Pimco Bond Guru Bill Gross

Top 9. Mar 17, 2004 9:25 AM

» Kirk - Re: Re: Pimco Allowed Market Timers !!!!

In response to message posted by lcha:

I agree. Lucky for me, I "did the math" back in 1991 and started tracking just how much I was losing to funds and taxes in mutual funds.

Without the encouragement from anyone except a broker at Merril Grinch who said I'd someday have his job if I kept it up (he is now the branch manager in Cupertino, a VERY rich town) I decided that I want most, if not all, of my equity funds in taxable account in individual stocks. That 1% average fee over 50 or 70 years I felt I might live seemed too high a price to pay.

I do have money in bond funds in IRAs... and I've recommended Gross's best Pimpco fund to several I help on an individual basis who have access to the Class A shares with no load (they wave the loads for large S&P500 companies since he high expense ratio more than covers their added costs). I've also been recommending one of his bond funds in my newsletter... that might change any day now!

Like you, I felt Bill Gross had too much easy money with these deals at large S&P500 companies to allow any of this nonsense. I guess I was wrong if the reports are true. I am so happy that the three other fund families I recommend these days (and use myself) are still clean from this mess. Fidelity was pretty clear up front that they have front end load fees to pay and they have funds DESIGNED for market timers to use so they can keep their other funds low ezpense and fair to the small investor.

-- posted by Kirk

http://www.pimco.com/LeftNav/Late+Breaki...

Top 10. Mar 17, 2004 9:54 AM

» Kirk - Gross: Letter to Clients and Friends of PIMCO 2/19/04

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Bill Gross's side of the story:

Letter to Clients and Friends of PIMCO

February 19, 2004
TO CLIENTS AND FRIENDS OF PIMCO:

The time has come for clients and PIMCO supporters to hear something from the top in addition to depositions and newspaper articles, and so Bill Thompson and I are putting our signatures to this personally written letter in an attempt to briefly explain our side of the story. If you will permit me, I would like to start from the very top as we always do in our investment process, and work my way down to at least some of the facts at the bottom.

Societies have a balancing mechanism when things go too far. That's why we've learned in the past year or two about Enron and WorldCom and why indictments and some convictions have been handed out. It's why Martha Stewart is on trial even though I have no idea if she's guilty. Societies deplore excess and especially so if they disadvantage the public. I applaud that process and was applauding along with the rest of you when some of the rascals were rounded up and brought to trial. I believe the SEC, Eliot Spitzer, and yes the attorneys general from New Jersey, California, and Massachusetts are performing a legitimate and valuable service, as are the press and the media in general. They are just doing their jobs and in most cases doing it well.

Sometimes a cleansing process can go too far. This does not imply strong medicine is good for everyone but PIMCO. You see, Bill Thompson and I --as well as many of you-- know PIMCO through a different set of eyes. We know from our company's inception in the early 1970's that we have always tried to place the client first and the company second. Perhaps there was ultimate self-interest there -- knowing that strategy would lead to a successful franchise, but nonetheless that has always been our priority. I know that at the end of every trading day, my focus is not how many new accounts we brought in or even how much my personal portfolio went up, but how many basis points the portfolios managed to outperform the competition. Check our track record---it works! That same attitude defines the culture of our firm and while we don't always get it right, it is the strongest ethic we embody--THE CLIENT COMES FIRST.

Recent events call that into question. "200 market timing trades"? "Sticky assets"? Is PIMCO -- the bond manager--really down there at the bottom of the barrel? We shout an emphatic "NO!" To the best of our knowledge, PIMCO has never had any arrangements pertaining to "sticky funds", late trading/stale pricing arbitrage, or improper dissemination of fund holdings. Yes, unfortunately, Stern/Canary became an investor in our funds both with and without our knowledge. The investments we knew about, clearly acknowledged as "timer" money, were made under an arrangement that did not violate the shareholder protection of our prospectuses, and which had monitoring provisions to prevent excessive trading. It apparently worked. To our knowledge, this Canary trading was infrequent, did not come close to violating the prospectuses and harmed no shareholders in the fund. In perfect hindsight, we wish we had never attracted the name Canary/Stern among our many thousands of loyal fund shareholders. But we can't change that and if any investor in our funds was disadvantaged by this arrangement, then we want to give assurance we will make it up--in full.

