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Economic and Market Commentary

The End of History and the Last Bond Bull Market

"For now, and for the next few years, enjoy the gradual then more rapid progression of our 'last' bond bull market."

They say “Life is a journey, not a destination” and I suspect for the most part that’s true. One-time lottery winners revel in their fifteen-minutes of profligacy, but since their journey rarely involves anything more strenuous than a trip to the 7-Eleven® Lotto counter, it’s hard to imagine much passion or intensity beyond the discovery of the magic ticket. Better to have entered a multitude of lifetime Lottos – advancing and falling back like a two-step forward, one-step back Sisyphus than to have hit the big one out of the blue. Building relationships, families, and careers seems personally much more valuable when viewed as an experience rather than a backward-looking achievement. God may have created the world in six days and rested on the seventh, but while relaxing in a heavenly easy chair, I’ll bet He (She) was thinking about all the fun that was had between Monday morning and Saturday night.

Not to trivialize this thought but I must tell you that my most recent affirmation of the “Journey vs. Destination” proposition has come from my new iPod and the building of a playlist. Now to you youngsters, the advent of the iPod must have seemed like one more small technological step for man – but for me it was more like a great leap for mankind. I mean just turning the thing on and off was and remains a major achievement for me, let alone creating a library of hundreds of CDs inside a cell phone look alike. But my wife Sue is into creative change and keeping young, so last month she bought me an Apple and an iPod and we spent enough time at the local Mac store here at the mall to figure out how to transfer music from my hundreds of CDs to this little itsy-bitsy thing I could barely hold in my hand. My God what fun. Not playing the music mind you. I haven’t had time for that. It was the creation of the playlist that was the fun; deciding which songs to keep, which to delete; transferring them into the Mac and then to the iPod; sifting, culling, condensing, organizing – two-steps forward, a moment of technological panic then one-step back. Now that I’ve created a playlist of 2,000 songs, however, I’ve sort of reached a temporary destination. I mean how many songs can you really play? Can I possibly listen to all of this music in my sleep? Hardly. I’ve decided though that since the experience was so much fun, I’ll just have to root for Steve Jobs or Bill Gates or some other technological wizard to come up with the next new thing so I can keep on “experiencing” as opposed to “reaching destinations.” What a funny little game life can be sometimes.

My “experience” in recent days in the bond market has been something I wouldn’t want to be replicated on an iPod playlist: too much tension, too many sleepless nights. Market turning points have a habit of doing that and this time has been no exception. That statement, of course, explicitly announces that I think the high in interest rates has been reached, something I rather brashly and perhaps recklessly announced on Bloomberg TV and Reuters on July 7th. Chock up another “Dow 5,000” perhaps – sometimes I just can’t help myself when it comes to the press. Nonetheless, despite the rather cryptic pronouncement that the bear bond market was over, an enormous amount of PIMCO time has been spent in the formation of that decision, with piles of it, now decorating my trading desk, provided by investment grade corporate head Mark Kiesel and up-and-coming PIMCO professionals such as Saumil Parikh and Rahul Seksaria. Not that that’s proof of anything, but we have done our homework. As I begin to describe some of the results let me first point out that the end of a bond bear market and the peaking of Fed Funds are not necessarily coincident. As a matter of fact, bond prices usually bottom several months before the last FF hike as the market begins to anticipate the Fed, which in turn is attempting to anticipate the economy and inflation.

The process in many ways is reminiscent of Keynes’ description of a beauty contest. If you want to find out the winner he hypothesized, don’t look to the stage but at the judges’ faces. The bond market not only tries to gauge the expression on the Fed governors’ faces, but to anticipate them – sometimes correctly, sometimes incorrectly as yours truly would admit to over the past six months. Nonetheless, despite premature calls for Fed Funds peaks throughout 2006, this is my first attempt this cycle at calling a bear bond market bottom, which is a somewhat different process – beauty contest and all.

Figure 1 is a line graph showing the gradual decline of the 10-year U.S. Treasury note yield from 1988 to 2006. In 2006, the rate is around 5.5%, up from around 4.2% in 2004 and a low of 3.5% in 2003. But the trend has been down over the period, with the highest peak in 1989 of around 9.4%, then lower peaks of about 8% in 1994 and 6.8% in 2000. Four shaded regions represent periods of Fed tightening: the late 1980s, 1994 to 1995, 1999 to 2000, and 2004 to 2006.

Why then should the Fed be stopping and the bond market have bottomed in early July? The overarching reason is that 425 basis points of short-term hikes and the concomitant tightening of the yield curve in the past several years has been more than enough to slow economic growth and contain inflation. That’s a bold statement to make in the face of an apparently still strong domestic economy, a booming global environment, and accelerating core CPI numbers, but PIMCO’s cyclical analysis would suggest that it is justified. No doubt, Asian and Euroland growth is acting as a strong magnet for U.S. exports but the tightening cycle in the U.S. seems to have run its course, primarily because of its effect on housing and related repercussions on consumer spending and economic activity.

To gauge the relationship between Fed tightening/housing/and the domestic economy PIMCO looks at a number of evolving relationships including the rather dominant connection between Fed action and economic activity which tends to span 12-18 months in terms of lead times. Having begun tightening over 24 months ago, we should be experiencing a slowdown by now and in fact we are. Consumption, employment, and even capital spending aggregates are on a downward growth path, not at a pace that would indicate recession, but something more indicative of a 2% real GDP economy with probabilities for even lower percentages as we move toward year-end. Recession/no recession is really a faux decision to be entertaining at bond market turning points. Any number of cyclical histories point toward bond market prices bottoming – and the Fed peaking – as the economy downshifts into second or first gear as opposed to breaking to a full stop.

