After citing Rogoff and Reinhart's tome "This Time Is Different" and PIMCO's own "new normal" moniker for the post 2008 environment, Gross left us to ponder this crucial take away:
These risks and the associated two per cent growth stall speed have several overall investment implications. For one, risk spreads will be constantly volatile as good and bad news hit the tape intermittently. Sovereign credit spreads will be subject to rather desperate policy endgames and equity and corporate bond risk spreads will follow in line despite the overall health of the corporate sector in the current upturn. Secondly, investors should expect an extended period of “financial repression” during which policy rates are kept extraordinarily low. Picking the pockets of investors and savers is an historically validated manoeuvre to re balance sovereign balance sheets. Instead of an inflation plus one per cent policy rate which has characterised the past thirty years, we must get used to inflation minus one or two per cent, a dramatic reversal in the fortunes of financial markets.(emphasis added by me)
The expected negative real-policy rate will influence much of the US Treasury curve as well. Like a black hole, twenty-five basis point interest rates suck two and five year rates down with them, producing shockingly low returns that cannot possibly cope with the higher inflation they produce. Alternatively, thirty year rates stay high for fear of inflationary consequences in future decades. The result is a dramatically steep yield curve that promotes roll-down strategies as bonds appreciate in value as yields decline over time and, for banks and hedge funds, levered positions which take bets on duration, as opposed to on credit risk.
The US Federal Reserve's intervention in the fixed income and money markets (QE & QE2) has been a fascinating exercise in applied monetary economics. Conventional wisdom would have forecasted rising rates along the yield curve after June 30, 2011. Instead, the influence of end of quarter balance sheet window dressing by banks and other financial firms, the flooding of cash into the money market, and the FDIC's deposit insurance fee have all played a part in the further lowering of rates in the repo market (a colleague of mine was asked to provide cash --i.e. a negative return-- in exchange for collateral in the immediate aftermath of QE2 ending.
No policies work in isolation especially under such circumstances where the veneer of economic stability is removed. Conventional neoclassical economics sells students the idea of the primacy of monetary policy and the notion of fiscal policy being a blunt instrument given the long and variable lags in policy implementation and the inherent counter cyclical stabilizers present in capitalist economies with safety nets. This is a false idea; fiscal policy remains of inordinate importance.
Moreover, it is an intrinsic part of the human condition that as a species we have short memories and no sense of history hence the idea of a liquidity trap happening here was incomprehensible to those in the West when Japan grappled with it during the 1990s, the first decade of its lost decades; living through one illustrates the predicament of conventional thought.
Bill Gross' opinion is not conventional: I think that "we must get used to inflation minus one or two per cent" policy rates is spot on; the implication is that the idea of rate normalization touted by central banks is a false one. There will be intermittent bouts of commodity inflation to confuse matters but the "wage push inflation" that central banks are leery of will not occur unless there is a dramatic and (in my opinion) highly unlikely push to the left in the corridors of political power in advanced economies.
Not a very comforting read. Well, the (slightly) good news is that PIMCO has been increasing its holdings of US Treasuries.ReplyDelete