Janus Portfolio Manager and purported “bond king” Bill Gross appeared on “Bloomberg Markets” to discuss his latest investor letter, in which he criticized loose-money policies of the world’s central banks, comparing them to gluttons who’ve feasted on bonds.
The unprecedented stimulus measures adopted by the Federal Reserve, the European Central Bank, the Bank of Japan and others have created distortions in markets, rendering widely followed historical models like the Philips Curve and Taylor rule useless, Gross said.
Because of the central banks’ bond-buying binge, which created $5 trillion of negative yielding sovereign debt, Gross said the yield curve my not need to flatten as much – i.e. short-term rates may not need to rise as aggressively – to trigger a slowdown in growth or even a recession.
“I still think interest rates should be raised to a more normal level in order to favor business models that are currently being hurt like pension funds and insurance companies and so on,” Gross said.
Counterintuitively, a slowdown might have more long-term benefits for the US economy than maintaining the status quo, according to Gross, who cited Joseph Schumpeter's theory about "creative destruction."
“I simply warned that based upon our historical knowledge of yield curve flattening between 3-month Treasuries and 10 year Treasuries we may not have to flatten as much as historically in order to produce a growth slowdown or a recession. I actually think that a slowdown or a recession would probably do the economy some good. You clear out some of the dead wood and you prevent forest fires. It’s the same with concepts such as Schumpeter’s creative destruction, or Minsky's conclusions from five or ten years ago,”
Hyman Minsky, an economist who spent his entire life in obscurity, but whose research found renewed relevance after the financial crisis, has been dead since 1996. But his "Minsky moment" theory – a study of how excessive debt levels can trigger an abrupt crash in asset valuations – has found renewed relevance.
As Gross explained in his letter, in an economy with record levels of corporate and consumer debt, the cost of short term financing shouldn’t need to rise to the level of a 10-year Treasury note to trigger a recession. Indeed, “proportionality” would suggest that short-term interest rates only need to increase modestly to trigger a marked slowdown in growth.
"Most destructive leverage – as witnessed with the pre-Lehman subprime mortgages – occurs at the short end of the yield curve as the cost of monthly interest payments increase significantly to debt holders. While governments and the U.S. Treasury can afford the additional expense, levered corporations and individuals in many cases cannot…But since the Great Recession, more highly levered corporations, and in many cases, indebted individuals with floating rate student loans now exceeding $1 trillion, cannot cover the increased expense, resulting in reduced investment, consumption and ultimate default. Commonsensically, a more highly levered economy is more growth sensitive to using short term interest rates and a flat yield curve, which historically has coincided with the onset of a recession."
In his letter, Gross argued that the Fed should proceed with caution. This fall, not only will investors be grappling with rising rates and the beginning of the Fed’s balance-sheet unwind, but a looming battle over raising the debt ceiling is already promising to inject more volatility into markets.
In a sign of investor dread surrounding the looming debt-ceiling battle, Treasuries expected to mature in mid-October have risen markedly in recent weeks, causing the 3mo-6mo curve to invert. The CBO has said the Treasury will run out of cash around then. Another sign that investors are worried about the short-term outlook for credit was Monday’s 3-month bill auction, which surprised the market with the highest yield since 2008.
Investors will hear more from the Fed tomorrow after the close of its two-day July policy meeting. Since there’s no press conference scheduled, investors will be on the lookout for clues surrounding the balance sheet.
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