Saturday, June 2, 2012

Bill Gross Warns the 1%, Part 2

“Thar she blows,” screamed Captain Ahab, and similarly intentioned debt holders may soon follow suit, presenting the possibility of a new global monetary system, or if not, one which is stagnant, dysfunctional and ill-equipped to facilitate the process of productive investment. While all monetary systems are a balance between debtors and creditors, absent voluntary defaults it is usually creditors that establish the rules. Such was the case in the late 1960s as France’s de Gaulle threatened to empty Ft. Knox unless a new standard was imposed. Now, with dollar reserves widely dispersed in Chinese, Japanese, Brazilian and other surplus nations, it is likely that there will come a point where 2% negative real interest rates fail to compensate for the advantages heretofore gained in buying sovereign bonds. China, for instance, may shift incremental Treasury holdings to higher returning commodity/real assets which might usher in a gradual (or even sudden) reconfiguration of our current dollar-based credit system. Having a reduced incentive to purchase Treasuries and curtail Yuan appreciation, the Chinese and their act-alikes may look elsewhere for returns. In addition, previously feared but now tamed private market bond vigilantes like PIMCO have similar choices, if clients broaden their guidelines. Together, there is the potential for both public and private market creditors to effect a change in how credit is funded and dispersed – our global monetary system. What that will look like is conjectural, but it is likely to be more hard money as opposed to fiat-based, or if still fiat-centric, less oriented to a dollar-based reserve currency. In either case, the transition is likely to be disruptive and an ill omen for investors. This transition continues to point towards higher global inflation as a solution to overextended debt-ladened balance sheets. Investors in general will be hard pressed to repeat the performance of the past 30 years, an era based on excessive credit expansion. Deleveraging economies and financial markets present a different and lower-returning kettle of fish. That is because historical leverage was almost always applied by borrowing at a short-term rate and lending longer and riskier at a higher yield. That “spread” practically guaranteed levered returns over and above the policy lending rate during the past 30 years. No matter whether it was at 10%, 5% or eventually approaching 0% the lending spread at a higher yield was threatened only on a temporary basis during cyclical economic contractions brought about by temporary periods of tight money on the part of the Federal Reserve. As long as the economy bounced back, credit extension and its profitability were never threatened. All of that changed, however, as de-leveraging produced narrower yield margins, asset price exhaustion, and a reluctance on the part of lenders to lend (and in many cases, borrowers to borrow). Combined with now negative real interest rates of 200–300 basis points on the front end of the lending curve, the ability to successfully lever financial market returns has been jeopardized. Bond, equity and all financial assets which are structurally bound together by this dynamic must lower return expectations. The world’s financial markets currently seem obsessed with daily monetary and fiscal policy evolutions in Euroland. Euroland is just a localized tumor however. The developing credit cancer may be metastasized, and the global monetary system fatally flawed by increasingly risky and unacceptably low yields produced by the debt crisis and policy responses to it. Investors should sail carefully and the Wall Street 1% should put on their life vests if they expect to weather the inevitable storm that may threaten the first-class cabins they have come to enjoy." - William H. Gross