Podcast Transcript: Alfonso Peccatiello (Alf) on Money Printing, US Risks and ECB Surprises

This is an edited transcript of our podcast episode with Alfonso Peccatiello (Alf) published on 8 February 2022. He is the author of The Macro Compass, a financial newsletter providing educational macroeconomic insights & actionable investment ideas. Previously, he was the head of a $20 bn Investment Portfolio for a large European bank. In the podcast we discuss, how money is created, where the credit cycle is right now, ECB hikes, and much more. While we have tried to make the transcript as accurate as possible, if you do notice any errors, let me know by email.

Introduction

Bilal Hafeez (00:01):

Welcome to Macro Hive Conversations with Bilal Hafeez. Macro Hive brings you actionable investment insights for all markets from crypto to equities to bonds. For our latest views, visit macrohive.com.

It’s nice to see markets in the green rather than a sea of red. It seems investors are digesting a hawkish Fed and US corporate earnings have been strong. The question now is whether inflation will stay high in the US and so will we see another ratchet higher in Fed hike expectations later this year. We feature an important piece by Dominic Dwor-Frecaut on this subject and make sure to read the piece as the Fed view has a big, big impact on equity markets. It’s also Chinese New Year and I’ve written a piece looking at how constitutions of China and the US affect the link between economic growth and their respective equity markets. It will make you rethink your positions in Chinese stocks. On crypto, we’ve updated our flow and on chain metrics for Bitcoin and we give our latest view. Finally, we feature a new explainer on volatility. What is it and how does the market price it? These explainers are super useful for investors of all level of experience.

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Now onto this episode’s guest, Alfonso Peccatiello. Alf is the author of The Macro Compass, a financial newsletter providing educational macro insights and actionable investment ideas. Before this, he was the head of a $20 billion investment portfolio for a large European bank. Now onto my interview.

So welcome Alf. It’s great to have you on the podcast show.

Alfonso Peccatiello (02:09):

Hey, Bilal. My pleasure to be here.

Bilal Hafeez (02:11):

Well, before we jump into the meat of our conversation, I always like to ask my guests something about their origin stories. Where did you grow up? What did you study? Was it inevitable you’d end up in finance and how did you end up where you are now?

Alfonso Peccatiello (02:22):

So I was born in the south of Italy in a town close to Naples. Grew up here for the first 21 years of my life. Also studied a bachelor degree at university around my hometown, and it was always a destiny at the end that I would end up in finance because my mother is a treasurer of a small bank in the south of Italy, which meant being exposed to the futures chart at lunchtime already when I was at school. I mean, during a lunch break, she would come home and we would eat together. And we always had this table with Futures and mostly BTPs, but also something else on the table. So I was always curious about it and I ended up asking her, “I mean, what the heck are we looking at here?” While we eat our lunch.

Bilal Hafeez (03:04):

I think not many children grew up being exposed to BTP Futures. So you already have quite an unusual upbringing.

Alfonso Peccatiello (03:10):

Yeah, that’s true. And to be honest, I was also lucky to be very curious since my childhood. So you can ignore these charts and these lines moving on the screen, or you can be curious about it and you can ask me what’s that. And so being from the south of Italy, my mother is also a very passionate woman. So she really likes doing what she does and also explaining what she does. So she spent some time and I got fascinated by the topic and I chose to go then at university following a macroeconomics course, and then a markets course, but basically, I had the chance to have a parent that was very passionate about markets, and I could actually get my curiosity in as well. And that helped me becoming exposed to a topic from a very early stage. And that naturally led to the, basically, career progression at least to entering the world of finance and markets.

Bilal Hafeez (03:58):

Okay, great. And then you ended up working for ING for a number of years.

Alfonso Peccatiello (04:03):

That’s correct. So I started with them something like seven years ago, straight out of university in Germany. And then I moved to the Netherlands and I moved back to Germany anyway. It was always with the same bank in the treasury department that was basically, I would say, great experience because it gives you an inner look into how, while really the funding and the liquidity mechanism of a bank work from the inside. It also gives you a very relevant exposure to regulation, which is paramount important in understanding flows in these markets. And well, it also exposes you to markets straight away because when you are in the treasury department, you need to handle interest rate risk, credit risk, spread, swaps bonds, and what have you. So I found it to be a fantastic school because it gave you both the market action you need to get your hands dirty, literally and trade the markets, but also a much more broader overview that also includes liquidity, regulation and all these incentive schemes that are well, very interesting, I would say from a real money perspective. And you can only really get a grasp of that if you are within, I think the belly of the beast.

Bilal Hafeez (05:08):

Yeah. And then in recent years you left the establishment, so to speak, to set up on your own and you have this excellent newsletter. You’re very political on Twitter as well. Can you talk a bit more about what made you make that transition?

Alfonso Peccatiello (05:20):

Sure. So basically I now write newsletter that I was writing in the past as well, called The Macro Compass. It’s a free newsletter, you can just look it up on Google, where I share four to six times a month my thoughts on macro. It’s an educational newsletter with investment ideas in there as well, so it’s also actionable. And together with that, I am very active as well on social media. You can find me on Twitter @MacroAlf or name and surname of LinkedIn, that’s Alfonso Peccatiello, I know it’s very tricky.

Bilal Hafeez (05:47):

Hence why you’re known as Alf.

Alfonso Peccatiello (05:49):

Yes. Alf works much better, I guess, for a non-Italian speaker. And so I also have a pro to pro bespoke service for more institutional clients where they can effectively get consulting from my side when it comes to different topics. It can be talking about monetary policy or how a real money would think about markets or anything that comes to mind.

