Gross: The Bull Market In Bonds is Over

  • The Fed’s announcement of a renewed commitment to Quantitative Easing has been well telegraphed and the market’s reaction is likely to be subdued.
  • We are in a “liquidity trap,” where interest rates or trillions in asset purchases may not stimulate borrowing or lending because consumer demand is just not there.
  • The Fed’s announcement will likely signify the end of a great 30-year bull market in bonds and the necessity for bond managers and, yes, equity managers to adjust to a new environment.

These three bullet points is how Bill Gross summarizes his Investment Outlook for November 2010. Notable in these bullets is the last part about the bull market in bonds coming to an end. While bonds can rally yet further from the already low yields we see today if disinflation continues into deflation, the risk/reward of that trade is not good.

As for the second bullet, Gross explains much as John Hussman did earlier in the week:

We are, as even some Fed Governors now publically admit, in a “liquidity trap,” where interest rates or trillions in QEII asset purchases may not stimulate borrowing or lending because consumer demand is just not there. Escaping from a liquidity trap may be impossible, much like light trapped in a black hole. Just ask Japan. Ben Bernanke, however, will try – it is, to be honest, all he can do. He can’t raise or lower taxes, he can’t direct a fiscal thrust of infrastructure spending, he can’t change our educational system, he can’t force the Chinese to revalue their currency – it is all he can do, and as he proceeds, the dual questions of “will it work” and “will it create a bond market bubble” will be answered. We at PIMCO are not sure.

So what do you do, if you are the Fed? You print money anyway, even at the risk of creating more bubbles – or at least that was my takeaway from what Fed Vice Chair Janet Yellen recently said. I know that David Blanchflower, formerly of the BoE has been musing about other ways to approach quantitative easing  to give it a more ‘fiscal’ aspect, like buying municipal bonds. But I don’t think this will happen unless things get very dire.  The Fed still has to worry about the politics of an aggressive policy. Marc Chandler’s comments about a shift in policy tones this morning on ‘QEII-lite’ are more to the point, especially in the wake of comments in the Wall Street Journal in this regard.

Nevertheless, Gross is worried and this is what has him contemplating the end of the bond bull market. He writes:

Bondholders, while immediate beneficiaries, will likely eventually be delivered on a platter to more fortunate celebrants, be they financial asset classes more adaptable to inflation such as stocks or commodities, or perhaps the average American on Main Street who might benefit from a hoped-for rise in job growth or simply a boost in nominal wages, however deceptive the illusion.Check writing in the trillions is not a bondholder’s friend; it is in fact inflationary, and, if truth be told, somewhat of a Ponzi scheme. Public debt, actually, has always had a Ponzi-like characteristic. Granted, the U.S. has, at times, paid down its national debt, but there was always the assumption that as long as creditors could be found to roll over existing loans – and buy new ones – the game could keep going forever. Sovereign countries have always implicitly acknowledged that the existing debt would never be paid off because they would “grow” their way out of the apparent predicament, allowing future’s prosperity to continually pay for today’s finance.

Now, however, with growth in doubt, it seems that the Fed has taken Charles Ponzi one step further. Instead of simply paying for maturing debt with receipts from financial sector creditors – banks, insurance companies, surplus reserve nations and investment managers, to name the most significant – the Fed has joined the party itself. Rather than orchestrating the game from on high, it has jumped into the pond with the other swimmers. One and one-half trillion in checks were written in 2009, and trillions more lie ahead. The Fed, in effect, is telling the markets not to worry about our fiscal deficits, it will be the buyer of first and perhaps last resort. There is no need – as with Charles Ponzi – to find an increasing amount of future gullibles, they will just write the check themselves. I ask you: Has there ever been a Ponzi scheme so brazen? There has not. This one is so unique that it requires a new name. I call it a Sammy scheme, in honor of Uncle Sam and the politicians (as well as its citizens) who have brought us to this critical moment in time. It is not a Bernanke scheme, because this is his only alternative and he shares no responsibility for its origin. It is a Sammy scheme – you and I, and the politicians that we elect every two years – deserve all the blame.

