Friday, October 29, 2010

The Beginning of the End

The End of a Bull Market in Bonds

PIMCO's Bill Gross shook me up the other day with his October commentary. Bond investors do not like it when a bond guru writes that the Fed's announcement of renewed quantitative easing next Wednesday "will likely signify the end of a great 30-year bull market in bonds."

Whoa! I've been raking in easy if modest returns with a portfolio tilted toward high credit quality bonds. That's what you do in a debt deflation, isn't it?

"Safe Spreads"

Always prone to hyperbole, Gross softened the message toward the bottom of his commentary, when he said that PIMCO had no intention of suffering a bear market in bonds, and that they could maneuver around this little problem of no more bond bull. Specifically, he intends to invest in what he calls "safe spread" securities that offer higher yield "without taking a lot of risk" of inflation.

One example is emerging market debt with higher yields and non-dollar denominations, and another is high quality global corporate bonds. Gross added: "Even U.S. Agency mortgages yielding 200 basis points more than those 1% Treasuries, qualify as 'safe spreads'.”

You know, I wouldn't call a bond portfolio exactly safe it includes a lot of securities sensitive to highly correlated risks like currencies and emerging market economies. So, how does this square with the "end of a great 30-year bull market in bonds?" Well, with Gross we know that he likes to engage in a hyperbole and that he doesn't tell the whole story.

Bonds Are Not "Over the Cliff"

Gross appeared on Bloomberg Surveillance Thursday and was more nuanced in his explanations. By an end to the bond bull he means "not over the cliff" for the entire market but a recognition that "certain maturities can't go much lower." Two-year maturity Treasuries, for example, are yielding near the overnight rate. Not much opportunity for return there. He explained that Fed purchases make it mathematically impossible for bonds to do much better.

He also explained that "safe spreads" refer to securities that offer yield without being vulnerable to inflation expectations. This concern with inflation sensitivity seems an important point.

Gross added that he hasn't shortened the maturity of his Total Return portfolio, which is still in the vicinity of four to four and a half years. This is in contrast to Dan Fuss, who said on Bloomberg Surveillance the day before that he had reduced the average maturity of his Loomis Sayles portfolios.

Rather than reducing PIMCO's bond maturity, Gross has gone "to a space not vulnerable to inflationary expectations."  A lot of securities are much less sensitive to inflation than are Treasuries, and he is focusing on the "safe space.".

It is interesting that Gross is concerned with vulnerability to inflation. Inflation is what the Fed is trying to achieve with QE, and with the suggested 2.5% inflation target. If PIMCO takes it seriously, perhaps there is a risk that they will succeed, or at least that investors will be spooked by the expectation.

Higher Rates in Three to Five Years

Another reason that Gross hasn't changed his portfolio's average maturity yet is that "the Fed isn't changing its target rate." So, he isn't expecting inflation soon, but apparently he thinks that it is a possibility sometime in his planning horizon. He believes that the Fed will tighten eventually.

The timing of inflation is influencing the maturities in his portfolio. Gross said that he is avoiding the 10-year Treasury because policy rates may go higher. The "safe maturities are five years and in, not five years and out." So apparently five years is approximately the horizon at which the Fed is expected to tighten. (I have no idea how anyone can predict if and when the Fed will tighten, but there it is.)

Gross reinforced this estimate of a five-year "safe" period when he said that CD investors could go out in maturity to three or four years. Five-year CDs might appeal a risk taker. Just to make it clear that he is willing to make a prediction, he added: "The Fed won't raise for three years, maybe four or five."

Stagflation Coming?

Given that the Fed is unlikely to restart the economy with monetary policy, it is natural to wonder why the Fed might raise rates within three to five years. The answer may be stagflation. If the Fed creates inflation through dollar devaluation or speculative bubbles, it would probably result in stagflation rather than ordinary wage-price inflation, given the likelihood that the economy will remain weak. Stagflation would be very negative for Treasuries. Rates would rise in general, and the Fed would have to follow.

It would take something very serious, like stagflation, to get the Fed to raise rates with the economy still weak. We have to wonder how badly higher rates would affect the economy and the servicing of US debt, which suggests that recovery through inflation is a self-limiting process.

No Inflation at Present

However, inflation risks are for the future and not the present, according to Gross. He sees even the low yields of short Treasuries as "safe" at the present time. "A two-year Treasury and a three-year Treasury only yield 37 to 60 basis points, but that's safe yield because the Fed isn't going anywhere."

Gross also suggested that the Fed may not be able to go much farther with monetary policy, and that fiscal policy will have to take over soon. "We've been willing to accept the lower yield in anticipation of a hand-off to federal officials maybe six months down the road."  Gross didn't say, but this would be after newly elected Congressmen have taken office in what is expected to be a more Republican House. Given the likely stalemate in Congress, it is hard to understand exactly how this "hand-off" is to work.

Does This Mean Anything?

Gross loves to dampen his clients' expectations by expressing caution. A look at his past commentaries shows that he has called for the end of the bond bull before, only to be followed by huge bond rallies. Maybe this is another of those times, but on the other hand, maybe his remarks are justified and even prudent at this time.  No one knows what the Fed is going to announce next week or the market reaction. The stakes of the anticipated QE II are huge, and it would make sense to hedge bond portfolios ahead of the meeting. Gross's comments aren't much at odds with the fears that most bond investors hold these days, and at least we have another plausible scenario for consideration.

We definitely need some scenarios to think about to protect our portfolios.  Another PIMCO guru, Mohammed El Erian, also said this week that Federal Reserve purchases of Treasury securities likely will spur inflation, while leaving unemployment untouched.