How money is created

Bilal Hafeez (06:09):

Yeah, no, it’s great. I mean, and one of the things I like about your work is the way you explained the inner workings of the system, so to speaks. So maybe we can start on that to begin with. And let’s start with the big topic that’s been on so many conversations and pieces about how money’s created. So there’s this notion that the Central Bank, the Fed or the ECB prints money through different mechanisms. They buy bonds or something, or they just have a machine somewhere where they print money and that creates money and then that leads to all sorts of inflation everywhere. But you’ve obviously been inside the treasury of a bank. So you see, I suppose the transmission mechanism off that. So maybe you could talk through how you see money being created.

Alfonso Peccatiello (06:48):

Yeah. So, Bilal, the most common misconception in finance, I would say to this stage is that central banks print money. And they technically do a form of money, which is bank reserves, but these bank reserves do never access the real economy. They have no way to get out in the real economy. So the misconception is actually comes from the fact that people think that banks lend reserves. They don’t lend reserves, they actually create money out of thin air.

So let’s start from central banks first, because that was the question. So the idea at that central banks print money, it’s immediately referred to as quantitative easing. It’s an immediate reference. And that happens because when a central bank does quantitative easing, it expands their balance sheet. Yes they do, obviously, because they buy bonds with newly created reserves. So the liability side of the balance sheet goes up, that’s bank reserves for a central bank and the asset side of their balance sheet also goes up with the newly purchased bonds that are extracted from the private sector and then stored on the central bank balance sheet.

So I just described QE from a ECB perspective. For instance, if you move this from the ECB into the balance sheet of a European bank, for instance, then what happens is that the European bank on the asset side of the balance sheet head a bunch of bonds and a bunch of loans and other stuff they have on the asset side of the balance sheet. And now after QE, they find this composition of the asset side of the balance sheet being swapped in its composition. So they have less bonds. Those bonds have been taken away and moved to the asset side of the ECB. And instead of having more bonds, they have more bank reserves. And these bank reserves sit on the liability side of the ECB balance sheet. So the ECB balance sheet has literally expanded, but the balance sheet of a commercial bank, European Commercial Bank has not expanded, it’s actually the same size as before, it’s just swapped the composition of the asset side of this balance sheet from a 100 bonds and 10 reserves to 50 bonds and 60 reserves. That’s what QE does on aggregate to the commercial bank balance sheet.  Now, so these newly created reserves, so liability side of ECB, asset side of commercial banks, are in no sense they can be interpreted as inflationary forms of money. And the reason why I say that is because these reserves can never get out there, European banks or American banks or any bank in the world do not land the reserves. First of all, it will be an interesting concept because reserves already sit on the asset side of the balance sheet of a bank. So there will be a mechanism under which those reserves are transformed into loans. That’s not really how it works. How it works is when Bilal or myself enter into a bank, the bank looks at us, Bilal or Alf or wherever the creditor wants to be and assesses two things, basically. Our credit worthiness, so are we able with our private cash flows to sustain the newly created credit effectively that they will want to extend to us A, and B, what is the loan yield compared to the capital I need to attach to the loan I will want to extend to Bilal? Does it make sense from a risk reward perspective and from a return-on-equity perspective, which is highly influenced by the regulation and the capital that will need to be attached to this loan. Those are the two things they look at. They definitely do not look at the amount of reserves they have out there before deciding whether they will lend money to Bilal or Alf.

Bilal Hafeez (10:05):

So just to be clear, just so that we haven’t lost some of our listeners here, so when the central bank expands as balance sheet by buying government bonds, that’s an asset that the central bank gets, and it has a liability which is its reserves, which banks face off against. So the banks then have that reserves as assets, but from a bank perspective, all that’s happened there is that they’ve reduced some of their bonds, which have gone to the central bank and some of those bonds have been swapped into reserves. So there’s been a switch in the asset profile but it hasn’t expanded the commercial bank balance sheets. So what we care about here is commercial banks, regular banks, balance sheet to be expanded. That’s a true measure of credit entering the real economy. That’s when it gets on the guys on the street. And what you are saying is that’s really a function of the bank deciding that they want to lend more money to somebody who walks into their branch.

Alfonso Peccatiello (10:58):

And that is correct. And that has absolutely almost nothing to do with the amount of reserves a bank holds. The decision whether to expand the balance sheet of commercial banks, which is the real inflationary forms of money creation, and remember with QE the balance sheet of a commercial bank didn’t expand. It just was swapped in composition on the asset side from bond to reserves, expanding the balance sheet of a commercial bank, which is literally expanding the amount of credit the private sector gets at any point in time has nothing to do with the amount of reserves they own. So I was going there explaining what do they look at before lending to Bilal or Alf.

Bilal Hafeez (11:34):

And just one question here, if their assets suddenly have these reserves, does that make them more comfortable lending more? I mean, is there something about having these more liquid forms of assets on their balance sheet that makes them more comfortable to lend?

Alfonso Peccatiello (11:48):