Over the short-term, the Fed is in full control of interest rates, of course. Looking at the Federal Government and the Federal Reserve as one consolidated balance sheet, we know that the Federal Government is the monopoly issuer of the currency and can dictate rates simply by setting the Fed Funds rates. It is ready to defend this rate by buying unlimited quantities of financial assets. If it telegraphs that Fed Funds will essentially be zero for "an extended period," market participants bet against this at their peril (and folly). This is why bondholders are beneficiaries of Fed largesse via capital appreciation (in excess of 11% YTD on Treasuries) over the short-term.

However, there is no guarantee where rates will be after this ‘extended period’ of artificially low rates. This is why the likes of Goldman are issuing 50-year paper now. And this is also why commodity prices are through the roof as the Fed has successfully increased inflation expectations. The Fed’s actions today are predicated on its successfully being able to unwind the stimulus it has created when a more normal economic environment causes the demand for credit to increase. If the economy goes into a Japanese-style malaise for twenty years, this is a moot point; the extended period language will extend. If we do have a real recovery, the Fed will need to orchestrate a good way of reducing its balance sheet in an orderly way despite the illiquid assets it has taken on. Otherwise, inflation will be a problem down the line.

P.S. – also read Gross’ letter for the political commentary. He has taken an increasingly populist stance on American politics of late. In this letter, it is no different; he has some very pointed words.

Source: Run Turkey, Run, Bill Gross

  1. Tom Hickey says

    Fed cannot “print money” in the sense of increase net financial assets in the present system unless it does so through a disguised fiscal move like buying and eating toxic debt. All the Fed does in QE by buying tsy’s is shift the composition of assets with respect to maturity. No nongovernment net financial assets are created or added to.

    All that increases is liquidity. What this does is increase the global pool of hot money, and this will inevitably look for higher return in other asset classes by taking on higher risk. What this does is increase the level of risk in the system. Some asset classes will be priced much higher than fundamentals justify, i.e. what they are really worth economically. This increases inefficiency. Just what we need right now.

    Commodities are now considered an asset class, so commodities will likely appreciate. This is lead to marginal compression of profit in industries and firms without sufficient pricing power to pass this price hike through to consumers in an environment of lagging demand.

    Calling this “inflation” is not correct in that price hikes are not the result of nominal aggregate demand chasing insufficient aggregate supply at full capacity and there is no supply bottleneck. It is appreciation resulting from financial speculation that has nothing to do with supply and demand relative to the real economy.

    The Fed is trying to wag the dog’s tail by creating some inflation or at least some inflationary expectations. All this is going to accomplish is annoying the dog and running the change off getting one’s hand bitten.

    It’s useless, on one hand and, on the other, if it “works,” it is madness. This is just blowing more bubbles, and we’ve seen how that worked. The Fed is actually perpetuating the end stage of the long financial cycle that Minsky called “Ponzi finance” instead of addressing the causes of it as the overseer of the financial system. Hint: “It’s the corruption, stupid.

    Bernanke and Geithner have to sit down with the leadership of both parties and tell them that if fiscal means are not appropriately employed, the Fed cannot be responsible for the consequences, since it has no fiscal authority. After the meeting, Bernanke and Geithner need to leak this to the press.

    1. Edward Harrison says

      Tell the millions of people in the US and elsewhere that buy food every day the massive increase in commodity prices is not inflation. We are seeing a repeat of the massive increase in ag commodities that brought us riots in 2008. That most certainly is inflation, the kind that most people in the world (who aren’t rich Americans and spend the majority of their earnings on food) care about frankly.