You know, I am regularly asked for my opinion on the economy and the bond market and even sometimes the stock market---- and I don't even mind if the stock market proves me wrong for a period of time!!! But on this one let us both tell you from the top of PIMCO: allegations are different from facts and our representatives will work vigorously with regulators to make all of the facts understood. In today's environment we also cannot rule out future legal developments. We are not perfect and we are not above the law, but throughout my 30+ years at PIMCO, and for the past 10 for which Bill Thompson has been CEO, we have endeavored to build a franchise that we, our fellow professionals and associates, our family and friends, and you our clients can be proud to be a part of. That attitude will continue to dominate our future behavior. Should you have questions of either one of us please feel free to write or phone and we will get back to you as soon as possible.

Chief Investment Officer Chief Executive Officer

Click here to e-mail us with any questions or comments

Write or contact us at:
Pacific Investment Management Company
840 Newport Center Drive, Suite 300
Newport Beach, CA 92660
USA

TEL (949) 720-4500

-- posted by Kirk

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http://biz.yahoo.com/djus/040304/1315000...

Top 11. Mar 17, 2004 9:58 AM

» Kirk - 3/4/04: Morningstar Recommends Holders Sell Pimco Stock Funds

Dow Jones Business News
Morningstar Recommends Holders Sell Pimco Stock Funds
Thursday March 4, 1:15 pm ET
By John Shipman

NEW YORK -- Morningstar Inc. said Thursday that investors should consider selling stock funds run by Pimco Equity Advisors.

The investment research firm offered the recommendation following civil- fraud charges brought against Pimco by regulators last month, a suggestion Morningstar has made for every mutual-fund company accused of allowing improper market-timing trades.

While Morningstar's stance tells shareholders to consider ditching stock funds that carry the Pimco name, the researcher said it hasn't changed its opinion on Pimco's better-regarded bond funds.

Last month, New Jersey Attorney General Peter Harvey charged Pimco with civil fraud under allegations that the firm allowed certain investors to rapidly trade in and out of its funds, contrary to stated policies regarding such trading.

The New Jersey complaint named PEA Capital LLC, Pimco Advisors Distributors LLC, Pacific Investment Management Co. LLC and Pimco-parent Allianz Dresdner Asset Management as defendants. PEA Capital runs the firm's stock funds, while Pacific Investment Management Co., or Pimco, runs the firm's bond funds.

Morningstar analyst Eric Jacobson said the Chicago investment researcher based its recommendations on the specific allegations and exhibits provided in the New Jersey complaint.

In his report, Mr. Jacobson said Morningstar made no change to its opinion on funds run by Pimco's California-based fixed-income operation because the case presented by New Jersey "appears less compelling" than the case against PEA Capital, formerly known as Pimco Equity Advisors.

Mr. Jacobson said the accusations against Pimco's bond business center around an agreement made between a hedge fund and Pimco marketing executives that would have allowed the hedge fund, Canary Capital Partners, to make no more than one round-trip trade a month in Pimco's funds.

While the New Jersey attorney general says that overlooks the fund prospectus limit of six round-trip trades a year, "We don't believe these charges are nearly as conclusive as those made against PEA," Mr. Jacobson said.

While Morningstar's Mr. Jacobson isn't sold on New Jersey's allegations regarding Pimco's bond group, he said he finds the charges and evidence against PEA Capital to be "extremely troublesome."

Based on his review of the complaint's exhibits, the analyst said, "It seems quite clear that the firm had a sticky-asset deal that amounted to the sale of timing capacity in exchange for Canary's willingness to park money in other funds."

The Morningstar recommendation also takes into account its view on the quality of the firm prior to the allegations of improper trading.

"On that score, Pimco fares quite well," he wrote, noting that the firm has "a relatively long history of excellent management and a shareholder friendly management style."

Mr. Jacobson also said that evidence strongly indicates that executives at Pimco Advisors Distributors, or PAD, which is essentially responsible for fund sales, "were well aware of the timing arrangements at PEA Capital."