So these reserves basically having more reserves on the asset side of the balance sheet achieves basically, let’s say two things for banks. The first is they have more liquidity to settle interbank payments. That’s what reserves are for. So ING or whatever bank, Rabobank and Commerce Bank will have clients that make transaction within each other facing each others bank during the day, right? So they will be a $100, €100 flowing left and right between Rabobank customers and Commerce Bank customers throughout the day. At the end of the day, Rabobank and Commerce Bank will have to settle against each other a tab of payments. They will be basically on the background, settling the payments within the two bank, the clients of the two banks. And they will do this with bank reserves. Now the more bank reserves they own, the more they will feel comfortable they can settle liquidity and interbank payments amongst each others. So that’s what reserves are really for and you are giving an inert asset that owns no return because in Europe, it even yields negative 50 basis point apart from the tiering facility. But in general, it yields negative 50 basis point. It has no credit risk, no duration risk, so it also hedges no risks on the liability side of a bank balance sheet. It’s just an inert asset sitting there. It’s a huge pool of liquidity to settle interbank payments and they also qualify for HQLA, which is High Quality Liquid Assets, which is basically the numerator of this liquidity coverage ratio metric that has been introduced to make sure that banks all over the world in Europe, in the US own enough liquid asset on the asset side of the balance sheet to meet stressed outflows on the liability side of the balance sheet. So basically they have a regulatory liquidity purpose for HQLA reasons. Also bonds do by the way. So they are not a better form of HQLA than bonds are. They are still an HQLA form, and they’re used to settle in the bank payment system. So interbank liquidity, regulatory liquidity. And that is it really. Having a gazillion of bank reserves will not incentivise a European bank to land if the prospect of the return they will be making on loans is relatively poor compared to the credit worthiness of the creditor and the capital they need to attach to this loan, which makes the return-on-equity pretty poor. If those things don’t change, regulation, loan yields, or the credit worthiness of the private sector, European banks can have a gazillion reserves. They still want land. And your typical example, Bilal, is Japanese banks. So Japan did an incredible amount of QE, something like 20, 25 years ago. So I have a chart I always pull out also to clients and I show the bank of Japan monetary base. So the amount of bank reserves at the end of the day, that was increasing as a result of the first attempt of the BOJ to do QE. And then I’m basically showing the bank loans the amount of the bank lending that was going through in Japan at the same time. And if you think that banks lend reserves, you have to imagine there is a correlation, which is at least a tiny bit positive. It’s not maybe one, one, but it’s 0.1 or 0.2. And actually what I show is that as bank reserves went up, bank loans in Japan went down. So banks had more reserves than before, and they ended up shrinking the loan book. And I can do the same example for Europe, because if I look at bank reserves because of QE, they have gone through the roof, but the amount of loans they are getting, let’s say the equivalent of CNI loans in America, so commercial, industrial loans for capex productive purposes in Europe have been flat in nominal terms but in real terms have gone down over the last five years, despite the amount of bank reserves, having doubled, tripled, whatever the ECB balance sheet did over the last few years.

Where the credit cycle is right now and why the European growth cycle looks better than the US

Bilal Hafeez (15:33):

And then on the credit trends at the moment, I mean, how are commercial bank lending balance sheets looking in recent quarters in Europe and the US?

Alfonso Peccatiello (15:41):

So over the last two quarters in the US, we have seen some pickup in bank lending, which is always a result, Bilal, of the late cycle attitude of commercial banks. So when there is a cyclical recovery ongoing and commercial banks feel that the private sector is doing better. When we have this advanced late cycle stage, then generally banks are more incentivised to lend. Because the credit worthiness is cyclical improving for the private sector at the same time, yields are slightly moving up a tiny bit. So you start from the risk free layer. So say front-end yields are starting to move up a bit. Credit spreads, maybe they stabilise or they start moving a tiny bit wider. Central banks remove accommodation, which makes loan yields as an aggregate, which is the sum of risk-free yields and credit spreads, basically, it makes loan yields go up a tiny bit against, and a slightly cyclical improved credit worthiness from the private sector, which generally incentivises banks to lend a bit more. Now, what I always look at is the impulse of this lending. Our system is based on continuous credit expansion. I mean, it’s just a matter of, we need to get more leverage up now to overlay cyclical growth today to basically masquerade the very poor structural trend that are coming over the long-term due to demographics. We have an ageing population. We have an highly advancing technology, et cetera, et cetera. Those structural trends are very difficult to fight. So in order to grow cyclically much stronger than the structural trends would imply, we use credit, we use leverage, we basically borrow future purchasing power. So the fact that credit expands is just the feature of the system, it’s just how it works. What I look at is the acceleration or the deceleration in this credit creation. So are we creating new credit at a very fast pace or a very slow pace because not creating credit means de leveraging, which is very painful. We have tried that in Europe with austerity, didn’t really work well. And if I look at the impulse, the impulse of credit creation has been super strong throughout 2020 and 2021. Banks landed a lot because the government was guaranteeing credit losses, basically. And the government itself transferred resources to the private sector by a fiscal stimulus in huge sizes. So the private sector received credit from banks, resources from the government. We felt that this is going to be the regime change, which is what we hear a lot during cyclical up-swings. Obviously, the impulse has gone down materially we haven’t created new credit at an accelerating pace in late 2021 and beginning of 2022. The fiscal stimulus effectively stopped. So you actually end up having a credit cliff rather than another credit rush.

Bilal Hafeez (18:22):

And is that the same in Europe as well?

Alfonso Peccatiello (18:24):

Interestingly, great question. In Europe, the fiscal stimulus has been fazed away much better and that’s because the fiscal stimulus happened by NGEU fund, so the recovery fund of the Eurozone. And the disbursement out of the recovery fund happened in tranches at a later stage. So we’re going to see a lot of that coming through 2022, a lot of that coming through 2023. And in America instead, the fiscal stimulus has been very focused, very constant traded around 2020 and March 2021. And so you have sent cheques to people literally to be spent or saved to whatever they chose to do mostly throughout 2020 and beginning of 2021. In Europe, you have approved a decent fiscal stimulus package and not the same size in percentage of output cap or GDP than America. They still are relatively sized for European standards package, but the disbursements, so literally the fiscal impulse goes through a bit more phased out, which actually I think helps Europe to avoid a much, much sharper fiscal cliff. And actually in my opinion, would both decently for European growth later this year, especially in relative terms compared to the US or other places where the fiscal input has already gone through the economy, which also means the fiscal cliff is much harsher now.

Bilal Hafeez (19:40):

Okay. So basically Europe has drawn out it is fiscal stimulus and that’s going to allow it to just have more stability in some ways, rather this up and down that US has had. Now what’s your view on the Fed? Obviously we had a Fed meeting last week. The market got very excited. It looks like markets are pricing four to five hikes for this year. Are you on the same page? Do you think that’s how much they’re going to hike?

