're a political entity, and they're focused on current inflation, they say, oh, my God, we got to reverse everything, cut interest rates as hard as you can, right. And then that just swings the cycle back.
And so that's why we entered these booms and busts.
And for a long time, we were able to sort of the Federal Reserve was able to cheat the system because they weren't getting goods inflation, because they were getting so much cheap labor from China, from India, all these other places, were providing a damper on goods, price inflation, but asset price inflation just keep going up for the last 20 years.
And now we've reached the end of that road where labor costs in China are much higher than they used to be all of the excess capacity that was built up after the great recession has been taken up.
So now you run out of things. And now you're left with all this mal invested capital that was put in place, because there was an arbitrage not because it was a good idea.
And so as a result, we've reached the end of that road, and that the end of that road is highly inflationary.
And it's a very difficult situation for the Central Bank, because they can either accommodate the inflation and just allow it to keep rising, or they can trigger a liquidation and a rationalisation of the capital structure, which is what they should do.
But I think that the institutional changes that have taken place at the Fed over the last since the crisis, but have been locked in in the last three years, those are going to prevent any sort of liquidation and we're going to get an inflationist reaction to any sort of downturn.
We've already seen that in March of 2023, where that was their opportunity to show that they actually would allow bad investments to be liquidated.
But as soon as the unwind started, right, interest rates rose, they leveraged structure started to break, and the crypto shadow banking system that had developed to replace the asset backed securities, shadow banking system.
It's interesting how much they realised those two things were the same, but they clearly rushed to the rescue immediately.
And by bailing out the unsecured depositors, those unsecured depositors were not mum and pop with their retirement savings and Silicon Valley Bank. Those are private equity funds, that were stashing the deposits from stable coins, which were the sort of front-end mechanism of the shadow bank, the crypto shadow banking system.
And by bailing out those unsecured depositors, what they did was in one motion, they did what took them a while in 2008, when they started rolling out all the alphabet soup, if you remember all the different….
So those are the alphabet soup of facilities that was meant to expand the money supply and span the official umbrella of protection of official money into the private money that had been created by the shadow banking system.
So the shadow banking system, people think of it in terms of debt.
And that is an important aspect of it. But what the really important from an economic standpoint, aspect of shadow banking is that it creates private money.
And private money is money until all of a sudden everyone decides it's not. And so right so that so you have a sudden expansion of the money supply and the ability to consume and invest. And then all of a sudden that gets called into question and everybody says, well, this is actually just some stupid token. This isn't actual money. Oh my god, right, and they head for the exits. This time the Fed was partly because it was easier.
They could just say, well, you know, we already have these systematic rules in place.
That's all money, don't worry.
And so they in one swoop expanded the umbrella of public money into this gigantic private money supply.
And what they should have done was allow that system to crash and we would have had a bad recession and liquidation and return to rationality and capital markets.
But by preventing that all they did was sow the seeds of the next inflationary wave, which is coming soon.
Peter Higgins 19:18
Thank you for that reply. And I think it's interesting that we're, I think we're already feeling that inflationary wave, since some of the reactions and it's always reactionary, it's not precautionary.
And so we're in a situation now where, across the UK and the US, they're fighting inflation, and they're saying do one thing, we're going to get it down and down, interest rates are still creeping up or staying sticky, as well as inflation. So why do keep repeating the same mistakes historically. Brian, in your view?
Brian Pellegrini 19:48
That's a great question. I mean, part of it is that the operating framework of most economics excludes the possibility of a bubble.
So they believe that the transversality constraint is respected.
And transversality constraint is, is that no one would lend you more money than you can make in your lifetime, so that you would never you could never die with a negative balance, right?
But that's clearly not true.
People go bankrupt all the time, right? We have institutions in society to allow that to happen.
And so they exclude that possibility as a reality, you know, their focus is on tomorrow, their focuses on inflation in the present and the very near future.
So in their view, if you take a bunch of short term equilibriums, right, so they're thinking in terms of present equilibrium of goods and services, demand goods and services supply.
And so they say, okay, how do we get demand to equal the supply that's in place that they feel they have no control over? Right?
In their view, the private sector sets the supply, and it has bouts of irrationality that the Fed has nothing to do with and no way to control. And the only thing that they can do is match up demand and supply.
