(US) PIMCO Bill Gross May Monthly Outlook: Achoo!

Read more from Bill Gross here.

The old saying goes that when the U.S. economy sneezes, the world
catches cold. That still seems to be true enough, although Chinese influenza is
gaining in importance. If both sneezed at the same time then instead of God
bless you perhaps someone would cry out God have mercy. We’re not there yet,
although in this period of high leverage it’s important to realize that the
price of money and the servicing cost of that leverage are critical for a
healthy economy. 

The Great Recession occurred significantly as a result of
central banks raising the price of credit too high in the face of households
and levered speculators who eventually could not afford to pay the increasing
interest rate tab. As defaults on U.S. subprime mortgages and high yield bonds
began to mount, lenders not only refused to lend more but were forced to
liquidate levered holdings, producing a literal run on the Bank of Credit which
in the U.S. now totals an estimated 75-85 trillion dollars.

As the Fed raised short-term rates to 5% in 2004/2006 they were
following a historically standard model that followed the thesis of flattening
the yield curve, making credit more expensive, and slowing the economy in order
to moderate inflation. The 5% destination was in part determined by what was
and still is known as the Taylor Rule as well as a rather practical assumption
that short-term rates approaching the rate of nominal GDP growth had usually
been the ultimate destination in a tightening cycle. What the Fed failed to
factor in was the increasing amount of leverage in the system that could no
longer tolerate standard Taylor/nominal GDP rules of monetary policy.

I bring up this history to illustrate the problem that not only the Fed
but all central banks face in this new epoch of high leverage. High debt levels
dont necessarily change the rules of finance (you gotta pay to play), but the
models upon which they are based. Interest rates have to be lower in a levered
economy so that debtors can survive, debt can be reduced as a % of GDP, and
economies can avoid recessions/depressions! In a levered landscape, what is the
magical neutral policy rate that can do all of that? Hard to know. No wonder
the Fed and other central banks stumble along with QEs and Twists, extended
periods of time, magical blue dots, and other potions and elixirs to try and
produce a favorable outcome.

Despite the uncertainty and the recent importance of historical models
using unemployment as a practical guide, there has been research that might
point to a proximate neutral fed funds rate. Thomas Laubach and John Williams
working for the Fed Board of governors wrote an early 2003 piece titled
Measuring the Natural Rate of Interest. Their updated model from the San
Francisco Fed website suggests the neutral nominal fed funds rate might be as
low as 50 basis points currently and 150 basis points assuming 2% PCE inflation
in the future. Others, such as Bill Dudley, President of the New York Fed, gave
an important speech in May of 2012 suggesting a neutral real rate close to 0%
which would imply a 200-basis-point nominal rate if the Feds inflation target
was hit. PIMCOs Saumil Parikh in a March 2013 Asset Allocation Focus concluded
that a 100-basis-point or a 1% nominal fed funds rate was long-term neutral
stabilizing inflation at 2% and nominal GDP growth close to 5%.

These estimates are just that approximations of a neutral policy rate in
a New Normal economy burdened by high debt leverage and other structural
headwinds such as globalization, aging demographic influences, and technology.
But I suspect these estimates which average less than 2%, are much closer to
financial reality than the average, 4% blue dot estimates of Fed participants,
dismissed somewhat by Fed Chair Janet Yellen herself last month. 

Why is this
academic Fed Fight important to markets? Well, if a bond investor knew whether
4% or 2% was the long term neutral policy rate, he/she would literally have the
key to the kingdom. Forward markets now anticipate a 4% nominal policy rate
sometime out in 2020. If the neutral policy rate was 2% instead of 4% then
bonds instead of being artificially priced, would be attractively priced.
Instead of facing a nearly 100% certain bear market currently forecast by
market mavens, bond investors could draw some comfort from a low returning yet
less volatile future. Bonds would shed the certificates of confiscation label
for yet another decade or so, as this 2% neutral policy rate delevered the
economy without igniting inflationary fears.

At PIMCO, we believe that this focus on the future neutral policy rate
is the critical key to unlocking value in all asset markets. If future cash
returns are 2% (our belief) instead of 4%, then other assets such as stocks and
real estate must be assumed to be more fairly priced as well. Current fears of
asset bubbles would be unfounded. A 2% neutral policy rate, however, is not a
win/win for investors. It comes at a price the cost being a financial future
where asset returns are much lower than historical levels. When you think about
it, savers would much prefer to receive a 4% yield on their savings than a 2%
rate. No-brainer there. But the journey to 4% would be much bumpier and bear
market would be an apt description of the next half-decade. That is what the
Fed is trying to avoid, but in the process they financially repress markets,
offering a Yellen put but distributing low asset returns as a result.
Potentially 2% instead of 4% for cash; maybe 3% instead of 5% yields for
10-year Treasury bonds; 4% returns instead of 57% for stocks; financial
repression ultimately is not an investors friend, because it lowers returns on
cash and all other financial assets.

So you say you need more? Join the club. 

Most pension funds assume 78%
total returns in order to fund future retirement liabilities. Investors want
their cake, priced at current market prices, but they want to eat future
returns of near double-digits. That wont happen with a 2% neutral policy rate.
Still there are ways to fight back most of which involve taking different risks
than you may be commonly used to taking: alternative assets, hedge funds,
levered closed-end funds, a higher proportion of stocks vs. bonds in a personal
portfolio. Portfolio managers at PIMCO who understand this can also transform a
total return bond portfolio into a higher returning asset. All of these
alternatives are potentially higher returning assets in a world of 2% policy
rates where cash is a poor performing asset, but likewise a cheap liability
that can be borrowed to an investors advantage. Look to PIMCO for your common
cold solution. If you sneeze, well just squeeze your hand and tell you we are
blessed to have you. Hopefully vice versa. Don’t need a pinch of snuff to know
that.– SourceTradeTheNews.com