Alfonso Peccatiello (20:00):

I think the Fed has a best case in their mind they want to hike four times, but what really matters, Bilal, is that Powell chose explicitly not to truncate the distribution of future outcomes from the right-tail. He was asked plenty of times, ‘Can you hike 50 basis point?’ So let’s go to the right tail of distribution. ‘Can you hike 50 basis point? Can you hike at every single meeting? What do you think of labour force participation rate? It hasn’t been picking up materially.’ So he was asked questions where he could decide to truncate a bit or to really shallow the right side, the hawkish side of the Fed distribution of outcomes in 2022. And he deliberately chose not to. He literally left open all the options. He didn’t deny any of those, which tells you actually that he was probably pretty happy with financial condition repricing where they were. He was pretty happy with the bond market pricing in the front end, back then before the press conference a bit more than four hikes. And so that tells you something about his own stance. He also said he wanted to review his own PC forecast by few tens, that’s what he said, which probably meant he wanted to review it up to around 3% at the year end. So if your Powell and you have this political pressure from Biden, looking at midterm elections with real wages being negative, and on top of that, you are definitely switching from a dual mandate focus way I need to fight inflation, full stop, focus, then obviously probably your base case is to hike four times, but I was pretty impressed by his complete denial of trying to not cut at all the right side of distribution. He didn’t even try, not at all. So I think you need to take this into account and naturally you give a green light to markets to go and chase those trades that are still in the right tail and not priced accordingly.

So if I look at the financial condition index, one of the things coming to mind is high yield spreads. So financial condition index is real interest rates at the front end, equity is premium, credit spreads, all of those actually going to the basket of financial condition index. And if you look at front-end real yields and nominal yields, they obviously have repriced up. If you look at equity risk premium, well until a couple of weeks ago, they had widened pretty aggressively and credit spreads were sort of the outlier. So high yield credit spreads were still around 320 basis point, which for such a twist from the federal reserve during a relatively strong slowdown in growth impulse, look at Atlanta Fed GDP, Q1 is at 0% being updated for Q1 analysed basis. Credit spreads were holding pretty well. And so the market then went after those and they widened lot.

My overall thinking is that the data will slow down hard enough in H1 2022 in real terms, so real economic data will slow down and disappoint hard enough and that will save the Fed from making the mistake of over tightening. So then as the economy basically slows down due to the credit cliff in America, Powell has to worry less about an aggregate demand feeding loop into inflation. And so it can just decide to basically tighten, but not to over tighten as the economy’s going to do the hard work for him in terms of reducing depression, inflation because of aggregate demand going down, and that ultimately will find its own equilibrium. That’s my base case.

Bilal Hafeez (23:24):

And so the market implication you alluded to there was you think that credit is the most vulnerable in H1 because the that’s the market that hasn’t repriced for this more negative scenario of the Fed tightening and slower growth.

Alfonso Peccatiello (23:35):

The way I see that, I mean, for credit at this stage, for credit spreads to tighten further, it’s a pretty bad risk-reward trade. I mean, you either need the fed to completely twist basically a 2019 move, early 2019 move and to say, “I’m sorry about… We are not far away from neutral. The labour market cannot handle a lot of interest rate increases,” that’s what Powell said. So it makes a complete twist. And then obviously the little risk premium pricing credit spreads can be priced even narrower because from a monetary policy perspective, you’ve made an 180 degrees twist. Or you need earnings to come in very strong. You need the cyclical recovery to continue, and you need data to surprise through the upside. I really can’t see any of those to be my base case. And by the way, credit spreads at 320 basis point when there were at weeks ago in high yield, just leave maybe about 20 basis point of tightening plus the carry of course of tightening left. And on the widening side, on the other hand, I see either the Fed still not truncating the right side of the hawkish distribution, that will be pretty bad over time for credit spreads and/or I see an economy that’s likely to disappoint on the downside. And so when I look at the risk return of the trade, then I find high yield credit spreads to be trading still relatively tight, and to be a place where from a risk reward perspective, you can decide to try and lean short. And then generally, there are other relative value trades that I like a lot. So one that I have on is long NASDAQ and short Russell, if you move to the equity markets. And there is a similar situation, I mean, for the Russell to overperform the NASDAQ, you basically need earnings to come in very strong and/or you need nominal yields and the curve to be pretty steep, reflecting future outcome for growth and inflation to be sustainably high. And so in this environment, I honestly can’t see neither of the two happening. And I saw obviously risk premium being repriced across the board and high beta being hit, which hit the NASDAQ relatively aggressively, which can be true, but in relative terms against the Russell, I think if you have to be invested in the stock market, choosing quality names, the NASDAQ also includes non-quality names, but as an index trade, quality structural trends name that can mean some of the names in NASDAQ compared to the Russell that really needs this tailwind from economic growth and a steeper nominal yield curve that projects this nominal growth to continue down the road, I just can’t see that happening.

ECB hikes

Bilal Hafeez (26:05):

Now, you had more of a positive growth view on Europe. I mean, one first question I have really is will the ECB ever raise rates or not? That’s the first question. Perhaps let’s start there.

Alfonso Peccatiello (26:16):

