Photo: Wikimedia Commons
This week saw something stunning: The world’s most famous bond manager, Bill Gross, was forced to send out an apology to investors over his dismal performance this year.It’s obvious why he had to do it. With equity markets incredibly volatile, people think of their bond investments as their anchor of stability, smoothing out volatility and cancelling out losses in any climate. The PIMCO Total Return Fund (PTTAX) has failed to do that, and is actually down over the last year. As such, his fundraising numbers have shriveled.
PTTAX 1-Year Performance
What made his year so bad? Well, as he puts it, he expected a “new normal” (2% growth, 2% inflation) but things have gotten much worse, causing a rush into long-term fixed income instruments which he was betting against.
But going back over his writings over the past year, you can see that his error actually went much deeper.
A key reason he’s shied away from U.S. debt (up until now) is his fear of massive U.S. deficits, and the belief that these deficits would turn investors away from our debt.
His August 2011 letter — which was basically written right at the peak of the chart above — lead off with three bullet points that got right to his thinking at the time
- Nothing in the Congressional compromise reached over the weekend makes a significant dent in our $1.5 trillion deficit.
- In addition to an existing nearly $10 trillion of outstanding Treasury debt, the U.S. has a near unfathomable $66 trillion of future liabilities at “net present cost.”
- Aside from outright default, there are numerous ways a government can reduce its future liabilities. They include balancing the budget, unexpected inflation, currency depreciation and financial repression.
Because he expected “unexpected inflation,” “currency depreciation,” and “financial repression” he was not going to be exposed to U.S. Treasuries. Instead, he wrote:
Based on historical example at Moody’s and Standard & Poors, it just might take 50 years for them to downgrade U.S. credit, but be that as it may, you and PIMCO as savers and savings intermediaries can take precautionary or even retaliatory measures to preserve purchasing power. favour countries with cleaner “dirty shirts” and higher real interest rates: Canada, Mexico, Brazil and Germany come to mind. Shade equity and fixed income investments away from dollar based indexes towards those of developing nations with stronger growth prospects. Purchase commodity based real assets before reserve surplus nations do.
This was an extremely costly conclusion to make. Fear of deficits, and the belief that higher deficits would be bad for fixed income, clearly cost PIMCO a lot of money.
Other economists saw the blunder in real time.
In June of this year, right before the Total Return Fund started going off the rails, Paul Krugman wrote a brutal post called The Decline Of PIMCO Macro:
For the past year or so, however, Pimco seems to me to have been making less and less sense. Gross bet big on the idea that rates would spike when quantitative easing ends; I guess he has three weeks to be vindicated, but it sure doesn’t look like it. And the economic logic was all wrong. Now Mohamed El-Erian is claiming that inflation in China and Brazil is Bernanke’s fault; again, the economic logic is all wrong.
What’s strange about this is that nobody was better at laying out the logic of deleveraging and its consequences than Pimco’s Paul McCulley. But maybe that’s the explanation: McCulley has moved on.
In fairness to Bill Gross, this fear of deficits extends all the way to the top, and by that we mean the decision makers in Washington DC.
While the economy clearly could use more government stimulus, the dominant talk in Washington is all about where to cut back and how to “get our fiscal house in order.” And because Washington is obsessed with this, we had to go through the wrenching debt ceiling fight, which seems to have clearly dealt a confidence blow at the worst possible time.
In fact, you can go back even further, to Obama’s first days in office, and the original stimulus, and see that fear of deficits and bond vigilantes was one factor in making the original stimulus too small.
So literally every American (not just those in the Total Return Fund) who depends on a robust recovery is hurt by this misplaced fear of deficits.
It’s because the misplaced fear of higher deficits is so costly that Richard Koo of Nomura recently wrote that we should not even be uttering anything about them, even when talking about the long term!
Arguing need for longer-term fiscal consolidation is irresponsible
The insistence that fiscal consolidation is necessary in the longer term is like the doctor who, faced with a patient who has just been admitted to the intensive care ward, repeatedly questions the patient about his ability to afford the treatment. This is both lacking in decency and irresponsible.
If the patient loses heart after learning the cost of the treatment, he may end up spending even longer in the hospital, leading to a larger final bill. Completely ignoring the policy duration effect of fiscal policy and constantly insisting on longer-term fiscal consolidation was what prolonged Japan’s recession.
And really, the costliness of deficit fears is all over the place. Kyle Bass has been betting against the Japanese Yen for a while now due to Japan’s deficit issues, only to watch the yen race to mult-decade highs.
Unfortunately, no matter how badly the theory (that higher deficits will cause interest rates to shoot up) fails to jibe with reality, the misconception persists. Just two weeks ago, a well-known newspaper’s op-ed page was railing on Bernanke for keeping the bond vigilantes at bay via quantitative easing, wailing that if only the Fed weren’t involved, the market would be forcing some real discpline on Congress via higher rates.
The fact of the matter is that this connection between deficits and rates is patently false.
This is true over the long term, as seen here comparing the US debt to the 10-year rates:
And it’s true over the short term. Here’s a look at deficits and 10-year rates just during the Bush administration.
Until this misconception goes away, we’re almost certainly going to see plenty more policy mistakes, as well as big investors losing their shirts by betting the wrong way.