Pimco Sees Greater Risk of Flash Crashes, Market Volatility

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World financial markets appear more susceptible to flash crashes and bouts of volatility as rules designed to make the system safer have depressed trading activity, according to Pacific Investment Management Co.

Summing up the results of the company’s annual forum last month to plot investment strategy, three senior Pimco executives also wrote in a report that global fixed income and equity markets seem reasonably valued. Over the next three to five years, they see bond yields, stock prices and the dollar rising amid a “cautiously optimistic” outlook for the world economy.

“We are operating in a less risky” financial system thanks to rules promulgated in the wake of the crisis, Andrew Balls, Richard Clarida and Daniel Ivascyn wrote in their review of the forum. Yet investors must be prepared for “ongoing periods” of volatility as those same regulations have made banks and brokers “less able to function as market-makers.”

Those middlemen are constrained from taking big positions in financial markets by rules limiting their leverage and the scope of their activities. That means markets are less liquid and more prone to sudden swings when investors want to buy or sell en masse.

In the latest sign of that heightened market instability, bond prices worldwide have gyrated in recent weeks, driving the yield on the 10-year U.S. Treasury note to a seven-month high of 2.34 percent as of 10 a.m. in New York, from 1.87 percent on April 17.

Bernanke, Trichet

Former Federal Reserve Chairman Ben S. Bernanke, now a senior Pimco adviser, participated in last month’s forum. Jean-Claude Trichet, president of the European Central Bank from 2003 to 2011, and former Central Intelligence Agency Director Leon Panetta also made presentations. Newport Beach, California-based Pimco, a unit of Germany’s Allianz Group, manages some $1.6 trillion in assets.

The three Pimco executives said the world economy “is learning to live with record levels of public and private debt.” That is coming at the expense of slower trend growth and is being supported by “historically low” interest rates from global central banks.

Negative Rates

In the euro area and Japan, Pimco expects real, inflation-adjusted policy rates to be negative over most, if not all, of the next five years. The ECB and the Bank of Japan appear “willing to continue unconventional monetary policies for as long as it takes to move as close as possible to their 2 percent inflation targets,” Balls, Clarida and Ivascyn wrote.

While the Fed would like to reduce its $4.5 trillion balance sheet, it will do so carefully so as not to jeopardize its goals of price stability and maximum employment, they said. “We judge that the Fed would, if necessary, recalibrate the pace of balance sheet normalization so as not to compromise its dual mandate objectives.”

The Pimco officials expect the rise they see in bond yields in coming years to be “slow and, most likely, bumpy.” They continue to favor investing in Treasury Inflation-Protected Securities. “A break-out of inflation to the upside of central bank inflation targets is not as unlikely as many seem to assume,” Balls, Clarida and Ivascyn wrote.

In Europe, they suggested core country bond yields may rise as the region recovers, though they may be subject to occasional periods of downward pressure stemming from ECB bond purchases or concern about a break-up of the currency zone. Germany’s 10-year bund yield hit 0.87 percent on Wednesday, the highest in seven months.

The Pimco executives also see a further rise of the dollar. After the last year’s gain of about 15 percent on a trade-weighted basis, “expectations for further dollar appreciation must be far more modest,” they said.

Ivascyn is group chief investment officer for Pimco, while Balls heads up fixed income investment worldwide. Clarida is global strategic adviser.

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