Bill Gross: "The Treasury Market Is On A Collision Course With Financial Repression"

Tyler Durden's picture

In his latest just released monthly letter, Bill Gross continues to explain why those expecting a cover of PIMCO's short treasury exposure will be disappointed for at least one more month: "Although we have warned for
several years of the deteriorating creditworthiness of America’s AAA
rating, our de minimis Treasury positions had less to do with much more
immediate issues than America’s balance sheet prospects. We are highly
sensitive to the pocket-picking policies that governments in general
deploy to right the ship." This time the symbol for the US (and global) economy, and specifically artificially low interest rates is a "tanker" analogy: " While the global
financial tanker was on automatic pilot, we had changed course well in
advance and it has been relatively smooth sailing since." Needless to say, Gross is convinced said ship is on a collision course. Ergo the title of this month's piece: "The Caine Mutiny." As usual, it is the 'Treserve' that is at fault for doing everything in its power (selling treasury puts?) to keep rates artificially low, a move which Pimco not surprisingly not in favor of: "holding Treasuries at
these yield levels for an extended period of time represents an
abdication of responsibility.
" Yet Gross does not advocate an outright mutiny, but renewed vigilance: "PIMCO advocates not so much a mutiny but a renewed vigilance on this new ship, stressing bond market “safe spread” alternatives available globally, including developing/emerging market debt at higher yields denominated in non-dollar currencies." Bottom line: "The
Treasury market is on a collision course with financial repression and
it is time to adjust your rudder to starboard to get home safely
." Undoubtedly the usual response will be that Gross is just being unjustly alarmist. That is, until he is proven 100% correct.

From The Caine Mutiny (Part 2):

  • Low policy rates and the increasing negative real yields that
    they engender as inflation accelerates represent an immediate threat to
    investment portfolios.
  • Bond prices don’t necessarily have to go down for savers to get skunked during a process of “debt liquidation.”
  • PIMCO advocates a renewed vigilance, stressing bond market “safe
    spread” alternatives available globally, including developing/emerging
    market debt at higher yields denominated in non-dollar currencies.
The Gross household is a robe-wearing household – at least on the
distaff side. Sue has a closet full of them, all white, and is thrilled
each and every Christmas with a new white one under the tree. Go figure.
I on the other hand am a little more casual about nighttime attire, a
habit I picked up or at least observed during my Navy years in the South
China Sea. But I am getting ahead of myself. Back in 1969, yours truly
was a lowly ensign whose responsibility among other things was to
substitute for the captain when he was sleeping. Vietnam era captains
couldn’t be at the helm 24/7 so during relatively calm hours, the
benchwarmers got a chance to quarterback the ship. Such was the case on a
warm September evening, making 20 knots on our way home to San Diego in
the middle of the vast and totally empty Pacific Ocean, 2,000 miles
west of Honolulu. I was standing the dreaded “mid-watch” – midnight to
4:00 am – and under instructions to wake the captain if anything
“unusual” took place; FAT chance, aside from the occasional mermaid or sea monster sightings, and no one ever woke the captain up for that.
 
Well, around 2:00 am there was
a sighting – quite remarkable, actually, because the Pacific is BIG and
the occasional freighter was rare indeed. Ten miles at 15° off the bow,
I spotted an oil tanker on the horizon, apparently headed our way.
There is a Navy axiom that even an idiot ensign can remember, which
tells a navigator whether or not a mid-ocean collision is possible –
“constant bearing, decreasing range,” or CBDR for short. If, for
instance, that tanker was closing to five miles and was still positioned
15° off the bow, well, there would be a growing chance that we would
meet head-on five miles later. Ah, wouldn’t you know it – this tanker
had a CBDR and yours truly was the only one who was aware of it. Tankers
set their controls on automatic pilot during the midnight hours, so the
approaching ship wasn’t about to change course. I was the only officer
awake. Not for long, though – I called up the captain like the good
little ensign I was, and here, dear reader, is where I finally
circle back to the underwear. A captain in full dress uniform is an
impressive sight – four stripes on the epaulets, heavily starched white
shirt. “Yes Sir!” is the almost automatic response. But an unshaven,
60-year-old, pot-bellied captain in his underwear? Now there’s a
disconcerting sight. “I got the deck,” he said, which meant he was
assuming control as he plopped into the captain’s chair with a toot and
an expulsion of natural gas worthy of the prior evening’s pork and
beans.
 
Well, to this point, the incident was a paragon of human comedy not
tragedy, but it quickly turned serious. Two miles 15°, one mile 15°,
1000 yards 15° – “Captain – constant bearing, decreasing range!” Ah, but
El Capitan wasn’t hearing me – he was asleep at the helm, and
half-naked no less: in command, in his underwear, and off somewhere in
la-la land. Twenty seconds after my warning, the tanker came within 20 yards of cutting us and 150 young sailors in half.
I in my fascination with a captain in his jockey shorts had assumed he
was awake and knew what he was doing. He in his Fruit of the Looms and
2:00 am exhaustion was incapacitated, temporarily incompetent, and
anything but a Naval captain. “What the hell was that?!” he screamed as
it passed astern after nearly disemboweling our 300-foot destroyer. I
was speechless and subject to a potential court martial, so I meekly
replied, “A tanker, sir”. “The Grim Reaper” would have been a better
description. It is with that as a reminder that there are no white robes
under the Christmas tree for yours truly. I wear a t-shirt and jockey
shorts if only to remind me of a sleeping pot-bellied captain and that
old Navy adage – constant bearing, decreasing range – constant bearing,
decreasing range.
 