And in their view is if you take a bunch of short term periods and match them all up and have supply and demand equal each other, then that will give you long term equilibrium.
And one of the, towards the end of his career, Mervyn King gave a lot of great speeches that I would definitely recommend people go back and look at the audacity of pessimism is a great one, where you know, he was coming towards the end of his time as Governor. And so he could be a little more open with his discussion, right. And, you know, he pointed out that the right thing for us as an inflation targeting Central Bank, the right thing for the Bank of England to do in the short term is exactly the wrong thing for us to do in the long run.
And so by stringing together the short run equilibrium, if you don't get a long run equilibrium, you get further and further away from the long run equilibrium. And the invisible hand does its job, right, where the rational actors in the economy try to get back to equilibrium. So these crashes are not panics, people do panic.
But they're not the result of a panic, the panic is the reaction to repricing of capital. So these periodic crashes that we get are not irrational. They're not based on fear. They are rational actors in society trying to efficiently organise capital. And the central banks of the world have stood against that for 30 years now, right, where they will not allow a full adjustment, right?
And we saw an allowance of liquidation in the United States in the 1991 recession, right?
They did allow liquidation of bad investments that take place in 2000. They sorted it, but they did come to the rescue. In 2008, they started to and then they said, oh, my God, the precipice is there. Right?
And they completely stopped shut down the repricing. And then the combination of that attitude happened in March of 2020, where the reaction to the COVID crisis was very, very similar to the oil price shock of 1973, where you have a supply event, right, where they should be raising interest rates to stop people from consuming, right, the supply side of the economy has shut down, there is no more production, don't consume anything, you don't absolutely need to because we're going to need to live off of inventories for a while, right? But they did the opposite.
They cut it and they did this in 1973. They said oh my god, there's going to be a recession. And you know what, that's going to be bad for our political bosses. So we better do something.
And they did they reacted very violently in economic terms, and cut interest rates and fed the increased consumption and investment at a time when it should have been contracted until the supply shock and passed.
And so that inflation this attitude has now been codified in the Feds operating framework, right. So they focus on maximum employment, not full employment anymore.
It's maximum unemployment. It's not how many people should be working so that we can have balanced. It's how many people can we get to jobs? Absolutely.
And inflation is only considered a problem when it's visibly too high and rising. So they deprioritise the inflation mandate and put employment above that. And so at the first sign of any sort of employment weakness, they're going to say, well, forget about the inflation mandate, the operating framework says that we're supposed to focus on employment.
And, you know, it's very much a return to the pre Volcker Fed and the way that it operated back then, and if you look at recent speeches by you know, Lael Brainard and Lisa Cook, there's a lot of emphasis on the Employment Act of 1946, which is a highly Keynesian codification of the government's responsibility to make sure that everyone has a job and that they should be protected from economic shocks.
And so, you know, we're right back to that inflationary mindset. And that's what people should be looking out for the next 10 years until there is a political reckoning where the populace says we're sick of inflation deal with it. Until that happens, we're just going to get worse and worse inflation.
And it's important to think of it in terms of inflation, volatility is not going to go to 20%. For 10 years, you'll have year over year, inflation will probably hit 20%. At some point, it will come down, but it'll come down to 6% or 8%.
Right, but the price level will stay high. So your purchasing power, even though that it's not going to be hyperinflation that just keeps going. Investors need to be really concerned about protecting the real value of their capital over the next 10 years, because the government has a huge incentive to repress interest rates, and liquidate its massive world war two size, debt load via inflation instead of austerity and unemployment, that’s the reality.
Peter Higgins 27:21
That's a great reply.
Thank you for that, Brian.
Now, I want to touch a little bit on the fact that you're working with Bernard Connolly, and the rest of the team, then you moved on to set up your own shop, as we call it with Intertemporal Economics.
Can you give us an overview of your firm, when it started, and the sort of clientele that you work with as well, because we're talking about all the macro and the micro-economics of the markets?
And these clients are actually wanting all of that research that you're putting together for them?
Brian Pellegrini 27:56
Yeah. So Bernard retired and went back to Britain, at the end of 2017.
To write a book, which is just about to come out, I have an advanced copy, you always hurt the ones you love.
It's a spectacular exposition of his genius.
