Rx for the Economy: A Weaker Dollar
Bill Gross, manager of the world's largest bond fund, is everybody's go-to guy when it comes to reading the tea leaves about Federal Reserve policy and the potential direction of interest rates. Lately, though, the manager of the $94-billion PIMCO Total Return fund has found himself making some off-the-mark projections. A year ago, he pegged 10-year Treasury rates going no higher than 4.5% during the next three to five years. They are now 5%.
In his most recent monthly investment letter to clients he writes: "10-year Treasuries are sort of outside of our forecasted range, wouldn't you say? 'My bad' -- to use Generation Y jargon." His mea culpa notwithstanding, the plain-talking Gross still sees some logic behind that call. For instance: The growth of the U.S. economy could come to a halt as rates near 5.5% and as new Fed Chair Ben Bernanke continues on his quest to contain inflation. As a result, a too-restrictive policy could cause some unintended pain, prompting the Fed to reverse course and ratchet rates back down to 4.5% or so. Gross talked with BusinessWeek Banking Editor Mara Der Hovanesian on what's behind the whipsaw nature of the global markets and how the dollar's decline will work to America's benefit. Edited excerpts of their conversation follow.
So what's eating the global markets right now?
Today [June 13] is an interesting day on top of an interesting month or four to six weeks. Gold is down another $45, and that's indicative of an unwinding of risk positions in many asset categories. Other commodities like copper and so on are down substantially and off their highs. Equity markets around the world are in many cases 10% to 25% off their highs. It started two or three months ago with poor little Iceland. They always had a high-yielding currency and a huge balance of payments deficit and no one seemed to care.
The rating agencies downgraded their bonds and first one investor noticed and then another and then the whole world doesn't want to own Icelandic bonds. People looked around and wondered if this was going to be another Russian/Asian crisis of 1998. So for a few weeks nothing happened and then some fringe markets started to sell. And so at the moment, you've had a sort of George Soros' "reflexive" market, one that unwinds speculative positions. So today leveraged money is moving away from risk assets and into safer havens, one of which is, by the way, the dollar.
Why has this happened?
I think a number of forces are at play. The most bandied about has been about [Federal Reserve Chairman] Ben Bernanke, and when the Fed stops rising rates, where's inflation and what's the number tomorrow going to be ... all of those things. And can Bernanke convince the markets in a way that he has a firm hand on the tiller? And if he can, will that eliminate some of the risk? Bernanke is being compared to [former Fed Chairman Alan] Greenspan ... and to be fair Greenspan departed just at the point where when the Fed's action was becoming uncertain anyway.
They had gotten up to 4.5%, a point where there were increasing question marks about how high they could go anyway. Bernanke came on the scene and now there's a "does he or doesn't he" kind of thing. To some extent he's been blamed unfairly. In any case, we have an uncertain environment and that's one of the causes and the one that gets the biggest headlines (see BusinessWeek.com, 10/26/05, "Bill Gross: Bernanke is the 'Right Guy' ").
But that's not the major reason we're seeing such volatility and uncertainty?
The major reason is what's occurring with the Bank of Japan, not the Fed. The Bank of Japan has been at what they call zero interest rate policies and even beyond that in terms of providing liquidity to the global marketplace for years now. It's not a delicate topic; very difficult to understand and write about; your head starts to spin to think about the Yen carry trade and figure out who's doing it. There's no doubt that one of the three major central banks is at a zero percent interest rate and that's been a decent provider of global liquidity -- and now that's at risk.
Instead of mild deflation they have mild inflation, and so the world knows what our Fed is doing, but they don't really [know] where the Bank of Japan is going. Now they've announced plans to hike, the market is guessing about where they go, and since they provided such a tremendous liquidity to the global marketplace, including to hedge funds, that's the biggest level of uncertainty (see BusinessWeek.com, 3/9/06, "BoJ: Cash Machine No More").
What's the role of hedge funds in all of this uncertainty?
We don't have to blame the hedge funds for all of this. The world in general, as reflected in the U.S. housing market, has seen a lot of speculation. That's something that your readers can understand and it's been driven by our Fed and by low interest rates. So all of this money is piled into risk positions, whether it's homes or condos in the U.S. or the emerging market debt held by hedge funds invested in commodities like gold or copper. These were all risk positions that made sense when you could borrow money at zero percent or at 1%. Now they don't make as much sense and nobody really knows where any of these banks stop, although with our Fed there's the most confidence that we stop sometime soon.
Central banks hold it within their power to squeeze some of the leverage out and I think that Bernanke has. Even though he disclaims focusing on asset markets like Greenspan, there's no doubt his speeches are laced with [concerns over] housing prices. One of the ways we can rebalance this misaligned global economy is to slow down housing, which means slow down the U.S. and to therefore to rebalance our current account deficit.
How does this thinking coincide with Buffett's?