Yeah. So the answer to this question is yes, they will and ECB would love to be able to do that. So the thing I learned in my real money career is that in incentive schemes are paramount important in trying to understand what will really happen. And if you manage to talk to the vice president of the ECB back then, as I managed to talk in private, he once told me, “Look, Alf, the structural trends of growth in the Eurozone, real growth are horrible. I mean, real growth in the Eurozone over the very long term will be determined by the amount of people that actively join the labour force on a net basis and how productive this labour force is, and how productive capital is.” Basically that’s long term real growth, potential growth. He said, “If I look at all these factors, it’s very hard to foresee how these robust, positive trend growth will come from. Because the labour force is shrinking year after year, that’s undeniable. If we manage to keep a flat 0% labour force growth, we are happy,” actually said. So the trends are not looking good. Population is ageing, so they leave the labour force. We’re not making enough kids to replace them, et cetera, et cetera and we all know that. The productivity of this labour force and capital is also not offsetting this drop in the labour force strong enough to produce a total potential growth that is decent. So he was talking about real potential growth in the Eurozone to be mildly positive. And so when he pushes that out, then obviously you know you will need to be accommodative and keep real rates pretty low. Now the point is, at some point there is a zero lower bound or an effective lower bound. And Europe is not a zero lower bound, it’s a negative 1% lower bound, call it as you wish, but we’re very, very close to that. And so in that environment, the incentive scheme for a central banker is to try and get away from that bound when he feels can do that without hurting aggregate demand on the economy, such that in the next downturn, he has some weapons. Obviously, they are in trouble from a weaponry perspective if you’re too close with the effective lower bound. And so he said, it’s a very tough job because ultimately from a structural perspective, you will need to keep real rates really, really low. So you will need to really be close to these effective, lower bonds for a sustained period of time, which makes it a very risky position to be in if you’re a central banker, which also makes your incentive scheme to try and get out of it when you can, without having to hurt the aggregate demands out of the equation. And so I think because of this phased out fiscal stimulus that we will see helping Europe from this perspective this year. And because we are in a cyclical mature phase of the growth cycle where the labour market participates, matures, it tends to bring in more people into the labour force naturally. This is the state of the economic cycle we are in. This will be a situation where the ECB will try to take action, especially if it’s backed by the data below.

Bilal Hafeez (29:18):

And timing wise, when do you think they could first possibly move? Would it be next 2023 or could they even do it at the end of this year?

Alfonso Peccatiello (29:26):

End of this year is the very likely I would say. So the schedule that they have now, phasing out APP by the end of the year, Q4, let’s say Q4, will leave them with a bit of time to make the market digest the full tapering of the PEPP and then will, I think, enable them to go with the first 10 basis point hike by the end of the year. Let’s say December is a life possibility. Interestingly, the future markets are now pricing 10 basis point hike by July. I just tweeted about it. And it’s like, “Okay, well, that’s quite a stretch. I mean, I like… The bond market tries to chase narratives. I mean, we guys in the bond market used to be very aggressive. It’s either A or Z. And in this case, it’s A, we need to chase narrative and 10 basis point hike by the summer is really hard to foresee. You literally need them at the March meeting to move forward the schedule of the pep taping from Q4 to Q2, to June. And then you need to base say, I will leave zero to one month time between the tapering of the PEPP and the first hike.

Bilal Hafeez (30:28):

I mean on that, do you think there’s a possibility they could separate the two out so they could keep the QE programme running, the APP, whatever version is, and then do the policy rate hike even while they’re still doing QE. So not linked the two together, so not to end APP, not to end the QE and then do the policy rate hike, but just keep it running in the background and do the policy rate hike whenever they feel like.

Alfonso Peccatiello (30:51):

They could, but for years and years have said that the path of policy tightening first foresees bringing net purchases to zero and then giving the market a tiny bit of time to digest this new environment and then start hiking rates. This has been the forward guidance. They really care about make it explicit, make it easy for people to understand in order for basically risk premium, not to be built in the wrong way, which is because of uncertainty about the future path of monetary policy. They really hate that. They’ve been very vocal. And the fact that Lane is in the governing council is very important, Bilal, because he’s a very good economist from this perspective and he understands as well market functioning and the importance of forward guidance. So the risk reward of changing this composition of a forward guidance is pretty bad, I think from the ECB perspective. So I would say that their objective should be to taper to zero and then hike following their guide.

Long EUR/USD and Long NASDAQ/short Russell trades

Bilal Hafeez (31:48):

Yeah, they set the framework up, no point to change everything now. And in terms of trades for Europe, you mentioned some views on US markets. I mean, given this perspective you have, somewhat more optimistic cyclically on Europe, the possibility of an ECB move. But what types of trades are you looking at in Europe?

Alfonso Peccatiello (32:05):

So, over the medium term, it’s not something I have on now, but I’m looking to go long EUR/USD for the second half of the year, because obviously as you will, tightening the interest rate differential being pricing forwards, and also literally from a nominal growth perspective, Europe might overperform consensus more than the US will be able to overperform consensus. I think EUR/USD looks pretty decent going into the second half of the year. And from a, let’s say, pure European perspective, there is one trade that I really like here, which is based on the fact that I expect repo levels to become less expensive across the board. So let’s start first from… Maybe let’s start from the trade. The trade is to be short bonds and receiver of swaps here. So you can choose French bonds or shatz, and then basically be short the bond and receive the swap against it so it’s an asset swap trade. And the reason why I think those trades will work is that the largest explanatory variable for most of these trades is where you can fund them on a relative term basis, and that’s the repo levels. And so, let’s talk about why do I think these repo levels will move to be less expensive than they are today. So, the reason why repo is so expensive today, you can fund a loan in a 10-year French government bond position, few basis point below €STR levels, which are below the ECB deposit rate. So basically repo for a French bond is about negative 60 basis point, 60. And so the ECB depo rate when you park the cash you receive from the repo transaction is negative 50 basis point if you’re a European bank, which base leaves the owner of bond sitting on a pretty decent 10 basis point margin between the repo level it can achieve and where it can park the money that gets back from the repo when he lends the bond away to another counterpart.

Bilal Hafeez (33:52):

Yeah. And that’s relatively very low risk.

