Gross warns QE2’s end could sink markets

March 2, 2011, 8:56 PM UTC

 Bill Gross says stocks and bonds could be in for a world of hurt this summer.

Gross, who runs the world’s biggest bond fund at investment manager Pimco, said in his March investment outlook that when the Federal Reserve’s quantitative easing program ends in June, bond yields are likely to go “higher, maybe even much higher.”

Time to run for cover?

That will spell pain for bondholders because rising yields reflect falling prices. But it could also spell bad news for stocks, which have risen sharply since the Fed said in August it would buy more bonds to support U.S. asset prices and keep inflation from falling too low.

Indeed, Gross worries that the economic recovery so many commentators are so eager to sign on to appears unlikely to continue without a steady drip of Fed liquidity. That could mean a wild summer as investors adjust to a sobering new reality.

“Bond yields and stock prices are resting on an artificial foundation of QE II credit that may or may not lead to a successful private market handoff and stability in currency and financial markets,” he writes.

Gross, who has been urging investors to steer clear of government bonds for most of the past year, reasons that yields will have to rise to keep attracting buyers who up till now have been willing to accept bond returns that are well below their historical average.

Government bonds have rallied in the past week or two along with oil prices and fears that rising costs will short-circuit the global economic recovery, putting the yield on the 10-year Treasury note at around 3.4% (see chart, right).

Gross says that is about a point and a half below what he takes to be its normal level, judging by history. He says the 10-year Treasury normally carries an interest rate that’s about the same as the current forecast for U.S. economic growth.

With forecasters predicting that the economy will expand about 5% in nominal terms, unadjusted for inflation, Gross says, it is clear that the price on government bonds has considerable room to fall.

He doesn’t expect it to do so immediately, because for now the Fed is in the market daily buying up Treasury bonds. It has bought 70% of Treasury bonds issued since November, Gross estimates, with foreigners soaking up the rest.

But if QE2 ends on schedule at the end of June, that bid will disappear – and the government will presumably have to offer somewhat higher interest rates to appeal to purchasers who are increasingly concerned about the prospect of inflation down the road.

Of course, Gross has a dog in this fight. He has been paring back on Treasurys himself, in anticipation of a big selloff.

And as plausible as his forecast sounds, some commentators question his reasoning. They note that the private sector is running an enormous surplus — the counterpart to the oft-discussed public sector deficit — that will have to go somewhere. Government bonds, it stands to reason, will naturally get their share.

Indeed, Gross even concedes that even if the Fed backs away from Treasury bonds,

Someone will buy them, and we at Pimco may even be among them. The question really is at what yield and what are the price repercussions if the adjustments are significant.

Still, there’s no doubting that a sharp rise in interest rates, should it come to pass, would make the oil price runup of the past month look like a walk in the park.

“By eliminating QE II, the Fed would be ripping a Band-Aid off a partially healed scab,” Gross writes. “Ouch!”

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