Bond-fund king William H. Gross has long been a critic of Federal Reserve Chairman Alan Greenspan's interest rate maneuvers. As chief investment officer at Pacific Investment Management Co. (PIMCO), the world's largest bond-fund manager, which has $513 billion in assets, Gross has a lot riding on which direction rates go.
With news that President George W. Bush has chosen former Fed board member Ben S. Bernanke to replace Greenspan, Gross got a chance to give the "maestro" a few parting zingers, as well as share his thoughts on America's housing bubble. Here are edited excerpts from his Oct. 25 conversation with Christopher Palmeri, BusinessWeek's Los Angeles bureau correspondent:
What do you think of our new Fed chief, Ben Bernanke?
I think he's the right guy. I've been publicly promoting him -- not that he needed promotion. His academic credentials, his experience at the Fed, his excellent leadership skills are all in his favor. During the deflationary or fear-of-deflation period in 2002, it was Bernanke who was the intellectual force who made the appropriate speeches convincing the Fed governors and the investment public to move to a rather extraordinary 1% interest rate.
I like his inflation-targeting approach. We benefit as bond investors, and it benefits the U.S. economy. Inflation-targeting central banks, of which there are nearly 20, the bulk of the visible ones have lower long-term yields than the U.S. The U.K. [central bank] and ECB [European Central Bank] are the most prominent examples.
When Bernanke was first confirmed [as a Fed board member], he stated that he disagreed with Greenspan in terms of inflation targeting. Greenspan didn't want to be boxed in. Bernanke set a range, which the market interpreted as 1% to 2%. That was too confining for Greenspan. Bernanke was never successful in wooing the other Fed governors to his side. That would have been tantamount to a palace revolt. But it wasn't intended to displace the maestro.
You see him differing from Greenspan in other ways?
I like Bernanke better. Greenspan's approach in terms of throwing money at the problem, lowering rates whenever there was a crisis -- it appears to have worked. At the same time, it has led to a substantially leveraged U.S. economy. That's the legacy he leaves Mr. Bernanke. It's my view that extremely low interest rates of recent years, as well as his lowering of rates in a crisis -- such as the Long-Term Capital [Management] and Orange Country debacles -- that approach has induced a sense on the part of the private sector that they will always be bailed out.
It led to various bubbles, the first being the Nasdaq. Greenspan, in effect, bailed out the market. And it led to the housing bubble. Investors and consumers of housing simply believe that if things get too tough, if prices fall too far, the maestro will ride to the rescue once again. That approach in the long term is destabilizing. It promotes speculative activity. That's the corner that Greenspan has painted the economy into.
What do you think Bernanke will do differently?
I don't suggest Bernanke will be much different, in terms of riding to the rescue in terms of low interest rates. I would hope that in a future crisis we'll see a faster return to normalcy. The 1% interest rate stuck around too long and promoted a sense of euphoria and speculation. I have no idea whether he'll have a better sense of timing. Inflation targeting gives him a better chance.
You thought the Fed rate increases were going to stop a few months ago and they didn't?
It's fair to say we've been surprised. We're still holding to the view that, because we're in a levered economy, current increases are starting to bite in the housing market, in some of the more bubbly cities.
By the time Greenspan retires [in January], most if not all of the heavy lifting -- that being rate increases -- will be over. Others think 5% is more reasonable. That's the topic du jour, the line in the sand [that] the bond market has drawn and which we're fighting.
You've also been impressed with Bernanke's theory about global savings and why it has kept long-term rates low?
He came out six months ago with his globalization speech that suggested that the conundrum -- that was Greenspan's term, which is interesting because it implies he can't figure it out -- Bernanke said, "I have the answer, an excess of global saving."
That's been our explanation, our sense of excess saving being recycled back into the U.S. bond market. These are Chinese, Japanese, and OPEC currency reserves, built up from trade surpluses, that go straight back into the U.S. bond market. It keeps their currencies low and lowers our rates. I think he had a great explanation for that. He wasn't the first to answer the conundrum, but he did do it.
You've been studying the U.S. housing market. What impact will a slowdown in housing prices have on the economy?
It depends on how it deflates, whether it pops, or whether it evolves like the U.K., where prices just go flat. Housing is the asset that has kept this economy going. The second-mortgage loans and the like. The homeowner taking advantage of capital gains and withdrawing equity -- that's what has kept consumption going. If housing stops, equity withdrawal ceases -- all this over a future period of time -- then the economy slows down.
The investment implication is that Bernanke stops raising rates at 4.5%. The dollar, which is banking on 5%, starts to weaken. The third implication is that stocks -- once the market realizes 4.5% is the top -- stocks have a good 2006.
But stay away from the mortgage lenders?
The mortgage-lending group has been terribly weak, weaker that the builders. That would be an area I'd avoid.
And for bonds?
With much of the market geared toward short-term rates, that promotes an all-clear sign, an end to the bear market in bonds. Not a return to the halcyon days of 1%, though.
What else is PIMCO looking into, in terms of the big picture?
Our macro story is the forces of globalization and the impact it has on lower inflation. That's the topic du jour. Our argument is that globalization and the arbitrage of low-wage countries, Asian primarily, and high-wage countries, the U.S. primarily, is promoting a disinflationary period. Energy costs aside, ultimately it's wages that dominate the inflationary future. There's little way for U.S. wages to begin to accelerate in the face of the Chinese juggernaut.