View Full Version : Economics Beware 'Credit Supernova' Looming Ahead : Gross
02-04-2013, 12:01 PM
Pimco's Bill Gross looks at the investing universe and sees a dangerous supernova - a looming explosion that could see investors lost in space.
The head of the Pacific Investment Management bond giant has issued an ominous forecast in which he worries that the global central bank-induced credit bubble "is running out of energy and time." (Read More: Federal Reserve Should Do Less, Not More: Morici)
As a result, investors will have to get used to an atmosphere of diminishing returns and portfolios that will hold more hard assets like commodities and fewer less-tangible financial assets like stocks.
"Our credit-based financial markets and the economy it supports are levered, fragile and increasingly entropic," Gross said in his February newsletter.
"When does money run out of time? The countdown begins when investable assets pose too much risk for too little return; when lenders desert credit markets for other alternatives such as cash or real assets," he added.
Gross advocates investors turn to gold and other commodities for inflation protection and currencies and assets in other countries that don't have such active central banks and huge debt loads. He favors Australia, Brazil, Canada and Mexico. (Read More: Money Pouring Into Stocks 'Is Usually a Negative Sign')
In the U.S. alone, the Federal Reserve has created a shade under $3 trillion in new money to buy more than $1.7 trillion in Treasurys and $968 billion in mortgage-backed securities, according to the most recent Fed balance sheet. The Fed will be buying $85 billion a month of the two debt instruments as it seeks to continue stimulating the slow-growth economy, which actually contracted 0.1 percent in the fourth quarter.
The inability of central banks to generate robust growth despite all the money-printing has stoked concern about future returns by Gross and Pimco, which manages $1.92 trillion for clients.
"Unless central banks and credit extending private banks can generate real or at second best, nominal growth with their trillions of dollars, euros, and yen, then the risk of credit market entropy will increase," Gross said.
His "credit supernova" metaphor describes a condition in which "our current monetary system seems to require perpetual expansion to maintain its existence" similar to the physical universe.
That expansion to $56 trillion, though, has generated consistently lower results, he said. Consequently, the investor base needed for the expansion to continue may not last.
"The end of the global monetary system is not nigh. But the entropic characterization is most illustrative," Gross said. "Appreciate the supernova characterization of our current credit system. At some point it will transition to something else."
02-04-2013, 10:12 PM
Fears of a bond bubble are overblown.
There is no bond bubble.
No, there probably isn’t a bond bubble
Posted by Neil Irwin
on February 4, 2013 at 10:31 am
One peculiar legacy of the financial crisis is that, among the financial commentariat, there is a tendency to see a bubble whenever the market for a particular asset rises.
We’ve seen it lately with the resurgence in the stock market, which commentators are quick to say is a built-on-thin-air creation of the Federal Reserve (even though price-to-earnings ratios are the lowest they have been in a generation). And then there are the modest rises in home prices — also seen as a bubble (even though price-to-rent ratios (http://www.washingtonpost.com/blogs/wonkblog/wp/2013/01/23/yes-the-stock-market-is-booming-no-it-isnt-a-bubble/) show no sign of becoming unhinged from reality the way they did in the early 2000s).
But no bubble fears are as widespread as those for the markets for government bonds — in the United States in particular but also in many other nations. It almost passes as a mark of seriousness to argue that Treasuries are the next big bubble to pop, the biggest in a long series that also included the stock market bubble of the late 1990s and the housing and mortgage securities bubble of the 2000s.
That kind of talk heats up whenever bond prices start to fall a bit, as they have in the last few weeks. (The phrase “bond bubble” appeared in major world publications included in the Nexis database 28 times in January, up from two in January 2012). And, yes, bonds have been in a remarkable 30-year rally (http://research.stlouisfed.org/fred2/graph/?id=DGS10), their prices climbing as interest rates have fallen almost constantly since the early 1980s.
Of course, bond prices could drop (and, conversely, longer-term interest rates rise). But that change is more likely to occur for good reasons – -because the economy is getting back on track — than for bad reasons, such as out-of-control inflation.
So, I’m not particularly worried that Treasury bonds are a bubble about to pop. Here’s why:
The simplest reason to be skeptical of the bond bubble story? A bubble means that people are buying an asset at ever-rising prices for speculative reasons, not for the fundamental value of the asset but because they are assuming somebody else will buy it at a higher price. I see no evidence of this behavior by buyers of Treasury bonds. They tend to be people looking to get their 2 percent yield and their money back at maturity. And while they may complain that the yield is so low (and the price of the bond, by extension, so high), that they are buying the bond because the guaranteed 2 percent is a better deal than the alternatives — not because they’re convinced that interest rates will fall further and they’ll be able to “flip” the bond at a profit.
