Bill Gross’ July 2017 Investment Outlook: Recession Can Come Without a Flat Yield Curve


Bill Gross Investment Outlook: Curveball, July 2017

  • Monetary policy in the post-Lehman era: can’t seem to stop buying bonds, although as compulsive eaters and drinkers frequently promise, sobriety is just around the corner
  • Since the start of global QE, over $15 trillion of sovereign debt and equities now overstuff central bank balance sheets in a desperate effort to keep global economies afloat
  • At the same time, over $5 trillion of investment grade bonds trade at negative interest rates in what can only be called an unsuccessful effort to renormalize real and nominal GDP growth rates
  • Adherence of Yellen, Bernanke, Draghi, and Kuroda, among others, to standard historical models such as the Taylor Rule and the Phillips curve has distorted capitalism as we once knew it, with unknown consequences lurking in the shadows of future years
  • Private economists adhere to historical models which attempt to “prove” that recessions are the result of negative yield curves
    • Over the past 25 years, 3 US recessions in 1991, 2000, and 2007-2009 coincided nicely with a flat yield curve between 3-month Treasury Bills and 10-year Treasuries
  • Since the current spread of 80bps is far from the “triggering” spread of 0, economists and some Fed officials believe a recession can be nowhere in sight
  • But the reliance on historical models in an era of extraordinary monetary policy should suggest caution
    • Logically, in a domestic and global economy that is increasingly higher and higher levered, the cost of short term finance should have to rise to the level of a 10-year Treasury note to produce recession
  • Most destructive leverage – as witnessed with the pre-Lehman subprime mortgages – occurs at the short end of the yield curve as the cost of monthly interest payments increase significantly to debt holders
    • While governments and the US Treasury can afford the additional expense, levered corporations and individuals in many cases cannot
  • Commonsensically, a more highly levered economy is more growth sensitive to using short term interest rates and a flat yield curve, which historically has coincided with the onset of recession
  • While today’s yield curve would require only an 85bps increase in 3-month Treasuries to flatten the yield curve, an 85bps increase in today’s interest rate world would represent a near doubling of the cost of short term finance
    • Same increase prior to the 1991, 2000 and 2007-2009 recessions would have produced only a 10-20% rise in short rates
  • The relative “proportionality” in today’s near zero interest rate environment therefore, argues for much less of an increase in short rates and ergo – a much steeper and therefore “less flat” curve to signal the beginning of a possible economic reversal
    • How flat? I don’t know – but analysis shows me that the current curve has flattened by nearly 300 bps since the peak of Fed easing in 2011/2012
  • Today’s highly levered domestic and global economies which have “feasted” on the easy monetary policies of recent years can likely not stand anywhere close to the flat yield curves witnessed in prior decades
  • Central bankers and indeed investors should view additional tightening and “normalizing” of short term rates with caution

Bill Gross, considered the “king of bonds”, is the co-founder and former Co-CIO of PIMCO. He left PIMCO in 2014 and joined Janus Capital as Managing Director and CIO. Janus Henderson is an investment firm based in Denver, CO with disciplines across fixed income, equity, global macro, and alternatives.

Image Source: Federal Reserve Bank of St. Louis, Janus Henderson

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