bill gross investment outlook nov_05

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Investment OutlookBill Gross | November 2005

Takin It To The Blog

A wiser man would stay silent and let the freshly chastened New York Times ex Judith Miller or agrowing number of mainstream publications carry the load. People resent moneyed financiers suchas George Soros reinventing themselves as public policy experts and this Outlook may beinterpreted as such. But I am no expert, just a bond manager with a blog who has earned theprivilege of readership concerning bonds over the past 30 years, and who sometimes speaks hismind on other matters. Management at PIMCO and some of you clients wont necessarily agree withme. PIMCO doesnt have a foreign policy view. I do. My views represent the politics of an ordinaryAmerican citizen with Republican roots, devoid of top secret or inside information a Will Rogerspolicy: all I know is what I read in the newspapers. Still as the Doobie Brothers once sang, I aintblind and I dont like what I think I see. They took their song to the streets. Im takin it to the blog.

I find it interesting that nearly every second-term presidency in modern history has its scandal, withrecent ones accompanied by the infamous special prosecutor. The hubris of power may in part beresponsible but the oppositions patterned response is really a result of our democratic processmandating a fixed four-year term. Unable to bring the current government down and dissolveParliament/Congress and the Executive Branch when things go wrong, as is the case in Europe, weappoint special prosecutors to neuter an out of favor administration for the next 2 or 3 years untilredress can take place at the polls. Clinton was neutered and even impeached. Reagan wasneutered via Iran Contra. Nixon was expelled. Now Bush Juniors number is being called.

The reason that W is on the hot seat of course has nothing to do with whether Karl Rove or ScooterLibby outed CIA agent Valerie Plame, and everything to do with the Iraq War, and perhaps even agrowing dissatisfaction with Americas course in general our changing perception as the worlds

leader as well as the unbalanced distribution of wealth within our own borders. The war, Katrina, gasprices, and Republicans continuing focus on tax cuts as the elixir to cure everything are gettingordinary citizens downright depressed. Plame-gate is the result. Their dissatisfactions focal point isthe war: the pretenses under which it was initiated, the lack of visible progress despite the recentapproval of an Iraqi constitution, and the absence of a timeline for an exit of U.S. troops.

My position on Iraq was well publicized before the war and doesnt require repeating here. In the 2+years since I last wrote, much has come to the publics attention and it is obvious at least to me thatthere is blame aplenty, including not only the President and his advisors, but an uncritical Congressand the press, conservative and liberal alike. But it doesnt change things now that we didnt discoverweapons of mass destruction (WMD). What that realization should change, however, is how weapproach the future hopefully with greater scrutiny from all parties including the public, which justsort of trusted its elected first and second estates and assumed that the fourth estate was doing its

job. What America needs now are more reporters like Frank Rich and fewer Judith Millers; morepoliticians like former Governor Howard Dean and fewer like the go along to get along John Kerry. Ithink we should also be looking for the first authentic presidential candidate Republican orDemocrat to stand up and recommend a future course of action that offers Americans a choice atthe polls beginning in 2006. We deserve a leader with the willingness to at least address thepossibility of a policy change in Iraq, and who is willing to risk disapproval from a vocal minority oreven a silent majority to lead his or her party and this great country of ours towards a resolution infuture years.

Shifting now from a foreign policy blog to an Investment Outlook blog, its fair to speculate how BenBernanke will do as the new Fed Chairman. I view him favorably, especially his views on inflation

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targeting, which if accepted as policy, should help intermediate and long-term bond yields to staylow. Inflation targeting central banks in other parts of the world such as the U.K. and implicitly the

ECB, have economies with lower inflation and lower long-term yields than here in the U.S.Admittedly their economies (Euroland) and accounting standards (U.K.) promote lower yields, butinflation targeting is part of the explanation as well since it induces a greater degree of confidence inthe admittedly fragile value of paper money.

