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BIll Gross: Beware The "Unknown Consequences Lurking In The Shadows"

Starting off with two macabre examples of extreme behavior - one man who can't stop eating and another one who can't start - in his latest monthly letter Bill Gross says that "monetary policy in the post-Lehman era" has become the modern equivalent of gluttony: "they can’t seem to stop buying bonds, although as compulsive eaters and drinkers frequently promise, sobriety is just around the corner."

Pointing out a number we discussed just yesterday, Gross notes that "to date, since the start of global Quantitative Easing, over $15 trillion of sovereign debt and equities now overstuff central bank balance sheets in a desperate effort to keep global economies afloat." What Gross is referring to, of course, is the chart we showed just yesterday in "The Most Dangerous Moment": Why Every Bank Is Suddenly Talking About Q3 2018"

Going back to his, and our, favorite topic, namely mocking central banker stupidity, the Janus investor slams central bankers' reliance on historical models such as the Taylor Rule and the Phillips curve, saying that "at the same time, over $5 trillion of investment grade bonds trade at negative interest rates in what can only be called an unsuccessful effort to renormalize real and nominal GDP growth rates." and warns that "the adherence of Yellen, Bernanke, Draghi, and Kuroda, among others, to standard historical models such as the Taylor Rule and the Phillips curve has distorted capitalism as we once knew it, with unknown consequences lurking in the shadows of future years."

It's not just central bankers who are transfixed by broken models, Gross also takes aim at economists and their overreliance on the shape of the yield curve as a (pre)recession indicator:

"similarly, private economists adhere to historical models, which attempt to “prove” that recessions are the result of negative yield curves, as seen in Chart 1. Over the past 25 years, the three U.S. recessions in 1991, 2000, and 2007-2009 coincided nicely with a flat yield curve between three-month Treasury Bills and 10-year Treasuries. Since the current spread of 80 basis points is far from the “triggering” spread of 0, economists and some Fed officials as well, believe a recession can be nowhere in sight."

At this point Gross makes the same point we have observed on many occasions, when we said that in the current centrally-planned age models are meaningless, and says that "the reliance on historical models in an era of extraordinary monetary policy should suggest caution. Logically, (a concept seemingly foreign to central bank staffs) in a domestic and global economy that is increasingly higher and higher levered, the cost of short term finance should not have to rise to the level of a 10-year Treasury note to produce recession.

"Most destructive leverage – as witnessed with the pre-Lehman subprime mortgages – occurs at the short end of the yield curve as the cost of monthly interest payments increase significantly to debt holders. While governments and the U.S. Treasury can afford the additional expense, levered corporations and individuals in many cases cannot. Such was the case during each of the three recessions shown in Chart 1. But since the Great Recession, more highly levered corporations, and in many cases, indebted individuals with floating rate student loans now exceeding $1 trillion, cannot cover the increased expense, resulting in reduced investment, consumption and ultimate default. Commonsensically, a more highly levered economy is more growth sensitive to using short term interest rates and a flat yield curve, which historically has coincided with the onset of a recession."

Finally, after explaining that the conventional wisdom on yield curves may be wrong...

Just as logically, there should be some “proportionality” to yield curve tightening. While today’s yield curve would require only an 85 basis increase in 3-month Treasuries to “flatten” the yield curve shown in Chart 1, an 85 basis point increase in today’s interest rate world would represent a near doubling of the cost of short term finance. The same increase prior to the 1991, 2000 and 2007-2009 recessions would have produced only a 10-20% rise in short rates. The relative “proportionality” in today’s near zero interest rate environment therefore, argues for much less of an increase in short rates and ergo – a much steeper and therefore “less flat” curve to signal the beginning of a possible economic reversal.

 

How flat? I don’t know – but at least my analysis shows me that the current curve has flattened by nearly 300 basis points since the peak of Fed easing in 2011/2012. Today’s highly levered domestic and global economies which have “feasted” on the easy monetary policies of recent years can likely not stand anywhere close to the flat yield curves witnessed in prior decades. 

... Gross issues a warning to Yellen whose actions continue to push up the short-end, saying that any additional tightening should be done very carefully:

Central bankers and indeed investors should view additional tightening and “normalizing” of short term rates with caution.

Then again, considering that financial conditions just hit the "easiest" they have been in two years, maybe Yellen still has quite a bit of leeway.