And it really explains how we got here, and how to understand the interest rate capital nexus, and how that fits together and how those bubbles are born. So it's a great work, I helped him work on it.
And I would highly recommend it to the readers, I have an advanced copy.
So you'll all have to wait out there, but it should be coming out, it'll come out soon. And you can preorder it definitely would recommend it.
So yeah, so Bernard had left and, you know, I needed to find something to do with myself. And so I, you know, asked some of the clients if they would have me, you know, as a research provider.
And so my clients are many of them are legacy Connolly Insight clients, but I have some new ones as well.
And it's primarily, you know, it's a mix, you know, sort of the base is definitely global macro hedge funds. Those are people who can monetise it most easily.
So they can take it and turn it into investments very quickly.
But I have I also advise banks and high net worth individuals, and you know, economics should be for everybody, it's, you know, you can also go to my Substack Capitalist Pig Collective, that's a little bit more affordable option for people, you know, so what I do is, I try and provide my clients with the tools about how to think about important phenomenon in the markets in the economy that are, I feel are being misunderstood or underappreciated by the market consensus.
And so instead of just giving them point forecasts or telling them, you know, out of a black box, this is what's going to happen. What I do is I look at what are the determinants of outcomes, right, so how does the machine work that's going to decide what happens in this case, you know, that can be purely economics that can be political economics is frequently one of the main factors that you have to consider.
And political economics is something that it's probably the easiest of all economics to understand, but it takes a long time and so people tend to in this fast paced society that we live in, it gets horribly ignored, because it's like, well, that's two years away, might as well be in another planet, right?
But the reason that political economics is so reliable, in terms of being able to forecast is that people react to incentives the same way across time.
So a person in the 1700s, and a person in 2023, is going to react to the same set of incentives, and probably the same way human beings don't change that much, right?
And so you can say, okay, well, if I'm a Central Bank Governor, who's, you know, if I'm the Federal Reserve Chairman, and my job is renewable every four years, and I have to keep a political person happy, then I need to respect my inflation mandate, because that's part of how the Fed is able to do what it does is that it has credibility.
But at the end of the day, if I like my job, and I want to keep it, I have to do what is politically beneficial to my boss, the president, right?
And so when inflation is low, and real interest rates are low, there's very little incentive for political capture of the Central Bank.
So the Central Bank can operate credibly, because, you know, it's sort of a self-fulfilling cycle where as long as inflation is low, the politicians will leave them alone, because great, that's fine, right?
And as soon as inflation starts to rise, that becomes a dilemma.
Because the way to defeat it is to push down demand and inflation expectations and by causing a recession and increasing unemployment, and politicians will accept that to a certain extent, especially if you can blame it on someone else.
But as inflation rises, the cost of bringing it down gets higher and higher. And one of the great economist Claudio Borio, at the BIS has focused on an inflationary equilibrium. And when an inflationary Equilibrium occurs, that's when the cost of bringing down inflation becomes politically too high.
And we've reached that point, unfortunately, in the Western world where the actual cost of bringing it down, they're not going to put up with it, they're going to interfere in any way they can.
And so until the political cost of that inflation becomes greater than the cost of bringing it down, you should expect that they'll do things to try and stop it when it gets so high. But they'll never squeeze out the expectations, they'll never beat it down to the point where, as Paul Volcker did in 1980, to raise interest rates while there isn't a recession, because inflation expectations were still rising. That's the key to have someone who's willing to say, well, measured inflation is going down. That's great.
But inflation expectations are not. And therefore we need to show everyone that despite all the pain despite the unemployment, we're still going to keep money tight.
And that only occurred because you had a president and chairman of the Federal Reserve who were not of the same party, were both very strong people and didn't like each other. And Reagan tried to intimidate Volcker.
But there was a light years later Volcker told about a secret meeting with James Baker and Reagan where Reagan didn't speak. He said it was weird.
They went in and like it was like a like talking dummy, where this treasury secretary was talking for the President. And you know, like ventriloquism, right, like, so Reagan just sat there mute.
And Baker said the President would like you to cut interest rates and or not raise interest rates. And so he was he didn't say anything, because he wasn't going to anyway, and he didn't want him taking credit for it. But, you know, even in that case, where, you know, the President had said very publicly that he respected the independence of the Fed and that he was against inflation, once the political costs was concerning to him, that went away.