Since PAD acts as distributor of Pimco's bond funds as well as its stock funds, Mr. Jacobson suggested the bond group separate itself from the distribution unit, and either hire a different distributor, or lobby parent Allianz Dresdner Asset Management to clean house at PAD.

The report said if Morningstar doesn't see such actions "in a very short timeframe, we will reconsider our stance on the Pimco funds overall."

Pimco officials weren't immediately available for comment.

-By John Shipman, Dow Jones Newswires; 201-938-5171;

-- posted by Kirk

Top 12. Apr 1, 2004 5:29 PM

» Kirk - April 2004 Investment Outlook

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Good graphs here
http://www.pimco.com/LeftNav/Late+Breaki...

Summary:

The 1% money market rate, as a matter of fact, along with a 1% or so risk premium for holding longer dated bonds is a pretty good approximation for what an investor in U.S. bonds should earn over the next 4-5 years. Staring 2% returns in the face, what is a bond investor to do?

and

In addition, it’s instructive to summarize just how overvalued U.S. Treasuries are to put the proper upside or downside of this outsourcing strategy into perspective. How much do you the client stand to gain by selling Treasuries and buying Bunds or Gilts? The first two exhibits hint at anywhere from a 100 basis point to a 150 basis point overvaluation of Treasuries relative to historical parameters which if rectified is equivalent to a relative loss of 7-10% in price terms.

Good reading.

-- posted by Kirk

Top 13. May 7, 2004 7:33 AM

» lcha - SEC sues another fund firm

May 6, 2004, 11:57PM

SEC sues another fund firm
By MARCY GORDON
Associated Press

WASHINGTON — Federal regulators accused Pimco Advisors Fund Management and two individuals of civil fraud Thursday for allegedly secretly giving a hedge fund special trading privileges in stock mutual funds involving more than $4 billion.

The Securities and Exchange Commission said Pimco and two related companies defrauded its mutual fund investors by allowing hedge fund Canary Capital Partners to "market time" Pimco fund shares from February 2002 to April 2003.

Market timing is a type of frequent trading that is not illegal but is restricted by most mutual funds because it skims profits from other shareholders.

Pimco is the latest to be swept up in an industrywide scandal that began last fall when New York Attorney General Eliot Spitzer accused Canary of securing special trading privileges at several big-name mutual fund companies, including Bank of America, Banc One, Janus and Strong.

Since then, Canary, Janus, Bank of America and other fund companies and executives have agreed to pay hundreds of millions of dollars to settle their cases.

In the new case, the SEC alleged that the chief executive officer of Pimco Advisors, who also was the chairman of a Pimco funds company, approved market-timing deals to enrich the management company at the expense of ordinary investors.

In the suit filed Thursday in federal court in Manhattan, the SEC is seeking civil fines and restitution from Pimco Advisors Fund Management; PEA Capital; Pimco Advisors Distributors; and Stephen Treadway, CEO of Pimco Advisors Fund Management and Pimco Advisors Distributors; and Kenneth Corba, former CEO of PEA Capital. Pimco Advisors Fund Management recently changed its name to PA Fund Management.

"We are disappointed the SEC chose to take this action now, and we look forward to completing settlement discussions with the SEC, which have been under way, so we can achieve a prompt and equitable resolution to this matter," PEA Capital said in a statement issued late Thursday.

Corba's attorney, Jim Rehnquist, said his client "adamantly denies" the allegations and "looks forward to his day in court and is confident he will prevail."

-- posted by lcha

http://money.cnn.com/2004/09/29/markets/...

Top 14. Sep 30, 2004 8:51 AM

» Kirk - Gross says "Cash Some 10 Yrs in now"

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Bill Gross said sell bonds last night on TV

PIMCO's Gross: Inflation is higher

Bonds tumble after fund manager says inflation may be 1 percent higher than official figures.
September 29, 2004: 10:15 AM EDT

NEW YORK (CNN/Money) - A top U.S. bond fund manager said late Tuesday that he believes the rate of inflation is running well ahead of government estimates and Treasury holders may want to take some profits from the recent bond rally.

U.S. Treasury prices tumbled Wednesday, with the benchmark 10-year note dropping 20/32 and pushing the yield up to 4.07 percent, after Bill Gross released a written statement on the PIMCO Web site.