Alfonso Peccatiello (33:54):

Yes, absolutely. It’s a collateralised overnight repo that leaves you with a decent buffer of return if you’re bond owner. So today, owning bond and repoing them out, it’s pretty lucrative exercise even if the bond is not a AAA bond, but it’s a French bond. So it’s pretty liquid government bond, but not of the highest quality. This is because the imbalance between bonds and reserves, let’s call them cash for a second, allow me for this simplification, is now highly skewed towards cash. There is an incredible amount of reserves or bank deposits, lets called them cash, in the system, which is the result of quantitative easing swapping out this bonds of taking this collateral out and putting these newly created reserves into the system so that these reserves are effectively trying to who chase regulatory well-traded assets. So if you are a pension fund, for instance, and your bank deposits, so pension funds can’t go in reserves, if the pension fund is on the other side of the QE trade, they will have their bonds taken away by the central bank and they will have bank deposits. If they don’t have access to the ECB, they have to park their newly created cash over and night at a bank. This overnight bank deposit is basically as credit risk. So if a pension fund decides to place cash at Commerzbank, it’s running credit risk on Commerzbank as a bank. Anything above a €100,000 actually runs that risk. It’s an uncollateralised overnight bank deposit.

Now that’s not a great proposition, isn’t it? Especially because a pension fund will need to pay €STR levels approximately to the bank for this new deposit.

How asset swap trades work

Bilal Hafeez (35:31):

And €STR levels just for the audience is what?

Alfonso Peccatiello (35:34):

It’s a negative 55 at this stage, minus 55 basis points. So it’s even more punitive than parking at the ECB depo rate. And it sounds secured. It’s running risk on a commercial bank, right? You’re depositing overnight at a commercial bank. It’s a pretty bad instrument. So what pension funds do is they use a lot of reverse repos. They get all this cash and they say, “Well, can you give me some collateral where I can literally lend you this cash overnight and you please give me collateral?” So they’re looking for this French bonds as collateral for reverse repo transaction, which makes repo levels then go negative and negative because there is way too much of these reserves and bank deposits that are inert, that entities, financial institutions of banks, asset managers, pension fund are looking to get rid of literally, because those are inert assets owning very bad yields, either negative 50 or worse. And they sometimes even run credit risk, for instance if it’s a bank deposit.

So all these imbalance is creating these repo levels to be very tight, very, very expensive, which is making swap spreads or assets or bonds much more expensive on a relative term basis to swaps. Now, if you reverse this and this will be reversed because you will stop QE this year, we just discussed about that, you will stop QE in the Eurozone and you will also have no new TLTROs and actually incentives I would argue for European banks to repay some of these TLTROs, it will reduce the amount of excess liquidity in the system. So as you reduce the amount of excess liquidity, Bilal, and you’ll still issue bonds, this collateral cashing balance will reverse a tiny bit towards less reserves, less cash and more bonds, more collateral available to the private sector, which in turn will make the repo levels a bit less expensive, which will weigh on these asset swap spreads.

Bilal Hafeez (37:24):

Okay. Yeah. It could sound a bit complicated to people, but just to simplify it, if I may, essentially with all this QE and that’s happened over the past few years, there’s too much cash in the financial system, so entity such as pension funds, they have this cash, what can they do with it? They can deposit it at the European bank. But the problem there is the interest they get is very low and they get the bank credit risk that they don’t want. So instead they say, “Okay, let’s lend that to people who have bonds and they can then use the cash to repo the bonds that they have.” So in that sense, they have the collateral of the treasury of the bonds, which is good. It’s better than the bank credit risk. But because they’re supplying all of this liquidity, all of this lending into that market to allow people to borrow against the bonds, that has pushed down the repo yield. So it’s very easy for people who have bonds to be able to borrow against it. So the yields are really, really low and that makes bonds very expensive because everybody just can engage in this trade and just buy the bonds, borrow in repo. But when you reverse all of this QE, then everything goes into reverse. So suddenly that trade becomes less attractive, then bonds will start to trade cheaper and then swaps will then become more attractive. So then you can do the asset swap as you say.

Alfonso Peccatiello (38:40):

Very true. Much better explained than I did.

Draghi and Italian risks

Bilal Hafeez (38:43):

Yeah. And this is probably the day to day that you did for a long time I imagine at the treasury. Now you are Italian, of course. No, you mentioned at the beginning. So what’s going on in Italy? I see there’s been reaffirmation of the presidency. Draghi was supposed to be bumped upstairs to the presidency that hasn’t… I mean, what’s going on politically in Italy and then also we can talk about just BTPs as well.

Alfonso Peccatiello (39:04):

Yeah. So I would say to people investing in BTPs that the Italian politics must be by far the most complicated variable, because if you’re Italian, you can get complicated. If you’re not, it’s, wow, basically a black box. So let me try and help from that perspective for what I can. Again, it’s all about incentive schemes. And so the fact that Draghi could become president was never a possibility in my head because the president of the Republic in Italy, basically, it’s a very institutional role. It is. It’s a rubber stamper role in reality. And Draghi as a personality is not a rubber stamper, I can tell you. And everybody knows that, I guess. I don’t need to explain this to anybody. So he wants to make the difference when it comes to decision making and the president of the Republic has institutional decision making, but no more than that and Draghi wants to have active decision making. So he was never going to be the president of the Republic if you ask me, and indeed he was not elected to be, which makes the government very likely to run at least until the budget of 2023 is passed, which normally happens in Italy between October and December of current fiscal year. So that means I can imagine the current coalition backing Draghi all the way until 2022.

Bilal Hafeez (40:18):

And who’s in the current coalition, which parties are in the current coalition?

Alfonso Peccatiello (40:21):

Basically. Everybody is.

Bilal Hafeez (40:22):

Okay. It’s like a big grand coalition.

Alfonso Peccatiello (40:24):

Yes. It’s basically an institutional government apart from the very far right, which chose to be much less supportive of the Draghi government.

Bilal Hafeez (40:33):

That’s La Lega (Lega Nord) yeah?

Alfonso Peccatiello (40:35):

No, no. La Lega it’s formally supporting the government, but Meloni from Fratelli d’Italia. So the very, very, very far-right. But she’s been doing very well in polls, actually eating some of the Salvini success away within the right. And she has basically chosen not to explicitly support Draghi government. Now the coalition is very broad, nevertheless, and I think because of incentives schemes again, will survive all the way until the end of 2022. So they can claim the benefits of passing through the recovery fund resources to the Italian private sector, and then they can work most likely on an electoral law change, which is still not fully defined.

