Why Was Bill Gross so Certain Interest Rates Were on the Rise Back in February 2011?: Tuesday Focus for September 30, 2014
Joshua Brown: “Do we need to fire Pimco?”: “In February of 2011, [Bill] Gross loudly proclaimed…
…[that] Pimco Total Return had taken its allocation to US Treasury bonds down to zero. As recently as the previous December, Pimco Total Return had been carrying as much as 22 percent of its AUM in Treasurys…. Gross compounded the move by being extremely vocal about his rationale–he went so far as to call Treasury bonds a ‘robbery’ of investors given their ultra-low interest rates and the potential for inflation. He talked about the need for investors to ‘exorcise’ US bonds from their portfolios, as though the asset class itself was demonic. He called investors in Treasury bonds ‘frogs being cooked alive in a pot’. The rhetoric was every bit as bold as the fund’s positioning. It’s really hard to pound the table like this and then be flexible in the aftermath…”
Yes, Bill Gross’s judgment in February 2011 that U.S. Treasuries were overbought has been an absolute disaster for PIMCO’s Total Return Fund vis-a-vis the market portfolio:
Holdings of ten-year U.S. Treasuries gained 20 cents on the dollar between Gross’s bet and the summer of 2012, as interest rates collapsed in the summer of 2011 and took another lurch downward in the spring of 2012. (They recouped 14 of those cents between the summer of 2012 and the end of the summer of 2013 “Taper Tantrum”, but today stand ten cents above their February 2011 value.
That being said, from Bill Gross’s perspective the belief that bonds as of February 2011 were overbought must have been irresistible, and not for reasons that were clearly wrong at the time. Since the start of 2008, 10-year Treasuries had been trading in a 2.5%-4% range appropriate for a safe asset in a low-inflation economy on the edge of or in the midst of a significant depression:
But at some point relatively soon, it seemed to Gross back in 2011, the economy had to recover to something like normal–in which case 10-year Treasuries ought to return to their 4%-5% trading range of the post-dot.com era:
if not to their 5%-7% trading range of the fast-growth 1990s:
And, Bill Gross thought, there was already light at the end of the tunnel: the economy was recovering, and the only things keeping expectations of recovery over the next five years from pushing up 10-year Treasury rates now was that the Federal Reserve was artificially restricting the supply of 10-year Treasuries via quantitative easing. And so when QE II ended, Gross was confident, Treasury rates would jump sharply–and Treasury bondholders would lose bigtime.
So what went wrong? Why did Gross’s expectations as of the winter of 2011 turn out to be so wrong? The standard answer is that long-term rates will not normalize until investors expect the normalization of short rates within half a decade, that short rates will not normalize until the Federal Reserve is confident that the zero lower bound crisis is over and will not return, and that that confidence is further away now 3.5 years later than it was back in February 2011. The IS curve needs to shift out and to the right in order to create an environment in which the Federal Reserve is comfortable normalizing short-term rates, and why should that happen?
But is that really an adequate answer? Didn’t, in the Hicksian language of the past paragraph, Bill Gross have good reasons to expect the IS curve to shift out and to the right? He must have. The puzzle is: what were they?
http://delong.typepad.com/2014-09-29-bill-grosss-directional-bet.numbers