Bill Gross Investment Outlook Apr_04

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InvestmentOutlook Bill

Gross

April 200

A nything B ut Treasuries – and JGBs(The Last Vigilante, Part III)

Here’s an investment mind bender (ormind blower if you happen to have grownup in the late `60s): A “re ating” economyis ultimately bad news for a bond investor.Still, the “re” portion of the word is ini-

tially invigorating for bond prices and totalreturns since it implies a central bank on adownward interest rate path. Greenspan’smarch from 6 % at the beginning of 2001to what is probably an ultimate low of 1% today epitomizes the feel good sizzleof “re”- ation. Since that date, the bondmarket has produced a total return of over26% – more than 8% annualized – withhigher prices contributing 6% of the total.

Once a central bank reaches its ultimatedestination, however, (and who couldargue that 1% is not far from absolute 0?),a bondholder is stuck with the worst of all worlds. Not only is she earning a low“real” interest rate (negative, as a mat-ter of fact in today’s market), but she hasto look forward to the inevitable day inwhich rates go back up and prices back down. She is damned with a 1% moneymarket fund and damned with a 4.8% 30-year Treasury that almost inevitably willgenerate capital losses, as the re-“ ation”steers long yields higher. The 1% moneymarket rate, as a matter of fact, along witha 1% or so risk premium for holding longerdated bonds is a pretty good approxima-tion for what an investor in U.S. bondsshould earn over the next 4-5 years. Star-

ing 2% returns in the face, what is a bondinvestor to do?

My Investment Outlooks of February andMarch (The Last Vigilante I and II) sought

to answer that question in part. The twoIOs separately discussed the bene ts of owning in ationary insurance via TIPS aswell as employing the front end of re at-ing country yield curves to participatein the rolldown/carry made possible bythe magnet of low short rates themselves.This month’s discussion will center onthe durational position of a “re ationary” bond portfolio that might be character-

ized as thrice damned – damned if youshorten, damned if you lengthen, damnedif you don’t do a thing. The solution tothis conundrum is to be rather choosyabout the country where you hold yourduration, to reduce it in re ating countries(U.S., Japan) and increase it in relativelyvigilant ones (Euroland, U.K.). In so doing,the potential pain from holding bondsin a re ating global environment can bereduced if not anesthetized entirely. Notonly are some offshore yields currentlyhigher than U.S. alternatives to beginwith, but future price erosion should be minimized as well since re ation isnot as advanced. German 10-year Bundsfor instance yield 3.92% vs a 3.85% U.S.alternative. U.K. 10-year Gilts yield 4.75%,almost 100 basis points more than Trea-



Investment Outlook

April 2004

suries. In short, I recommend getting thehell out of Dodge City, USA and reinvest-ing in London and Frankfurt. Constructan A B T portfolio – Anything But Trea-suries, and hand those Old Maid Treasury

bonds to the Japanese and the Chinese orany other country whose domestic growthconcerns dominate their investment com-mon sense. That a U.S. Treasury note or bond resem- bles the Old Maid is not immediatelyobvious. With domestic in ation at 1- 2% and 10-year Treasuries close to 4%, a bond investor is not exactly making hay

but things could be worse. Well maybe– but as it turns out – only in Japan wherein ation is 0% and 10-year yields are 1.7%.Elsewhere, the hay makin’ is considerablymore attractive as I will attempt to pointout over the next few pages. My rst setof rather commonsensical proofs are dis-played below. Bond investors know, butoftentimes lose sight of the axiom, thata country’s interest rates should be cor-

related rather closely to its nominal GDPgrowth.