But this cycle in particular has been dominated by the accelerating trend in housing prices – making consumers feel wealthier and able to borrow/spend more money than ordinarily is the case. And so it has been a particular focus of PIMCO (and the Fed as well) to concentrate on the fate of housing in order to forecast the future of the economy, inflation, and therefore the bond market. It’s not looking that good folks – housing that is. PIMCO’s on-the-ground analysts, who for nearly a year now have roamed the country with random real estate agents in search of local housing trend information, report that prices in many areas are actually declining which has significant implications for the economy, inflation, and interest rate trends. A just-released report by the National Association of Realtors confirms that nationwide the year-over-year housing price gains have virtually disappeared and seem to be heading into the red.

One of our centerpieces in analyzing this cycle dominated by housing is a Federal Reserve Study finished in September of 2005 entitled House Prices and Monetary Policy: A Cross-Country Study 1. The 65-page treatise covers 35 years and housing cycles in 18 different countries including the U.S. While too extensive to go into detail here (and too singular to rely on entirely) I will summarize the critical two paragraphs:

We find that real house prices are pro-cyclical and tend to reach a maximum near business cycle peaks, often after a prolonged period of buoyant growth in activity has raised output above its potential level and inflation pressures have begun to emerge. Subsequently, real house prices fall for about five years and their previous run-up is largely reversed. Real GDP growth slows during the first year or so after house prices peak as do growth rates of private consumption and investment.
House price booms are typically preceded by a period of easing monetary policy with FF rates bottoming out about three years before house prices peak. Rates then reverse quickly (after the peak) in response to falling GDP growth (my emphasis).
Figure 2 is a line graph showing the year-on-year percentage change of median existing U.S. single family home prices, from 1990 to June 2006. Near the end of the graph, the metric drops sharply to near 0% by June 2006, down from around 17% in late 2005. For most of the period shown, the percentage change fluctuates between about negative 2% and 10%, but in 2005 it breaks to the upside, reaching the peak of 17% before it plummets. Its lowest rate was about negative 3% around late 1990.

While there have been myriads of Fed studies, many of which have proved fallible, I find many of the statistical correlations and conclusions in this one highly significant and certainly eerie in terms of the current U.S. housing boom: FF bottoming out three years (July 2003) before a housing price peak (July 2006?); buoyant GDP growth and inflationary pressures beginning to emerge (1st half 2006); and of course the critical follow-on conclusion shown in Chart III, a quick reversal of rates shortly thereafter (1st half 2007?).

Figure 3 is a line graph showing median of U.S. real house prices, the nominal policy rate and inflation, from 20 quarters before and after peaks pre-1985. Real house prices are scaled inversely on the left-hand side of the graph as the percent deviation from the peak, with zero at the top. The nominal policy rate and inflation are scaled on the right-hand side as a percent. Both of those metrics roughly track percent deviation of housing prices from their peak. By 20 quarters after the peak, the nominal policy rate gradually falls to 10%, down from a peak of around 12% four quarters after the real house price peak. The U.S. CPI (consumer price index) also trends downward to 7% 20 quarters after, down from a peak of around 12% roughly 3 quarters after the peak in housing prices. The deviation of house prices from their peak fall to 20 percentage points about 19 quarters after the peak, then shift slightly upward.

On average, short rates have fallen by over 400 basis points once a peak in housing prices has been established, a necessary function of central bank policies worldwide in order to rejuvenate asset prices – housing, equity, and bond markets among them.

I previously referred to piles of PIMCO studies on my trading desk in addition to the Fed paper described above. One of them, an analysis of the “embedded” average coupon of Treasury, mortgage, and corporate yields in relation to Fed Funds rates was the topic of my January 2006Outlook. Other studies relate economic statistics and leading indicators to cyclical halts in Fed hikes. Almost all of them point to June/July of 2006 as a serious inflection point.

Well we shall see won’t we – whether July 7, 2006 will be another “Dow 5,000” or not. Tricky business this forecasting. Even when posing as a long-term oracle as Francis Fukuyama did when he wrote his famous The End of History and the Last Man in 1989, the world can zig and zag and stone you intellectually faster than you can say Islamic radicalism. I shall don sufficient armor and prepare to be stoned. If such is not to be my fate, then the title of thisOutlook makes an intriguing additional claim – that this bond bull market will be the last; that history, as almost all active bond managers have known it since 1981, will come to an end a few years hence. Whether it bottoms at yield points lower than reached in 2003 is not really forecastable at this point; nor is the claim that this will be the last bull bond market a realistic one. Like Fukuyama’s book title, it’s more of a headline-grabber than a truism. The important idea is that such a forecast speaks to eventual reflation, inflation, and declining bond prices sometime out there in 2009 and far beyond as the U.S. seeks to address its enormous future liabilities concentrated in social security, healthcare, and foreign holdings of U.S. bonds. But that is a story for next month’sOutlook – I promise, I’ve already written it. For now, and for the next few years, however, enjoy the gradual, then more rapid progression of our “last” bond bull market. It should be a great experience and – while it lasts – a marvelous destination.

William H. Gross
Managing Director


1 ( http://www.federalreserve.gov/pubs/ifdp/2005/841/ifdp841.pdf)

Past performance is no guarantee of future results. This article contains the current opinions of the author but not necessarily those of Pacific Investment Management Company LLC. Such opinions are subject to change without notice. This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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