Bill Gross and the Bond Bubble

This week could decide how much it costs I.O.U.S.A. to push the stimulus through. The U.S. Treasury will attempt to sell $35 billion in 3-year notes tomorrow, $19 billion in 10-years on Wednesday and $11 billion in 30-year bonds on Thursday. The later two auctions are the first long-term efforts since the bond crisis began in earnest… thus success is critical to Uncle Sam’s agenda.

Yields are already perking up, a sign things might not go so smoothly. A 10-year currently yields 3.83%, barely off Friday’s seven-month high of 3.88%.

“It is obvious,” writes Bill Gross, “that the Chinese and other surplus nations cannot fund the deficit even if they were fully on board – which they are not. Someone else has got to write checks for up to $1.5 trillion additional Treasury notes and bonds…

“The concern is that this can be accomplished in only two ways – both of which have serious consequences for U.S. and global financial markets. The first and most recent development is the steepening of the U.S. Treasury yield curve and the rise of intermediate and long-term bond yields. While the Treasury can easily afford the higher interest expense in the short term, the pressure it puts on mortgage and corporate rates represents a serious threat to the fragile ‘green shoots’ recovery now under way.

“Secondly, the buyer of last resort in recent months has become the Federal Reserve, with its publicly announced and near-daily purchases of Treasuries and agencies at a $400 billion annual rate. That in combination with a buy ticket for over $1 trillion of agency mortgages has been the primary reason why capital markets – both corporate bonds and stocks – are behaving so well. But the Fed must tread carefully here. These purchases result in an expansion of the Fed’s balance sheet, which ultimately could have inflationary implications. In turn, nervous holders of dollar obligations are beginning to look for diversification in other currencies, selling Treasury bonds in the process.”

So how does Gross recommend you proceed?

“Bond investors should, therefore, confine maturities to the front end of yield curves, where continuing low yields and downside price protection is more probable. Holders of dollars should diversify their own baskets before central banks and sovereign wealth funds ultimately do the same. All investors should expect considerably lower rates of return than what they grew accustomed to only a few years ago.”