So we’re basically creating the grounds for 2023 elections, which naturally will happen between April and May 2023. That’s the natural end of current legislation in Italy. And there is a tiny chance that these elections will be brought a little bit forward by basically passing the 2023 budget law and then effectively calling for new elections. So without waiting for this four to five months, they can be anticipated few months forward, doesn’t make much of a difference. The main case is that the government will survive 2022 and we will have elections in Italy in 2023. Now I don’t even think Draghi will want to be in the race for elections in 2023. I think he probably did what he wanted to try and achieve in Italy throughout his tenure, which was basically to stabilise the situation and redirect the recovery fund resources where he thought they could be more useful and productive for the country. And then his next step is likely to be, I think in Europe when it comes to decision making at a European level. That’s my own perspective. When it comes to the Italian electoral framework of 2023, a lot of the results and the future government in Italy will literally depend on the electoral law. So if you’re investing in BTPs, you must be paying attention to electoral law developments and discussions throughout 2022.

Bilal Hafeez (42:33):

And when will we start to hear about changes in electoral law? Is that the H2 story? Could it have happened now?

Alfonso Peccatiello (42:40):

I expect you will start to hear that in few months already, because this generally takes time, all this discussion. And a lot of political parties have different incentive schemes on which electoral law to use. Some of those prefer a non proportional system where you get a boost. If you’re the first party, then you get a boost. Other parties prefer a more proportional system. So there will be a lot of incentive scheme clashing against each other, depending on which party belongs to which coalition and what is the best electoral law for each of the Italian parties. But you should pay attention to the discussions and the likely final result because this will shape ultimately the likelihood of having a more pro-European coalition or less pro-European coalition. In Italy today, there are no parties that are explicitly against the Euro, like they were maybe in 2018. So the stance has been watered down pretty remarkably, even from Salvini and Meloni over the last few years. But nevertheless, there’s a very strong difference between having democratic party leading the governing coalition and Salvini or Meloni leading the coalition. And most of the final outcome will depend on what will be the electoral law used actually in 2023.

Bilal Hafeez (43:51):

And do you have a view on BTPs? BTP spreads over the last few months of widened a bit. They’ve stabilised a bit recently, I guess. Do you have a view on BTPs or is it a case of just staying on the sidelines?

Alfonso Peccatiello (44:02):

No. I would say that at the moment, it doesn’t scream to be a great trade either side. If somebody would ask me, would you be long or short spread wise in spread terms, I’d rather in short than long at this stage with a view you of six to nine months going forward. And the point again is if you’re long BTPs, you are not long for the mark-to-market of the trade, you’re probably long for the carry of the trade. I mean, you have something that is carrying much better than any other liquid instrument in the Eurozone. This carry can be wiped out pretty quick from mark-to-market moves if things start to become volatile. And as you start talking about electoral laws, incentive scheme, perhaps early elections, chapter about early elections once the budget is passed over in full of 2022, I think this carry doesn’t really reward you for a lot of this volatility going forward especially if you use a 10 year BTP as a benchmark. And obviously there will be period where being long will make more sense, but on a structural basis, I think that both the macro environment with the ECB becoming less accommoditive with the amount of access reserves dropping in the system and with the amount of collateral being available to the private sector to absorb going up and with some volatility around electoral law and political discussions in Italy and elections coming in 2023, doesn’t look great to be honest here.

China’s credit cycle turning

Bilal Hafeez (45:24):

Yeah. Just the risk return doesn’t look as good. It’s not good to lean that way. Now, I know you also don’t just look at the US or Europe, you also look at China as well. What’s your outlook on China?

Alfonso Peccatiello (45:33):

So China is an interesting juncture in the cycle and they’ve gone through a huge leveraging cycle for the private sector. So Xi Jinping has gone after Alibaba first and then a few other tech IPOs that were supposed to happen. Then has clumped on online tech and then it decided to move to the residential sector basically, to the real estate sector in China. So he hit different sides of the private sector and the de-leveraging happen there has been pretty large, pretty, pretty large. And so we are now at a point where we have had the first signal, Bilal, that this de-leveraging seems to probably be over. So the most acute sign that I’ve seen is not the PBoC cutting rates here and there, but it’s rather officials giving clear indication to state owned banks in China, that they want credit to be redirected to certain sectors again

Now China has this incredible feature and power to be able to redirect credit where they want it, when they want it and how they want it to be. And so they can just work to state on Chinese banks and they can say, ‘I need credit to go again through the real estate sector or again, to the tech sector,’ or whatever they want it to be. We have had literally Chinese officials coming out on the wire saying that they have suggested to state on banks to redirect credit in these beaten up sectors. And it’s showing up as well in the Chinese credit invoice, which is a very followed metric for a very good reason, because China has been the largest contributor to credit creation in the whole world over the last 10 years. So the Chinese private sector credit creation is very large on a percentage basis all over the world. It seems like from preliminary data, they have started the engine slowly again, not by coincidence because the Politburo meeting, the five-year long term meeting of the Chinese Communist Party is supposed to happen by the end of this year. And I don’t think anybody has any interesting in getting in there with the private sector bleeding relentlessly from continuous deleveraging. Even China has political incentive schemes at the end of the day, right?

Long China real estate trade

Bilal Hafeez (47:35):

And does this make you positive on Chinese equities? I mean, they’ve been battered quite heavily.

Alfonso Peccatiello (47:40):

So I’m long Chinese real estate. There’s a relatively liquid ETF that gets you equity exposure to China developers, which is called CHIR ETF or there is much more liquid one with which is high-yield Asia Pacific credit. So that’s not equity, but it’s credit. It’s high yield credit. So tiny bit up on the equity ladder, but not that much. And that has about 35% to 36% of Chinese real estate exposure into that. So it gets you good proxy and it’s much more liquid. But I am long these assets because I think they have really suffered from very large drawdowns. And as you start pumping credit again and oiling these sectors once again, you should be able to see some upside there, especially as you start from pretty buttered down levels.

