Friday, May 13, 2011

The PIMCO Mystery

There is an interesting article on Bill Gross and PIMCO in The Atlantic.  It highlights PIMCO's decision to dump and then bet against U.S. treasury bonds.  According to Tyler Durden, the amounts involved are significant.  Bill Gross' explanation for these decisions is that the bond market is being artificially propped up by QE2 and once it ends so will bond prices. 

These decisions have me stumped.  First, Gross' view assumes that the flow of QE2 purchases is what matters to bond prices.  There are good reasons to think, however, that it is the stock of QE2 purchases that matter.  If so, there should be no bond market correction since the Fed is not planning to sell its newly-acquired assets anytime soon. Second, given the weak economic outlook the expected short-term interest rates going forward should remain low.  That in turn should translate into low long-term bond yields.  Finally, if PIMCO's view were correct would not the bond market be pricing it in already? The figure below gives no indication of the U.S. bond market bottoming out.  If anything, there is a downward trend in the long-term treasury yield since the start of the year.


Now Bill Gross and the folks at PIMCO are smart.  They saw the housing bust well in advance and have made lots of money over the past few decades. So when they place so big a bet against U.S. bonds it should give us pause.  Maybe they are bond vigilante harbingers. Or maybe they are wrong.  For now the bond market seems to be supporting the latter view. 

6 comments:

  1. Gross mentions the paper by Carmen Reinhart and Belen Sbrancia. He thinks investors can get a much better deal in EM bond markets.
    He says
    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.

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  2. Can stock effects explain consistently-negative 5yr yields? These have ranged as low as -50bp in recent months.

    The stock of Treasuries and government-guaranteed paper available to the public is in excess of $15tr. The Fed has reduced this stock by about $2.2tr, or roughly 15%. This modest reduction came at a time when the Treasury was adding another few trillion to the stock of Treasuries. Did the Fed's reduction cause investors -- for the first time ever -- to want to pay the government to take their funds for five years (reaching seven years into a recovery)?

    Gross is implying the flow effect occurs through front-running by speculators. The trade is to buy Treasuries as long as the Fed is there to sell to. A speculator engaged in this trade does not care about negative real 5yr returns, he cares about riding the nominal yield curve (borrowing near zero and lending at 1.85%) as long as he can off-load term Treasuries when needed. Once the "trade" is over, Gross argues, the speculators will disappear, and negative real rates will evaporate. The problem with Gross's arguement is EMH: traders should have already discounted the end of QE2. In his latest piece, Gross counters by arguing that the bond market is not efficient.

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  3. Above in the first paragraph, I meant to write, "consistently-negative 5yr REAL yields".

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  4. Thanks ECB and David for your comments. If you look at Gross newsletter a few months ago he was not talking about financial repression. That is a more recent defense of his actions. His early story was that bond market is going to struggle once the Fed stops buying. It was that simple. For example, see his March, 2011 newsletter where he asks who will buy when the Fed stops buying. His story has changed over time.

    David, I see your point about taking advantage of the spread but as you say why hasn't the bond market priced its ending into the bond prices if it is a big deal?

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  5. David,

    Its hard to say why the bond market has not reacted.

    One I thing I will say is that the agency problem is pervasive -- even in the Treasury market. Large bond market participants are not focused on long term real returns, whether they be hedge funds, foreign central banks, shadow banks or even public pension funds. Take the example of the pension funds: most have unrealistic portfolio return targets (8-9%!) which they are stubbornly refusing to lower (for political reasons). The targets give them an incentive to "swing for the fences". This helps explain why term rates and credit spreads are so low right now.

    In other words, the "portfolio balances effect" of QE and ZIRP works in unintended ways when, as a result of the agency problem, "investors" act like "speculators".

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  6. Re. your stocks and flows point. From a trader's perspective, when a large buyer who has been participating on the bid side (ie. as a buyer) of the bid-ask spread walks away, there are now less buyers than before (and less traders trying to front run that buyer), with the result that there is now an overhang of sellers. This increases the odds of a selloff. That's all Gross is saying. Pretty basic stuff.

    "Finally, if PIMCO's view were correct would not the bond market be pricing it in already?"

    Maybe. But if PIMCO's views were correct about a potential housing bust, wouldn't the market already have priced that in? Everyone has an opinion, its just that some people's opinions are consistently better than others.

    Disclosure, I am neither long nor short bonds.

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