he 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.
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.
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.
Wlliam H. Gross