Friday, May 20, 2005

PIMCO bullish on long bonds?

In his latest commentary, Bill Gross of PIMCO (perhaps the most influential bond trader in the world) comes very close to sounding bullish on long bonds. This is a rather amazing turnaround, since over the last couple of years he has been warning repeatedly about an interest rate meltdown.

Gross now seems convinced that our Bretton Woods II currency regime will survive another 3-5 years, and that the dominant trend is deflation exported from China. He reasons that several years of nearly zero (real) interest rates have failed to produce significant inflation in the US economy. Thus, once the stimulative effect of low interest rates goes away, we are in for a period of deflation, which will be kind to bonds - he is bold enough to predict 10 year yield as low as 3%!

Gross: "Future finance-based consumption, however, is limited by our ability to keep pumping lower and lower yields, which in the past have led to higher and higher TIPS, home, stock, and associated asset prices. Let me do the TIPS math for you and then you can draw the implications for other asset classes. The 14% 5-year TIPS capital gain over the past few years that Alan Greenspan has been able to manufacture probably can only go up by 5 more points, because a 0% real yield for a 5-year maturity TIPS serves as a practical limit that investors will tolerate during deflationary, and most low inflationary environments. A 5-year TIPS moving lower in yield from 1% to 0% goes up 5 points. Even if the Fed continues to “Pump,” then, we are ¾ of the way complete in terms of the Fed’s ability to continue to stimulate asset prices, because its 21st century journey started at 4%, we are now at 1%, and 0% is the practical limit. That doesn’t mean that the housing “bubble” can’t keep going because it likely will if the Fed “Pumps” real yields closer to 0%. But there are limits, and we are heading down the home stretch of this U.S. race towards prosperity based on asset price appreciation.

Our point on the “Pump” then, is to suggest that in combination with a globalized free trade-based economy exhibiting a surfeit of cheap Asian labor, it will be difficult to generate U.S. inflation higher than our current 3% even if interest rates fall further. If 3% inflation is all we can get from the past 5-years’ asset inflation, it’s hard to believe that we get more from what’s left. The potential to reflate via interest rates is nearly over. We draw the same conclusion for Euroland and Japan. Japan, of course, is the primary example of how 0% nominal yields can fail to generate any inflation whatsoever, is it not? Continued disinflation not reflation, then, will rule our fragile future kingdom, with the potential for 1-2% CPI prints in most years between 2006 and 2010 throughout much of the global economy. Readers may remember our past few years’ Secular Forum descriptions of the tug-of-war between disinflation and reflationary forces. We have proclaimed a winner based on our observation of massive fiscal and monetary global stimulation described above, the limited inflationary response, and the lack of further ammunition. Long live our disinflationary King.

If we had to forecast (and we do), we believe a range of 3 - 4½% for 10-year nominal Treasuries will prevail during most of our secular timeframe..."

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