Bill Gross did not see this major selloff in bonds coming. He discusses the setup in his recent Investment Outlook called The Tipping Point.
Much of the article is about how he almost tipped a ship while in the Navy. He uses the tipped ship metaphor to talk about the position in bonds.
Gross says “Markets just had too much risk, and in PIMCO’s opinion, too much hope for a constant QE and for the growth that it would produce. In effect, the ship was top heavy with too little ballast. Guess I should have known, huh?“
That’s water over the dam at this point so the question Gross asks now is “Well where does the ship go from here?“
Here is a snip of Gross’ explanation.
Should you as a bond investor jump overboard and risk the cold money market Atlantic Ocean at near zero degrees? We don’t think so – and not because we want to keep you on board – we just don’t think so. Why not?
1) The Fed’s forecast of the economy which prompted tapering panic is far too optimistic. If 7% unemployment is tapering’s final port of call, we simply think that we’re much further away than the Fed’s compass would suggest. We argue for structural headwinds – demographic, globalization, and technology influences – that have had and will continue to have dampening effects on domestic and global growth. The Fed, we would argue, is too cyclically oriented, focusing substantially on housing prices and car sales. And speaking of housing, since mortgage rates have risen by 1½% in the last six months and the average monthly check for a new home buyer is up by 20–25% as well, then as I tweeted several weeks ago, “Mr. Chairman are you serious?” Growth will be negatively influenced.
2) Inflation, according to the Fed’s own statistics is running close to a 1% pace. The Fed has told us that they “target,” “ target” 2% and for the next 1–2 years are willing to accept even 2½% until they reverse engines. Fed Governor Bullard of the St. Louis Fed was in our opinion correct where he dissented from the majority decision several weeks ago, citing the distant shores of 2%+ inflation and the seeming inability to even move in that direction.
3) Yields have adjusted by too much. While T.V. and the press focus on 10-year Treasuries at 2.55% as their guiding star, subjective stabs by yours truly or anyone else are difficult day to day. … To my eye, Fed Funds will not increase until at least mid-2015 and even then subject to a consistently strong economy that produces 2%+ inflation. I wonder if we can get there in this decade to tell you the truth. But the beauty of this North Star Fed Funds sextant is that it can be rather directly observed in futures markets, either for Fed Funds or for Eurodollars, which are a close companion. Right now, Fed Funds futures markets are predicting a 75 basis point yield in 2015, and Eurodollars validating a similar conclusion. That would suggest a mispricing, despite the obvious caveat of professional observers that some of the 75 is a surcharge for potential volatility. In any case, if frontend curves are up to 50 basis points cheap, then intermediate curves – the 10-year Treasury – may be as much as 35 basis points too cheap. They belong in our opinion at 2.20% instead of 2.55%.
So there you have it, fellow passengers and paying clients. Don’t jump ship now. We may have reached an inflection point of low Treasury, mortgage and corporate yields in late April, but this is overdone.
Emphasis by Bill Gross
A Tipping Point That Won’t Tip
Gross’ message is clearly “the ship has reached a tipping point but don’t worry, the ship won’t tip”. Let’s discuss each of Gross’ three main points.
1) “The Fed’s forecast is far too optimistic“.
I certainly agree with Gross that the Fed (and almost everyone else) is overly optimistic.
But what if growth is not the Fed’s only concern? What if the Fed is concerned about the bubbles it has blown in stocks and bonds? What if the Fed is concerned about renewed speculation in housing?
Perhaps that scenario is far-fetched, perhaps not, but at least some Fed governors have those concerns.
2) “The Fed’s inflation target is 2%“
OK, the Bernanke Fed has an inflation target of 2%. But Bernanke will soon be gone. Will the next Fed have the same target? Any target? Given that Janet Yellen is likely the next Fed Chairperson, it is likely but not a given.
And how does one measure inflation? Will the Fed ignore housing like it did between 2002 and 2007? Will it ignore all brewing bubbles?
3) “Yields have adjusted too much”
Have they? Let’s assume that Gross is correct.
Gross emphasizes the yield on a 10-year note belongs at “2.20% instead of 2.55%”.
Lovely! Let’s once again assume Gross is right. The upside is 35 basis points. And what is the downside if Gross is wrong?
Is this what things have come to? That’s it’s necessary to speculate on a gain of 35 basis points because that is fair value? And where was Gross on “fair value” when the yield was 1.5%?
If it is correct to play for 35 basis points now, why was he in bonds when the yield was 70 basis points too low? Can you have this both ways?
And why is this suddenly a “3–5% for both stocks and bonds” when he tweeted “@PIMCO The secular 30-yr bull market in bonds likely ended 4/29/2013. PIMCO can help you navigate a likely lower return 2 – 3% future.”
So, is this a 3-5% world or a 2-3% world?
Questions abound and answers are few.
I actually suspect Gross may have this correct, but what is the risk-reward if he is wrong? What if the bond revolt continues? What if the Fed has lost control? That’s what Gross does not discuss, and that’s where he missed the boat.
For further discussion, please see Calmer Waters for the Bond Market? Gold? Worst Over?
Mike “Mish” Shedlock