Gross Says Market Mispricing Eventual Fed Target Rate Increase

Pacific Investment Management Co.’s Bill Gross said investors should focus on purchasing debt that will benefit from the market’s mispricing of when the Federal Reserve will eventually increase borrowing rates.

“If you want to trust one thing and one thing only, trust that once QE is gone and the policy rate becomes the focus, that fed funds will then stay lower than expected for a long, long time,” Gross wrote in his monthly investment outlook posted on Newport Beach, California-based Pimco’s website today. “Right now the market, and the Fed forecasts, expect fed funds to be 1 percent higher by late 2015 and 1 percent higher still by December 2016. Bet against that.”

Fed policy makers cut rates to a record low as the financial crisis mounted in 2008 and vowed to keep them there until the economy and employment show sustained signs of recovery. The central bank, which has kept its benchmark overnight bank lending rate in a range of zero to 0.25 percent since 2008, has said it will maintain that rate while unemployment held above 6.5 percent and inflation stayed below 2.5 percent. The Fed held steady in its most recent policy meeting its $85 billion in buying of mortgage and Treasury debt, known as quantitative easing or QE.

Given the Fed will increasingly focus on forward guidance as a policy tool when it begins to taper its bond buying, investors should purchase Treasury debt with shorter maturities as well as “volatility sales explicitly priced in 30-year agency mortgages” as well as Treasury Inflation Protected Securities, known as TIPS. Avoid longer-term Treasuries, the manager of the world’s biggest bond fund wrote.

Fed Estimates

The Fed estimates that interest rates will stay not far from record lows for the next three years.

The federal funds rate target will be 2 percent at the end of 2016, according to the median of estimates by Fed board members and regional presidents detailed on Sept. 18 in the central bank’s quarterly Summary of Economic Projections. That forecast compares with the median estimate of 4 percent for where the rate should be at a time of full employment and stable prices, according to the report, which also includes individual forecasts for gross domestic product, inflation, unemployment and interest rates.

“The U.S., and global economy, may have to get used to financially repressive -- and therefore low policy rates -- for decades to come,” Gross wrote. “Now that more certainty and more liquidity have been restored, it’s time for the policy rate and forward guidance to assume control.”

The $250 billion Total Return Fund managed by Gross has gained 1.7 percent in the past month, outperforming 98 percent of comparable funds, according to data compiled by Bloomberg. The fund has returned 7.9 percent on an annual basis in the past five year, placing it in the 89 percentile.

Pimco, a unit of the Munich-based insurer Allianz SE (ALV), managed $1.97 trillion in assets as of June 30.

To contact the reporter on this story: Liz Capo McCormick in New York at emccormick7@bloomberg.net

To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net

Enlarge image

PIMCO Co-CIO Bill Gross

Andrew Harrer/Bloomberg

Pacific Investment Management Co. Co-Chief Investment Officer Bill Gross said “right now the market, and the Fed forecasts, expect fed funds to be 1 percent higher by late 2015 and 1 percent higher still by December 2016. Bet against that.”

Pacific Investment Management Co. Co-Chief Investment Officer Bill Gross said “right now the market, and the Fed forecasts, expect fed funds to be 1 percent higher by late 2015 and 1 percent higher still by December 2016. Bet against that.” Photographer: Andrew Harrer/Bloomberg

9:48

Oct. 1 (Bloomberg) -- Bill Gross, co-chief investment officer at Pacific Investment Management Co., talks about the impact of the U.S. government shutdown on the nation's economy and risks to U.S. Treasuries should the federal government default on its debt. Gross speaks with Trish Regan and Adam Johnson on Bloomberg Television's "Street Smart." (Source: Bloomberg)