Paul McCulley, Managing Director, Portfolio Manager

Mr. McCulley is a Managing Director, generalist portfolio manager, member of the investment committee and head of PIMCO's Short-Term Desk. He also leads PIMCO's Cyclical Economic Forum and is author of the monthly research publication Global Central Bank Focus. Mr. McCulley joined PIMCO in 1999, previously serving as Chief Economist for the Americas for UBS Warburg.

During 1996-98, he was named to six seats on the Institutional Investor All-America Fixed-Income Research team. He has 22 years of investment experience and holds a bachelor's degree from Grinnell College and an MBA from Columbia University Graduate School of Business.

Every year, PIMCO's investment professionals from around the world gather in Newport Beach for the firm's annual Secular Forum, a three-day discussion of the outlook for the global economy and financial markets over the next three to five years. In the interview below, McCulley discusses the key conclusions from the 2006 Secular Forum and how those conclusions are influencing PIMCO's global investment strategy.

Q: PIMCO held its annual Secular Forum in early May to discuss the 3- to 5-year outlook for the global economy and financial markets. Before we discuss the conclusions from the Secular Forum, could you sum up the global economic environment heading into the Forum?
McCulley: In recent years, the global economy has been working with a tailwind of reflationary policies from the Federal Reserve, the Bank of Japan and the Peoples Bank of China.

The Fed cut the Fed funds rate to one percent, held it there for a year and has been very measured in returning it to a neutral level. The Bank of Japan committed in 2001 to quantitative easing, backing up its zero interest rate policy. The BoJ only recently announced that it is ending the quantitative easing policy. And China, by maintaining a fixed exchange rate to the U.S. dollar, has essentially imported the Fed's reflationary policy.

In each of these cases, the central bank pre-committed to absorbing risk from the global markets. China pre-committed to absorbing dollar depreciation risk, the Fed precommitted to holding short-term rates accommodative for a considerable period and then to removing that accommodation in a measured way, and the Bank of Japan precommitted to absorbing short-term interest rate risk in Japan.

These reflationary policies, which we could also call anti-deflationary policies, have been very successful at stimulating economic growth and lowering risk premiums around the world. But they have also contributed to massive imbalances in the global economy that we have referred to as a "stable disequilibrium." So, heading into the 2006 Secular Forum, one of our key goals was to assess the stability of the disequilibrium in the global economy and the implications for financial markets.

Q: What did PIMCO conclude about the outlook for stable disequilibrium?
McCulley: The central conclusions of the Secular Forum were (1) the reflationary policies pursued by global central banks so far this decade have been successful—global growth is strong and deflationary risks have been truncated; and (2) the ongoing removal of those policies makes the stable disequilibrium a little bit less stable, with imbalances becoming more important going forward.

Central banks are pulling back from being warm and fuzzy. The Fed has obviously pulled back massively, and the Bank of Japan is just about ready to start. We are also seeing a very slow but gradual appreciation in China's currency. And that implies that we are going to have an economy that is going to become more fragile, because risk premiums will be restored in a lot of risk assets around the world.

As Bill Gross said in his Investment Outlook, Bretton Woods II may be morphing into Bretton Woods III. And the point is that Bretton Woods III is not going to be as stable as Bretton Woods II because we will have China and the Bank of Japan on the move, where for most of the Bretton Woods II period they were solid as a rock.

Q: Does the success of reflationary policies suggest inflation will be a concern over the secular timeframe?
McCulley: Secularly, we think that overall inflation will remain benign. Cyclically, inflation may drift up a little bit, but we are not expecting a big reflation in goods and services prices. The reflationary policies that were put in place several years ago were all about reflating asset prices. And it worked. But with the removal of these policies, we are concerned that we had too much reflation in a number of asset prices, including property markets in the United States as well as around the world. Having said that, we do expect commodity prices to rise in real terms over the secular timeframe.

Q: How are these primary conclusions from the Secular Forum influencing PIMCO's overall investment strategy?
McCulley: The overriding theme of our secular investment strategy is that we are anticipating an increase in risk premiums across a whole array of assets. The slope of the yield curve is also called the term premium and we are watching daily as the term premium comes back into the bond market. Put differently, the conundrum that Mr. Greenspan made famous is being unwound, as the market is putting a risk premium back into the slope of the yield curve. The market is also putting risk premiums back into the emerging markets and we think that we are going to see risk premiums come back into the corporate bond market.

We are also seeing an increase in volatility, which increases implied volatility in options, which is another form of risk premium. So our overall theme right now is to be risk-averse, as risk premiums--which are skinny--widen back out.

Q: What is PIMCO's secular view on duration strategy?
McCulley: Our secular view doesn't give us a compelling duration story, either overweight or underweight. What it does give us is a compelling story on currencies. As growth in the rest of the world picks up and America slows down, and as the Fed stops tightening and the rest of the world continues tightening, that is a siren signal that the dollar is going to decline on trend. The dollar is not necessarily going to fall every day, every week, every month or every quarter, but one of the biggest implications of the secular economic outlook is that the dollar is probably going to be in a bear market over the secular horizon.

A bear market in the dollar would not argue for a strong overweight position on duration, so we are essentially duration neutral, with the caveat that we also conclude that the odds of a recession increase the further out you go over our secular horizon. And in a recessionary scenario, we would want to be very long of duration because I think a recessionary scenario would be very deflationary and would put sharp downward pressure on real interest rates. So, over the secular horizon, there is not a compelling long or short viewpoint on duration. But if over the secular horizon we get into a cyclical recession, we would look to extend duration to create a powerful cyclical position.

Related article: To read a summary of the 2006 PIMCO Secular Forum, click here.