Market Outlook: Bill Gross Has It Exactly Right

Bill Gross is exactly correct.

The entire market is stupid rich. Two-year AAA municipal yields are at 0.75%, 30-year Treasuries are at 4% in the face of insanely large deficits, and the S&P is priced at twenty times backward-looking earnings. The price of commercial mortgage backed securities rated single-A has more than doubled since March, which is just madness.

The Financial Times Sept. 27 suggested that this might prompt a bank rally:

The recent rally in the markets for “toxic” securities could deliver a significant boost to US banks’ third-quarter earnings if financial groups decide to book accounting gains on assets that caused them billions of dollars in losses during the crisis.

Wall Street executives and analysts say the significant rise in the price of mortgage-backed securities and other once-battered debt offers banks the first meaningful chance to “write up” some of the value of these distressed assets.

It’s a better guess that this already has caused a bank rally which is well past its best-used-by-date.

The only way to finance a Treasury deficit pushing $2 trillion is through the banking system. Even if savings rise to 10% of GDP and all savings go into Treasury securities, that only covers a trillion dollars. Foreign purchases might reach $300-$400 billion as China and other creditors are forced to swallow more US obligations for lack of other things to buy.

But I note that since May, although total bank credit has fallen from $9.35 trillion to $9.12 trillion, bank holdings of Treasury securities have risen to $1.383 trillion from $1.26 trillion. Expect this to continue: the Fed will keep money easy so that banks can continue to buy into the long end of the curve with security and keep long-term yields (and mortgage rates) low (click to enlarge).

link to Fed's original chart here

This is a potentially unstable meta-equilibrium, but banks have to do something with money (as does PIMCO), and they are buying the long end of the curve, where the yield is.

What should investors do who do not have to do anything? The best combination is fixed income (towards the long end of the curve) along with hedges against a dollar collapse, e.g. gold mining stocks. That was the stance I recommended on July 9 and I’m sticking to my story.

Comments

[Roger Knights:]

"The best combination is fixed income (towards the long end of the curve) along with hedges against a dollar collapse, e.g. gold mining stocks."

Julian Robertson likes Norwegian investments. Roger Nusbaum describes various Norwegian stocks and bonds, here: seekingalpha.com/artic...

Here's a link to an SA article on a stronger bank than those in the US--the Royal Bank of Canada. One can buy stocks and bonds through it:
seekingalpha.com/artic...

Sep 30 04:56 AM

[coldcall:]

Well i think a good balance between bonds and equities is the right way to hedge at the moment.

And i also think one should not just have the gold stocks but some other cyclicals like oil as well as some defensive stocks which have clearly underperformed the rally since March.

Currently ive got a nice balance of all those things and im finding it is a very robust portfolio, nothing is ever all up or down but always a mixture of up and down.

Sep 30 08:00 AM

[chap08:]

Bill Gross does not have it right. He may have a good short term position, but in investment terms (which is what he claims to stand for) he is wrong.

You say that "banks have to do something with money (as does PIMCO), and they are buying the long end of the curve, where the yield is". This is known as yield chasing. Up until last year, yield chasing banks went for CDOs. The results will be the same this time around.

If "the entire market is stupid rich", this is because there is too much MONEY. If there is too much money around then invest in gold, commodities or something valuable. Don't waste your money chasing illusory yield.

Sep 30 08:17 AM

[Emerald:]

It's called spread investing in a deflationary environment. The banks receive taxpayer funds via the Treasury and but Treasuries in return. They have no corporate loan volume and need to earn the spread. "Chasing yield" in government bonds is not the same as high yield debt, CDO's, etc. Bill Gross does have it right!

Sep 30 11:39 AM

[Thomas J. G...:]

If banks are buying treasuries that could explain why long treaureis (10yr to 30yr) have been dropping when most of us think they should be rising. "although total bank credit has fallen from $9.35 trillion to $9.12 trillion, bank holdings of Treasury securities have risen to $1.383 trillion from $1.26 trillion" doesn't seem like that big a change. I would add one other piece of data to this conversation. Banks have what is called "core capital". I think Treasuires count as "core capital" whereas a car loan doesn't count as core capital. So if banks can borrow at fed funds (almost nothing) and lend at 3/4% treausury rate and it counts as core capital one can see why rates are falling.

