Bill Gross: Flat Yield Curve Crushes Capitalism

‘Capitalism does not function well, and profit growth is stunted, if short-term and long-term yields near the zero bound are low and the yield curve inappropriately flat,’ Gross writes

Bill Gross says low long-term yields depress the economy. (Photo: Jim Tweedie) Bill Gross says low long-term yields depress the economy. (Photo: Jim Tweedie)

For most of 2015, famed bond investor Bill Gross has been railing against the Federal Reserve’s zero interest rate policy, urging the Fed to raise short-term interest rates because current low rates are stalling economic growth and short-changing savers.

But today, Gross proposed a new tack for the central bank: raise its inflation target, now at 2%, and sell long-term Treasuries and mortgage-backed debt from its trove of more than $2 trillion and use the proceeds to buy two- to five-year debt.

This latter strategy, which Gross calls “Operation Switch” – the reverse of the Fed’s former “Operation Twist” strategy — plus a higher inflation target would steepen the yield curve, undoing the flattening curve that has been depressing growth, writes Gross in his latest investment outlook from Janus Capital.

“Capitalism does not function well, and profit growth is stunted, if short-term and long-term yields near the zero bound are low and the yield curve inappropriately flat,” writes Gross, who manages the Janus Global Unconstrained Bond Fund.

Gross explains that a flattening yield curve, with rates near zero, and the expectation of continued low rates reduce bank profit margin, corporate profits and any incentive to invest long term.

“It would seem that lower borrowing costs in historical logic should cause companies and households to borrow and spend more,” writes Gross. “The post-Lehman experience, as well as the lost decades of Japan, however, show that they may not, if these longer term yields are close to the zero bound.”

Gross includes a chart showing that U.S. corporate profits, between 1993 and 2015, declined during periods of falling interest rates:

Click to enlarge. Source: Bloomberg via Janus Capital

He adds that a flattening curve with rates near zero also slows returns on investments for insurance companies and pension funds, which could further squeeze corporate profits as companies with defined benefit plans are forced to increase contributions.

“All central banks should now commonsensically question whether ultra-cheap money continually creates expansions as opposed to reducing profit margins and hindering recovery,” writes Gross. “They should produce a much steeper yield curve and a higher policy rate to allow banks, financially oriented businesses, as well as household savers themselves to increase margins and restore profit and disposable income growth.”

The Fed, meanwhile, appears poised to raise interest rates at its December meeting or early next year. Its statement released after the last policymaking meeting in late October explicitly noted that the Fed will be considering “whether it will be appropriate” to raise rates at its “next meeting.” The statement also excluded any mention of global developments, which it had referenced in its September statement after choosing not to raise rates at that meeting.

Fed policymakers meet again in mid-December. By then, they will have seen two more employment reports plus a slew of other indicators of the state of the U.S. economy. In the meantime, Fed Chair Janet Yellen may give more direction about Fed policy when she testifies Wednesday before the House Financial Services Committee on Fed regulation of the financial system. It will be her first public appearance since the Fed’s last policymaking meeting in late October, and she’s almost certain to be asked about the Fed’s plans to raise rates.

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