Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Print Print Cite Cite
Style: MLA APA Chicago Close


Some thoughts on the Bill Gross blog

by Brad Setser
October 27, 2005

Fitzgerald now has an office above the TREASURY Starbucks?!? 

UPDATE: Guess not.  Fitzgerald is still across the street from the Treasury Starbucks.

And Bill Gross is hip.  He is a BLOGGER.

He does not confine his blog to the bond market either; his transformation from moderate Republican to Deaniac is sort of interesting.   The money (political) quote:

"The war, Katrina, gas prices, and Republicans' continuing focus on tax cuts as the elixir to cure everything are getting ordinary citizens downright depressed."

His bigger point though is that a more leveraged US economy is now more exposed to interest rate rises (seems right to me).  The 230 bp rise in the five year Treasury note over the past few years will slow the economy significantly in 2006 (he forecasts 2% growth), leading the Fed to cut rates. 

No doubt that implies additional pressure on the dollar – pressure that will test Asian central banks' willingness to step up their reserve purchases (and in China's case step up from already high levels) to keep their currencies from rising against the dollar (see my previous post).

One should assume that Gross, like other portfolio managers, talks his book.  Still it is interesting that he is squarely in the low interest rate school of adjustment – which I think means he thinks Asian central banks will step up their intervention should the dollar come under new pressure/ not demand compensation for the risk of further dollar depreciation, allowing US rates to remain low even though the US remains dependent on inflows from abroad.   In some sense, that is the core debate.  Pretty much everyone thinks the dollar has to fall at some point (when is more of a question), but the implications of a falling dollar for the fixed income market are very much up in the air … 

But if Gross is right, and:

"Because the U.S. economy has evolved into a highly levered finance-based economy, it stands to our reason that this modern day version is more sensitive to changes in interest rates than those of years past."  (emphasis in original)

We in the US had better hope that our external creditors prove very generous indeed, as any spike in interest rates would prove far more damaging than in the past.


  • Posted by Guest

    jim grant concurs 😀

    “In the Greenspan era, the United States became an immense net debtor. A prudent American central banker, it might seem, would therefore be at pains to spare these overseas accumulators of greenbacks any unnecessary anxiety about inflation damaging the shelf life of their money. Not Mr. Bernanke…

    “Mr. Bernanke, as sure of himself as he is of the future, won’t soon be changing the way the Fed operates. Rather, it will be the world’s dollar holders who will change the way they operate.

    “If America’s creditors sense that inflation is robbing them of their wealth and that the Bernanke Fed is too slow to raise its interest rate, they will sell their dollars and dollar-denominated securities. Such an exodus would, among other things, tend to increase the costs of imported goods and drive up dollar-denominated interest rates. In other words, events would control the Fed.”

    as does maurice greenberg!

  • Posted by bsetser

    well, i am not quite in Mr. Grant’s camp, i don’t think Bernanke is quite the dove some think. His suggested inflation target of 1-2% is a bit too low for my taste … 2-3 seems fine. or something centered around 2, not with 2 as an upper limit.

    incidentally, foreign creditors should worry more about dollar depreciation than us inflation — obviously, they are linked, but it is also possible for the dollar to depreciate by more than us prices rise. us investors have to worry about inflation.

  • Posted by Guest

    hmmmm, it seems pinalto is around there too…

    “My view is that the rate of inflation should average about 1½ percent, as measured by the Personal Consumption Expenditure price index, over periods of about three to five years.

    “Inflation is certain to vary in the short run, even when we achieve the objective over time. So putting a range around that long-run objective makes sense to me. My personal tolerance zone is a 1 percentage point spread above and below my 1½ percent inflation objective.”

    i wonder if she meant the core-PCE price index or the trimmed-mean? or just straight up? and how she’d deal with revisions (or bernanke for that matter 🙂


  • Posted by PC

    Bill Gross was bearish on Treasurys in 2004 based on fundamentals. Even as recently as in his March 2005 Investment Outlook (since when did he become a blogger?) he wrote:

    “What they call bull flatteners (long rates going down) are as rare as Ahi tuna that never hits the grill. How then to explain it, and is there an irrationality to this market that speaks to overvaluation or perhaps even a bubble?” PC Translation – Gross was saying, “Mr. Market, you are wrong and I am right!” In the same outlook, Gross then wrote:

    “Four percent is the floor for 10-year Treasury notes in my view……….Why would a central bank buy 10-year Treasury paper below 4% if it expected 3-month Treasury Bills to be yielding 3½% by the end of the year?”

    Well he was wrong all the way as Treasurys kept rallying and rallying. If he had walk the talk then he would have missed out on some juicy returns.