Gross wrote that the core consumer price index, which excludes food and energy prices, doesn't accurately reflect the actual needs of consumers because everyone needs to buy gasoline and food.

He said that inflation figures are also skewed when the government adjusts the prices for goods based on increases in the quality of those products.

"The government says that if the quality of a product got better over the last 12 months that it really didn't go up in price and in fact it may have actually gone down," he wrote, adding that 46 percent of the weight of the CPI comes from products subject to this type of adjustment.

Gross estimates that inflation may be 1 percent higher than official figures.

Treasury investors watch inflation rates closely because it erodes the value of fixed-income holdings.

Gross finished by saying "if those [people] are holders of government bonds based upon a benign outlook for inflation, they had better cash some of them in, especially at today's 4.0 percent yield for 10-year Treasurys."

Find this article at:
http://money.cnn.com/2004/09/29/markets/...

-- posted by Kirk

Top 15. Sep 30, 2004 11:22 AM

» collguy - Re: Gross says "Cash Some 10 Yrs in now"

In response to message posted by Kirk:

He's being really charitable with the 1% figure. I'd say it's more like 2-4% understated. Oil at $50, gold at $420, dollar pummelled-read between the lines. CPI figures are just more lies along with GDP, productivity numbers etc.

-- posted by collguy

http://www.pimco.com/LeftNav/Late+Breaki...

Top 16. Nov 30, 2005 11:30 AM

» Kirk - December 2005 Investment Outlook

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Nice summary of what he missed when he predicted higher rates and why he thinks rates will stay low for many years. Also note how he is preparing Pimco for the peak of the fed tightening cycle.

Investment Outlook
Bill Gross | December 2005

Secrets

“The secret to success is to know something nobody else knows.” – Aristotle Onassis

Golf is an eternal conflict between elation and despair. My favorite response to Sue’s perfunctory “How’d you shoot?” upon returning home after a decent Saturday afternoon’s round is a rousing “I think I found the secret!” Inevitably the next weekend’s retort is a hopeless “I think I lost it.” Secrets come and go in golf faster than an episode of Desperate Housewives. You can find one and lose it again between the 13th and 14th holes. And even if you’ve rediscovered the magic, it doesn’t help to have a bunch of secrets stored in your head just as you’re about to start your backswing. The brain can’t handle “straight left arm, head down, swing to one o’clock, full follow-through” all at the same time. “Just hit it” seems to work the best but then that’s not much of a secret. And if hitting the ball is an enigma, just try putting it. National TV appearances, keynote speeches before a thousand people – nothing compares to the pressure of making a five-foot putt for par. I push’em, I pull’em, I leave’em short. They say every shot in golf makes someone in your foursome happy. If so, I’m a philanthropic hacker the likes of which has rarely been seen. I put smiles on everyone’s face but mine and money in their pockets on the 19th hole to boot. Secret? The secret to golf is like the secret to quitting smoking: don’t start.

The biggest secret during the past few years in the bond market has been why intermediate and long-term interest rates have remained so low in the face of a 300 basis point uplift from the Federal Reserve. Departing Chairman Greenspan has called it a “conundrum” while incoming Chairman Bernanke sought to provide answers via his “global savings glut” speech in early 2005. PIMCO, to be fair, teed off on the conundrum long before Bernanke pulled the cover off his driver, elaborating as far back as our 2003 Secular Forum on the lack of global aggregate demand and the dampening effect it would have on global growth. We did not, however, draw the logical extension from declining G-7 investment spending/reserve recycling to a flattening yield curve and stationary long-term rates. Too bad. What is clear to us now, however, as well as to a growing list of other investment managers, economists, and even Federal Reserve Board researchers is that interest rates have been lowered for a number of logical reasons that are likely to persist for some time:

1) Economic globalization has led to the prioritization of export supply over domestic demand as Asian and OPEC countries have adopted a mercantilistic model emphasizing reserve accumulation and the recycling of those reserves into global bond markets.

2) U.S. and Euroland corporations are accelerating the global savings glut by conserving cash flow instead of investing it. With China offering huge returns on investment relative to G-7 economies, it’s hard to blame them.

3) Asset/liability trends stressing long-end maturities as well as reduced risk premiums due to central bank transparency may have added a marginal although difficult to measure compression to the longer end of global curves.

