Brynjolfsson's take on interest rates

John Brynjolfsson successfully has traded alternative real assets for more than 25 years. And, in 2009 he traded his career at PIMCO for his own firm, Armored Wolf, which trades a global macro strategy emphasizing real assets. Brynjolfsson’s experience includes trading commodities, global inflation-linked bonds, event-linked catastrophe bonds, as well as asset allocation and risk management. We talked to him about trading, including the career move from a big traditional asset management firm to his own firm, along with his pursuit of alpha. Here’s an excerpt from his interview with Futures (Brynjolfsson: The Armored Wolf in pursuit of alpha) in which he provides some in depth analysis on interest rates and outlines where they are headed.

FM: You are the co-author of “Inflation-Protection Bonds” and co-editor of “The Handbook of Inflation-Indexed Bonds” and once were responsible for trading $160 billion in TIPS [Treasury Inflation Protected Securities] for PIMCO.  As an inflation expert, what’s your outlook for the near- and long-term?

JB:  Obviously the global economy is, and has been for five years, in the midst of one of the toughest deleveraging cycles of the past 100 years. This, combined with unprecedented monetary policy, not just at the U.S. Fed, but at all major central banks globally, puts inflation at a knife’s edge.  I suspect that inflation in the near term will remain contained, and there is even a risk of disinflation. However, my concern is the huge amounts of “dry gunpowder” in terms of excess reserves in, and lagged effects of, negative real interest rates globally, that speak to inflation risk on the upside and that would be difficult to control.

FM: You’ve written extensively on the U.S. Federal Reserve’s actions over the past few years. Would you share your current economic overview and outlook?

JB: The two-trillion-dollar question is “exit strategy.”

The Fed is capitalized with $55 billion of  “paid-in capital.” The actual number may be much larger or much smaller than this, [because] implicitly the Fed has the backing of the Treasury and taxpayer (Yup, it’s too big to fail!), and also has implicit obligations [that] are unstated. But, I like to begin at least with the “facts” as they are stated, in this case on the audited financials of the Federal Reserve System. So by any measure, $3 trillion of assets on the Fed balance sheet is a lot of leverage. What leverage does is amplifies swings, or puts entities on the knife’s edge. That doesn’t per se speak directionally to inflation or deflation. What it speaks to is the following:

Low volatility “great moderation” is obviously behind us, as 2008 proved. However, it also is likely that the low volatility, inflation pegged at 2%, current environment will not endure. Markets are too complacent if they think interest rate moves are measured in basis points and inflation ticks up or down 0.1% a month to peg inflation at 2%.

Disinflation is certainly a possibility, as monetary policy is largely pushing on a string, and fiscal policy (with debt-to-GDP in the United States and most developing countries at over, or near, 100%) is hamstrung. Therefore there is little ability of the economy to respond to a negative macroeconomic shock.

Right now the United States seems to be motoring along, with pent-up demand and low interest rates, being roughly offset by headwinds created by fiscal tightening, the combination of tax hikes and spending cuts.

China, Japan and Asia more generally face headwinds to growth and are slowing. In China, secularly, we are seeing slowing from [an] historic rate of 10% to 12% being recalibrated toward a more sustainable 6% to 8%. But within that secular range, we are seeing inflation flare up, from 1.8% last fall to 3.2% now. That has triggered policy tightening in various forms, and in this sense is running somewhat counter to cyclic and policy dynamics elsewhere. Japan is facing slowdown, though it has a new, almost experimental, radical policy easing being promised and implemented at this time.

Europe is a basket case, and has already experienced a recession characterized by negative real GDP growth, falling inflation and rising unemployment among young and old, periphery and core. The macroeconomic challenges, an uncompetitive exchange rate, combining with dysfunction of the labor and capital markets brought about by befuddled policy, are being strained by political challenges. The uncertainty created by political forces,  both those centrifugal forces pulling the Eurozone apart, and the domestic forces within nations created by the wealth disparities, unemployment, and austerity imposed on large populations, make capital formation almost impossible.

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