Image credit: Brad Swonetz\/Redux<\/em><\/p>\nIn February 1993, as the fledgling Clinton administration grappled with the nation\u2019s budget woes, campaign adviser James Carville groused to The Wall Street Journal: \u201cI used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone.\u201d If Carville were serving in the Obama administration today, he\u2019d be seeking reincarnation as Bill Gross. The founder and co\u2013chief investment officer of PIMCO, Gross runs his firm\u2019s Total Return Fund\u2014the world\u2019s largest mutual fund, with holdings entirely in bonds. And for some time, he has been an outspoken critic of U.S. economic policy.<\/p>\n
Gross demurred when I suggested that James Carville might want to be him. \u201cI thought the remark was striking at the time,\u201d he said, \u201cbut no, I didn\u2019t feel that they were catering to us at every turn.\u201d<\/p>\n
But Democrats wrestling with the legacy of Ronald Reagan\u2019s deficits resented the influence of what the analyst Ed Yardeni had dubbed \u201cthe bond vigilantes\u201d: the investors who enforce fiscal and monetary discipline when governments won\u2019t. If your political system inflates its currency, or fails to align its spending with its tax revenues, the bond vigilantes will raise your interest rates until you either get it together \u2026 or catapult into a crisis.<\/p>\n
In the 1990s, we chose to get it together; thanks to tax hikes under both Bush I and Clinton, and a massive influx of capital-gains-tax revenue from the stock-market bubble, we even enjoyed a brief surplus. The bond vigilantes retreated over the horizon. But now deficits are back\u2014and bigger than ever. In 2010, the United States spent $1.3 trillion more than it took in.<\/p>\n
This year, the Congressional Budget Office expects us to borrow another $1.5 trillion. In just two years, we will have borrowed almost 20 percent of gross domestic product, or more than $9,000 for every person in the United States. But we won\u2019t be borrowing it from Bill Gross. For some time, he\u2019d been selling his Treasury holdings, and by early March, he had reportedly dumped all of them. Then in mid-April, Gross upped the ante by placing bets against U.S. bonds in the market, a move that pushed the Total Return Fund\u2019s holdings of U.S. debt to the equivalent of minus 3 percent. If the bond vigilantes really are getting the gang back together, then the size of Gross\u2019s funds\u2014and his recent divestment\u2014would seem to make him their leader. With economists and politicians warning about the dire consequences of out-of-control deficits, it seemed like a good time to sit down and ask Gross how dire the situation was. Is the United States really heading for an epic showdown with the debt markets? And if it comes, how badly will we be hurt?<\/p>\n
A trim, gentle-seeming 67-year-old, Bill Gross doesn\u2019t look much like a vigilante. He speaks so quietly that my voice recorder gave up and turned itself off. PIMCO\u2019s Newport Beach, California, office has the understated elegance of one of those five-star western resorts where executives go to de-stress. The tranquility extends even to the trading floor, where Gross still sits for most of the day. I spent the latter half of the 1990s installing networks on New York trading floors, and even the smallest of them operated at a low roar. But PIMCO\u2019s 100-seat floor is so eerily silent that I half-expected to see the traders communicating in sign language. Showdowns with PIMCO come, not with a bang, but with the almost imperceptible clicks of traders calmly keying in their sell orders.<\/p>\n
I started by asking Gross the questions on the mind of every economic pundit in Washington these days: Why did he sell? Does he think the U.S. will default on its debt?<\/p>\n
Gross shook his head (gently). \u201cActual default is unimaginable.\u201d He must be pretty confident in that judgment, because he confirmed rumors that he\u2019s made a sizable bet against a default. \u201cWe\u2019ve taken probably $1 billion worth of U.S. credit-default swaps on the long side at a yield of 0.5 percent per year, which is more than the 0.25 percent being offered by the feds.\u201d Effectively, Gross is selling insurance on U.S. bonds\u2014and getting a better return than he would by buying those bonds.<\/p>\n
Default is the most obvious risk that bond investors face, but not the only one\u2014they also need to worry about things like inflation. Gross has left Treasuries simply because he thinks the yield offered is no longer high enough to compensate him for things like inflation risk. \u201cGlobal savers have earned yields of 1 percent over inflation over the last half century,\u201d he told me. \u201cNow you\u2019re not earning the historical rate.\u201d<\/p>\n
