Bill Gross: Fed Doesn’t Get ‘New Neutral’

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June 19, 2014
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Pimco co-founder says central bank’s real policy rate target of 2 percent is dangerously high.

Policy rates have always provided a fundamental foundation for asset prices, and if the Federal Reserve is right in looking for real policy rates to stabilize around 2 percent, markets could be headed for trouble, said Bill Gross on Thursday. The co-founder of Pimco and manager of the largest bond fund in the world made his remarks at the Morningstar Investment Conference in Chicago.

Gross argued that, instead, a more reasonable projection would be for real policy rates to stabilize around zero, from the -1.25 percent levels they are today, in what he calls a “new neutral.”

“In a highly levered economy, a 2 percent real rate is far too high,” Gross told an audience of about 2,000 financial professionals. “If the new neutral is closer to zero, then asset prices are less bubbly. They can survive at these rate levels, but they can’t survive at 2 percent.”

This so-called new neutral is marked by exceedingly low real policy rates for the next three to five years, which will mean only modest return potential for most investors. During that period, the global economy should not show signs of serious recovery, but should by and large find stability amid sluggish growth.

“The real new neutral is not -1.25 percent, which is where we are right now,” he said. “That level has not allowed the U.S. economy to reach its goals of 5 percent GDP. A negative rate for a long period of time has not done much, but it has stimulated financial markets, and that’s why we think the Fed will move interest rates higher.”

Back in 2007, real policy rates were around 1 percent, and given the amount of leverage in the economy, that was enough to “break the financial markets,” he said. “That alone tells me that to return to a 2 percent real policy rate—which is what the Fed believes—would be to dice with another possible disaster.

“The new neutral is a critical idea for investors and central bankers, and I would say that the new neutral is the most significant element in asset pricing today or in the past,” Gross said. “If the new neutral is closer to zero, we have a market where you can take measured risk, and earn not a decent return, but a return that’s positive and relatively less volatile.”

The real challenge is that no one really knows where rates are going, and investors have to make choices for their portfolio now. Those choices should be centered on an awareness of quantitative easing and the end of it in the U.S. as a policy choice, as well as a focus on the long-term yield curve going forward. It wouldn’t hurt to have a preference for exposure to interest rate and credit spreads rather than duration at this point, Gross said.

Gross, who manages the world’s largest bond fund, the $230 billion Pimco Total Return fund, has seen first-hand what investor jitters over rate policy can mean for asset flows. In the past 12 months, the mutual fund has bled $50 billion in assets even as it outperformed its benchmark.

In the ETF space, the Pimco Total Return Bond ETF (BOND | B) has been consistently bleeding assets since the Federal Reserve first said in May 2013 that it would begin tapering quantitative easing. In the past 12 months, the fund has faced more than $1.3 billion in net redemptions, according to our data, despite what’s been a positive performance.

BOND_1_Yr_Perf

Chart courtesy of StockCharts.com

The ETF owns primarily investment-grade bonds and looks to keep its portfolio duration within two years of the Barclays Capital U.S. Aggregate Index. Right now, BOND has an effective duration of 4.5 years, and more than $3.4 billion in assets today.

 

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