Guest Author - Tony Daltorio
The $237 billion Pimco Total Return Fund is the world's biggest bond mutual fund. It is run by one of the most influential persons in the bond market – Bill Gross.
So when Mr. Gross speaks, people usually listen. And recently, he has spoken volumes – both in his words and in his actions.
In his March investment outlook for shareholders, Mr. Gross said Pimco estimated that the Federal Reserve had been buying 70 per cent of annualized issuance of US Treasuries since its QE2 (quantitative easing/ money printing) program began. Mr. Gross last year aired his views on QE2, likening it to a Ponzi scheme.
In his latest statement, Mr. Gross said he was worried about, at the least, a temporary void in demand for US Treasuries once QE2 is scheduled to end in June. If he is correct about demand for US Treasuries drying up, the yields for these bonds will rise and the prices will fall. This will hurt anyone holding Treasuries in their portfolio.
So Mr. Gross has taken action to protect his shareholders. His Pimco Total Return Fund has cut its holdings of US government-related debt to zero for the first time since early 2008.
After this move, the fund holds approximately 23 per cent in cash. The remainder is invested in US mortgage bonds, corporate bonds, high yield bonds and emerging market debt.
Pimco is hardly alone in its thoughts about the US government debt market. Investors have recently poured $500 million of new money into exchange traded funds that will profit when US yields rise. Examples of such funds include the ProShares Short 20+ Year Treasury ETF and the ProShares Short 7-10 Year Treasury ETF.
The Fed vs a Lousy Economy
The decision to sell Treasuries in the Total Return Fund was based on the direction of Federal Reserve policies. But another key factor in determining the direction of interest rates will be the pace of the US recovery.
Mr. Gross actually is rather a lonely voice in the bond market. Most bond investors are very gloomy about the US economy and argue that rates will stay low for a very long time.
One argument countering the case for a jump in interest rates is the concern about the impact on consumers of the sharp rise in oil and other commodity prices.
Higher food and oil prices, the argument goes, will drag on the economy rather than stoke broader inflation. The argument is that higher commodity prices act as a tax on US consumers, slowing the economy.
Another factor dragging on the US economy is the fact that many US states with large deficits are under pressure to cut spending and raise revenues.
In addition, the US still has many homeowners stuck in negative equity positions after sharp falls in property prices. And the sharpest private sector deleveraging since the Great Depression continues to go on.
All of these negative factors, the gloomsters say, are working against the massive flood of monetary stimulus that the Federal Reserve has unleashed.
A Pertinent Question
The Federal Reserve has indeed unleashed a tsunami of money. It has been buying about $100 billion of bonds a month through its QE2 program. Since last November, it has accumulated $419 billion of government debt. That takes the Fed's current total Treasury holdings to $1.23 trillion.
By the time QE2 ends in June, the Fed will have bought approximately $800 billion of Treasuries, pushing its total holdings to $1.6 trillion!
So Mr. Gross' question about who steps in to fill the gap when QE2 ends is therefore a very pertinent question. But is it the right question?
Probably not. Why? Because when QE2 ends, it is highly likely there will be a QE3 and a QE ad infinitum. Rumors of QE3 sent the stock market higher this past week.
Continued easy monetary policies from the Federal Reserve will actually have very little to do with the state of the US economy, but with the health of US financial institutions.
Most major US financial institutions are loaded to the gills with US government bonds. And they are either not hedged at all or poorly hedged against a rise in US interest rates.
Therefore any cutoff of Fed purchases of US Treasuries is most unlikely. The Fed does not want a replay of the 1994 devastation in the bond market. Not with so many US financial institutions still on shaky ground.
Bottom line - the monetary floodgates will stay wide open.