Focus on front-end yields, because the Fed can’t raise policy rates in a levered economy

The title is the gist of Bill Gross' monthly missive.

Here is the Bond King's takeaway:

If you want to trust one thing and one thing only, trust that once QE is gone and the policy rate becomes the focus, that fed funds will then stay lower than expected for a long, long time. Right now the market (and the Fed forecasts) expects fed funds to be 1% higher by late 2015 and 1% higher still by December 2016. Bet against that.

(underlined emphasis added) 

Read the rest here.

Those opposed to Gross' view will argue that he is talking up his own book. This post does not argue for against that motive: differences of opinion are what makes financial markets tick. But it is worthwhile considering his viewpoint even though no one is infallible.

The current shutdown of the US Government and the upcoming debt ceiling debate is political theater. It warms the cockles of hearts of financial journalists who further conflate the budget of the U.S. government with that of a struggling lower middle class household. Struggling middle class households are not the custodians' of exorbitant privilege.

The United States will default only if it wishes to: as the world's most powerful nation militarily, consumer of last resort, the destination of global capital and preferred destination of global goods, and home to the Mecca of financial capital, Wall Street, there is nothing to benefit the nation were its political class to enforce a default. 

This blogger's view on rates remain unchanged as one could gather from these posts: from 2011, and 2012, and earlier this year.

Time shall tell.

Coming home to Canada, and for those in the circles of punditry forewarning of rising rates to come, they would do well to remember that the country remains a price taker in economic matters that matter. The Bank of Canada cannot go it alone with rate hikes and a floating exchange rate in a world where the five central banks that count in terms of capital markets: U.S. Federal Reserve, European Central Bank, Swiss National Bank, Bank of Japan and Bank of England are undertaking monetary stimulus and, by extension, ensuring financial repression on savers. 

Monetary policy is close to its effective limit here and abroad while the political will to expand fiscal policy is constrained. Absent the financial sector expanding credit channels further to the household sector there is simply nothing on the horizon but (at best) a slow growth recovery in the coming years that will flirt with recession. 

Of course, mortgage rates north and south of the 49th parallel have risen as preemptive exuberance from the bond markets over existential concerns --tapering et al-- created a rush to sell off medium and longer term issues. Moreover,  concern over impending policy hikes in Canada have led households to lock in lest they be caught on the wrong side of rising prime-linked variable mortgages. But the opinion shared here repeatedly since 2011 has been that the policy rate will be going nowhere but in the event it does go higher any hikes are not going to result in rate normalization (defined loosely where the BOC policy rate is at a 200 bp spread above core CPI) that economists have warned about. Looking at the money markets, we see that rate expectations in Canada remain moribund: the OIS curve is pricing no hike over 1 year and little chance over 2 years while the short end of the Canada curve remains popular with little to no liquidity premium over the policy target rate.

Bill Gross: One Big Idea – policy rates cannot normalize

GROSS: One Big Idea – policy rates cannot normalize. Portfolio implications: curves remain steep, bullets beat barbells.
— PIMCO (@PIMCO) July 22, 2013

Policy rates cannot normalize

10 months ago (September 2012):

We are in the age of inflation

See The Lending Lindy

Using a different framework, your humble blogger argued for No "rate normalization": a case for a secular trend of low rates in Canada in 2011.

Comment:

The current policy of financial repression is too convenient for central banks to give up and expedient enough for national governments to embrace. As the idea of nominal GDP targeting gains traction amongst central banks, perhaps first with the Carney led Bank of England, as the the next great policy initiative, there will learn that creating inflation is less about managing "inflation expectations" and more about understanding the dynamics of income distribution and rises in real wages in a globalized world where off shoring and technology makes heretofore regular work uncompetitive. A world where advocacy for balanced budgets for every nation as preferred policy flies in reality's face where imbalances remain and there is no reconstruction of the monetary and financial systems on the horizon. Those managing bank balance sheets in the west worry relentlessly about interest rate risk. This is only sensible. But they should be just as concerned about long term spread compression as dynamics conspire against policy rate normalization.

Mr. Gross weighs in on "the new normal"

Bill Gross, founder, managing director and co-CIO of PIMCO and generally considered the master bond investor of his generation has weighed in on what investors should expect going forward given the dynamics of debt deleveraging --which he terms as "structural headwinds"-- dragging growth in the developed world in today's FT piece: Developed world cannot thrive at 'stall speed'

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.

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.

(emphasis added by me)

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.