Favourite trade: US 2s10s flatteners

Bilal Hafeez (48:24):

Yeah, no. That’s great. Are there any other trades you’re looking at the moment before we talk about some more personal stuff?

Alfonso Peccatiello (48:31):

Yeah. The master trade I have on I think, or at least one where I have the highest conviction going to work, it’s a 2s10s flattener in the US, which is something I have on, and it’s already largely in the money, but I think it can run further until the curve actually inverts. That’s because I really saw Powell being very committed in making sure that he will deliver when it comes to tightening. And as he does that while the impulse of growth is slowing down and the curve tends to flatten and 2s10s in swaps when I enter, we’re still at 65 basis point, and there is some way to go before it goes even flatter to a point federal officials start to be worried about it. And so I thought the risk reward here seems to be pretty decent. And I think curves will flatten in the US. They are also flattening now in Europe, by the way, as we speak, Bilal. 5s30s swaps in Europe just trade at the flatter level since 2008, if you exclude the COVID blip, so if you cut the few illiquid days where may have happened, and you look at weekly or biweekly trends, then we are at the flat level since 2008. I think that’s a pretty strong signal.

Bilal Hafeez (49:33):

No, that’s great. I mean, we’ve covered so many markets now. Let’s get onto some more personal questions. One, again, actually related to investments are what’s the best investment advice you’ve ever received?

Alfonso Peccatiello (49:43):

Okay. I think I have the answer, and the answer is stop your ego out. That’s what my mentor used to say a lot to me. And so he was very vocal on the fact that if you attach your ego to trades, it’s a recipe for failure because then you are not going to be able to look at the risk-reward and the development of market prices against your entry, in an objective way, you will be emotionally involved, which is a terrible place to be for an investor in the first place. So stop out and stop your ego out of trades. Even the ones you are the most passionate about, they can just be wrong, flat out wrong as any other trade.

Bilal Hafeez (50:17):

Yeah, no, that’s great. Now I know you are very prolific on Twitter. You’re writing newsletters, you are covering lots of different subjects and topics. I mean, do you have any productivity hacks or tips that you use? Do you have a system to absorb all this information and analyse things?

Alfonso Peccatiello (50:33):

Sleep eight hours a night. It’s by far the most productive announcing tip I have. I don’t know if it’s eight hours or seven or whatever works for you, but give yourself a regular night’s sleep and just stick the routine and force yourself to sleep. At least for me, it works magic. I can see when I don’t do that, I’m a wreck and I’m not able to deliver what I’m supposed to deliver. For the rest is get somebody to work in teams, generally speaking, at least two people, because having a back and forth of ideas, it’s a huge productivity boost. It’s not a linear sum. It’s more of something that works in a compounding way. When you bounce off ideas against each other, you can generally deliver much more than just the sum of each other’s idea. Those are the two. Sleep and get yourself and brainstorm with people.

Bilal Hafeez (51:17):

Yeah, no, that’s great. And finally, are there any books that really influenced you?

Alfonso Peccatiello (51:22):

Yes. Pragmatic Capitalism from Cullen Roche. It’s a must read book when comes to money to understand why a bank reserve is different than inflationary forms of money and who prints this potential inflation forms of money and who doesn’t. So it’s basically a monetary plumbing book, let’s say. I think it’s a fantastic start for people to understand. It’s very short, 100 pages. It’s an easy read. And then when it comes to macroeconomics in general, I would say Richard Koo is a great resource and he has two books, but I would suggest people to start from The Holy Grail of Macroeconomics. It’s a great book. And also Balance Sheet Recessions. I think it talks about Japan, which is, I guess, a place which is always interesting to look at.

Bilal Hafeez (52:03):

Yeah, Richard is great and he’s got some really great insight. I used to work with him when I was at Nomura actually. He’s got some very strong opinions and his view on the Balance Sheet Recession was great, that kind of way of looking at things.

Alfonso Peccatiello (52:11):

I think there’s two books. And then there’s a third one that gets you into the weeds of how hedge funds and risk takers really think, which is Inside the House of Money, the book is called. And it’s a series of interviews from, honestly, I don’t… Drobny, I think. And that is a great book because he interviewed not only hedge fund managers, but also treasurers and the prop traders. So you really have a diverse group of people that will go through their strategy and how they think about risks, how do they generate trade ideas? It’s a fantastic book.

Bilal Hafeez (52:40):

Yeah. No, I agree. I’ve read that book before as well. Actually it’s very good. Now, before we go, how can people follow you? What’s the best way for people to follow your thoughts and so on.

Alfonso Peccatiello (52:49):

The easiest is my newsletter. It’s called The Macro Compass. It’s on Substack. You can just Google Alf, The Macro Compass, you will find it.

Bilal Hafeez (52:56):

I’ll also include the link on the show notes as well.

Alfonso Peccatiello (52:58):

Thank you, Bilal. And then Twitter and LinkedIn are the social networks were are the most active. And the handle on Twitter is @MacroAlf and the name and surname on LinkedIn and you’ll be able to find me.

Bilal Hafeez (53:07):

Great. Now that’s excellent. So with that, thanks a lot. Is it’s been great speaking to you and I’m sure we’ll have another podcast soon as well. So it’s great to have you on the show.

Alfonso Peccatiello (53:16):

Thank you, Bilal and congrats for the huge work you’ve been doing at Macro Hive.

Bilal Hafeez (53:20):

Thanks for listening to the episode. Please subscribe to the podcast show on Apple, Spotify, or if you’re already listened to podcast, give a five star rating and a nice comment and let other people note about the show too. We’d be super grateful. And finally sign-up to become a member of Macro Hive and macrohive.com. We’ll be back soon, so tune in then.

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)