Will the world’s central bankers choose to go on a healthy monetary diet, or will they be forced to do so? And will the world economy and its global citizens face seriously negative consequences when the bankers’ feasting come to an end?
“Monetary policy in the post-Lehman era has resembled the gluttony of long-departed umpire John McSherry – they can’t seem to stop buying bonds, although as compulsive eaters and drinkers frequently promise, sobriety is just around the corner,” said Gross.
Quantitative easing has meant that more than $15 trillion of sovereign debt and equities now “overstuff” central bank balance sheets, he explains, “in a desperate effort to keep global economies afloat.”
Meanwhile, $5-plus trillion of investment grade bonds are trading at negative interest rates “in what can only be called an unsuccessful effort to renormalize” both real and nominal GDP growth rates.
“The adherence of [Janet] Yellen, [Ben] Bernanke, [Mario] Draghi, and [Haruhiko] 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,” Gross argued.
Some economists, he points out, try to “prove” recessions result from negative yield curves. They point to the recessions of 1991, 2000, and 2007-2009 as coinciding with flat yield curves between three-month Treasury Bills and 10-year Treasuries.
Today, though, the spread of 80 basis points “is far from the ‘triggering’ spread of 0,” leading some Federal Reserve officials and others to view a future recession as “nowhere in sight,” Gross explains.
While this view may pan out as they foresee it, relying on historical models in a time “of extraordinary monetary policy should suggest caution,” Gross points out.
“Logically, (a concept seemingly foreign to central bank staffs) in a domestic and global economy that is increasingly higher and higher levered, the cost of short term finance should not have to rise to the level of a 10-year Treasury note to produce [a] recession,” the fixed-income fund manager explained.
The most destructive leverage, like that tied to “pre-Lehman subprime mortgages,” takes place at the short end of the yield curve, he says. That’s when the cost of monthly interest payments increases “significantly” to those holding debt.
Yes, governments and the U.S. Treasury can “afford” such an extra expense. But many levered companies and individuals cannot – as was the case in the past three recessions, he adds.
Highly levered corporations and individuals with debts tied to floating rates will be unable to cover this increased expense, Gross says, and that could mean “reduced investment, consumption and ultimate default.”
In other words, the more levered an economy is, the more sensitive its growth is to central bankers’ use of short-term interest rates and a flat yield curve, and that “historically has coincided with the onset of a recession,” he points out.
Thus, Gross argues, there should be some “proportionality” to yield curve tightening.
Today’s yield curve would require just an 85-basis-point increase in 3-month Treasuries to “flatten” the yield curve shown, he says.
But an 85-basis-point hike could represent “a near doubling of the cost of short term finance.”
The relative “proportionality” of today’s near-zero interest rate environment (when compared with rates in the pre-recession period) makes the case “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,” according to Gross.
He says the current curve has flattened by almost 300 basis points 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,” the fund manager stated. “Central bankers and indeed investors should view additional tightening and ‘normalizing’ of short-term rates with caution.”