While that relationship varies basedupon periods of “easy” versus “tight”money, the correlation has an economiclogic and an historical validity. The twocountries shown in Exhibit I’s 25-year his

tory display 10-year government yieldsaveraging 150 to 250 basis points overtheir respective nominal GDP growthrates. I would be the rst to admit that theabove relationship was derived during adisin ationary (high real short rate) inter-est rate environment and that Germany’sincorporation of East Germany in 1991distorts their GDP numbers to the down-side. Still, the comparison between the

U.S. and Germany is stark. My, oh my,what a difference! Today’s German/Euro-land yields remain safely above nominalGDP growth rates as measured by the dif-ference between the red line and the blue baseline, which represents nominal GDP.Not only that, but 10-year yields presentlyare 32 basis points above 25-year averagesas represented by the blue line. The U.S.on the other hand is a mirror image. Its

10-year Notes yield nearly 200 basis pointless than nominal GDP and 356 basis

Germany 10-yr versus Germany GDP Growth Rate(*Average excludes 1991 calendar year due to German unification)

-15.00%

-10.00%

-5.00%

0.00%

5.00%

10.00%Difference: Germany 10yr Less Germany GDP Growth RateAverage from 1979 to Present

D i f f e r e n c e

i n Y i e l d a n d

G r o w t h R a t e

Source: PIMCO

79 81 83 85 87 89 91 93 95 97 99 01 03

Average Spread* = +243 bpsCurrent Spread = +275 bpsCurrent 10yr = 3.95%Current GDP = +1.2% y/y

U.S. 10-yr versus U.S. GDP Growth Rate

-8.00%

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%Difference: U.S. 10yr Less U.S. GDP Growth RateAverage from 1979 to Present

D i f f e r e n c e

i n Y i e l d a n d

G r o w t h R a t e

Source: PIMCO

79 81 83 85 87 89 91 93 95 97 99 01 03

Average Spread* = +153 bpsCurrent Spread = -203 bpsCurrent 10yr = 3.87%Current GDP = +5.9% y/y

Exhibit I



points less than historical average levels.Granted, Germany’s economy is now dis-playing higher growth rates which willnarrow the comparison over the next 12months, but German yields currently offer

378 basis points or 3.78 % more “yield toGDP” than its U.S. bond market competi-tion. Which country would you ratherown?

Here’s another mind blower. Exhibit IIdisplays a comparison of 10-year govern-ment yields as a function of their “cur-rent account balance as a % of GDP.” Thestraight line is a PIMCO drawn “best- t”

regression line, which de nes the statis-tical correlation between the two as of year-end 2003. The logic here is that acountry running an annual “de cit” withits trading partners should be required topay higher interest rates relative to thosethat run a surplus. While geopolitical andcurrency reserve status considerationsultimately affect the number, the correla-tion is a good one, not just for 2003 but for

the past several decades as well.

If so, the attractiveness of a country’s bonds can be viewed by the “distance”from the best- t line. Germany, as repre-sented by “E.U.” is smack on top of whereit should be given its mild current account

surplus. The U.S. on the other hand tradesat yields approximately 100 basis pointsless than where the model suggests theyshould. For those wanting to play thereserve status/geopolitical “get out of jailfree” card, let me point out that U.S. yieldsas of March 2004 were at near historicallynegative spreads using this methodol-ogy as shown in Exhibit II’s right handchart. There seems little doubt to me that

Japanese and Chinese buying of Treasur-ies, combined with the Fed’s historicallylow interest rates which pay no respectto currency support mandates normallyrequired of a current account debtornation, are the key culprits. Should eitherof these conditions change, U.S. yieldsmove higher. In Germany and theU.K. on the other hand, value is muchmore apparent and future bear markets

less likely.

Exhibit II

U.S. Current Account Deficit versus 10-yr Yield

0.00%

2.00%

4.00%

6.00%

8.00%

12.00%

10.00%

14.00%

1 0

- y r Y i e l d

Source: PIMCO

-10.00 -5.00 0.00 5.00 10.00 15.00

Current Acct Deficit % of GDP

2003

1990

1991

1992

1993

1994

1995

1996

1997

1998

2000

1999

20012002

Source: PIMCO

Current 10-yr Government Bond Yield versus2003 Year-End Current Acct Balance % GDP

1 0

- y r

G o v t . B o n

d Y i e l d

0

1

2

3

4

5

6

-8.0% -6.0% -4.0% -2.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0%

New Zealand

Australia

U.S.

U.K.Canada

Japan

E.U.

Switzerland

Sweden

Current Acct Balance % GDP

Bill Gross Investment Outlook Apr_04

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