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Intertemporal Disequilibrium and a World of BubblesFebruary 2014

Bernard ConnollyBrian Pellegrini, CFA---Connolly Insight LP

1Introducing Our Research Team

Bernard Connolly, Founder & Principal ResearcherBernard founded Connolly Global Macro Advisors (the precursor to Connolly Insight) in 2009 after spending 11 years as Chief Global Strategist at Banque AIG and AIG Trading. Bernards key insights and unapologetically independent analysis made him a must read for leading market participants and policymakers.Prior to AIG, Bernard worked with the European Commission in Brussels, leading the unit responsible for monetary policy. In this role, he was a member of the Monetary Policy and Foreign Exchange Policy sub-committees of the Committee of Central Bank Governors and of the OECD Group of High-Level Monetary Experts. In 1995, Bernard authored The Rotten Heart of Europe: The Dirty War for Europes Money, predicting many of the consequences of the European monetary union. Rotten Hearts publication led the Wall Street Journal Europe to name Bernard as one of its outstanding Europeans of 1995 and in March 2001 he received the Frde Jakobsen prize, awarded in Denmark for outstanding moral courage in public affairs. Bank of England Governor Mark Carney has identified Bernard as one of the very few economists who predicted the recent global economic and financial crisis.

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Brian Pellegrini, CFA, Senior AnalystBrian Pellegrini has worked at Connolly Insight since 2011 and currently holds the title of Senior Macroeconomic Research Analyst. Brian specializes in monetary policy, the energy sector, structured finance, and global macro portfolio strategy. Prior to Connolly Insight, Brian gained experience in positions across Wall Street. Brian's experience includes working with high-growth technology firms as an Investment Banking Associate at Merriman Capital. During his time at Morgan Stanley, Brian's responsibilities included structuring options trades for exchange-listed structured products as well as modeling and valuing ABS. Brian's role in structured products overlapped with the 2008 financial crisis. He played a key role in valuing and unwinding complex trades. Brian holds a Master's Science in Finance from Northeastern University and a B.S. in Computer Science from Columbia University; he is also a CFA charterholder.

About Connolly Insight

What We DoProvide a rigorous alternative to the orthodox economic worldview Analyze how newly released data ties into that view and the implications for the near-, medium- and long-termWe provide our clients with independent and refreshingly blunt analysis to assist them in understanding the economic environment and implications for financial markets Research mix approximately 30% U.S., 30% Europe, 20% global, 20% Japan/China/UK

What We Dont DoProvide regularly scheduled news updates on economic dataForecast upcoming economic dataProvide price targets for specific securities or markets

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Why Connolly Insight?

We provide economic clarity in a spin-free environment by thinking independently while being relevant, timely and incisiveOur economic worldview is considerably different from the economic orthodoxy practiced in academia and most central banks, but is highly respected by current and former central bankersWe benefit from our research teams extensive and varied experienceBernards time in the monetary policy sector gives him key insights into the methods and mentality of central banksWe maintain close relationships with current and former central bankers in order to understand the way they look at the worldWe pride ourselves on our lack of conflictsWe do not manage funds or receive commissionsWe are not an investment bank beholden to clients or government agenciesWe take nothing for granted and shun Wall Streets echo chamber

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Setting the Stage: Central Bank Policy and Bubbles

5Neo-Keynesianism vs. Hayekian Economics6

Neo-Keynesian policy seeks to find the short-term interest rate that will balance supply and demand in the current period. The assumption in Neo-Keynesian policy is that a series of short-run equilibriums will add up to long-run prosperity.Neo-Keynesian economics is the orthodoxy among central bankers, academic economists and the professional economists they educate.In contrast, Hayekian economic policy seeks to find the long-term rate of interest that keeps supply in demand in balance over the long-run.A focus on the short-run is dangerous because it ignores the buildup of long-run imbalances. By focusing on the short-run, instead of errors being mean-reverting and self-correcting they can become self-reinforcing. The name for a misalignment of supply and demand across time periods is intertemporal disequilibrium.