Gross is known for getting out when the getting isn\u2019t good. You can perhaps credit his Canadian parentage for his remarkable discipline. Canada\u2019s banking system is one of the few entities that skirted the financial crisis\u2014as did the funds run by Bill Gross, who was worrying about a mortgage crisis as early as 2005, and positioned his funds accordingly. Yet even with solid Canadian genes, that discipline wasn\u2019t always easy to maintain. \u201cIn 2006 and 2007, we were sort of questioning our own judgment, because we were half a percentage point behind our peers \u2026 You question whether you\u2019re just really being a stubborn donkey, or your premises are right.\u201d<\/p>\n
Unfortunately, they were; they usually are\u2014the Total Return Fund has averaged 7 percent returns over the past 10 years, ranking it third among intermediate-term bond funds. Gross says the essential trick is being \u201ca contrarian, but not an extreme contrarian \u2026 a pessimist, but not an extreme pessimist.\u201d Being right too early, he points out, is almost as bad as being wrong\u2014as the folks who shorted the stock market in 1996 can attest. Yet the predictions he\u2019s making now sound pretty pessimistic: after a 30-year rally in the stock and bond markets, he thinks we now have to adjust to a \u201cnew normal\u201d of slower growth and lower returns.<\/p>\n
In some ways, this is just Gross\u2019s \u201cold normal.\u201d He started investing in the early 1970s, when inflation was soaring. Inflation is bad for bonds, because they have a fixed payout\u2014as money loses value, the real value of your interest payments declines, and worse, people want to buy the bonds from you only at a discount. \u201cThe first 10 years, it was \u2018Preserve capital, preserve capital, preserve capital,\u2019\u201d Gross told me, adding glumly, \u201cNow we\u2019re back to that.\u201d<\/p>\n
But in between, he profited greatly off a long rally, which has spanned most of his career. In 1980, the Fed finally got tough on inflation, which declined, along with interest rates, slowly but steadily for most of the next three decades. It was the 1970s in reverse. As Gross says, \u201cInvestors got used to being on this magical journey, with bonds not only producing a nice yield, but some capital gains too.\u201d In 1984, the yield on a 10-year Treasury note averaged 12.46 percent. By 2001, it was 5.02 percent.<\/p>\n
But now the rally has ended, as it had to (inflation couldn\u2019t fall forever). Indeed, yields are even lower than you\u2019d expect. As of mid-March, they were around 3.3 percent\u2014lower than they were in 1962, when inflation averaged just 1.3 percent. These low yields are partly due to a global \u201cflight to quality,\u201d which has pushed up the demand for safe assets. U.S. Treasuries are a prime destination for capital refugees, because our government\u2019s default risk is low, and our economy is very, very large. Especially with the Obama administration obligingly running record deficits, we\u2019ve had a lot of Treasury debt to go around. Thus, the financial crisis that started in our financial markets has ironically made borrowing much cheaper for our government.<\/p>\n
Gross argues that increased demand is not the only factor pushing down yields. To fight the crisis, the Federal Reserve has aggressively expanded the money supply, in large part by dumping new money into the Treasury market. \u201cWe\u2019ve been supporting Treasuries almost one for one,\u201d he tells me. \u201cAt 8 a.m., the Fed calls up and asks our Treasuries desk for offers to buy, and one hour later, the Fed\u2019s asking for bids to sell them.\u201d The Fed, complains Gross, is \u201cpicking the pockets\u201d of investors. Though he can\u2019t quite bring himself to blame the financial powers that be. \u201cGod bless Ben Bernanke and Tim Geithner for what they\u2019re trying to do, but the net result of a lot of what they\u2019re doing is to take money out of the hands of savers.\u201d<\/p>\n
This outcome was perhaps predictable. According to Carmen Reinhart and Ken Rogoff, the authors of This Time Is Different, a 500-page encyclopedia of the disasters that have beset overindebted governments and economies, the ratio of government debt to gross domestic product usually doubles after a crisis. Reinhart, now a senior fellow at the Peterson Institute for International Economics, just released, with Rogoff, a global forecast of government debt levels over the next 25 years. Even in their \u201coptimistic\u201d scenario, total U.S. government debt rises from 43 percent of GDP in 2005 to 86 percent in 2015.<\/p>\n
And after that? I asked Reinhart the same question I asked Bill Gross: Is the U.S. government going to default on its debt?<\/p>\n
Like Gross, she thinks such a scenario\u2014\u200bwhich she calls \u201cdebt with drama\u201d\u2014is unlikely. Instead, she predicts that the United States will engage in \u201cfinancial repression,\u201d a sort of stealth default. Financial repression relies on inflation, regulation, and fancy accounting instead of forced restructurings, or outright refusal to pay. In 1932, for example, New Zealand did a \u201cvoluntary\u201d debt swap that converted short-term debt to longer-term debt at lower interest rates. \u201cYou look at this deal and you ask yourself, \u2018Why would anyone do this? It\u2019s insane,\u2019\u201d says Reinhart. \u201cAnd then you see that they changed the tax rules, so that if you didn\u2019t do the swap, you\u2019d lose a ton of money.\u201d<\/p>\n
