Bill Gross weighs in on interest rates

by Wayne Ferbert on October 11th, 2013

We have talked a lot about how the low interest rate environment has really helped to fuel the stock market. Investors can borrow at low rates and re-deploy those funds in the stock market. And while some have borrowed to invest, more often investors have just fled the low yields in fixed income market and pushed in to stocks as an alternative with a higher upside. That is what has fueled this market.
 
But we all know the Fed can’t keep going on with QE forever – as the US balance sheet can’t sustain it.
 
Bill Gross weighed in with his highly read monthly investment outlook. His big takeaway: the Fed will have to Taper – but they will keep the spot and future Treasury rates at historically low levels.  Here is the link to his monthly outlook:  http://www.pimco.com/EN/Insights/Pages/Survival-of-the-Fittest.aspx
 
Gross doubts the current Fed forecast. The Fed forecast assumes a 1% higher Fed funds rate in December 2015 and another 1% higher on top of that in December 2016. He says it won’t happen – even though he believes that Taper will likely be in effect by then.
 
Here is his exact statement: If you want to trust one thing and one thing only, trust that once QE is gone and the policy rate becomes the focus, that fed funds will then stay lower than expected for a long, long time. Right now the market (and the Fed forecasts) expects fed funds to be 1% higher by late 2015 and 1% higher still by December 2016. Bet against that.
 
His argument is that the US balance sheet is highly leveraged – and the last time it was this levered, the US kept 10 year Treasuries at 3% below the nominal GDP growth for 25 years. The end result: our US balance sheet removed the leverage it was forced to put in place for World War II.
 
Now, here we are with a weak economy and few prospects to get the economy growing at a significant enough clip to right our US balance sheet. So, he expects the Fed to keep the Fed fund rates low.
 
It is a smart argument – and it is meaningful.  As we wrote the other day, the risk-free rate of return starts and ends with US treasuries. And the risk-free rate is the start of discussion for all other expected returns for every other asset class.
 
There is a lot riding on where interest rates currently sit. When they get to these low levels, the prices adjusted higher to accommodate the lower effective yields. Small moves up can have big price impacts. An example:
 
If the average investment grade corporate fixed income with 10 years to maturity and a 6% coupon was sold today with an effective yield of 4.7%, it would trade at about $110 – compared to $100 par. However, if the effective yield just moves up by 1% in the next year, that price drops to $102. That is around an 8% drop in value.
 
So, if you are invested in fixed income, the Taper decision and the impending interest rate decisions by the Fed will have a lot of say in the forward value of your portfolio!

My net/net: the all clear flag cannot be waved in the fixed income market yet. Rates can still rise – meaning prices can still fall. Taper is coming eventually and Yellen is not as much as of a ‘known’ entity as the talking heads have described her. She may be more centrist than everyone expects.



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