Remember how much attention PIMCO’s Bill Gross got when he went short Treasuries earlier this year?
He made a big call about how the end of QE would lead to a demand vacuum for Treasuries, causing rates to soar.
But the bet went wrong. Treasuries went on a huge rally, causing Gross to be a major underperformer this year. What he didn’t take into account was that QE2 actually caused rates to rise (by being stimulative and promoting inflation) and that the absence of Fed bond buying meant that a deflationary, low-rates environment would return.
Now he’s made another stunning bet.
David Schawel at EconMusings explains his latest move, which came out yesterday. Basically, he’s gone ultra-long the long bond, and ultra-short the short end of the curve:
(The) news out of Newport Beach was nothing short of astounding: PIMCO raising effective duration of their $200+billion Total Return Fund up to 7.14. Zero Hedge erroneously reported duration of 8.97, which is their weighted average maturity. Categorically, the only major changes to PIMCO’s allocation was an increase in MBS from 32% to 38% and a further reduction of cash from -9% to -19%. How did they accomplish this?
- Longer MBS- They DIDN’T accomplish this by buying longer MBS. In this prepayment environment, even low coupon 30yr passthrough such as a 30yr 3.5% pool has a duration no more than ~7-8. This would only move the needle marginally.
- Copying Gundlach?- Could they have taken a page out of Doubleline’s book by buying last cash flow, locked out CMO’s? Possibly, but given the size of the fund, I find that it’s unlikely that they could add this type of CMO in any type of significant size.
- Bond Swap?- This is the most likely reason. I would venture to guess that PIMCO swapped out shorter term treasuries & IG credits for longer maturities. Adding 30yr-ish bullets such as these would have the most impact of adding duration. Treasuries & IG credits are among the most liquid bonds, hence they’d be able to trade in enough size to affect a portfolio this large.
What it means, by the way, that duration is now at 7.14 is that his portfolio will suffer 7.14% for every 1% increase in rates.
Now you might think that this is a natural and smart Operation Twist trade, since the Fed is buying the long end of the curve and selling the short end. More frontrunning the Fed (kind of).
But in a way, it looks like he might be making the same mistake (in reverse) this time as he did when he went short Treasuries at the end of QE2. If Operation Twist proves to be at all stimulative, it will cause higher long-term rates, not lower ones.
And though it’s obviously too early to declare a verdict on the trade, we’ll note that since the twist was announced, Treasuries have seen their biggest selloff in a long time.
Check out the decline in 10-year Treasury futures since the end of September. In fact, they’re definitely below where they were pre-twist.
This has all the scent of a hail mary bet.
If the economy collapses, then there’s a good chance yields will collapse and Gross will look like a hero. But the latest trend of somewhat improved data, and less fear of systemic collapse does not work in his favour on this one.
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