Forty years later, I find myself in a similar position, this time,
however, displaying the four-striped epaulets myself as a co-captain of
the SS PIMCO, a $1.2 trillion carrier designed to travel the world and
the seven seas in a quest for principal protection and alpha generation.
And I thought the mid-watch was a hassle! Whatever it is, Mohamed and I
either alternately or in unison maintain 24-hour surveillance for
tankers on a collision course with your investment portfolios and
savings. There should be no “what the hell was that!” moments at PIMCO,
even on Lehman Day 2008. Indeed, there was not. While the global
financial tanker was on automatic pilot, we had changed course well in
advance and it has been relatively smooth sailing since.
 
The metaphor begs the question however as to what tanker is now
on a constant bearing decreasing range, and indeed there would seem to
be many such blips on the radar screen: global imbalances in trade,
finance and currencies; excessive private and sovereign debt levels;
growing disparities in wealth between the rich and the poor; aging
demographics threatening aging and younger generational priorities. Lots
of ships out there. Our upcoming Secular Forum will analyze these
topics and many more next week, after which Mohamed and I will alert you
to the prospects.
 
For now I would like to continue down the route of previous months’ Investment Outlooks
and discuss the immediate threat to investment portfolios represented
by low policy rates (fed funds in the U.S.) and the increasing negative
real yields that they engender as inflation accelerates. I spoke last
month to the reality of investors being “skunked” and having their
pockets picked simply by receiving yields less than inflation, and
suggested that as a major reason why the PIMCO ship was carrying a
limited supply of Treasuries on board. Although we have warned for
several years of the deteriorating creditworthiness of America’s AAA
rating, our de minimis Treasury positions had less to do with much more
immediate issues than America’s balance sheet prospects. We are highly
sensitive to the pocket-picking policies that governments in general
deploy to right the ship.
 
Well, ahoy matey, as quick as you can shout “thar she blows,” an
academic working paper by Carmen Reinhart and M. Belen Sbrancia affirmed
the same thing but in much more grounded, well-ballasted research. The
paper, titled “The Liquidation of Government Debt,” contains a
historical analysis of how governments attempt to get out from under the
crushing burden of a debt crisis. For developed countries such as the
United Kingdom and the United States, the period beginning in the
mid-1940s (when depression and WWII sovereign debt loads were
oppressive) was used as a starting point for pocket picking, “skunking,”
or what they term “financial repression.” While the ancient Romans used
to shave metal coins in an attempt to monetize existing debts, our
evolving financial system has used more sophisticated techniques. With
inflation accelerating, due to WWII and post-war demands on commodities,
the Treasury capped long-term bond yields at 2½% and in so doing
ensured that its debt/GDP ratio would be reduced. If savers received an
average 2% on their Treasuries while the nominally based economy was
advancing at 5% or more annualized growth rates, then debt to GDP could
be lowered from its peak level of 116% to 112%, to 109%…etc. every 12
months. In fact, the authors found that “for the United States and the
United Kingdom, the annual liquidation of debt via negative real interest rates amounted
on average to 3 or 4% percent of GDP a year…which quickly accumulated
(without compounding) to a 30 to 40% of GDP debt reduction in the course
of a decade.” Even after interest rate “caps” were removed in
1951 via the Fed-Treasury Accord, extremely low/negative real interest
rate policies continued until the Volcker revolution in 1979.
By
that time, U.S. (and U.K.) debt levels had been normalized, primarily
at the expense of savers who had been “repressed” (and depressed!) for
over three decades. At that historical turning point, government bonds
were labeled “certificates of confiscation.” Not only had savers
received Treasury bill rates that were negative for over 25% of the
nearly four decades, but they were holding long-term AAA rated bonds
trading at 30 to 40 cents on the dollar.
 
The point of the Reinhart paper was not to state the obvious – that inflation is bad for bonds. Their
financial repressionary thesis points out that bond prices don’t
necessarily have to go down for savers to get skunked during a process
of “debt liquidation.” The argument over whether the end of QEII on June
30 will result in higher yields and lower Treasury bond prices is, in a
sense, a secondary one. Even if 10-year Treasuries stay where they are
at 3.30%, and fed funds close to 0%, savers and financial intermediaries
are being shortchanged by both of these yields and everything in
between.
Today’s rates resemble the interest rate caps prior to
the 1951 Accord. Either through QEI, QEII or the Fed’s “extended period
of time” language reinforced at Chairman Bernanke’s recent press
conference, U.S. Treasuries and the bond market in general are being
“repressed,” “capped” or simply overvalued compared to the prior 30
years. Bond investors forced to invest in dollar government bonds either
through indexation, convention, regulatory guidelines or simply falling
asleep at the helm are being shortchanged by 1 to 2% annually compared
to historical norms and in many cases receive negative real yields, as
shown in Chart 1. If Reinhart’s history is any guide, an investor should
expect these overvaluations to be with us for years if not decades.
While that still leaves open the question of price behavior following
QEII, there should be little doubt that simply holding Treasuries at
these yield levels for an extended period of time represents an
abdication of responsibility.
 
 
Bond – and stock – investors have been sailing on the “Good Ship
Lollipop” for over 30 years following the Volcker Revolution and the
return of high real interest rates to investment markets. Now, however,
with governments attempting to impose financial repression, bond
investors should revolt. Their ship should more likely be christened the
“USS Caine” in memory of a silver screen mutiny that, while traumatic,
eventually returned all sailors safely to port. Many of these countries have more
pristine balance sheets and higher real interest rates than those
currently being imposed in some developed markets subject to current and
future “repression.” If AAA quality is your requirement, then Canadian
or Australian bonds may also fit your horizon. Join us, along with
Carmen Reinhart, in shouting “constant bearing/decreasing range!” The
Treasury market is on a collision course with financial repression and
it is time to adjust your rudder to starboard to get home safely.