How Bill Gross Got It All Wrong

Earlier this year Bill Gross, the head of bond giant PIMCO, announced in grand fashion that he was getting out of U.S. Treasuries. His reasoning was quite rational: The end of the Fed's quantitative easing program, which ended in June, would be bad for bonds. Prices would fall causing yields (or interest rates) to rise. This would happen because the Fed was the number one buyer of U.S. debt. Without the Fed buying bonds one of two things would have to happen to prevent yields from rising:

1. Some other country would have to step in to buy the Fed's volume of U.S. Treasuries which was highly unlikely, or
2. The U.S. government would have to significantly moderate their borrowing to shrink the volume of U.S. Treasuries being sold on the market. At the present time for every $1 spent by the federal government about 40 cents of that amount is borrowed.

So what do you think are the chances of either #1 or #2 happening? Not likely is it? Looking at it from this perspective, it seemed quite unlikely that another country could purchase the enormous quantity of bonds that the Fed had been buying over the last two years. And it also seemed unlikely that the federal government would reduce its need to borrower.

This past week people were crowing about how Bill Gross got it all wrong and how he lost a lot of money for his bond fund investors. He even admitted sheepishly that it had been a "mistake" to get out of U.S. treasuries. Since Mr. Gross’s announcement in March the 10 year treasury rate has plummeted from 3.46% to 2.02% (Sep 2nd). So how does someone of Mr. Gross's caliber get it wrong? What did he miss?

Back in March when Mr. Gross made his announcement there was no way for anyone to predict:

1. That the sovereign debt crisis in Europe would reach critical mass this year. European leaders had been successful over the years in “kicking the can down the road” and it seemed likely this year would be no different. Wrong!
2. What the impact of the sovereign debt crisis would have on the U.S. treasury market. Fear of a default of sovereign debt by Greece and then by Italy has caused a panic among Europeans. And when panic ensues, investors take their money out of risky investments promising a return on their money and instead invest in less risky investments, in this case U.S. treasuries, where they focus on getting a return of their money.

What has happened is the law of supply and demand has kicked in. Concerned European investors have dramatically increased the demand for U.S. treasuries while the supply has stayed the same. When that happens, yields decline. It’s really that simple.

But the big question is, “How does this affect those of us in the commercial real estate market?” We are currently seeing historically low interest rates.  A lower interest rate means a lower mortgage payment which means better cash flows after debt service. If you own commercial real estate now is the time to lock in long term fixed rate financing.

I know I sound like the boy who cried wolf one too many times but some day we are all going to wake up and the world will be different. Some unpredictable catastrophic event will have occurred (a run on U.S. banks perhaps) causing interest rates to skyrocket and when that happens those who had the foresight to lock in the low rates will be the big winners.

Source: Bill Gross and the Case for Buy Low and Hold, Morgan Housel, The Motley Fool, August 31, 2011.