Here and now, she thinks much of the debt will be \u201cmonetized,\u201d or inflated away, by means of regulations that \u201cencourage\u201d the financial sector not to sell its government debt in the face of inflation. That means regulations such as the new set of international bank-capital standards known as Basel III, which heavily favor government debt, or Britain\u2019s recent move to increase the percentage of each bank\u2019s reserves that must be held in government bonds.<\/p>\n
This strategy will probably work for Japan, which owes something like 95 percent of its massive debt to domestic savers and financial firms. Unfortunately, about half of all publicly issued U.S. debt is owned by foreign entities, such as central banks that buy a lot of dollars in order to keep their own currency artificially cheap. Then there are the free agents such as Gross. Will they really stand by as we let inflation\u2014or a sinking dollar\u2014eat away most of the value of their investments?<\/p>\n
Given how much money we\u2019re borrowing, we need them to both hold on to the Treasuries they have and keep buying more. Even the optimistic projections of the Obama administration show us borrowing $735 billion by 2020. And foreign central banks, and investors like Bill Gross, are already expressing reluctance to keep financing our deficits.<\/p>\n
Some observers point to our current low interest rates and ask, \u201cWhy worry about deficits right now?\u201d Paul Krugman, for example, regularly derides the people who are worried about the \u201cinvisible bond vigilantes.\u201d But of course, as Gross says, what\u2019s keeping Treasury-note prices low is not so much the free market as the behavior of central banks, which are buying for reasons that have nothing to do with their assessment of our fiscal rectitude.<\/p>\n
Reinhart, who has done extensive research on the topic, was even more dismissive of Krugman\u2019s analysis. \u201cAre interest rates a good indicator of impending crises? The resounding answer is no.\u201d Deficit doves seem to assume that bond interest rates will act as a sort of early warning system: when they start to creep up, then we should start cutting our deficits. But Reinhart argues, \u201cBefore the crisis, Ireland\u2019s rates were imperceptibly higher than Germany\u2019s.\u201d By November 2010, the Irish were paying an extra 6 percent annual interest to borrow money. \u201cI certainly wouldn\u2019t call this my baseline scenario for the U.S.\u2014but the message is: think the unthinkable.\u201d<\/p>\n
This sort of \u201cjump shift\u201d would probably be less disastrous for us than it was for Ireland, but it would still be a terrible reckoning. Even if the Fed monetized part of the debt, the tax hikes and spending cuts would be sudden, drastic, and slapdash. And economies that punish people for saving and investing tend to have trouble building up the kind of productive infrastructure that can \u201cwin the future.\u201d<\/p>\n
Indeed, even the belief that the government will expropriate and\/or inflate away savings can be enough to stunt investment. Gross has already voted with his feet, and he expects at least a few others to follow. \u201cSale of Treasury bonds is the easiest way of staging a mini-revolution and saying \u2018Hell no, we won\u2019t go,\u2019\u201d he told me, still with an almost beatifically mild expression.<\/p>\n
So what does Gross need to see before he\u2019s willing to unsaddle his horse and return to the Treasury market? \u201cHigher yields!\u201d he said promptly\u2014but he\u2019s also watching the deficit. Like Reinhart, he worries that the government will try various ways to stealthily reduce the value of its debt\u2014and the larger the deficit, the more likely, and more drastic, such actions become. \u201cDebt-to-GDP is not egregious,\u201d he said, \u201cbut it\u2019s moving up the list.\u201d And worse, \u201cI\u2019ve seen no willingness to tackle the difficult problem of entitlements from any political party.\u201d<\/p>\n
This is exactly the problem, really. Our national conversation about deficits is about politics\u2014about ideology\u2014not math. It\u2019s a proxy war in our eternal battle over how much to tax and spend. Republicans care about deficits when spending is on the table, but as soon as they get a chance to pass some tax cuts, they forget they ever cared. Meanwhile, Democrats, who were outraged\u2014outraged!\u2014when the deficit averaged less than 3 percent of GDP under George W. Bush, are now silent about deficits that are running three times as high, and that are projected to stay above Bush\u2019s even after Obama has left office. Very few true deficit hawks are left in America\u2014only deficit vultures.<\/p>\n