And it was only that the Chairman of the Federal Reserve didn't really care and was like, wow, whatever.
Like if he fires me fires me, I don't care, because I don't like the guy. And so, you know, we don't have that situation right now, because Powell is not that sort of person, frankly, he's just a more compliant guy.
Peter Higgins 35:40
So are we are we not answering the inflationary equilibrium at the moment? And what's going on? It feels like with the push and the pulls going on, are we entering one or not?
Brian Pellegrini 35:50
We're definitely in an inflationary equilibrium.
The Fed has set itself up to be overly pessimistic about inflation in the near-term, and overly optimistic in the long-term.
So they're going to say they said, oh, we're expecting core inflation to be three and a half percent at the end of the year.
And they'll easily beat that inflation as measured by core PCE, we'll probably get down towards 2%.
And they'll say, oh, boy, we're worried about an overshoot now, right? And they're going to start talking about real interest rates.
And they might actually, they might actually tweak monetary policy and they'll say, we're not easing.
We're maintaining the level of tightness by cutting nominal interest rates to keep real interest rates stable, and that as a signal because they're worried about the long end of the bond curve right there, they're really, they're really worried about, they stuffed down the throat of the banks, all these treasury bonds in 2021, right?
Now they have to deal with the hangover.
And they are genuinely concerned about a financial crisis resulting from that, and how they're going to have to react to it.
So the best way that they can possibly do that is by cutting the expected path of interest rates without dramatically cutting rates, right?
Just 25 basis points or something, but the signal is what will be important.
And I think that eventually, we will move towards yield curve control in the United States, where the goal is going to be to repress interest rates and liquidate the debt through inflation. And the best way to do that without causing a panic is to control interest rates.
And they did that in 1942, it'll probably be a fairly similar sort of rollout to that the facilities are already in place.
So they have a standing repo facility, and they have a reverse repo facility, which do opposite things.
So why would you want to stand on both sides of the market at the same time, all that needs to be done to change right now they just have the general collateral rate.
So all Treasury is priced at the same rate, all they need to do to roll out yield curve control in the United States is say that we will discount bonds at X rate for this maturity for the one year for the two year for the three year and this is what the yield curve will look like.
They will probably move into yield curve control. Unlike the Bank of Japan, where they bullied the markets, they'll probably do it by acting as the broker dealer of first resort, which is what they do with the way that the Fed funds rate is administered now, right, so they don't set the Fed funds rate.
They set the interest on excess reserves. And they basically make it so that the banks wouldn't lend to anyone for less than the desired Fed funds rate.
And this is why this is what's so important in that I don't think that either the Fed but especially the market has appreciated the change in the way the Fed operates since 2008, right?
So when they move to an ample reserves regime, the locus of control shifted from the FOMC, which sets the Fed funds rate with a market rate of interest. It shifted to the interest on reserves, which is set by the Federal Reserve Board, the seven politically appointed members, right?
So the regional bank presidents have no say in the interest on reserves.
Really the Fed funds rate is it's convenient if it matches up with the interest on reserves, but it is not what sets the market rate of interest, right?
So now you have four highly partisan governors appointed by Biden.
They outnumber represent a majority of the Federal Reserve Board.
And the chairman of the Fed can never ever lose a vote, so it's not Arthur's roundtable, right?
So Mervyn King, he frequently was on the losing side of votes at the Bank of England, right? It's a much more intellectually honest committee, the FOMC is not that and it's not even the most important of the two committees right now, right?
The most important of the two is the Federal Reserve Board. So Biden is appointed four PhD economists, right, old professors who are, if you look at the work of Thomas Havrilesky, political pressures on monetary policy in the United States, it's a great book, he did a statistical analysis of voting patterns based on the resumes of the various board members going back to the start of the Fed.
And he found that the professors were the most politically reliable. And the reason is, it's very similar to picking Supreme Court members, right, where if you pick the board members of the year for 14 years, you can't fire them. So you're going to pick someone who you can rely on right?
A) Because they're partisan, or B) because they're just really stubborn in what they believe.
And so you can look at the papers that they've written and you can say, okay, this person is going to focus on labor almost exclusively, which is what all of the people that he's picked have focused on, and you can guess pretty reliably what they're going to do, as that political capture becomes more important and becomes a bigger factor, then you start to get actual partisans like Arthur Burns, or William Miller, who were picked by Richard Nixon and Jimmy Carter, respectively, who were just outright political boosters, in their careers of political fundraisers. Prior to being chairman of the Fed.
