T

he Gross household is a robe-wearing household – at least on the distaff side. Sue has a closet full of them, all white, and is thrilled each and every Christmas with a new white one under the tree. Go figure. I on the other hand am a little more casual about nighttime attire, a habit I picked up or at least observed during my Navy years in the South China Sea. But I am getting ahead of myself. Back in 1969, yours truly was a lowly ensign whose responsibility among other things was to substitute for the captain when he was sleeping. Vietnam era captains couldn’t be at the helm 24/7 so during relatively calm hours, the benchwarmers got a chance to quarterback the ship. Such was the case on a warm September evening, making 20 knots on our way home to San Diego in the middle of the vast and totally empty Pacific Ocean, 2,000 miles west of Honolulu. I was standing the dreaded “mid-watch” – midnight to 4:00 am – and under instructions to wake the captain if anything “unusual” took place; FAT chance, aside from the occasional mermaid or sea monster sightings, and no one ever woke the captain up for that.

Well, around 2:00 am there was a sighting – quite remarkable, actually, because the Pacific is BIG and the occasional freighter was rare indeed. Ten miles at 15° off the bow, I spotted an oil tanker on the horizon, apparently headed our way. There is a Navy axiom that even an idiot ensign can remember, which tells a navigator whether or not a mid-ocean collision is possible – “constant bearing, decreasing range,” or CBDR for short. If, for instance, that tanker was closing to five miles and was still positioned 15° off the bow, well, there would be a growing chance that we would meet head-on five miles later. Ah, wouldn’t you know it – this tanker had a CBDR and yours truly was the only one who was aware of it. Tankers set their controls on automatic pilot during the midnight hours, so the approaching ship wasn’t about to change course. I was the only officer awake. Not for long, though – I called up the captain like the good little ensign I was, and here, dear reader, is where I finally circle back to the underwear. A captain in full dress uniform is an impressive sight – four stripes on the epaulets, heavily starched white shirt. “Yes Sir!” is the almost automatic response. But an unshaven, 60-year-old, pot-bellied captain in his underwear? Now there’s a disconcerting sight. “I got the deck,” he said, which meant he was assuming control as he plopped into the captain’s chair with a toot and an expulsion of natural gas worthy of the prior evening’s pork and beans.

Well, to this point, the incident was a paragon of human comedy not tragedy, but it quickly turned serious. Two miles 15°, one mile 15°, 1000 yards 15° – “Captain – constant bearing, decreasing range!” Ah, but El Capitan wasn’t hearing me – he was asleep at the helm, and half-naked no less: in command, in his underwear, and off somewhere in la-la land. Twenty seconds after my warning, the tanker came within 20 yards of cutting us and 150 young sailors in half. I in my fascination with a captain in his jockey shorts had assumed he was awake and knew what he was doing. He in his Fruit of the Looms and 2:00 am exhaustion was incapacitated, temporarily incompetent, and anything but a Naval captain. “What the hell was that?!” he screamed as it passed astern after nearly disemboweling our 300-foot destroyer. I was speechless and subject to a potential court martial, so I meekly replied, “A tanker, sir”. “The Grim Reaper” would have been a better description. It is with that as a reminder that there are no white robes under the Christmas tree for yours truly. I wear a t-shirt and jockey shorts if only to remind me of a sleeping pot-bellied captain and that old Navy adage – constant bearing, decreasing range – constant bearing, decreasing range.

Forty years later, I find myself in a similar position, this time, however, displaying the four-striped epaulets myself as a co-captain of the SS PIMCO, a $1.2 trillion carrier designed to travel the world and the seven seas in a quest for principal protection and alpha generation. And I thought the mid-watch was a hassle! Whatever it is, Mohamed and I either alternately or in unison maintain 24-hour surveillance for tankers on a collision course with your investment portfolios and savings. There should be no “what the hell was that!” moments at PIMCO, even on Lehman Day 2008. Indeed, there was not. While the global financial tanker was on automatic pilot, we had changed course well in advance and it has been relatively smooth sailing since.

The metaphor begs the question however as to what tanker is now on a constant bearing decreasing range, and indeed there would seem to be many such blips on the radar screen: global imbalances in trade, finance and currencies; excessive private and sovereign debt levels; growing disparities in wealth between the rich and the poor; aging demographics threatening aging and younger generational priorities. Lots of ships out there. Our upcoming Secular Forum will analyze these topics and many more next week, after which Mohamed and I will alert you to the prospects.

For now I would like to continue down the route of previous months’ Investment Outlooks and discuss the immediate threat to investment portfolios represented by low policy rates (fed funds in the U.S.) and the increasing negative real yields that they engender as inflation accelerates. I spoke last month to the reality of investors being “skunked” and having their pockets picked simply by receiving yields less than inflation, and suggested that as a major reason why the PIMCO ship was carrying a limited supply of Treasuries on board. Although we have warned for several years of the deteriorating creditworthiness of America’s AAA rating, our de minimis Treasury positions had less to do with much more immediate issues than America’s balance sheet prospects. We are highly sensitive to the pocket-picking policies that governments in general deploy to right the ship.