This challenge to answer Greenspan’s conundrum has been a productive one if only from the standpoint of the amount of research and brainpower applied to the question. It’s as if a Nobel Prize were at stake with some papers emphasizing corporate savings, others stressing ALM trends/risk premiums, and perhaps a majority siding with Bernanke and his global savings glut thesis. None of them seem willing to acknowledge the totality of factors as if to suggest that the secret – the philosopher’s stone of the bond market – is theirs alone. I suspect not, but an astute investor has only to recognize that all of the above cited factors have a probable longevity that exceeds a normal business cycle, and will therefore keep yields low for some years to come. Globalization, demographics and central bank transparency are difficult trends to reverse and will likely be compressing yields in 2010 much like they have in 2005. That is why discretionary bond investors like PIMCO are comfortable in investing clients’ money at a 4½% 10-year Treasury rate instead of waiting for 6% which may have been a more “normal” yield during the investment frenzy of the dot-com years or the less than “transparent” central bank policy years of the 1980s.

Future Fed Chairman Bernanke has treaded mildly with this semi-permanent thesis for lower U.S. and indeed global bond yields by analyzing a rather esoteric and initially somewhat confusing indicator shown below in Chart 1.

The graph displays a history of the one-year real Treasury rate nine years forward into the future. Such yields can always be interpolated from existing yield curves although the extent to which they represent expectations as opposed to say a reduced risk premium, is difficult to measure. Nonetheless, in March of this year Bernanke went so far as to point out that the market expectation of the future one-year nominal short-term rate has declined during the past few years by as much as 1¼ percentage points, and that was before the additional decline of 50 basis points seen over the past six months. The global savings glut was his primary explanation, hinting that the change had longevity.

PIMCO analysis has gone even further, at least in terms of the conundrum’s magnitude. We would suggest the U.S. and indeed many global bond markets have experienced a reduction in forward nominal and real short-term interest rates of as much as 200 basis points due to the aggregate global trends discussed in preceding paragraphs, and that these yields are likely to represent the norm for years to come. If true, that means in terms of current monetary policy that the Fed is much tighter than standard analysis would presume. Today’s short rate of 4% is really equivalent to 6% in my view, a rate that was only 50 basis points shy of the cyclical tightening peak of 6½% in 2000. I find it a little perplexing to listen to economists expounding on the still stimulative level of today’s short-term and indeed long-term yields in the U.S. As seen below in Chart 2, the current recovery has been only average relative to the past 20 years or so in terms of GDP growth (and below average in terms of employment) despite massive Fed and fiscal stimulation over the past few years beginning in 2001. Now after 300 basis points and 17 months of tightening – which by the way is typical of prior bear cycles as well – it should only be logical to expect a slower economy in 2006, an end to Fed tightening, and the beginning of an easing cycle late in the year. While yields may not fall much on the longer end of the curve unless ALM trends accelerate, one- to five-year rates could decline by as much as 100 basis points over the next 12 months. This scenario is at risk of course should exporters such as China decide to invest their surplus funds within their own borders instead of in global bond markets – a possibility that at the moment appears years away.

<img src=http://www.pimco.com/NR/rdonlyres/060AD8...>

How best to prepare for this expected transition to lower yields? Well, despite skeptics who are suspicious of ulterior motives, we at PIMCO keep very few secrets. I like to think of us as the Ohio State Buckeyes of yesteryear, boasting a well advertised “three yards and a cloud of dust” and daring the opposition to stop us. So, printed below is a duplicate copy of a firm-wide memo just several weeks old.

<img src=http://www.pimco.com/NR/rdonlyres/060AD8...>

Whether or not such a portfolio will be successful in 2006 depends not so much on what Aristotle Onassis would claim as knowing something “nobody else knows” but on knowing something that the investment markets, economists, and a future Fed Chairman alike are slowly but surely coming to believe and by weighting strategy significantly in that direction. Short-term interest rates are high, not low, and by this time next year central banks the world around will be initiating easing cycles that favor front-ends of yields curves, longer than average duration portfolios and a high quality emphasis within the context of a slowing U.S. and global economy with contained inflation. Hopefully this forecast will in no way resemble my erratic golf game, because once you find even a well publicized secret in the bond market you’d better not lose it – or lose with it. Birdies are our objective and bogies are unacceptable as we try to stay atop the leaderboard. Hopefully the five-foot putts will be few and far between. Fore! I think we’ve found the secret.

