In a stunning vote of no confidence in the policies of the US central bank, the world’s largest bond fund, PIMCO, has dumped all of its investments in US government-related debt, including US Treasury bonds and agency debt.
According to reports overnight, PIMCO’s flagship Total Return Fund slashed its holdings of US Treasury bonds and agency debt to zero at the end of February. A month earlier, such investments made up 12% of the fund’s investments.
At the same time, the $US236.9 billion fund boosted its cash holdings. The fund held $54.5 billion in cash at the end of February, a sharp rise from $11.9 billion it held a month earlier.
PIMCO’s founder and managing director, Bill Gross, has made little secret of his concerns that bond yields could rise sharply – and bond prices fall – when the US central bank’s $US600 billion bond buying program expires in June.
In his latest Investment Outlook newsletter, Gross argues that the US central bank’s decision to engage in two rounds of quantitative easing – the first beginning in December 2008, and the second commencing last November – appear to have been successful. The US central bank’s plan has been to pump money into the financial system in order to reduce long-term interest rates, thereby forcing investors into riskier assets such as shares in the hope that this will create a wealth effect that will encourage consumers to spend more. And indeed the US share market has almost doubled since Ben Bernanke announced the first round of quantitative easing – dubbed QE1 – in late 2008.
But Gross questioned whether quantitative easing actually healed, as opposed to merely covering up, the symptoms of a sick economy. The real test of whether the US central bank’s policies had been successful would come when the current round of bond-buying – dubbed QE2 – came to an end.
“If on June 30, 2011 (the assumed termination date of QE2), the private sector cannot stand on its own two legs – issuing debt at low yields and narrow credit spreads, creating the jobs necessary to reduce unemployment and instilling global confidence in the sanctity and stability of the US dollar – then the QEs will have been a colossal flop.”
Gross pointed out that when the US central bank stopped writing $1.5 trillion in cheques each year, there was a risk that US interest rates could rise sharply, and this would cause the price of all financial assets, including shares, to drop.
Gross estimated that the Federal Reserve’s quantitative easing has been successful in pushing long-term US interest rates about 150 basis points (1.5%) below their natural levels.
“By eliminating QE2, the Fed would be ripping off a Band-Aid of a partially healed scab. Ouch! 25 basis point policy rates for an ‘extended period of time’ may not be enough to entice arbitrage Treasury buyers, nor bond fund asset allocators to re-enter a Treasury market at today’s artificially low yields. Yields may have to go higher, maybe even much higher to attract buying interest.”
But not all bond investors are as worried about rising US bond yields as Gross.
Some believe that the recovery in the US economy remains extremely fragile, and that high levels of unemployment and spare capacity mean that the economy is in little danger of seeing a surge in inflation.
Indeed, they argue there is a high likelihood that the US economic recovery could falter. And if this were to happen, long-term bond yields – which are currently around 3.5%– could slump back towards 3%. And this would be good news for bond investors because it would mean a strong rally in bond prices, which move in the opposite direction to bond yields.
This article first appeared on Business Spectator.
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