I think Buffett is on the same side of that equation…and that our trade situation has become terribly misbalanced and will eventually come back at some point to hurt us. Anyone who has any semblance of common sense knows there has to be a balance. And Bernanke, with tough inflation talk and references to housing and currencies, [is about getting] the dollar down, which would rejuvenate small U.S. manufacturing and therefore improve our exports and slow down our imports.
If the rebalancing must inevitably take place, and I think few would quarrel with the inevitability, some would suggest it would take several years. Our dollar must go down in order to increase our manufacturing competitiveness. It will make the price of imports more expensive so that we buy less of them and therefore "save more." A declining dollar is an inevitable part of this rebalancing process. The timing is always delicate. The dollar has gone up 5% in the last month, confounding the thesis that we're writing about; inevitably it has to go down over time if we are to balance our trade and balance of payments deficits.
Why is the strong dollar policy so detrimental to U.S. economic health?
The strong dollar policy that we've had at least in name for the last few years has been in place since Robert Rubin became Treasury Secretary in the mid-1990s. The way I see it, he thought that phasing out of manufacturing wasn't a bad thing as long as we could be a recipient of investment from the rest of the world and investment in high tech. We'd be at the top of the totem pole in idea creation.
He pushed this strong dollar policy basically as a signal for foreign investors that it was O.K. to be in the most productive country in the world; you don't have to worry about the dollar because it's strong. That's all well and good except we've come to a point where we've hollowed out manufacturing so much -- and Detroit is a good example -- where we don't make things any more. And so we are beginning to look around in terms of jobs and wonder where they are. So now the strong dollar policy is being questioned about whether it has lost its potency in a global marketplace where we don't make things any more.
How will the new Treasury Secretary, former Goldman Sachs CEO Hank Paulson, change things?
I would suspect that Paulson, as a Wall Street guy, will carry on the Bush tradition. But if he's anywhere as smart as I think he is, he would recognize that the time has come to stop promoting the strong dollar and to promote a gradual decline in order to rejuvenate U.S. manufacturing and rebalance the economy (see BusinessWeek.com, 6/12/06, "Mr. Risk Goes to Washington").
And what if we don't drop a strong-dollar policy?
It's like Peter Pan who shouts, "'Do you believe?' And the crowd shouts back, in unison, 'We believe.'" You can believe in fairy tales and Peter Pan as long as the crowd shouts back, "we believe." That's what the dollar represents, a store of value that people believe in. They can keep on believing, but there comes a point that they don't.
Greenspan was here two months ago and talked with us for two hours. The most interesting point was his comment that there will come a time when foreign central banks and foreign investors reach saturation levels with their dollar holdings, and so he sort of drew his hand across his neck as if they've had it. Why can't they keep on swallowing dollars? Logic would suggest that these things start to fray at the fringes. Once the snowball starts it can really get going.
So what gets the snowball going?
The dollar is really well supported by its yield. We've got 5% overnight rates and Japan has zero. You get over 2% relative to the euro, so obviously 5% or 5.25% is dollar-supportive, and the more that Bernanke sounds off that he's going even higher, the more that supports the dollar. The real question is what starts it on the way down? At the moment people believe that's O.K. and yes, housing is starting down, but the rest of the economy is looking good, 2% to 3% GDP growth isn't so bad. I would say that if that's the case we've got a pretty good little fairy tale going here.
But if it doesn't, if 5% leads to a crack in the housing market and the unwind of various global markets and the U.S. stock market ... If the stock market keeps going down then that's a sign that 5.25% is too onerous a rate. So what the question becomes then is can the U.S. economy be supported at that level? That's when the question of whether there's the possibility of an avalanche begins. If we get rates then down to 4.5% and then all of a sudden the [other central bankers] are moving up, the money flows out. It's not because of the [lack of a] yield advantage; they've had it up to their necks in terms of dollars. The unwind of the dollar can come from saturation or geopolitical issues or simply that the U.S. economy isn't as strong as people think and they stop believing in Tinkerbelle.
How is your portfolio strategy different from Warren Buffett's, who is also eschewing dollar-denominated assets?
There is a little bit of difference in terms of the risk we can take. No one is going to fire Buffett. PIMCO has to be careful. If we lose a lot of money, we might be out of the door while Warren Buffett is warm and cozy in Omaha. We're about 4% dollar short and that's about as much as we can be. That may sound like nothing, but that position does represent our maximum confidence that the dollar is going down in the next several years. We can't gauge imminent weakness of the U.S. economy any more than Bernanke can, but this is for us a several years' bet. And we're willing to suffer ... if we have to. Because we are expecting the economy to slow and housing to crack and Bernanke to start thinking about lowering rates, that basically suggests that you don't want lots of credit risk.
We have very few corporates, very few emerging market bonds. We own triple AAA pieces of paper. We're meeting with our investment committee on whether or not to increase duration in the face of what we're observing with asset markets. I suspect we will. That doesn't mean we make a fortune in the next six months, but most of the risk has been taken out of high quality bonds. I don't think the risk has been taken out of high yield bonds or emerging market debt. Those are the positions that are being unwound. For high quality investors it's not a bad time to get into bonds ... but there's still a caution.