The Neo-Keynesian Central Bank Strategy7

GDP GrowthTimeLong-term Trend GrowthEconomy in equilibriumPositive shock = Raise policy rateEconomy back in equilibriumNegative shock = Reduce policy rateEconomy back in equilibriumNeo-Keynesian strategy is to achieve a series of zero output gap periods leading to long-run equilibrium.Business cycle is driven by randomly occurring, normally distributed, transient positive and negative exogenous shocks.

Hayekian Central Bank Strategy8

Natural RateTimeNormal RatePolicy rate should adjust with natural rateThe strategy for a Hayekian central bank is to adjust long-term real interest rates to match the natural rate as closely as possible.Regulatory, fiscal and social policy play a much more important role in Austrian theory. These factors can move the natural rate up or down. Declining educational standards pull the rate down. Reducing red tape pushes it up.

What is Intertemporal Disequilibrium?

A misalignment between investment and consumption across timeRelationship between consumption and investment is governed by real interest rates relative to expected rates of return on investmentDisequilibrium develops when the actual rate of interest deviates from the natural rate for a long enough period for expectations to changeHaving real interest rates too low results in over-investment and over-consumption in the near-termWhen we reach the future we have oversupply compared to the available level of consumption

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Productivity Shocks and The Internet Bubble

The U.S. experienced a strongly positive productivity shock in the late-1990sRaised the ex ante return on investment (i.e. the Hayekian natural rate) driving a pickup in overall economic activityInflation did not rise so the Fed did not see the need to raise its policy rateMarket interest rates were now below the natural rate, spurring an increase in investmentThe business sector underappreciated the productivity boosting effects of the IT revolution and an incipient oversupply was apparent by the end of 2000The ex post rate of return on investment turned out to be lower than investors had expectedWhen the Fed started tightening policy and long-term real interest rates began to rise, capital asset prices crashed as well as investmentWith long-term real interest rates above the natural rate the desired aggregate capital stock will fall and there will be pressure to liquidateTo prevent liquidation, the Fed engineered a significant reduction in real interest rates after the internet bubble burstThe Fed should have increased policy rates in the mid-1990s to divert investment from low return sectors to high return sectors, while keeping aggregate investment steady10

The Hayekian Central Bank

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CurrentFutureAggregate Investment==Consumption=Aggregate Demand=Aggregate Supply=Supply of Consumption Goods=Output GapZeroZeroConsumer Prices==Scenario 1: Actual Interest Rate Tracks Natural RateThe Neo-Keynesian Central Bank

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CurrentFutureAggregate InvestmentConsumption=Aggregate DemandAggregate Supply=Supply of Consumption GoodsOutput GapStrongly PositiveStrongly NegativeConsumer PricesScenario 2: Natural Interest Rate Rises Above Actual RateThe Dangers of Inflation Targeting13

Central banks such as the Fed are trying to balance short-term supply and demand in a world where long-term supply and demand are very importantMarket real rate (i)Neutral Rate (U)Austrian Natural Rate (n)nAustrian Normal Rate (N)

UThe Yogi Berra Paradox14

The Current SituationRates are too low AND too high!!!Rates are above the neutral rate (U) so a negative output gap existsRates are below the natural rate and the normal rate, inflating investment and further pushing the natural rate downWith the natural rate below the normal rate the market rate must continue falling to avoid an output gap

n

Un

Ui > Ui < nInterest rates in the US are both definitely too low and perhaps too high at the same timeand would definitely be too high if they stopped being too low-Bernard Connolly, July 2004Path of U.S. GDP Relative to Potential15

Bankers Bubble vs. Traders Bubble16

A World of Bubbles

17Why a World of Bubbles?

To prevent a crash in investment :Continually falling real interest ratesContinually increasing government deficits (and/or)Private credit bubbleFalling real interest rates reduces the hurdle rate for investment in new projectsInvestment occurs in successively lower and lower return projectsReal risk-free rates cannot rise without triggering a crash unless risk premiums fall equivalently

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Evidence Found in Real Interest Rates

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1954-2000 Average

Continually Expanding Debt Bubble

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Continually Expanding Deficits Leading to Default

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The Euro Bubble

22Ex ante assistance

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Full Employment Current Account Is What Matters

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Evidence of Structural Improvement/Deterioration

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What Does Success Look Like?

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Wrap Up

27Our Product Offerings

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