Business June 2011

The Vigilante

Why the man who runs the world's largest mutual fund sold all his Treasury bonds
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Brad Swonetz/Redux

In February 1993, as the fledgling Clinton administration grappled with the nation’s budget woes, campaign adviser James Carville groused to The Wall Street Journal: “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone.” If Carville were serving in the Obama administration today, he’d be seeking reincarnation as Bill Gross. The founder and co–chief investment officer of PIMCO, Gross runs his firm’s Total Return Fund—the world’s largest mutual fund, with holdings entirely in bonds. And for some time, he has been an outspoken critic of U.S. economic policy.

Gross demurred when I suggested that James Carville might want to be him. “I thought the remark was striking at the time,” he said, “but no, I didn’t feel that they were catering to us at every turn.”

But Democrats wrestling with the legacy of Ronald Reagan’s deficits resented the influence of what the analyst Ed Yardeni had dubbed “the bond vigilantes”: the investors who enforce fiscal and monetary discipline when governments won’t. If your political system inflates its currency, or fails to align its spending with its tax revenues, the bond vigilantes will raise your interest rates until you either get it together … or catapult into a crisis.

In the 1990s, we chose to get it together; thanks to tax hikes under both Bush I and Clinton, and a massive influx of capital-gains-tax revenue from the stock-market bubble, we even enjoyed a brief surplus. The bond vigilantes retreated over the horizon. But now deficits are back—and bigger than ever. In 2010, the United States spent $1.3 trillion more than it took in.

This year, the Congressional Budget Office expects us to borrow another $1.5 trillion. In just two years, we will have borrowed almost 20 percent of gross domestic product, or more than $9,000 for every person in the United States. But we won’t be borrowing it from Bill Gross. For some time, he’d been selling his Treasury holdings, and by early March, he had reportedly dumped all of them. Then in mid-April, Gross upped the ante by placing bets against U.S. bonds in the market, a move that pushed the Total Return Fund’s holdings of U.S. debt to the equivalent of minus 3 percent. If the bond vigilantes really are getting the gang back together, then the size of Gross’s funds—and his recent divestment—would seem to make him their leader. With economists and politicians warning about the dire consequences of out-of-control deficits, it seemed like a good time to sit down and ask Gross how dire the situation was. Is the United States really heading for an epic showdown with the debt markets? And if it comes, how badly will we be hurt?

A trim, gentle-seeming 67-year-old, Bill Gross doesn’t look much like a vigilante. He speaks so quietly that my voice recorder gave up and turned itself off. PIMCO’s Newport Beach, California, office has the understated elegance of one of those five-star western resorts where executives go to de-stress. The tranquility extends even to the trading floor, where Gross still sits for most of the day. I spent the latter half of the 1990s installing networks on New York trading floors, and even the smallest of them operated at a low roar. But PIMCO’s 100-seat floor is so eerily silent that I half-expected to see the traders communicating in sign language. Showdowns with PIMCO come, not with a bang, but with the almost imperceptible clicks of traders calmly keying in their sell orders.

I started by asking Gross the questions on the mind of every economic pundit in Washington these days: Why did he sell? Does he think the U.S. will default on its debt?

Gross shook his head (gently). “Actual default is unimaginable.” He must be pretty confident in that judgment, because he confirmed rumors that he’s made a sizable bet against a default. “We’ve taken probably $1 billion worth of U.S. credit-default swaps on the long side at a yield of 0.5 percent per year, which is more than the 0.25 percent being offered by the feds.” Effectively, Gross is selling insurance on U.S. bonds—and getting a better return than he would by buying those bonds.

Default is the most obvious risk that bond investors face, but not the only one—they also need to worry about things like inflation. Gross has left Treasuries simply because he thinks the yield offered is no longer high enough to compensate him for things like inflation risk. “Global savers have earned yields of 1 percent over inflation over the last half century,” he told me. “Now you’re not earning the historical rate.”

Gross is known for getting out when the getting isn’t good. You can perhaps credit his Canadian parentage for his remarkable discipline. Canada’s banking system is one of the few entities that skirted the financial crisis—as did the funds run by Bill Gross, who was worrying about a mortgage crisis as early as 2005, and positioned his funds accordingly. Yet even with solid Canadian genes, that discipline wasn’t always easy to maintain. “In 2006 and 2007, we were sort of questioning our own judgment, because we were half a percentage point behind our peers … You question whether you’re just really being a stubborn donkey, or your premises are right.”

Unfortunately, they were; they usually are—the Total Return Fund has averaged 7 percent returns over the past 10 years, ranking it third among intermediate-term bond funds. Gross says the essential trick is being “a contrarian, but not an extreme contrarian … a pessimist, but not an extreme pessimist.” Being right too early, he points out, is almost as bad as being wrong—as the folks who shorted the stock market in 1996 can attest. Yet the predictions he’s making now sound pretty pessimistic: after a 30-year rally in the stock and bond markets, he thinks we now have to adjust to a “new normal” of slower growth and lower returns.

In some ways, this is just Gross’s “old normal.” He started investing in the early 1970s, when inflation was soaring. Inflation is bad for bonds, because they have a fixed payout—as money loses value, the real value of your interest payments declines, and worse, people want to buy the bonds from you only at a discount. “The first 10 years, it was ‘Preserve capital, preserve capital, preserve capital,’” Gross told me, adding glumly, “Now we’re back to that.”

But in between, he profited greatly off a long rally, which has spanned most of his career. In 1980, the Fed finally got tough on inflation, which declined, along with interest rates, slowly but steadily for most of the next three decades. It was the 1970s in reverse. As Gross says, “Investors got used to being on this magical journey, with bonds not only producing a nice yield, but some capital gains too.” In 1984, the yield on a 10-year Treasury note averaged 12.46 percent. By 2001, it was 5.02 percent.

But now the rally has ended, as it had to (inflation couldn’t fall forever). Indeed, yields are even lower than you’d expect. As of mid-March, they were around 3.3 percent—lower than they were in 1962, when inflation averaged just 1.3 percent. These low yields are partly due to a global “flight to quality,” which has pushed up the demand for safe assets. U.S. Treasuries are a prime destination for capital refugees, because our government’s default risk is low, and our economy is very, very large. Especially with the Obama administration obligingly running record deficits, we’ve had a lot of Treasury debt to go around. Thus, the financial crisis that started in our financial markets has ironically made borrowing much cheaper for our government.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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