William H. Gross
Managing Director

William H. Gross

Managing Director

-- posted by Kirk

Top 17. Jan 6, 2006 12:29 PM

» Kirk - January 2006 Investment Outlook

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The sum total of last month’s Investment Outlook’s "secret" and this month’s Investment Outlook’s "gift that should keep on giving" is that yields have peaked in the bond market and will soon peak in Fed Funds producing an economic slowdown in 2006. If the Fed goes beyond 4½% and inverts the yield curve, the possibility of recession will increase.

Investment Outlook
Bill Gross | January 2006
A Gift That Should Keep on Giving

From http://www.pimco.com/LeftNav/Late+Breaki...

Santa was good to me this year - too good to tell you the truth. While that’s not possible for a 6-year-old tot, it’s more understandable for a 61-year-old man who is in the process of simplifying as opposed to complicating his life. Why it was only 5 years ago on these Outlook pages where I swore that any friend who invited me to another dreaded Christmas party was no friend of mine. A year or so later I tried to send a message to my family via the Outlook that all I wanted for Christmas was to keep my two front teeth and maybe a comb or two. Combs, that’s what I needed, not shirts, sport coats, or books that I would never read. Who cares if they cost only 50¢ - I needed to comb my hair more than dressing up for next year’s Christmas gala that I would never attend. Ah, but no - they never listen. Package after package, ribbon upon ribbon - Santa, Frosty, and reindeer wrapping paper in endless gobs all over the living room floor. And when it was all over, what was the one present I raved about? An ordinary pair of reading glasses. "My God, I can read the newspaper," I screamed. And so it was that I had a merry Christmas after all, despite the plethoric overload of wrapping paper and redundant gifts. Next year I have decided to implement a one-gift maximum, hoping for more combs, reading glasses, and maybe a pair of socks. Sue keeps pointing out that the ones I wear to work have holes in the heels.

During the Christmas/New Years interlude there was considerable press and discussion about the coming of the flat/inverted U.S. yield curve and what it meant for the economy and financial markets. Five of the past 6 recessions have been preceded by flat yield curves or was it 5 of the past 6 flat yield curves have led to recessions? No matter, there’s a connection there that’s reflective of substantial Fed tightening that tends to inhibit future growth via an increased cost of borrowing - more on the short-term portion of the yield curve, but generally everywhere along it. During this cycle, however, with the "conundrum" and all, soothsayers point out that 5- and 10-year yields haven’t gone up very much and therefore the flat curve is not as restrictive as in prior cycles. In last month’s Outlook I divulged my/PIMCO’s "secret" which hoped to contradict that theory. I argued that today’s 4¼% Fed Funds rate, and in turn, today’s % longer dated yields almost everywhere on the curve were much more restrictive than they appeared. PIMCO’s "lack of global aggregate demand" and Bernanke’s "global savings glut" were the primary explanations, suggesting that it took these lower yields to generate even anemic domestic investment spending as well as to keep the housing asset bubble afloat which in turn was pumping consumption. Since higher yields worked with a 12-18 month lag in terms of their economic impact, it seemed clear to me that 2006 would be a year of slower growth, perhaps 2%, and that the Fed and indeed the yield curve was about to reach a plateau around 4½%.

This historical 12-18 month lag between a tightening cycle/flat yield curve is what fools many analysts into thinking that yields are still stimulative and that the Fed has more wood to chop. It takes that long for higher yields to affect the housing market, mortgage equitization, and corporate investment cycles, whereas many economists feel it should work more like an anesthetic in the operating room where the patient counts backwards from 10 to 1 and is out before he reaches 5. It doesn’t work that fast. The Fed knows this, but often is willing to risk an overshoot and a curve inversion in order to insure benign inflation and sufficient economic slack over the foreseeable future. Short rates can always be lowered quickly (and they are - within an average 6 months after the last hike) if the economy seems to be slowing too rapidly.

