Bill Gross is not happy with the decision by the Federal Reserve’s FOMC members “to hold off on their goal of normalizing interest rates” while the European Central Bank threatens to extend its quantitative easing policy with “more checks and more negative interest rates.”
Raising rates as Federal Reserve Board Chairman Paul Volcker did in the 1970s, he contends, led the financial markets to enjoy “positive real yields and a kick in the pants boost to other asset prices.” However, when “model-driven” central banks focus on employment numbers and “their ultimate impact on inflation,” their zero or 0.25% “financially suppressed yields” act as an “economic ‘sinker’ that ultimately lowers economic growth as well.”
“Zero bound interest rates destroy the savings function of capitalism, which is a necessary and in fact synchronous component of investment,” Gross writes in his early release October Investment Outlook for Janus Capital. He admits that while corporations have benefited by borrowing at the prevailing low rates and could have invested the proceeds “in the real economy,” they haven’t done so. Instead, those corporations have “plowed trillions into the financial economy as they buy back their own stock with a seemingly safe tax advantaged arbitrage.”
Gross, who almost exactly a year ago left PIMCO to become manager of the Janus Global Unconstrained Bond Fund, thus echoed the frustration felt by many economists and market watchers, such as Jeremy Grantham. In a June speech at the Morningstar Investment Conference, Grantham railed against the current corporate culture in which low interest rates have made it “desperately appealing” for corporate managers to borrow funds and buy back stock “at an annualized rate of $600 billion.” Buoying corporate profits through buybacks rather than capital expenditures and other business-building steps, like adding employees, is particularly appealing to managers since their compensation comes increasingly from bonuses and stock options, Grantham argued.
In his September Investment Outlook, Gross directed similar ire at the Fed, writing that the imbalance between savings/investment and consumption, “is not the only Frankenstein creation” of zero percent yields.
In his latest commentary, Gross extends the deleterious effects of zero interest rates, which he says destroy “existing business models such as life insurance company balance sheets and pension funds.” Those entities have assumed they could pay for their liabilities — “benefits for an aging boomer society” — with long-term 7% to 8% returns from a balanced portfolio of stocks and bonds. But with corporate bonds yielding only 2% to 3%, it’s become “obvious” to insurers and pension funds that “to pay for future health, retirement and insurance related benefits, stocks must appreciate by 10% a year to meet the targeted assumption,” Gross writes. “That, of course, is a stretch of some accountant’s or actuary’s imagination,” he says wryly.
However, it’s not just insurers and pension funds that are the “losers” from zero, Gross says. “Mainstream America with their 401(k)s are in a similar pickle. Expecting 8-10% to pay for education, health care, retirement or simply taking an accustomed vacation, they won’t be doing much of it as long as short-term yields are at zero. They are not so much in a pickle barrel as they are on a revolving spit, being slowly cooked alive while central bankers focus on their Taylor models and fight nonexistent inflation.” Gross directs plenty of scorn at those model-driven central bankers, wondering if they have even noticed that “Detroit, Puerto Rico, and soon Chicago, Illinois” cannot meet their promised liabilities. “Do they simply chalk it up to bad management and inept governance,” he asks, “and then return to their Phillips Curves for policy guidance?”
He continues: “Do they not know that if zero were to become the long-term norm, that any economic participant that couldn’t print its own money (like they can), will soon ‘run on empty,’” as described by former New York Fed chairman and Blackstone co-founder Pete Peterson in his 2004 book by that name which addressed the high level of unfunded liabilities in the U.S. and throughout the developed world.
Gross writes that the developed world already “is beginning to run on empty because investments discounted at near zero over the intermediate future cannot provide cash flow or necessary capital gains to pay for past promises in an aging society.”
His prescription to the Fed and the other central banks? “Get off zero and get off quick. Will 2% Fed Funds harm corporate America that has already termed out its debt? A little. Will stock and bond prices go down? Most certainly.”
But citing Volcker’s actions in 1979 as precedent, he argues that “the time has come for a new thesis that restores the savings function to developed economies that permit liability based business models to survive – if only on a shoestring – and that ultimately leads to rejuvenated private investment, which is the essence of a healthy economy.”
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