They were just political hacks. And so we don't we're not quite there yet. But we definitely have four partisans, and a chairman who's not who's not Paul Volcker.
He's not willing to have a fight, right? He's not going to be on the losing side. He's going to go along with what they say and we're entering an election year.
So you know, there's a pretty good bet that they're going to be looking out for Biden, and they're going to want to signal to the market that don't worry, there's not going to be any higher rates, if any sort of trouble erupts in financial markets were there for you don't have a recession everyone. Right?
That's their message.
Peter Higgins 43:01
Yeah, I understand that. So let me just go back a bit then. And you talked about the signals. So we've got a total drawdown in the ultra-long US Treasury bonds. That's now exceeded the stock market peak to trough of the crash financial crash of 2007 and eight and nine, why is no one taking any notice of that at the moment, then? The signals there, but that pick the trough regarding ultra-long treasury bonds, but it was going, it's okay. We'll carry on doing what we're doing.
Brian Pellegrini 43:31
I think that did start to happen in March of 2023. Right?
Peter Higgins 43:38
The signal was sent because it was banks. Yeah. Because it was banks. Yeah.
Brian Pellegrini 43:40
So the signal was sent to the banks.
I mean, that's the most important part of the financial system in general, right?
And so, you know, the credit creation has been allowed to continue, like people focus on bank credit, overall, but the securities portfolios have definitely shrunk.
But lending is still occurring and that's because they sent a signal to the banks, don't worry, we'll bail you out.
And if long-term interest rates continue to move up, there definitely will be continued pressure.
But my expectation is, is that through yield curve control, they will come to the rescue, and they will provide liquidity.
So it's one thing everybody focuses on interest rates being high. But at the end of the day, right, if you have a bond that's gone down in value, but the bank says, don't worry, we'll repo it at par, then okay, great.
So what right, I can take that garbage bond, and repo it and go lend it out and make even more money.
So their willingness to probably what they'll do is they'll what they did in 2020, and 2021, was to exempt treasuries from the supplementary leverage ratio.
So to incentivise purchasing of because they're going to need to fund this massive deficit that we have.
And the best way to do that is to say all those don't count, you can definitely buy those. And if you buy it, you get the rate of return on it.
And you can use it to show up to get even more cash at the Fed to then go do what you want with it.
So in 1942, the way that they finance the deficit was by incentivizing banks to give up treasury bills, and move into bonds and it worked spectacularly.
By the end, by the 1950s, early 1950s, the Fed almost owned almost all the treasury bills, and the banking sector held the huge position in bonds.
And so they're going to need to move people out the yield curve. And the best way to do that is to say, well, these things don't count for capital ratios.
And if you need cash, don't worry, we got it, forget what the interest rate is, we will give you par because those are risk free. That's it's a great distinction, right?
Peter Higgins 46:06
Absolutely. So today, the 10 year US Treasury yield exceeded 5% for the first time since 2007. What seems to be the understanding to the markets and investors today then?
Brian Pellegrini 46:20
They don't want to get involved, right? They would like for things to work out on their own.
And they're not Machiavellian.
They're not all controlling, but they will react if they see a problem.
So that right now they're hoping that falling measured inflation, and the job owning will cut down on those long term interest rate expectations, right?
So if you look at the a lot of the Fed speak lately has been that there's more tightening coming that's lagged, right?
And so they're all talking about the risk of over tightening.
Philip Jefferson has been very big on this and he's a Biden guy.
And so you know, they're talking about this lag tightening that's behind the scenes that's going to come and we got to watch out for that.
And the signal they're sending is, don't worry, more and more clearly, interest rates are not going any higher.
But at the end of the day, there's an inflation expectations component on the long end of the curve.
So if you're, you want to have your nominal rate be protected.
And so the market, you can't just physically go ask the market.
So why are interest rates going higher? So at the end of the day, the Fed can infer or say that it infers whatever it wants.
So they can say, well, we think that the market is over expecting higher interest rates from us, and we want to provide stability, and that's part of our mandate.