Not only the time lag but the level of interest rates is the critical question for bondholders, and while last month’s Outlook argued that they were now sufficiently restrictive, it acknowledged that there was considerable disagreement with that view because of the "conundrum." Let me introduce, therefore, another market "timing" tool, my holiday gift to you, that will hopefully add weight to my arguments that the current bear market in bonds is over.

Imagine, if you will, purchasing (receiving) a 5-year interest rate swap at some time over the past few years. For those of you who don’t spend 12 hours a day in bond trading rooms, that means owning a 5-year fixed rate bond and financing it (paying) with 3-month Libor which increases in yield every time the Fed raises its benchmark. Instead of mark to market changes in the 5-year swap price, what I would like to promote here is the concept of an increasingly more expensive "cost" to owning this 5-year swap as its financing rate (3-month Libor) increases. A 5-year swap purchased when short rates were much lower and the yield curve more positive, produced positive carry and therefore generated "profits" for anyone holding this longer dated maturity when viewed from an income statement perspective. But if you narrow or eliminate that carry via higher short rates (and a flat yield curve) those "profits" disappear.

This 5-year swap concept is important because the U.S. economy operates in much the same way. With close to a 5-year average life, the entire U.S. bond market can be compared to a 5-year fixed swap. That means that companies, homeowners, and consumers that have borrowed money in recent years - (and purchased assets such as a home that are akin in my example to a 5-year swap) - are now being squeezed in a flat yield curve environment. Visualize a real life example in which you have "financed" a home with an adjustable rate mortgage (in my example you finance a 5-year swap with floating 3-month Libor). As the cost of the ARM increases with higher short rates, your excess income available to spend on discretionary items begins to shrink. If that ARM rate goes too high, you hunker down even more by not eating out, going to movies, or taking a vacation to exotic destinations. The economy in other words slows down.

How does this translate into a bond market timing tool? Chart I shows but one of a series of graphs PIMCO uses to indicate when enough is enough - the point at which adjustable short rates rise sufficiently to make the owner of a home or a 5-year swap, or more importantly the economy, cry "no más!" That point comes in this example when Fed Funds rise to meet the average cost of intermediate Treasury financing issued over the past 5 years and the spread between the two disappears.

For sophisticates, please note that this is not the same thing as a flat yield curve. A flat yield curve is a concept comparing current short rates to current 5- and 10-year rates. What my chart does is to compare current short rates to the Treasury’s average intermediate term "coupon," a more reliable and indicative indicator of economic pain or restrictiveness since it uses an average embedded cost of debt concept instead of a current cost. The standard flatness as measured by current market rates in early 1995 (not shown here) never led to a recession, only a slowdown, just as Chart I would have indicated. In other words, this indicator called for a mild slowdown in 1995 which is what we got. The standard flat curve theory called for something more extreme which is something we never got. The embedded cost of debt indicator, therefore, shown in Chart I, has been more reliable.

For those of you whose heads are turning, simply accept the fact that by the time the line in Chart I bottoms or hits 0, bond market yields have already peaked - in other words the bear market is over. Bear market ending dates of 1/00, 12/94, 3/89, and 5/84 can all be compared to 0-line or near 0-line bottom points indicating sufficiently onerous Fed Funds levels to slow the economy and end a bond bear market. Data points from the early 1980s backwards tell a similar story but are much more extreme since it was necessary for the Volcker Fed to go to super tightness in order to knock out accelerating inflation.

The sum total of last month’s Investment Outlook’s "secret" and this month’s Investment Outlook’s "gift that should keep on giving" is that yields have peaked in the bond market and will soon peak in Fed Funds producing an economic slowdown in 2006. If the Fed goes beyond 4½% and inverts the yield curve, the possibility of recession will increase. Observant readers will have already noted that the current data point in Chart I is not only calling for an end to the bear bond market, but a recession at some point 12-18 months hence. Perhaps. Much will depend on the future condition of the U.S. housing market and of course global economies - primarily of the Asian variety. We shall see. But for now, hopefully you can take solace from a new timing indicator that says the worst is over for bonds and an indicator that should keep on giving in terms of its reliability for years and years to come. Enjoy and Happy New Year…for bonds!

William H. Gross
Managing Director

-- posted by Kirk