Gross sees bond market turkey shoot

October 27, 2010, 6:15 PM UTC

Those buying Treasury bonds at record low yields are turkeys being led to slaughter, Pimco’s Bill Gross writes.

Gross, manager of the world’s biggest bond fund, writes in his monthly investment outlook newsletter released Wednesday that the 30-year-long bull market in bond prices will end next Wednesday. That’s when the Federal Reserve is expected to announce it will start another round of asset purchases known as quantitative easing.

Insert joke about candied yams

The market has been anticipating QE2, as this second attempt at loosening financial conditions is known, for some time now. Bond yields have plunged to lows last seen half a century ago, as the economy has visibly weakened and traders have rushed into bonds ahead of the voracious Fed appetite for debt.

At the same time, investors are worried that the Fed will eventually succeed all too well in restoring economic growth. Some rushed this week to lock in a negative nominal return on some inflation-adjusted bonds in hopes of hedging against a successful Fed campaign to boost inflation.

But however QE2 goes, bond prices can’t keep soaring forever, Gross warns. That’s because ultimately the United States must come to grips with its fiscal profligacy – a process that won’t be pretty for those holding fixed-income securities.

“Bondholders, while immediate beneficiaries, will likely eventually be delivered on a platter to more fortunate celebrants,” Gross writes in an extended Thanksgiving allegory that fortunately stops just short of mentioning cranberry sauce.

He sees the diners at this inflationary feast as “financial asset classes more adaptable to inflation such as stocks or commodities, or perhaps the average American on Main Street who might benefit from a hoped-for rise in job growth or simply a boost in nominal wages, however deceptive the illusion.”

Of course, this isn’t the first time Gross has warned that the end of the long bull market in bond prices, and the corresponding decline in Treasury yields, was about to hit the wall. He did so in 2003, just as Alan Greenspan’s Fed was completing a campaign of rate cuts that would take the fed funds rate down to a then unthinkable 1%.

Gross was right, naturally, that yields would rise as the economy recovered, leading to losses for those who bought in at the peak. But it’s worth noting as well that the 10-year Treasury yield at the time of that prediction then was 3.71% — a full point and change above the rate that prevails now.

In any case, Gross makes no claims about predicting the precise timing of the anticipated bond market sell-off — though he does say Pimco is accordingly planning to invest its fixed-income funds in other asset classes, so as to sit out the Treasury market bloodbath.

Interest rates may be rock bottom, but there are other ways – what we call “safe spread” ways –to beat the axe without taking a lot of risk: developing/emerging market debt with higher yields and non-dollar denominations is one way; high quality global corporate bonds are another. Even U.S. Agency mortgages yielding 200 basis points more than those 1% Treasuries, qualify as “safe spreads.” While our “safe spread” terminology offers no guarantees, it is designed to let you sleep at night with less interest rate volatility.