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Bill Gross: Never mind tapering, this is more important

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Pimco's Bill Gross says there’s another instrument – the federal funds rate – which will become the Fed’s tool of choice when it eventually ends QE. Is Gross right that rates will remain low for some time to come even with tapering?

The market has been focused on if, when, and by how much the Federal Reserve Bank will taper its “quantitative easing” (QE) program. But PIMCO’s co-founder Bill Gross says there’s another instrument – the federal funds rate – which will become the Fed’s tool of choice when it eventually ends QE.

Over the past several years, the Fed has been buying US Treasury and mortgage bonds to add cash into the financial system. This policy, referred to as “quantitative easing”, led to a run-up in bond prices. Higher bond prices mean lower bond yields, and that brought the rates on the benchmark 10-year US Treasury bond down to as low as the 1.6% range earlier this spring.

(Read: With debt ceiling, are 'Obama bonds' the answer?)

In May, when Fed Chairman Ben Bernanke hinted that the Fed may taper the $85 billion it uses every month to buy the bonds, a large selloff in fixed-income securities began. Yields nearly doubled from May to the beginning of September as investors dumped large number of bonds. However, the Fed decided to hold off tapering and that to a bit of a rally in bonds. Today, the 10-year Treasury note yields around 2.6%.

PIMCO manages the world’s largest bond fund, the $250 billion Total Return Fund. While it had $5 billion in outflows last month, it also gave a return of 1.77% to investors, though it’s down nearly 2% so far this year.

In his October letter to investors published on PIMCO’s website, Gross writes:

“The Fed will have to taper, cease and then desist someday. They can’t just keep adding one trillion dollars to their balance sheet every year without something negative happening – either accelerating inflation, a tanking dollar or a continued unwillingness on the part of corporations to invest because of the resultant low and unacceptable returns on investment. QE (quantitative easing) has to die sometime.”

So, what’s the Fed to do if it can’t keep on buying long-term bonds to keep rates low and the money flowing? Gross believes the fed funds rate – the rate banks lend to one another overnight – will be what the Fed will start focusing on. The Fed targets what rate it wants the fed funds rate to be and will intervene in the bond market to achieve its goals.

Gross writes:

“It’s the policy rate, both spot and forward, that prices markets and drives economies and investment decisions. QEs were simply a necessary medicine for rather uncertain and illiquid times. Now that more certainty and more liquidity have been restored, it’s time for the policy rate and forward guidance to assume control.”

Worried about QE tapering? Gross thinks you shouldn’t because it soon won’t matter, writing:

"If you want to trust one thing and one thing only, trust that once QE is gone and the policy rate becomes the focus, that fed funds will then stay lower than expected for a long, long time. Right now the market (and the Fed forecasts) expects fed funds to be 1% higher by late 2015 and 1% higher still by December 2016. Bet against that.”

With a fund that’s long bonds, Gross is indeed betting against higher rates. Currently, the Fed targets the fed rates for a range of 0% to 0.25%.

(Read: Don't look for tapering anytime soon, says Fed's Rosengren)

So, is Gross right that rates will remain low for some time to come even with tapering? And, what can we expect from the 10-year US Treasury note?

Looking at the fundamentals is Erin Gibbs, Equity Chief Investment Officer at S&P Capital IQ Global Markets Intelligence. Gibbs is responsible for over $5 billion in equity assets under advisory. Analyzing the charts of the 10-year US Treasury note is Talking Numbers contributor Richard Ross, Global Technical Strategist at Auerbach Grayson.

What’s next in for the bond market? Watch the video to see what the fundamentals and technicals have to say about it.

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