Do you want to stay young? Bill to Ben

Do you want to stay young? Bill to Ben

 

After being a monk for less than a hour over the weekend, i.e., reading, praying and lunching in one of the biggest Buddhist temple here on West Coast, I returned to my pursuit in the mundane world outside of the temple, like other visitors.

 

Life is all about pursuit, even for monks, with many of them had similar pursuits like ours, before becoming monks and started a totally different pursuit.

 

Bill Gross of PIMCO, now in his 60’s,  is one of those heavy-weight bond guys in US and perhaps in world as well. He is a great thinker and writer as well, and I always enjoyed his writing.

 

Does Gross want to change his pursuit in bond world to that in Buddhism? Not likely.     

 

“The early 1940s generation may not have been the greatest one but it could have been the luckiest – although to be honest, I would trade it in for a crack at being a X’er or a Y’er if I could take my wife Sue with me. Youth is a most precious commodity.”

 

Gross is kind of Ben’s counterpart in financial market. Bond is the so-called the mind of market, if simply due to its size:

 

Daily trading volume of Treasuries by primary dealers. averaged $501B in 2004, while the combined daily trading volume of NYSE and Nasdaq together is about $70B. (data source in my previous post).

 

Of course, Gross is not going to ask Ben if the Chairman also wants to “trade it in for a crack at being a X’er or a Y’er”, “it” being anything else.

 

What Gross cares about as a big bond guy is not the subjective value of “being a X’er or a Y’er”  for Ben, but the value of his huge bet on the front-end of the yield curve.

 

Per Bloomberg.com

“Gross, who predicts the Fed will cut rates to 4.25 percent this year, has raised his holdings of cash-equivalent securities to the highest level in almost two years.”

Central in Gross’s prediction of the Fed rate cut (since 012006) is few things:

1. Fed has in past tightened long enough for US GDP growth slow to 2% or lower (real rate)

Back in 082006, Gross wrote:

“Why then should the Fed be stopping and the bond market have bottomed in early July? The overarching reason is that 425 basis points of short-term hikes and the concomitant tightening of the yield curve in the past several years has been more than enough to slow economic growth and contain inflation. That’s a bold statement to make in the face of an apparently still strong domestic economy, a booming global environment, and accelerating core CPI numbers, but PIMCO’s cyclical analysis would suggest that it is justified. No doubt, Asian and Euroland growth is acting as a strong magnet for U.S. exports but the tightening cycle in the U.S. seems to have run its course, primarily because of its effect on housing and related repercussions on consumer spending and economic activity.

 

072006 and later, Fed stopped but did not cut the rate as Gross had hoped. Consequently and reportedly, Gross got burned.

 

2. Gross to Ben: You got to let Joe to pay his mortgage and me to make my proft, and we can’t make it with 5.25% Fed rate

 

In making his point, Gross said he has been patient for those not in bond trading rooms (what’s the other room, dining hall or preying hall?)

 

Gross wrote:

“Imagine, if you will, purchasing (receiving) a 5-year interest rate swap at some time over the past few years. For those of you who don’t spend 12 hours a day in bond trading rooms, that means owning a 5-year fixed rate bond and financing it (paying) with 3-month Libor which increases in yield every time the Fed raises its benchmark. Instead of mark to market changes in the 5-year swap price, what I would like to promote here is the concept of an increasingly more expensive "cost" to owning this 5-year swap as its financing rate (3-month Libor) increases. A 5-year swap purchased when short rates were much lower and the yield curve more positive, produced positive carry and therefore generated "profits" for anyone holding this longer dated maturity when viewed from an income statement perspective. But if you narrow or eliminate that carry via higher short rates (and a flat yield curve) those "profits" disappear.

This 5-year swap concept is important because the U.S. economy operates in much the same way. With close to a 5-year average life, the entire U.S. bond market can be compared to a 5-year fixed swap. That means that companies, homeowners, and consumers that have borrowed money in recent years - (and purchased assets such as a home that are akin in my example to a 5-year swap) - are now being squeezed in a flat yield curve environment. Visualize a real life example in which you have "financed" a home with an adjustable rate mortgage (in my example you finance a 5-year swap with floating 3-month Libor). As the cost of the ARM increases with higher short rates, your excess income available to spend on discretionary items begins to shrink. If that ARM rate goes too high, you hunker down even more by not eating out, going to movies, or taking a vacation to exotic destinations. The economy in other words slows down.”

That’s for Joe and those who have mortgages.

 

As for WS, Gross wrote:

 

“It is my contention, in fact, that 21^st century capitalism depends upon a positive yield curve which provides the “vig” of short rate/intermediate rate arbitrage that banks, unregulated banks (hedge funds), and a host of financial institutions utilize to make structural profits”.

Bottom line: WS can’t buy low and sell high with 5.25% fed rate, and that, by the way,  would also make Joe and his employer’s life even harder

 

 

Showdown time, between Gross and Ben:

 

Fed may be just as tough as Gross and his alike.

 

Fed, I guess, has actually two things in its mind in trying not to ease, as long as economy permits: 

 

1.   further draining out of the excess liquidity produced partially by their last ease, the more the better;

 

2.   Inflation: CPI 2.7% is still obviously above Fed’s comfort zone; As about potential inflation threat:

 

“Overall capacity utilization in February increased to 82.0 percent from 81.4 percent in January. The consensus had forecast that capacity utilization would rise 81.3 percent from the initial estimate of 81.2 percent for January. For manufacturing, capacity utilization stood at 80.1 percent in February, compared to 79.9 percent in January”. “The capacity utilization rate reflects the limits to operating the nation's factories, mines and utilities. In the past, supply bottlenecks created inflationary pressures as the utilization rate hit 84 to 85 percent.” (barrons.com)

 

What’s Fed comfort zone on capacity utilization rate? I don’t know but guess it’s below 82%.

 

Rate of unemployment minus the rate of nominal annual wage growth: I don’t have data, but if it is greater than 50 base points,  it will be out of Fed’s “comfort gap”.   

 

So, unless US economy GDP falters under Fed’s target rate (what it is?), Fed is not going to ease.

 

 

Last summer, Fed stopped and but did not ease, and reportedly burned Gross and his alike, with goldilocks economy just doing fine until recently.

 

On Feb 28, 2007, Ben said that the US economy could strengthen by mid-year if housing and manufacturing stabilize.

 

That was then, and it is now.

 

 

March 19 (Bloomberg) -- Options traders are starting to say the Federal Reserve may cut interest rates three times this year as the housing slump threatens the economy's growth.

“Traders in options anticipate lower borrowing costs than economists or futures contracts, the most widely used barometer of Fed policy, amid increasing concerns about mortgage defaults. Futures show rates will fall to 4.75 percent by year-end and economists expect 5 percent, according to the median in a Bloomberg survey 73 forecasters from March 1 to March 7.”

 

Is subprime’s spread out of control a real thing or just another piece of  the emperor’s new cloth? It’s hard to tell now,  and Fed has to tell market what is Fed’s thought on this next week.

 

Will Gross and his alike keep shorting stocks and longing bonds until they get Fed to say, “ok, babies, I will give you guys a few drop of milk”?

marketreflections.com