      1. Marshall Auerback says

        I personally think it’s hard to put everything in an “inflation/deflation” paradigm. If incomes aren’t growing, but people are paying more for their food and energy, is this “inflationary”? In many respects, it’s highly deflationary because it cuts hugely into discretionary income. Clearly, in the absence of feedback loops, it’s hard to see to that translating into higher generalised inflation, which consists of sustained price increases.

        1. Edward Harrison says

          Commodity price inflation is not the sort of thing that becomes embedded in this environment, because, as you point out, it sows the seeds of its own destruction. This is certainly what we witnessed in 2008 and what has made the rise in oil prices so deadly.

          Fred Sheehan has a better paradigm than deflation or inflation in which he talks of both happening at the same time. I have started to see it through this framing.

          1. Marshall Auerback says

            I think Fred Sheehan is 100% correct.

        2. Edward Harrison says

          This is how Fred put it:

          “The incessant debate of whether the economy is inflating or deflating suffers from a vocabulary problem. This is as it must be since some (Federal Reserve Chairman Ben S. Bernanke) discuss deflation as falling prices of stuff while others concentrate on the debt deflation of an overleveraged economy. The latter is what matters.

          This debate often fails to address the important question of “what does it matter to me?” What matters most is the changing relationship of prices. For a worker who pays $3 instead of $2 for eggs, “inflation” is his greatest worry. If, at the same time, the worker receives a 20% pay cut, there may be many causes, and it is at least symptomatic of “deflation.”

          The “inflation” and “deflation” debates (at least, in the major media) are of limited interest when they take an either/or approach. In fact – back to “what does it matter to me?” – both conditions are present and moving towards a chaotic conclusion. This should be expected when the Main Street economy is appended to a financial economy, which by its nature (and high-frequency trading) is more unstable than a production economy. Since money-printing is still ascendant, more violent changes in price relationships are certain.”

          From an Austrian perspective, what we are seeing is a change in the price STRUCTURE because monetary policy is a blunt instrument that produces vastly different outcomes for prices within an economy. I think Fred captures this well.

      2. Tom Hickey says

        Ed, tell the people that government debt is not the same as household debt and they won’t believe you, either. The fact is that the public is hopelessly confused and the plutocratic oligarchy and their political cronies are manipulating public opinion to win votes for policies that undermine distributed income and wealth, encourage economic rent-seeking and enable cheating.

        What the public thinks or perceives is not the issue here; it is what makes economic and financial sense as applied to economic policy. The public has been propagandized and people at large have no idea about what is really going on behind the veil.

    2. Edward Harrison says

      The Fed will not reveal its impotence because this would be detrimental to its power, which, politically-speaking, is what denizens of Washington care most about. My understanding is that the Republicans are saying austerity will be priority #1 when they come to power in the house in 2011.

      My thinking here is that, if we have to go with QE or nothing in place of fiscal, I prefer nothing. But, you will hear Keynesians like Jim Hamilton or Mark Thoma, Brad DeLong or Paul Krugman say it’s better than nothing. Watch the inflated asset prices and the collateral damage and tell me that’s true after the fact.

  2. Fsheehan says

    I think Ed is 100% correct.

    I will add that current assumptions about policy often have little to offer in projecting future policy. “The Republicans are saying austerity will be priority #1” is not something a subsidized ethanol producer should be concerned about. Oh, how I fondly remember those halycon days of the Reagan Revolution – when supply-side economics meant the tax cuts had to be earned with reductions in spending! Enough on that.

    For those who think more fiscal juice is what we need, I would not lose rest worrying the Republicans will make a substantial reduction to spending.

    There may be some rollbacks of recent free rides but it will be interesting to see if the Republicans do anything about the temporary expansion of programs under Obama – the WIC program – milk for women, infants, and children, a very worthy effort, was recently expanded to include junk food. Food stamps can now be received by someone who has a half-brother living with him up to the age of 26. There are hundreds of such examples.

    If expanded fiscal policy has merit, this is not the way to do it.

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