Bill Gross has issued a new message to investors in a letter entitled Bon Appetit! He is worried about yield spread compression and refers to the past forty years as a “Gray Swan” event. I disagree. The demise of the carry trade is greatly exaggerated.
I am going to go out on a limb here and offer a mild critique of Mr. Gross’ letter. Admittedly, I am on the thin limb – actually, its more like a leaf… I have never completed a “carry trade” myself, nor am I articulate in the fine points of duration. The one thing I do know is what a yield curve looks like, and I don’t think the shape of that curve will change for many years to come: Up and to the right… The demise of the carry trade is greatly exaggerated.
Bill Gross is a very wise man and a fixed income investor par excellence, but he has also been wrong from time to time.
A couple of general observations about the latest Bill Gross missive:
First, Mr. Gross doesn’t provide any Earth-shattering revelations here (pun intended). With the exception of life insurance and pension fund managers, I don’t think there is anyone left who doesn’t believe that a large measure of returns in the investment world have been the result of steadily declining interest rates post-Volcker.
Second, I don’t believe anyone disagrees that the low hanging fruit of a wide yield spread has been squeezed out due to the proliferation of liquidity. Therefore the probability of risk mis-pricing has risen significantly. Mr. Gross’ point about the danger of illiquid assets is very relevant. I am in the commercial real estate industry and the compression of yields has been breathtaking.
Third, I am very surprised to hear Bill Gross talk of the past 40 years as a one-off “Gray Swan” event. He usually has a fantastic sense of historical context which he seems to disregard in his letter. World capitalism has faced severe disruptions, panics, and most of all – deflation. The last decades of the 1800’s were marked by massive over-investment in railroads and steel (enabled by foreign capital) which caused multiple panics and a severe depression. The Great Depression itself was a period of deflation where the entire banking system ceased to operate because there was no ability to borrow short and lend long. The depositors simply refused to “lend” to the banks at all. The current period, in many ways, is not unprecedented.
Mr. Gross contradicts himself. He says that volatility is very likely in a market with compressed yield spreads, and yet he glosses over the disruptions of the past. He says you will rarely find a 12 month period where bonds had a negative performance. To make this statement assumes that the ebbs and flows of credit markets have been homogeneous. In fact, there have been pockets of massive volatility in credit markets: The 1974 IMF intervention in the UK bond market, the capitulation of New York City’s municipal bonds, the massive defaults of the central american debt crisis of the early 1980’s, Long-Term Capital Management, the Asian and Mexican currency crises, etc were all relatively recent events. Each one of them required highly coordinated international central bank intervention. Each one of them alone could have rendered the 40-year “Gray Swan” analogy useless. Indeed, if the past 40 years is a “Gray Swan”, it is one of artificial nature – entirely managed by central banking intervention. 2016 may be an extreme moment in time, but again, it is not unprecedented.
Here are some specific disagreements I have with Mr. Gross’ position:
1. The playing field of the post-Lehman era is littered with bond managers (including Bill Gross on occasion) who have bet against a reversal in yields, only to find themselves on the wrong side of the trade. Rates have continued to decline.
2. Gross has contradicted himself by recently recommending securities like Annaly Capital (NLY) and the Nuveen Preferred Income Opportunities Fund (JPC), both of which rely on short term leverage to juice long term yields. Are these not carry trades?
3. Three reasons for declining rates show little signs of reversal. Inflation has continued to decline. Indeed, we may well be on the cusp of a Japan-style 20-year+ deflation cycle. Next, the entire banking system relies on the ability to borrow short and lend long at higher rates. The Federal Reserve will do everything in its power to maintain this friendly arrangement for as long as it takes. Finally, the carry-trade referred to by Mr. Gross limits its perspective to the domestic environment. It ignores the other main trend of the past few decades – the demand for US Treasuries as a safe haven and/or the repatriation of export-based dollars. The argument also ignores the desire to borrow money in a currency that is depreciating to obtain stronger dollar yields.
4. To the extent that inflation has the very strong possibility of turning into deflation, holding Treasuries sounds like a decent investment to me. Real yields improve in a deflationary environment. Meanwhile, pricing power at US corporations evaporates. What would you rather own? A piece of paper that can produce a 3% real yield (2% nominal yield) or stock in a commodity-based company that has falsely improved earnings per share through debt-binges for stock repurchases?
You may have to go to Mars to repeat the last 40 years, but the carry trade is going to continue for several more years right here on Earth.