Sep 30 12:15 PM

[Stevefoder:]

Anybody who lends money to the US treasury on 30 year notes at today's low interest rate (4.04%), is crazy.

Sep 30 12:29 PM

[PharmBoy:]

I'm currently long TBT and down 5.5% from my entry at 46.50. Was I too early on this trade? Should I cut my losses and re-enter when the longer-term picture is clearer or stick to the trade for the next 3-6 months? Thanks.

Sep 30 06:21 PM

[realold:]

Yes


On Sep 30 06:21 PM PharmBoy wrote:

> I'm currently long TBT and down 5.5% from my entry at 46.50. Was
> I too early on this trade? Should I cut my losses and re-enter when
> the longer-term picture is clearer or stick to the trade for the
> next 3-6 months? Thanks.

Sep 30 10:37 PM

[JasonC:]

"Banks have what is called "core capital". I think Treasuires count as "core capital" whereas a car loan doesn't count as core capital"

Um no. The capital of a bank is a liability side item, while both treasuries it owns and car loans in makes are asset side items.

The core capital of a bank is its common stock equity, its preferred stock equity, and its loan loss reserves. All at book value.

(As an aside notice, when a bank marks down its assets to add to loan loss reserves, this figure does not change. Realized losses do reduce it, provisions for future ones do not).

What you are probably thinking of is the credit risk reserve requirement under Basel II. Banks must have capital equal to 8% of risk-adjusted assets. The risk adjustment for loans or corporate credits is 100%, for first mortgages secured by real property it is 50%, and for government bonds it is 0%. (Some agencies and foreign government bonds get 20%).

So when a bank shifts part of its portfolio from car loans to treasuries it does not change its core capital - nothing moved on the asset side of the sheet changes the liability side of the sheet. What it does do is reduce their Basel II regulatory requirements for the ratio of capital to total assets.

So yes, shifting to governments from general loans to the market does reduce a banks capital *requirements*, but it doesn't change its *capital*.

Also note that all banks must also keep capital against interest rate risk, as distinct from credit risk. They often run swap books to manage this. A move from a T-bill to a 10 year treasury requires either extra capital against the greater interest rate risk, or a swap position to hedge it that will give up much of the incremental yield.

A move from a home mortgage to a 10 year, on the other hand, gains the bank convexity with the immediate interest rate risk reduced somewhat, while also reducing its credit risk capital requirements (to 0% of 8% of loan amount moved from 50% of 8% of loan amount moved).

Those are mechanics.

Oct 01 12:14 PM

[Thomas J. G...:]

JasonC, Thanks, that's a great and thorough explanation. You are very knowledgeable. If seeking alpha would allow training articles your response could have been an article. I guess what I was getting at is if the bank can borrow short at fed funds (.25%) and get a 3/4% yield on long treasuries and treasuries buy them something for their credit risk reserve requirements, that's an attractive deal. Long treasuries have been dropping even though the equity market was rising. I am looking for some fed caused reasons for long interest rates to fall in the current environment and this may be a partial explanation.

Oct 01 05:55 PM

[Larry Livin...:]

Based on data from the flow of funds report (table L.209) www.federalreserve.gov.../
Total treasury securities held by banks at the end of Q2 is only $125.4B...how do you explain this large difference?

Oct 02 07:19 AM

[Thomas J. G...:]

Larry, You mean difference from this which David said "But I note that since May, although total bank credit has fallen from $9.35 trillion to $9.12 trillion, bank holdings of Treasury securities have risen to $1.383 trillion from $1.26 trillion", right? 125 bill in the Treasury market is nothing. This is hard for those of us with a day job to figure out.

Oct 02 11:45 AM

[dieuwer:]

There is a word for markets that are "stupidly rich": BUBBLE.

Oct 02 12:51 PM