Well, ahoy matey, as quick as you can shout “thar she blows,” an academic working paper by Carmen Reinhart and M. Belen Sbrancia affirmed the same thing but in much more grounded, well-ballasted research. The paper, titled “The Liquidation of Government Debt,” contains a historical analysis of how governments attempt to get out from under the crushing burden of a debt crisis. For developed countries such as the United Kingdom and the United States, the period beginning in the mid-1940s (when depression and WWII sovereign debt loads were oppressive) was used as a starting point for pocket picking, “skunking,” or what they term “financial repression.” While the ancient Romans used to shave metal coins in an attempt to monetize existing debts, our evolving financial system has used more sophisticated techniques. With inflation accelerating, due to WWII and post-war demands on commodities, the Treasury capped long-term bond yields at 2½% and in so doing ensured that its debt/GDP ratio would be reduced. If savers received an average 2% on their Treasuries while the nominally based economy was advancing at 5% or more annualized growth rates, then debt to GDP could be lowered from its peak level of 116% to 112%, to 109%…etc. every 12 months. In fact, the authors found that “for the United States and the United Kingdom, the annual liquidation of debt via negative real interest rates amounted on average to 3 or 4% percent of GDP a year…which quickly accumulated (without compounding) to a 30 to 40% of GDP debt reduction in the course of a decade.” Even after interest rate “caps” were removed in 1951 via the Fed-Treasury Accord, extremely low/negative real interest rate policies continued until the Volcker revolution in 1979. By that time, U.S. (and U.K.) debt levels had been normalized, primarily at the expense of savers who had been “repressed” (and depressed!) for over three decades. At that historical turning point, government bonds were labeled “certificates of confiscation.” Not only had savers received Treasury bill rates that were negative for over 25% of the nearly four decades, but they were holding long-term AAA rated bonds trading at 30 to 40 cents on the dollar.

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. While that still leaves open the question of price behavior following QEII, there should be little doubt that simply holding Treasuries at these yield levels for an extended period of time represents an abdication of responsibility.

 

Bond – and stock – investors have been sailing on the “Good Ship Lollipop” for over 30 years following the Volcker Revolution and the return of high real interest rates to investment markets. Now, however, with governments attempting to impose financial repression, bond investors should revolt. Their ship should more likely be christened the “USS Caine” in memory of a silver screen mutiny that, while traumatic, eventually returned all sailors safely to port. PIMCO advocates not so much a mutiny but a renewed vigilance on this new ship, stressing bond market “safe spread” alternatives available globally, including developing/emerging market debt at higher yields denominated in non-dollar currencies. Many of these countries have more pristine balance sheets and higher real interest rates than those currently being imposed in some developed markets subject to current and future “repression.” If AAA quality is your requirement, then Canadian or Australian bonds may also fit your horizon. Join us, along with Carmen Reinhart, in shouting “constant bearing/decreasing range!” The Treasury market is on a collision course with financial repression and it is time to adjust your rudder to starboard to get home safely.

William H. Gross
Managing Director 

Disclosures

Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Europe Ltd (Company No. 2604517), PIMCO Europe, Ltd Amsterdam Branch (Company No. 24319743), and PIMCO Europe Ltd- Italy (Company No. 07533910969) are authorised and regulated by the Financial Conduct Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the UK. The Amsterdam and Italy Branches are additionally regulated by the AFM and CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act, respectively. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Financial Conduct Authority’s Handbook and are not available to individual investors, who should not rely on this communication. | PIMCO Deutschland GmbH(Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany) is authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The services and products provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2), Brandschenkestrasse 41, 8002 Zurich, Switzerland, Tel: + 41 44 512 49 10. The services and products provided by PIMCO Switzerland GmbH are not available to individual investors, who should not rely on this communication but contact their financial adviser. | PIMCO Asia Pte Ltd (8 Marina View, #30-01, Asia Square Tower 1, Singapore 018960, Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Asia Limited (Suite 2201, 22nd Floor, Two International Finance Centre, No. 8 Finance Street, Central, Hong Kong) is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862 (PIMCO Australia) offers products and services to both wholesale and retail clients as defined in the Corporations Act 2001 (limited to general financial product advice in the case of retail clients). This communication is provided for general information only without taking into account the objectives, financial situation or needs of any particular investors. | PIMCO Japan Ltd (Toranomon Towers Office 18F, 4-1-28, Toranomon, Minato-ku, Tokyo, Japan 105-0001) Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No.382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association and The Investment Trusts Association, Japan. Investment management products and services offered by PIMCO Japan Ltd are offered only to persons within its respective jurisdiction, and are not available to persons where provision of such products or services is unauthorized. Valuations of assets will fluctuate based upon prices of securities and values of derivative transactions in the portfolio, market conditions, interest rates, and credit risk, among others. Investments in foreign currency denominated assets will be affected by foreign exchange rates. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. | PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. | PIMCO Latin America Edifício Internacional Rio Praia do Flamengo, 154 1° andar, Rio de Janeiro – RJ Brasil 22210-906.

“Safe Spread” is defined as sectors that we believe are most likely to withstand the vicissitudes of a wide range of possible economic scenarios. All investments contain risk and may lose value.

Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks includting market, interest-rate, issuer, credit, and inflation risk. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio.

The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. The Quality ratings of individual issues/issuers are provided to indicate the credit worthiness of such issues/issuer and generally range from AAA, Aaa, or AAA (highest) to D, C, or D (lowest) for S&P, Moody’s, and Fitch respectively.

This article contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.