So as soon as the you know, I would say, as the TLT-VIX, right, the volatility on interest rates starts to get to a point where buying protection from those moves becomes prohibitively expensive, look for the Fed to step in as the broker dealer of first resort, which is what it's done in the money market.
They don't have to go down the exact road of the Bank of Japan, and I don't expect them to what I expect them to do is incentivize people banks to buy treasury bonds to fund the deficit by saying anytime you need cash, we'll give you to you at par.
Peter Higgins 48:40
Okie dokie. So given all that we've discussed thus far, Brian, I think what our global investors would like to know now, given all of the macro dynamics, political, geopolitical, as we've seen everywhere around the world at the moment, how do you go about investing yourself?
What's your investment strategy, asset allocation, how are you fighting the sign because of inflation interest rates?
Brian Pellegrini 49:05
In an environment of intertemporal disequilibrium, right, which is what we've been in since the 90s, investors need to focus on the return of capital, not just the return on capital, make sure you get your money back for a while that was watching out for defaults and the value of the investment going to zero in nominal terms when they were willing to have a liquidation, that game is now shifted, and you now need to worry about the real value of your capital, right?
So it's all well and good if you buy government paper, but it won't buy you a hamburger in 10 years.
You know, that's, that's the reality.
So what you need to do is you need to think about investments that will stay ahead of inflation, so inflation sensitive assets that will react quickly.
But one of the dangers of investing in inflation sensitive assets is that those will attract, there's a whole community of professional speculators out there, right, and they are going to pile into those assets at the first sign of inflation.
And as an individual investor, you're probably not going to beat those people in terms of timing. So you have a certain amount of downside risk, you shouldn't pile everything into inflation sensitive assets, because you're getting these ups and downs, you do have high inflation is really high inflation volatility.
And so on the downside of the inflation, you're going to lose out. So you have to take active bets that will stay ahead of inflation that will generate the returns, and then also look out for less sensitive assets that will take their real value, but then also not collapse in as soon as inflation starts to deteriorate.
So gold being an obvious example of that, and there are others. And so you make your bets on the inflation sensitive assets. And then as those bets start to pay off, move the money into inflation protected securities that will maintain their real value, even after the hottest period of inflation passes.
And be aware that unlike the 1970s, there's a huge asset bubble.
So there already has been a huge amount of inflation that's taken place, it's just been in the form of assets.
So there is the risk that at the end of this, you get an unwinding in deflationary terms, but I think that it's more likely that they bleed off the asset value is in real terms. So don't buy into people's enthusiasm, right?
As soon as the you know, is definitely something to be when you're looking at follow Mervyn King's advice and believe in the audacity of pessimism, I think that's the, that's the way to go is to realize that people will be selling solutions, and there'll be looking to move money into speculative investments that could generate high returns, I'm thinking, you know, AI, things like that, right.
But those are sensitive to liquidation and to busts. And those do occur in inflationary environments. So you need to be focused on staying ahead of inflation, but be aware of the investment busts that will be part of that.
Peter Higgins 52:58
Thank you for that reply, one of the companies that you mentioned was a capital preservation vehicle UK Investment Group Ruffer, you said that you'd like that one as a particular presentation vehicle.
Brian Pellegrini 53:11
Ruffer is a great firm there are near and dear to my heart, you know, they're a great alternative to you know, they're in the UK, but they're culturally, they're very different from firms on Wall Street, where a lot of hedge funds hire horses for courses, as they say, right, where it's just somebody who's in there to trade and make money in the short term for the fund.
And maybe if the investors get paid, that's nice, too.
But there isn't necessarily a whole lot of intellectual depth to these firms. But at Ruffer all of the portfolio managers are expected to publish research and to produce intellectual property that is thoughtful and valuable.
And so any the refer review is something that's publicly available, people can read it, they have a great podcast, not exactly a competitor to you.
So it's kind of a different, you know, sort of focus.
You know, I think that's a great, it's always a race with them to produce these insights, right.
Like they're a friendly competitor in that way to me, in that they're producing really important insights.
And they have done a great job of talking about inflation, volatility, and how investors can protect themselves from it.
And they've provided this free of charge to the general public who's interested in looking and you know, they provide it as a service to their investors, but they provide the knowledge to the general public, which I think is great economics should be for everybody.