But to go a level deeper, it helps to know some basics of finance theory. Think of the interest rate that a Treasury bond pays as a bunch of other rates added on top of each other. If you believe that the market for Treasury bonds is going to collapse, you have to determine why the conventional wisdom, as is priced into markets, is wrong about one or more of these things.
First, there is the future path of short-term interest rates, which is set by the Federal Reserve. Nobody would buy a 10-year bond yielding only 2 percent if they expected short-term interest rates were going to soon rise to 5 percent. As a starting point, bonds should price in what the market expects the Fed to do in the future. Conveniently, leaders of the Fed have become clearer than ever before about what they expect their future interest rate policies to be.
Fed vice chairman Janet Yellen even gave a speech (http://www.federalreserve.gov/newsevents/speech/yellen20121113a.htm) in November where she uses a slide show (http://www.federalreserve.gov/newsevents/speech/yellen20121113a.jpg) to explain her view of what the “optimal path for monetary policy” would look like. The chart shows the Fed starting to raise rates at the start of 2016 and shows short-term interest rates crossing the 2 percent line in late 2017.
Now, Yellen’s chart could turn out to be wrong. Perhaps economic growth or inflation will take off before 2016, and the Fed will tighten policy earlier. Conversely, there could be a new recession, prompting an even longer wait before rates rise. Another uncertainty is that when Ben Bernanke’s term as Fed chairman ends less than a year from now, his replacement might push the Fed toward a different set of policies.
But investors buying longer-term Treasury bonds know more than they ever did before about what Fed leaders themselves expect interest rate policy to be for the years ahead, and so the prices they pay reflect that. If bond prices fall (and yields rise) because the economy is doing a lot better, that’s a good thing overall, even if it means the value of bonds bought in 2012 fall in value.
Two more components of bond prices are tied to inflation. Investors demand compensation both for the inflation they expect to happen — after all, in 10 years the dollars they get back from the Treasury will be worth less than those they lend it now — as well as some compensation for the risk that inflation could be higher than they expect.
Markets are currently pricing in 2.5 percent annual inflation over the next decade (that’s the difference between what normal bonds are yielding and inflation-indexed bonds). But if it turns out that inflation soars higher, then bonds would indeed be worth less.
This is the most plausible case for why bonds could be overvalued. The economists at the Fed and most private forecasting firms believe that as long as there is so much slack in the economy — unemployed workers, idle factories, empty office buildings — inflation isn’t much of a risk. But if they’re wrong, prices could indeed start jumping, and the value of bonds would fall. And note that this also connects to the path of short-term rates; a world in which inflation suddenly spikes to 5 percent is also a world in which the Fed is hiking short-term interest rates more than it expects to do now.
The next factor in bond yields is “liquidity risk,” the idea that Treasuries may be harder to buy and sell in the future than they are today, that investors might have trouble getting out of their positions in the future. It is hard to imagine a world in which the market for U.S. Treasury bonds is not deep and liquid, however.
And finally, there is default risk. Investors demand some premium on the bonds they buy to cover the chance that they won’t get paid back at all. Companies default all the time, any time there is a bankruptcy. Countries default rarely, but it does happen. Ask Greek bondholders, who, after arduous negotiations, agreed to a restructuring of their debt that amounted to a default, even if it wasn’t called that. But the United States, unlike Greece, has its own central bank, so is less likely to go into default. The nation’s public debt is a lot larger than it was a few years ago, but plenty of nations have done fine for years on end with higher debt burdens.
So unless our political system becomes so dysfunctional that default becomes a real possibility—not for economic reasons, but because, say, Congress reneges on its financial commitments, there’s not much reason to fear default. Even during the height of the debt ceiling debate in August 2011, when a considerable faction of Congressional Republicans was threatening just that, rates fell rather than rose, as investors still viewed Treasuries as the safe place to park money when the world seemed dangerous.
So as long as growth remains slow, inflation low, and the political system exhibits even a modicum of functionality, bond prices are about right. If there is a “bond bubble,” one of those assumptions has to be wrong. It’s on the bubble heads to decide which to choose.
02-04-2013, 11:13 PM
Wtf is Neil Irwin?
