Gross misunderstanding

6 min read

(Correction appended)

I don’t think I agree with Bill Gross. In fact, to be frank, I know I don’t. I’m sure that you’ll be asking yourself, as do I, what right I have, a little wee strategist at a corner shop with probably total less manpower than Gross’s mighty $1.9 trn PIMCO employs in travel department – and with a fraction of the readership and influence – but I am still happy to disagree with Mr. Gross.

In his most recent newsletter, Gross points to the risk of incipient inflation in the US and, in referring to the way in which the Fed’s hands are tied for the next twelve months or so with respect to instituting a meaningful tightening policy, postulates an investment strategy focusing on the lower risk area at the front end of the yield curve. I can understand that he might be a little gun shy after taking a rather embarrassing 3rd quartile performance position last year with a negative performance in which, according to stats, the fund lost 1.92% but going short the index might not be such a great idea either.

There is no law of nature which determines that not even he can get it wrong twice in a row.

Let me explain. 2yr Treasuries are currently yielding just 0.37% per annum. 10 year notes are paying 2.86%, nearly 11 bp less (*) than they would have done before the most confusing of Department of Labor Non-Farm Payroll report of Friday. That reflects in a rally in the 10yr note of just under 1 point and hence well over three times the annual coupon income of a two year note. Before we even take a look at why there is no need to be running short duration, just step back and think of the opportunity cost of doing so.

The path to hell

In his piece, Mr Gross refers to the simple fact that investors don’t pay investment managers to lose money. True. However, they don’t pay them either to choose the risk free option, one which they can do themselves equally well and at a fraction of the cost. I won’t dwell on the carry issue for too long as I think of a trader I used to work with, an American called Tom Dolan who was as mad as a box of frogs but who’s memorable mantra was “The path to hell is paved with positive carry”.

I believe that for once the path to hell isn’t. We all know the Fed has lost the key to the room with the punch bowl in it and I struggle to see 10 year notes breaking sustainable north of 3% yield before the end of 2014. I certainly understand Mr Gross’s contention that markets would be well advised to focus on inflation ahead of unemployment but unless there is any meaningful indication that the Federal Reserve is thinking along similar lines, he risks being the little boy that cried “Wolf!”.

There is another point, namely that of real return. Formally instituting what is effectively a strategy of negative real return isn’t good either – CPI is running at 1.2%, roughly in line with interpolated 4 year Treasury yields. Now, I understand that moving $1.94 trn around is difficult at the best of times and we are clearly not in the best of times, liquidity wise. Trying to run nimble portfolio tactics is nigh impossible but I can’t subscribe to sticking everything at the front end waiting for the market to fall out of bed.

Laws of nature

PIMCO hasn’t become the powerhouse which it is by getting it consistently wrong and therefore I will be extremely cautious in believing that I can outsmart Bill Gross and his merry men but nobody is infallible. There is no law of nature which determines that not even he can get it wrong twice in a row. Apart from that, Gross has something of a reputation of talking his own book. Well, tell me who doesn’t?

Good point. I lunched with the principal of a London based hedge fund recently who flattered me by suggesting that he takes my opinions more seriously than those of strategists and analysts at the investment banks which service his fund precisely because I don’t have a book talk. Thanks mate, drinks are on me!

Anyhow, if the rally in the US dollar, which I am expecting to kick in any time soon, finally materialises, then inflation should find itself systemically suppressed. A rising currency due to falling energy imports and ever cheaper domestic supply should be disinflationary in their own rights and even though the overall labour market situation is ameliorating, I can’t see CPI getting out of hand, despite the Fed’s inability to act as flexibly as it might like to.

I see where PIMCO and Bill Gross are coming from but I’m afraid I can’t agree.

(Corrects the third paragraph from an earlier version to show that 10-yr Treasury yields fell, not rose, after the non-farm payroll report on Friday)