    Finally Gross “capitulated” in June this year and turned bullish. He was forecasting a yield of 3% for Treasurys. That was the signal to “sell” Treasurys when all these former skeptics capitulated. I wrote about it here

    Yields then bottomed out and have been moving higher steadily since then. I am not belittling Gross as he is the Bond King. Just shows not so easy to get the fundamentals right even for the Bond King

    Now he thinks yields will stay low when price action CLEARLY indicates much higher yields ahead. Fundamentals or Funny Mentals?

  • Posted by Guest

    Reserve diversification and the dollar

    Talk of central banks diversifying their $4,000bn foreign exchange reserves away from the dollar is a constant refrain of currency markets. Is it actually happening?

    Adrian Foster, head of foreign exchange strategy at Dresdner Kleinwort Wasserstein, argues Asian central banks decided to support the dollar in late 2004, recognising its importance to the region’s financial system and in pursuit of a strategy to maintain economic competitiveness and export strength. According to Foster, now that the widespread fears of dollar crisis have faded, large dollar holders have been diversifying their portfolios to move closer to an objective benchmark weighting, often in periods when the dollar reaches cyclical highs.

    However, the euro and the yen had a disappointing share of the increase in foreign exchange reserves last year as central banks added non-core currencies such as the Canadian and Australian dollar to their portfolios to boost yields.

    Other currencies such as the Norwegian krone, Swedish krona and New Zealand dollar have also attracted central banks’ attention. Mansoor Mohi-uddin of UBS says: “It is only a matter of time before foreign exchange reserves will be held in emerging market currencies as well.” He points out that a $2bn Asian bond fund has been set up to invest in less developed Asian markets by 11 larger Asians including Japan, China and Australia.

    China stands out as the country likely to have the largest foreign exchange reserves in the future, forecast to top $1,000bn in 2007 – according to Fitch, the ratings agency – as its capital account is liberalised allowing greater access for foreign capital, China does not provide currency composition information for its 20 per cent of global reserves.

    That leaves a huge hole in IMF data as 32.6 per cent of total official reserve holdings are reported without currency composition details. As China operated a dollar peg for more than 10 years, analysts estimate a large portion of its reserves (about 80 per cent) is in dollars.

    A recent report sponsored by the People’s Bank of China-backed Financial News, suggested Chinese reserves should shift from dollar-denominated assets in favour of investments in other currencies. It also said China should spend some of its reserves on strategic resources, such as petroleum and mineral products.

    Stephen Jen of Morgan Stanley says : “Reserve diversification [has two dimensions]: across currencies, as well as across assets within each currency.” So a move up the risk curve is also occurring, with central banks showing increased appetite for credit products, particularly US agency debt, mortgage-backed securities and corporate bonds.

    Diversification into riskier assets could still benefit the US as dollar-denominated asset markets are broader and deeper than those of the eurozone and other regions.

    Mr Jen expects central banks to consider splitting their reserves into liquity and investment tranches to manage currency shifts and increase returns respectively.

    The RBS Reserve Management Trends 2005 study conducted by Central Banking Publications shows three-quarters of 65 central banks (holding around 45 per cent of global currency reserves) it surveyed have also introduced new asset classes to their investment processes as part of a shift towards accepting riskier products.

    Gold used to account for 50 per cent of reserve holdings in early 1980’s but this has now shrunk to just 9 per cent. With the gold price moving higher, raising gold allocations might be one choice while another potentially attractive option is inflation linked bonds as an unanticipated increase in inflation is the biggest risk to capital preservation.

  • Posted by bsetser

    China will hit $1,000 in 06, barring a HUGE policy shift. it will end this year at over $850b. Otherwise, i quite liked the FT piece. Interesting that they once again put china’s $ reserves at @ 80%. Known $ dollar holdings from the US data put the total at closer to 60% — so that implies an additional 20% in dollars.

    PC — had not heard funny mentals before. brought a smile to my face. and you accurately described Gross’s evolution out of the roubini/ setser camp over the course of 05 …

  • Posted by TI

    What would be the realistic alternatives to diversify the central bank reserves of $4 trillion out of the dollar? Where would there be enough central bank rated instruments to put the money in? The euro? The stability pact prevents issuing government bonds and the private euro markets are not liquid enough. Gold is now quite marginal. Swedih currency is not a real alternative… There are lots of talk about diversification, but how would we expect the Chinese to realize this? And, as Brad above shows, they are not…

    Everybody is captive in the system. Escape from the dollar is not possible in a large scale and this keeps the rates relatively low. There is some desperation if the central banks start moving into dollar junk bonds (well, not quite yet, but point here is the acceptance of higher risks). This tells also that the petrodollars are coming. The imbalances are only growing and the problem may be that the US cannot increase its indebtness fast enough to supply all the bonds in demand.

    The correction will come one fine day, but more likely as a deep recession and not a dollar fall.