Unfortunately, no matter which ideological path we head down, we still must ultimately persuade people like Bill Gross to come along for the journey. I asked Gross whether it matters to him how we close the deficit. He shrugged and said that obviously we need to raise taxes on the rich by quite a bit. But he doesn\u2019t really have any particular political prescription other than doing whatever it takes\u2014tax hikes or spending cuts or both\u2014to bring the budget back in line. \u201cIn the developed world,\u201d he said, \u201cthe credit bubble is at an end, and investors are calling \u2018Game over.\u2019\u201d<\/p>\n
Yet he\u2019s not bearish on America. \u201cWe own U.S. corporates, Fannie and Freddie mortgages\u2014we haven\u2019t left the country, we\u2019ve just left Treasuries.\u201d It would be one thing, he told me, if this were 1943 and we were in World War II; but we\u2019re not, and he has a fiduciary duty to his investors that he can\u2019t violate just because his country doesn\u2019t want to make hard choices about taxes and spending.<\/p>\n
And would he have bought the Victory Bonds that the government sold to fund the war effort? For the first time in the interview, Gross obviously tried to hedge. \u201cWell, I\u2019d like to think that the government wouldn\u2019t have picked the pockets of its savers.\u201d<\/p>\n
But it did then, just like it is doing now, I pointed out; the government inflated away the value of the bonds so that they yielded negative real returns. Gross smiled.<\/p>\n
\u201cMaybe if they framed it as a \u2018Victory in Afghanistan\u2019 thing, I might be more favorably disposed.\u201d So the people worried about the bond vigilantes have at least one ray of hope after all. The leader of the gang may be tough\u2014but at heart, he\u2019s still a bit of a patriot. That may not be enough to save us. But perhaps it will buy us some time to clean up our act.<\/p>\n
This article is available online at the Atlantic Monthly.<\/strong><\/a><\/p>\nFidelity wins. <\/strong><\/span>This year, for the second year in a row, SmartMoney’s top discount broker is Fidelity, the industry giant with $3.5 trillion in assets; it won on the strength of its huge and fast-growing selection of investment options and a speedy, reliable website. Personally I like its Active Trader Pro software, which, amongst other things, is the source for all the charts I publish on this site.<\/p>\n![\"\"](\"..\/wp-content\/uploads\/2010\/08\/HarryNewtonNewShot2.jpg\" "\\"HarryNewtonNewShot\\"")
<\/a>
\n<\/strong><\/div>\nHarry Newton who is pleased with the dividends he’s getting from the likes of NLY, ANH and AGNC.\u00a0 There is risk here. But that discussion of mortgage REIT risk is for another day. (I haven’t forgotten my promise.) Meantime, I notice that several of these stocks have been upgraded and\/or coverage initiated favorably by various analysts. Maybe we’re all crazy — the analysts and me. But all three stocks are showing handsome appreciation on Muriel’s Allocation spreadsheet. Thank you Muriel.<\/p>\n","protected":false},"excerpt":{"rendered":"
Every week Muriel and I figure out what we call “Harry’s Allocation Spreadsheet.” This big Excel spreadsheet tracks money — where it is, where it went and how it came in. The bottom line adds everything from real estate, dividends, stocks, private equity funds and muni bonds. It purports to tell what’s working and what’s […]<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[1],"tags":[],"class_list":["post-7278","post","type-post","status-publish","format-standard","hentry","category-uncategorized"],"_links":{"self":[{"href":"https:\/\/www.technologyinvestor.com\/index.php?rest_route=\/wp\/v2\/posts\/7278","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.technologyinvestor.com\/index.php?rest_route=\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.technologyinvestor.com\/index.php?rest_route=\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.technologyinvestor.com\/index.php?rest_route=\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.technologyinvestor.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcomments&post=7278"}],"version-history":[{"count":0,"href":"https:\/\/www.technologyinvestor.com\/index.php?rest_route=\/wp\/v2\/posts\/7278\/revisions"}],"wp:attachment":[{"href":"https:\/\/www.technologyinvestor.com\/index.php?rest_route=%2Fwp%2Fv2%2Fmedia&parent=7278"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.technologyinvestor.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcategories&post=7278"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.technologyinvestor.com\/index.php?rest_route=%2Fwp%2Fv2%2Ftags&post=7278"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}
![\"\"](\"https:\/\/www.technologyinvestor.com\/wp-content\/uploads\/2011\/05\/BillGross.jpg\" "\\"Bill")
<\/a><\/p>\n