It's not something that's just for weirdos who work on Wall Street or geniuses or whatever, like it's something that every single person can and should understand.
Peter Higgins 55:16
Brilliant. Love that reply, Brian. I'm constantly time Brian.
So I'm going to ask you two more questions. And the first one I want to ask you is your greatest lessons learned through your career and other business interests because you've got some of the stuff that you do as well.
So what's been the greatest lessons and what you know what did you learn from all of this time in and out of Wall Street and dealing with the macro and micro economics?
Brian Pellegrini 55:39
Yeah, I would say it's to anytime someone presents you with the opportunity of a lifetime to invest in try and figure out what the scam is first. And if you can't figure out what the scam is, then maybe there isn't one.
Peter Higgins 55:56
But maybe it's you.
Brian Pellegrini 55:58
Brian Pellegrini 56:00
Don't allow other people's enthusiasm to sweep you up in bad investment advice.
Enthusiasm is not intellectual backing is great if someone's enthusiastic about something, but that can be affected.
It's not necessarily genuine and even someone who's enthusiastic about something might have no idea what they're doing.
So that's an important thing to understand is make sure that there's intellectual backing to what they're selling.
Peter Higgins 56:35
Fantastic. I love that reply. Now, lastly, I just want to ask you, with regards to the markets, per se, we're going into 2024 in three months’ time, where do you see the landline regarding interest rates, and inflation, what's your three to nine months sort of overview just to give our global audience some sort of pitch?
Brian Pellegrini 57:00
So right now in October of 23, measured inflation is coming down, because inflation works on like a pipeline, right?
So the end of the pipeline where you and I go to the store and buy something, that's where it gets measured in the official figures.
But that's already baked in, that's already that's done.
And the seeds of that inflation are at the beginning of the pipeline, the Chinese factories, the supply lines.
And so looking at the factors that I look at right now, I think we've got another two or three months, four months of core inflation coming down very quickly to the point where it's going to scare the authorities, and they're going to start to worry and talk about the possibility of an overshoot the most dovish members already are.
But by the spring, the things that are in the front of the pipeline now are going to start showing up. So you're going to start to see rising inflation coming, you know, say April, May, but the problem is, is that and especially if they have a policy tweak, to keep real interest rates stable, they're going to be embarrassed, and they're not going to want to raise interest rates.
And so they're going, there's going to be an embarrassing pause, where inflation is accelerating. And the Feds telling us once again, that it's transitory and temporary, and Vladimir Putin's fault.
And then you get to, and this is exactly what happened with the stop start monetary policy of the 1970s, then you get too early fall, and they need to react sharply because inflation is getting to scary levels, and they dramatically raise interest rates, if that leads to a that will likely lead to a recession.
And if you then also have whoever's president, but especially if you have a new administration coming in, they're going to be put pressuring very heavily for a reversal.
So I mean, if it's, if it's Biden, and he's got his four people on there, then they're going to be politically interested in helping him but even if it's not, the Fed is still reactive to the new administration, right. And so you're likely to get a reversal before the end of the year, because there's a recession, but then that's just like 1973. They're cutting interest rates before the inflation expectations have started to fall. And so that just feeds into that next cycle, and you have less fed credibility, and the cost of defeating inflation the next time gets even higher, so it's even less likely that they'll do something about it.
Peter Higgins 59:46
Brilliant. Love that response. Now, Brian, I'm conscious that we've got some global hedge funds that listen to the podcast, banks that listen to the podcast, and high net worth individuals that listen to the podcast. So please reiterate where these individuals can find you on the web, and other platforms as well?
Brian Pellegrini 01:00:04
The most direct way is to email email@example.com.
That's definitely the best way but you can find Intertemporal Economics on LinkedIn, you can go to the Capitalist Pig Collective Substack, https://capitalistpigcollective.substack.com/.
And that's sort of the retail offering and there's some of the work on there. Those are definitely the best ways.
Peter Higgins 01:00:30
Brilliant ladies and gents. That was Brian Pellegrini, the Founder and Senior Analyst at Intertemporal Economics, Brian, thank you ever so much for sharing your insights with us today. It's been absolute delight speaking with us.
Brian Pellegrini 01:00:43
Thank you, Peter. It was spectacular.
Peter Higgins 01:00:45
Thank you. Take care. God bless you.
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