Another round (or two) of quantitative easing from the Federal Reserve, muted growth and an end to the 30-year bull run in government bonds.
That's what Bill Gross, one of the largest bond investors in the world, sees for the U.S. economy in the coming year. Gross is co-chief investment officer of PIMCO, the giant asset managers whose Total Return Fund is the largest bond mutual fund with current assets of about $250 billion.
Gross says long-term interest rates have been rising in recent weeks (here's a chart of the 10-year U.S. bond) for two principal reasons. "Yes, inflation is rearing its head. We're seeing that in oil prices and other commodities, and we're seeing it in the numbers," he said. The consumer price index has risen 2.9% in the past 12 months. In addition, Gross says, the Federal Reserve's "Operation Twist" is scheduled to end in a few months. Under this plan, the Fed sold short-term debt and purchased long-term bonds in an effort to keep longer-term interest rates lower. At its meeting earlier this week, the Fed indicated that it didn't plan to extend the operation. "Yields have risen based upon the possibility that the Fed simply stops buying long-term bonds," he said. "If they do that, the question becomes, who is left?"
Despite the Fed's communiqué earlier this week, Gross doesn't believe the central bank's interventions in the bond markets are over. In two rounds of quantitative easing (QE), the Federal Reserve printed money to buy hundreds of billions of dollars of Treasury bonds and mortgage-backed securities. "I believe there will be a QE3, and perhaps a QE4," he said. Why? In the past few years, whenever central banks have stopped or paused their quantitative easing efforts, "stock prices have fallen and economies have slowed." The globe's private economies simply aren't sufficiently strong enough to support robust growth, and the world's central banks aren't willing to stand by and watch. "That's not a policy recommendation, it's simply a realization that the substitution of central bank monetary purchases will continue for a long time, as long as they [central banks] try to support private economies on a global basis," Gross said.
When Gross talks, the market tends to listen. But not all his calls are prophetic. A year ago, Gross famously said the Total Return Fund wouldn't hold Treasuries, as PIMCO deemed the risks of higher budget deficits and potential inflation not worth the paltry rewards bonds were offering. Of course, in the months after that highly public move, interest rates continued to fall and the value of U.S. government bonds broadly rose. "Obviously, I wish I could take that back," Gross says. The Total Return Fund missed out on a healthy chunk of last year's bond rally. But since last fall, Gross notes, "we basically gained all of that back, and the Total Return Fund is back on track of producing" positive returns. "But yeah, those were rather grim months for us." (On Thursday, Gross also spoke with my Breakout colleague Jeff Macke about PIMCO's new Total Return ETF. See: Bill Gross on the "Secret Sauce" in PIMCO's New Total Return ETF)
Still, Gross believes the 30-year long bull run for bonds may be coming to an end. "We're certainly close and have been close for a number of months," he said. It's very difficult to imagine interest rates going lower. "The bond market, whether it's Treasuries, mortgages, or investment-grade bonds in combination, basically yield a little higher than 2%," Gross said. "And unless the U.S. economy replicates Japan, where yields are down to 1% on average, then you'd have to say that we're close to the bottom in terms of yield." He adds: "It doesn't mean the beginning of a bear market, but it does suggest at least that the great bond bull market since 1981 is probably over."
Recent market activity in some bonds certainly ratifies that view. In recent weeks, the yield on the 10-year Treasury has risen from about 1.8% in late January to about 2.28% on Thursday. But "those yields aren't attractive," Gross says. Currently, about 15-20% of the Total Return Fund's portfolio is in Treasuries. Gross recommends that investors avoid longer-term bonds — i.e. 10-year and 30-year bonds — whose prices may fall if long-term growth and inflation expectations rise. However, they should also avoid short-term bonds. "The Fed has conditionally guaranteed that they won't be raising interest rates until late 2014, and that's almost three years from now." Gross believes that bonds that mature in five, six, or seven years occupy the sweet spot in today's market.
Bond holders tend to fear strong growth because it has the potential to ignite inflation and boost interest rates, thus reducing their returns. Gross says that while the economy has improved, it shows no signs of overheating. He believes the U.S. economy is growing at about a 2% annual rate in the first quarter "and probably beyond." That's about as good as can be hoped for. While the Federal Reserve has injected close to $1 trillion into the U.S. economy in the past year, growth is in large measure tied to what happens in the global economy. And the omens from abroad aren't particularly good. "China is slowing and the euro land is in recession," Gross said. The U.S. is growing at a decent clip, "what we call a new normal, but it probably won't get back to the 3 or 4% real growth numbers that we witnessed over the past decades."
Daniel Gross is economics editor at Yahoo! Finance
Follow him on Twitter @grossdm; email him at firstname.lastname@example.org
- quantitative easing
- the Federal Reserve