- PIMCO believes that the Fed needs real rates to stay low to avoid a "financial earthquake" - this is what they term the "New Neutral".
- The consequences of financial repression force bondholders to fight the Fed and thus increase leverage in the financial system and force real rates even lower.
- Instead of investors leveraging themselves up to fight the Fed's financial repression, they should consider alternative assets that do well in leverage unwind situations like gold.
Bill Gross's monthly "Investment Insight" letter is one of my favorite reads as it combines decades of experience in the markets with a personal touch (who knew that Mr. Gross's cat was named "Bob" and he doesn't own a cellphone (not sure I believe that one)). This month's was very interesting in that it dealt with an issue that should be very important to gold investors and anybody who cares about the future of the US economy.
In the June letter titled "Time (and Money) in a Cellphone", Mr. Gross discusses PIMCO's belief that we are in a "New Neutral". Essentially the "New Neutral" is an environment that combines extremely low historic real interest rates (the "New") that have declined from past periods and are newly lower.
Source: PIMCO Investment Insight
As investors can see, it is clear that real rates have declined and are indeed at a new, lower level. This is in contrast to many economists that believe that real rates should stay constant as interest rates would be discounted for inflation down to the real rate. This is a discussion for another day, but the point is (at least according to the graph) that real rates are indeed declining to newly lower levels.
The second portion of the "New Neutral", we'll turn it over to Mr. Gross:
"What about the "Neutral" - what does that mean? The Fed's answer is that it is defined as the rate consistent with full employment trend growth and stable prices. Janet Yellen actually described it in a recent interview as the "Goldilocks rate," a rate not too hot or not too cold but "just right." Neutral."
So the "Neutral" corresponds to the Fed keeping the Federal Funds (FF) rate at a level that is neither too high nor too low for the economy based on a number of economic factors. It is ultimately the attempt by the Fed to maintain the perfect rate for the economy.
This is where it gets interesting.
Mr. Gross continues and believes that another factor that the Fed doesn't mention that relates to this neutral FF rate is dependent on the leverage in the system. That is where he pens the most important part - the true gem of this piece (emphasis ours):
"Commonsensically it seems to me that the more finance-based and highly levered an economy is the lower and lower real yield levels must be in order to prevent a Lehman-like earthquake. If the price of money is the basis for an economy's prosperity - and it is increasingly so in developed global economies - then central banks must lower the cost of money to maintain that prosperity - and keep it low."
If you want to understand the future of monetary policy that paragraph is sufficient. The more debt and leverage you have the lower the interest rates must be to prevent collapse. We are not just talking about the US's economy, we have a situation where the world's debt levels are soaring - name an advanced economy and chances are you will see debt at historic levels.
So according to Mr. Gross (and we agree), central bankers must keep real yields extremely low or we will have a severe "earthquake" in the financial system.
Bondholders Fight Back
Mr. Gross also gives his solution on how bondholders can fight back and prosper in this "New Neutral". He suggests that bondholders should emphasize "carry" related debt instruments versus duration, but he also suggests:
"In addition, if "New Neutral" interest rates favor debtors as opposed to savers, then becoming a conservative debtor while structuring a portfolio appears to make common sense."
Basically, to fight the Fed's financial repression (negative real rates) bondholders should increase their debt load and reinvest that money in higher yielding instruments - essentially battling the Fed.
This is where we add on to Mr. Gross's terrific thoughts by looking at the bigger picture. Bondholders can indeed fight the Fed without selling their bonds, all they have to do is borrow more money and use that extra leverage to invest in more bonds. This, in turn, increases the leverage in the system and forces the Fed to push real yields even lower - which again pushes bondholders to increase their own leverage to make up for even lower yields. A vicious cycle that ends up pushing leverage higher and forcing the Fed to use whatever is in its power to push real yields lower.
This isn't the first time that the Fed (or governments in general) have used financial repression to try to lessen the debt burden in real terms - so why is it different this time? It is different this time because the nature of the financial economy, financial instruments, and financial transfers is very different. We are in an age where investors can very easily move money into all kinds of debt instruments that didn't exist in the past - in a matter of minutes. The financial ingenuity and sophistication of the 21st century is allowing bondholders to react in ways that counter the Fed's financial repression that they couldn't do in the past.
In the post World War I and II world when governments were also trying to lessen debt burdens through financial repression, they were fighting unsophisticated bondholders that didn't have the financial vehicles, the liquidity, the information, and the ability to increase leverage that they have today. In a nutshell, governments had an upper hand on bondholders and were thus able to lessen their debt loads and avoid the "Minsky-type Earthquake" that could strike their highly leveraged system.
This time though, it may be the bondholders that have the upper hand or at least are on a neutral playing field - thus the Fed's attempts to financially repress the consequences of the large, debt burdens are only leading to even larger debt burdens as these bondholders are able to fight back.
We now get to Gold…
As with any system, the higher the leverage in the system the more risky it becomes, and we believe the Fed's financial repression is merely increasing that leverage as bondholders like Mr. Gross fight back with more leverage.
At a certain point, either voluntarily (through the Fed experimenting with higher rates) or involuntarily, rates will rise. That would bring Mr. Gross's previously mentioned "Lehman-like earthquake" as the extremely leveraged system cannot support higher rates. Thus we believe that real rates will keep on falling and lead to higher leverage and debt until and uneasily rising stock prices until … boom! Some catalyst that nobody saw coming leads to Mr. Gross's Scenario B. We think gold is actually the perfect safe haven for Scenario B since it is the anti-leverage asset that thrives in financial chaos - and that is what we would have if the Fed lost control of rates and they began to rise.
Thus we believe that investors should consider having a large exposure to gold with positions in physical gold and the gold ETFs (SPDR Gold Shares (NYSEARCA:GLD), PHYS, CEF). We stress that there is a big difference between physical gold and the ETFs in a leverage unwind situation (a topic for another article), but investors should favor physical gold.
Investors looking for more leverage to the gold price may want to consider evaluating gold miners such as Goldcorp (NYSE:GG), Barrick Gold (NYSE:ABX), Newmont (NYSE:NEM), or even some of the explorers and silver miners such as First Majestic (NYSE:AG) (we're not suggesting these companies specifically - only suggesting them for further investor research). But as we've mentioned in our free gold-centric weekly newsletter, we believe that at this point there are more short-term risks for the miners than the underlying gold and silver and thus investors should favor them over the miners at this point (this is not an issue that should concern long-term precious metals investors).
So, Mr. Gross if you are reading this piece, we recommend that instead of leveraging up on the carry trade in bonds and similar instruments, find those assets that do well in an "anti-leverage" world such as gold (though we will give Mr. Gross a break since he is limited on what to buy since he runs a bond fund). Yes, there may be some money to be made as bondholders leverage and force the Fed to lower real rates further, but the race for the doors will be furious if a fire breaks out - we'd much rather watch this unfold from outside those doors with an asset like gold that does very well when others panic.