The key to interpreting Bernankes and the bond markets future rests with so many variables that itshard to throw them into one pot and come up with a palate-pleasing recipe: inflation (core or energyimpacted?), foreign buying of Treasury and corporate bonds, the fate of the U.S. housing bubble,and the ultimate resting point of the Greenspan/Bernanke Fed, head the cookbook. The Fed hasbeen on a mission for 15 months now to return money market interest rates to neutral and to imparta semblance of normality to the cost of borrowing. In analyzing this journey, PIMCO has for severalyears now focused on the real interest rate Fed Funds minus inflation as the most legitimateindicator of neutrality. Historically trading between 2% and 3%, which would imply a 4 - 5% rangein nominal headline terms, we have suggested it will be different this time. Because the U.S.economy has evolved into a highly levered finance-based economy, it stands to our reason that thismodern day version is more sensitive to changes in interest rates than those of years past. An itsdifferent this time hypothesis is rarely demonstrable from an econometric modeling perspective.Theres little history to model since it involves a jump-step transformation, and so logic must be theultimate arbitrator. Heightened sensitivity to interest expense in a levered economy seems more thanlogical to me, but I must admit that more than a 50 basis point increase in funds from this pointforward will call our thesis into question. At this juncture, with the market anticipating at least twomore 25 basis point hikes between now and Greenspans retirement, the real short-term interest rateis close to where we thought and said it would peak nearly two years ago. With January 2007 TIPStrading at a real yield of 1%, the implied level for real Fed Funds over the next 14 months hoversclose to our previous forecast. That rate has produced signs of significant economic slowing, butKatrina will fog Alan Greenspans glasses for months to come, obscuring as well any observationsas to the neutrality of current real short-term yields. It may be best, as featured in last monthsInvestment Outlook , to view the effect on a non-Katrina related sector housing more thanconsumer or business confidence-related indicators. If so, peaking to declining prices in some frothycoastal markets may be a sign that current real and nominal yields are starting to bite.

But for those still befuddled, it is wise to rely on a little history as the Fed feels its way along in thedark. Its certainly instructive to note that over six tightening cycles since 1983, the average FedFunds increase has been 250 basis points and those increases have taken an average of 12 monthstime to unfold. Granted this cycles beginning yield of 1% was an emergency deflationaryprecaution and more realistically would have settled closer to 1 - 1% if the perceived crisis hadnot hit the Feds radar. Even so, that would place this cyclical tightening in the 8 th inning to useDallas Fed President Richard Fishers terminology with 4% and November/December 2005

marking the historical average levels of extent and time. Economists/investment managers are alsoaware of the potency of a flattening yield curve shown in Chart 1. By the time 10-year and 2-yearTreasuries reach parity, as is almost the case now, the economy is typically slowing and the Fed isat or near the end of its tightening cycle. Only Volcker with his need to strangle inflation out of thesystem persisted into negative yield curve territory for longer than a few months.




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As a final piece of historical evidence that suggests current yields are approaching their peaks, Isubmit a chart of the 5-year Treasury as a proxy for the bite of interest rates, conundrum and all. Itis my favorite indicator, but one that is often ignored by the investment public since it takes so long tounfold and doesnt carry the immediate sizzle of a Fed hike. My take from Chart 2 is that tightermoney and higher yields in the intermediate portion of the curve unfold over 1-2 year cycles andgenerally in the magnitude of 200 basis points (the Volcker tightening being the exception). Thecurrent upward cycle is now 27 months in duration and 230 basis points in magnitude, enough byhistorical standards to slow an economy or even produce a mild recession given increased leverageand the exogenous shock of energy prices. Typically an economic slowdown occurs 18 months afterthe beginning of an upward move in 5-year rates, and this cycle appears to be no exception withindustrial production and service-related indicators having peaked nearly a year ago. We are due forwhat appears to be a 2% or less GDP growth rate in 2006, a rate sure to stop the Fed and to induce

eventual ease at some point later in the year. It will likely be Bernankes first policy shift and anindicator of his willingness to address the Feds dual mandate of inflation targeting and economicgrowth.




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While supposedly a bond market guru, as opposed to a foreign policy expert, I must admit I myselfam frequently chastened by rereading past Investment Outlooks , and so I approach this one with theusual caution. They dont always turn out to be true, much like the case of the missing WMD. Thisdoesnt mean, however, that we stubbornly retain our view in the face of changing evidence. ShouldBernankes Fed and Bernankes economy present a different face than the one we expect in 2006,youll be one of the first to hear about it.

William H. Gross Managing Director

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bill gross investment outlook nov_05

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