Is it just me or did Bill Gross just pull the pin on the bond vigilante grenade and lob it in the general direction of the Federal Reserve? I haven't read any analysis of his recent investment outlook (Devil's Bargain) that pointed this out directly, so maybe I'm off-base here. I'll go over what I read and what I understood it to mean. I'm sure someone will be more than happy to correct me if I'm wrong.
It seems to me that Mr. Gross may have signaled that PIMCO wants out of its devil's bargain and is willing to sell Treasuries to do so. More importantly, they are recommending that investors who are tired of negative real returns and talk of bondholder haircuts may want to do the same: "Bondholders and citizens of America unite!"
Hang Your Heads, Moneychangers
Gross begins his outlook with a stinging critique of his own industry, lamenting the increased financialization of our economy and lambasting those who have profited by it at the expense of others. Here are some highlights:
- Financial entities like bankers and ratings agencies have been at the root of many financial crises over the years: "The S&L debacle of the early 1980s, the Asian crisis, LTCM, dotcoms, subprimes, Lehman and the resurrection, instead of the reformation, of Wall Street, are major sins of the modern era of money."
- "As a profession we have failed miserably at our primary function – the efficient and productive allocation of capital."
- While he believes PIMCO's advice has been genuinely helpful to clients, Mr. Gross is highly critical of "rating agencies that perpetually fail at commonsensical quality judgments, bankers that make loans to subterranean credits and then extend the beggar’s bowl for themselves, and 80% of active money managers that underperform the market."
- "How can bond traders make ten, one hundred, one thousand times more money than an engineer or social worker given their dismal historical performance? Why is it that some of today’s doctors are using food stamps while investment banking executives complain about millions of dollars in compensation that might be deferred in case of a future bailout?"
- Financial innovation has only helped a select few. Gross agrees with Paul Volcker, who observed that the ATM is the only useful invention generated by the financial industry over the past generation.
- Americans need to elect a whole new slate of leaders "who who can create something more than a cash machine" and "a Congress that cannot be bought and sold by lobbyists on K Street, whose pockets in turn are stuffed with corporate and special interest group payola. Are record corporate profits a fair price for America’s soul?"
The Barbershop Quartet
Gross also looks at the mounting piles of global debt and sees the writing on the wall. There's no way all of that debt can be repaid. One way or another, bondholders will have to take some haircuts. In other words, they will lose money on their principal. There are 4 main ways this could happen:
- Principal Default: Countries could simply refuse to repay the debt, forcing bondholders to take the losses.
- Currency Devaluation: By allowing the value of the currency in which the debt is denominated to fall, countries can effectively lower the amount they owe.
- Inflation: Countries can tell people that "inflation expectations are contained" and ask them to avert their eyes when headline CPI repeatedly comes in many basis points above the almighty core inflation readings.
- Negative Real Interest Rates: This is the "most deceptive" tool of all, robbing savers and debt holders of about 160 basis points of real yield as a result of inflation miscalculation.
A Devil's Bargain for Bondholders
Although bondholders have reaped tremendous capital gains as rates fell steadily over the past 30 years, they are now faced with the reality of negative real yields and limited prospects for capital appreciation as many yields are bumping against the zero bound. According to Mr. Gross, however, central banks' willingness to bring rates down to unprecedented levels has "less to do with disinflation and more to do with providing fuel for an asset-based economy that promotes unsustainable wealth creation and a false confidence in perpetual capital gains."
In effect, Mr. Gross seems to be saying that the Fed is picking winners, and that they have chosen stocks over bonds. While it's true that bond prices have risen as rates have gone down, the zero bound of interest rates makes them structurally different than stocks or commodities, which can at least in theory, keep rising forever. So bondholders may have come to the end of the road, but stocks can go on without them.
The devil's bargain for credit markets is this: Bond investors have been willing to support Fed policy because they have enjoyed some nice gains from it over the years. Now, it seems the jig is up. Nominal rates can't go below zero, although real rates certainly can. Who wants a negative real return and almost no hope of capital gains? It looks like bondholders want out.
The Devil, the Barbershop and the Exorcist
So is PIMCO ready to pay the devil his due and take the haircuts offered? Mr. Gross puts it this way: "Well, not so fast. This lad and this company are not going away so easily." The old financial axiom is that money goes where it's treated best. Well, Mr. Gross seems to be saying that he's not happy with the way his clients' money is being treated by U.S. Treasuries or U.K. Gilts. More than that, he's ready to take action to exorcise those bonds from their portfolios as a result.
To me, that sounds like a battle call to bond vigilantes. Gross is telling bondholders that they don't have to take haircuts lying down. There are better places to put their money and he suggests they do so. With approximately $1 trillion in assets under management, PIMCO can move markets and incite others to follow their lead. This bears watching for stock and bond investors alike.
Could it be that we are nearing a moment that I wrote about a few months ago? Back in November of 2010, I mused that "the Fed’s policy relies on traders buying into the “Don’t fight the Fed” mantra. What if they didn’t? Many of the traders I’ve heard comment on this policy say that they don’t believe it will work, but that they have to stick to the textbook trade: Buy gold. Buy stocks. Short the U.S. dollar. If traders decided en masse to fight the Fed, the policy would be dead in the water." Did PIMCO just tell us that they're ready to fight the Fed?
Note to Ben Bernanke: Bill Gross doesn't like the rules at your playground anymore and he's taking his marbles elsewhere.