02-04-2013, 11:16 PM
I'll read this more in the morning but I'm glad we have Irwin to tell us that bond prices rise as interest rates fall. :facepalm:
02-04-2013, 11:21 PM
Wtf is Neil Irwin?
WTF is Jeff Cox?
02-04-2013, 11:23 PM
Wtf is Neil Irwin?
Ah, Pete is now very skeptical about sources and quality of information that comes from them.
02-05-2013, 07:17 AM
WTF is Jeff Cox?
the man reporting what Bill Gross said. WTF is Neil Irwin and where is he getting his info?
02-05-2013, 07:30 AM
Cliff Notes: Dollar rises, interest rates rise, bond prices start to tank....
Watch the Dollar: It Could Trigger the Next Crisis
Expectations of an end to ultra-easy U.S. monetary policy are likely to set in during the second-half of 2013, triggering a bull run in the dollar that could last for five years, says independent economist Andy Xie. And this, he argues, could lead to a "crisis" in emerging markets as hot money inflows unwind.
The U.S. economy has begun to show signs of life again - with factory activity touching a nine-month high in January - prompting talks about an end to the Federal Reserve's quantitative easing program.
Xie forecasts the dollar index – which measures the performance of the greenback against a basket of currencies - will rise to 100 in the next three years, a 25 percent rise from current levels around 80 on relative strength in the world's largest economy.
"The dollar bull market tends to trigger crises in emerging economies. This time is likely to be the same," the former Morgan Stanley economist said, citing the Latin American debt crisis in the 1980s and the Asian Financial Crisis in 1997, during which a rise in the U.S. dollar against local currencies led to a spike in interest payments on external debt.
"During the last ten year's dollar bear market, massive amount of hot money flowed into emerging economies, causing currency appreciation, asset bubbles.(But) when the dollar turns the direction, so does the liquidity. The virtuous cycle on the way up becomes a vicious one on the way down," he added.
(Read More: Flee 'Safe' Sovereign Debt, Says Hasenstab)
In the dollar bear market of the past decade, the BRIC (Brazil, Russia, India, China) countries have been the "darlings" of international speculative capital, making the them most vulnerable, according to the well-known economist. He did not provide targets for the BRIC currencies.
He said Brazil and India are most at risk among the BRIC countries because their capital markets are most open to foreign investment.
"A big worry this time is the hot money flowing in to local currencies, local currency debt by the big hedge funds, they were not there 15-20 years ago, they are planting money into emerging economies by buying local government debt," Xie said.
In Brazil, there is a high level of involvement by foreign investors in the country's local currency bond market, he said. Foreigners hold around 12.3 percent of the country's domestic debt, according to Reuters.
(Read More: Unlikely Market ScenariosCould Spring on Us in 2013)
While in India, foreign investors play a critical role in the country's stock market, contributing to around 30 percent of market turnover. Last year, foreign institutional investor inflows (FII) into the country's equity market, for example, touched $23 billion – the second highest net inflow in a single calendar year.
"When the dollar strengthens, these trades will unwind. This will trigger the emerging market currencies to go down, inflation to go up, and interest rates to go up, and then government bond prices will decline," Xie said.
Emerging Market Fundamentals Strong
Other analysts say that emerging market economies are in a stronger position than in the past and that should offer some protection against a sharp unwinding of foreign funds should the dollar start to rise amid an unwinding of the Federal Reserve's quantitative easing program.
Dariusz Kowalczyk, senior economist and strategist, Asia ex-Japan and Credit Agricole, disagrees that the emerging market currencies will be vulnerable, given the robust fundamentals of their respective economies.
"While we expect the U.S. dollar to gain against the euro and yen over the next two years, we believe emerging market currencies will appreciate against the dollar," he said.
Historically, when the dollar falls against major currencies, it has also declined against emerging market currencies, but this time around will be different, he said.
"Emerging markets are growing faster; they will attract inflows into the economies, equity and corporate bond markets, which will underpin their currencies. They will also attract reserve diversification inflows," he said.
Three years from now, Credit Agricole expects the Indian rupee and Brazilian real will trade at 49.4 and 1.88 against the U.S. dollar, from 53.3 and 1.99, respectively. This marks gains of 7 percent for the rupee, and 5.5 percent for the real.
(Read More: Here Are 4 Factors That Could Pull the US Dollar Down)
If there is a strong resurgence in the U.S. economy and the Fed subsequently raises interest rates at a faster-than-expected pace – making the interest rate differential less attractive – this emerging market currencies could come under some pressure, Kowalczyk said, adding that he does not foresee this situation playing out.
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