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I couldn’t believe what I was hearing on CNBC during the 2:00 PM Wednesday FOMC announcement pregame show. Bill Gross (PIMCO) called for Bernanke to specify a hyper-extended period of time for extraordinary low interest rates. Gross wants the Federal Reserve to add so much confidence to the carry trade that junk bonds and other toxic assets will form a new bubble.

The simplest definition of the carry trade is to borrow short and lend long, capturing the spread. The risk is that an investor’s spread could turn negative if short-term rates rise before they exit the trade or they cannot roll over their short-term borrowings. The Fed has already allowed banks to print money by paying near zero to depositors and commercial paper buyers while capturing higher intermediate term Fannie Mae (FNM), Freddie Mac (FRE) and Treasury yields. But Gross is not satisfied because with 4.69% 30-year fixed mortgages and the 10-year note near 3%, the play is already squeezed.

The liquidity of Treasury and agency bonds allows players to exit the trade fairly easily with minimum potential losses. But the Fed’s extended period of time is not comforting enough to fund illiquid assets with short-term debt. The Bear Stearns and Lehman liquidity traps are still too fresh.

Gross’s influence on Fed policy is unquestionable. He called for a massaged Fed balance sheet and the direct purchase of agency securities. Two trillion dollars later Gross is still not satisfied. Instead of likely profits, he is now asking for guaranteed profits. The free market survivors now want the total end of moral hazard.

Gross admitted that the Fed cannot lower rates below zero, and its credibility would be at stake if it restarted quantitative easing. Besides, the safety play has already driven agency and Treasury debt to unprecedented levels. Such a bubble that players need to be concerned about a reversal when the austerity measures in Europe bring into question the relative safety of the US debt. Sovereign debt for sovereign debt, the US could become riskier than Europe.

So the interest rate risk in treasuries and agencies is too great, and the liquidity risk in toxic assets also is too great without the Fed enhancing its low rate commitment. Gross wants the Fed to give him confidence to increase his risk and subsequently his spread.

Banks have reason to accept the low agency spreads. They appease their regulators by lowering their risk adjusted assets, while still earning a leveraged profit. This is less appealing to asset managers who play leverage to a lesser degree. Uninsured funding does not face regulatory capital requirements, so there is little benefit to playing the risk adjusted asset game.

I am sure Gross would like the Fed to specify that zero interest rates will be maintained through the end of 2012. But the Fed surely realizes that would be too obvious a gift to Wall Street. Look for the Fed to be more creative in removing moral hazard in response to the double-dip.

For you ice cream fans, I am predicting a triple dip. Dip one was the housing bubble burst, dip two is the receding consumer economy happing now, and dip three will be the start of mortgage foreclosure deficiency judgments preventing the consumer economy from reemerging. In spite of Bernanke, even with Gross’s prodding, foreigners will force US interest rates higher. Sorry Bill.

Disclosure: None

Source: Bill Gross Cries for a Guaranteed Carry Trade