Bill Gross, founder and co-chief investment officer at bond-investing giant Pacific Investment Management LLC and one of the most influential voices on financial markets in the world, gave The Globe and Mail an exclusive interview in the wake of the U.S. Federal Reserve Board's Aug. 10 monetary policy statement - a key decision at a time when many market leaders, including Mr. Gross, have become deeply concerned with the growing threat of deflation in the U.S. economy. The following is a transcription of his conversation with David Parkinson, investment reporter and columnist.
A lot of people are talking about deflation - that was the big context of what people were looking for from the Fed this week. How worried should we be about deflation, or disinflation?
Well, we should certainly worry about disinflation, and that's what prompted the addition [Fed]policy. Deflation is that critical negative from which serious repercussions emanate - real interest rates start to increase, companies start to suffer, and the potential for consumer demand to simply wait it out accelerates. We're not at deflation yet - although to be fair, the two-year U.S. CPI number is about right on the zero line, so that might be mincing words. But we're certainly at risk of enduring a zero-to-1-per-cent number for the next 12 months at least. The Fed's not comfortable with that; they would prefer 2 per cent. It promotes a positive reflationary momentum as opposed to deflation.
Should we be worried about it? Yes. I think markets are worried about it, and I think the Fed's worried about it, and that's what we saw [with the Fed decision]
And it's not just in the U.S. Canada's in better shape, but other countries, while they're experiencing relatively higher inflation, those rates are coming down. Even in cases like Brazil and China and developing markets, there's the beginning of a trend toward lower inflation. The entire world is probably more susceptible to disinflation than reflation at the moment.
What are the implications - what does this mean for both bond and stock markets?
For high-quality bond markets, where it's assumed that the principal can be rolled over and paid - as in U.S. Treasuries - the implications are obviously positive. A high-quality bond investor wants low inflation, and ultimately they're comfortable with deflation, as long as the country doesn't devalue their currency substantially. So, high-quality markets like Treasuries, over the past few months when deflation has crept into the deadlines, they do well.
But risk markets - we're talking about stocks and high-yield bonds - they begin to suffer under the possibility that profits and sales will deflate as opposed to inflate. That's the problem with stocks, for instance, they depend on an increasing top line or higher revenues in order to justify their leverage and their infrastructure. The moment the top line, sales, of the company begin to deflate, that points to negative consequences for the bottom-line profits. So the risk assets don't do well in a deflationary environment. We've seen a lot of that in the past six-to-12-to-18 months - the global economy is delevering, which is a corollary to deflation. As a matter of fact, some would argue that that's what causes deflation, the delevering of balance sheets of sovereigns and households.
That's why the Fed is so desperately trying to turn this ship around - because the basis of the economy is predicated not on Treasury bonds, but on the selling and rolling of risk assets, that being equity and corporate bonds. There's a risk here to financial markets.
The Fed did step in and make some tentative moves to try to address the issue, with the decision to re-invest principal payments on agency debt and mortgage-basked securities. How is that going to be felt by the bond market?
If they mean what they say, it's a $200-billion [U.S.]to $250-billion annual reinvestment. At the same time, it basically keeps the Fed's balance sheet at the same number - it basically keeps it from going down, from disinflating. It certainly doesn't add anything from this point forward, but it did prevent subtraction. That's good, I guess.
What it basically does is it prolongs the period at which investors feel comfortable that the Fed will stay at 25 basis points [in the benchmark Federal funds rate] I mean, if they were going to raise the Fed funds rate, they would stop this quantitative easing before they did that. So this effort basically says, 'Hey, we may be here for longer than you think' - which, to PIMCO's mind, means two or three years at least. Does that flatten the curve? Well, yeah. It basically means two-year Treasuries and three-year Treasuries aren't going anywhere, and that 50 basis points [the current yield on the two-year bond]is better than 25 overnight, which is what the Fed funds rate is. So people buy twos and threes and fours, and that ultimately impacts fives and 10s as well.