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.

Gross argues that increased demand is not the only factor pushing down yields. To fight the crisis, the Federal Reserve has aggressively expanded the money supply, in large part by dumping new money into the Treasury market. “We’ve been supporting Treasuries almost one for one,” he tells me. “At 8 a.m., the Fed calls up and asks our Treasuries desk for offers to buy, and one hour later, the Fed’s asking for bids to sell them.” The Fed, complains Gross, is “picking the pockets” of investors. Though he can’t quite bring himself to blame the financial powers that be. “God bless Ben Bernanke and Tim Geithner for what they’re trying to do, but the net result of a lot of what they’re doing is to take money out of the hands of savers.”

This outcome was perhaps predictable. According to Carmen Reinhart and Ken Rogoff, the authors of This Time Is Different, a 500-page encyclopedia of the disasters that have beset overindebted governments and economies, the ratio of government debt to gross domestic product usually doubles after a crisis. Reinhart, now a senior fellow at the Peterson Institute for International Economics, just released, with Rogoff, a global forecast of government debt levels over the next 25 years. Even in their “optimistic” scenario, total U.S. government debt rises from 43 percent of GDP in 2005 to 86 percent in 2015.

And after that? I asked Reinhart the same question I asked Bill Gross: Is the U.S. government going to default on its debt?

Like Gross, she thinks such a scenario—​which she calls “debt with drama”—is unlikely. Instead, she predicts that the United States will engage in “financial repression,” a sort of stealth default. Financial repression relies on inflation, regulation, and fancy accounting instead of forced restructurings, or outright refusal to pay. In 1932, for example, New Zealand did a “voluntary” debt swap that converted short-term debt to longer-term debt at lower interest rates. “You look at this deal and you ask yourself, ‘Why would anyone do this? It’s insane,’” says Reinhart. “And then you see that they changed the tax rules, so that if you didn’t do the swap, you’d lose a ton of money.”

Here and now, she thinks much of the debt will be “monetized,” or inflated away, by means of regulations that “encourage” the financial sector not to sell its government debt in the face of inflation. That means regulations such as the new set of international bank-capital standards known as Basel III, which heavily favor government debt, or Britain’s recent move to increase the percentage of each bank’s reserves that must be held in government bonds.

This strategy will probably work for Japan, which owes something like 95 percent of its massive debt to domestic savers and financial firms. Unfortunately, about half of all publicly issued U.S. debt is owned by foreign entities, such as central banks that buy a lot of dollars in order to keep their own currency artificially cheap. Then there are the free agents such as Gross. Will they really stand by as we let inflation—or a sinking dollar—eat away most of the value of their investments?

Given how much money we’re borrowing, we need them to both hold on to the Treasuries they have and keep buying more. Even the optimistic projections of the Obama administration show us borrowing $735 billion by 2020. And foreign central banks, and investors like Bill Gross, are already expressing reluctance to keep financing our deficits.

Some observers point to our current low interest rates and ask, “Why worry about deficits right now?” Paul Krugman, for example, regularly derides the people who are worried about the “invisible bond vigilantes.” But of course, as Gross says, what’s keeping Treasury-note prices low is not so much the free market as the behavior of central banks, which are buying for reasons that have nothing to do with their assessment of our fiscal rectitude.

Reinhart, who has done extensive research on the topic, was even more dismissive of Krugman’s analysis. “Are interest rates a good indicator of impending crises? The resounding answer is no.” Deficit doves seem to assume that bond interest rates will act as a sort of early warning system: when they start to creep up, then we should start cutting our deficits. But Reinhart argues, “Before the crisis, Ireland’s rates were imperceptibly higher than Germany’s.” By November 2010, the Irish were paying an extra 6 percent annual interest to borrow money. “I certainly wouldn’t call this my baseline scenario for the U.S.—but the message is: think the unthinkable.”

This sort of “jump shift” would probably be less disastrous for us than it was for Ireland, but it would still be a terrible reckoning. Even if the Fed monetized part of the debt, the tax hikes and spending cuts would be sudden, drastic, and slapdash. And economies that punish people for saving and investing tend to have trouble building up the kind of productive infrastructure that can “win the future.”

Indeed, even the belief that the government will expropriate and/or inflate away savings can be enough to stunt investment. Gross has already voted with his feet, and he expects at least a few others to follow. “Sale of Treasury bonds is the easiest way of staging a mini-revolution and saying ‘Hell no, we won’t go,’” he told me, still with an almost beatifically mild expression.

So what does Gross need to see before he’s willing to unsaddle his horse and return to the Treasury market? “Higher yields!” he said promptly—but he’s also watching the deficit. Like Reinhart, he worries that the government will try various ways to stealthily reduce the value of its debt—and the larger the deficit, the more likely, and more drastic, such actions become. “Debt-to-GDP is not egregious,” he said, “but it’s moving up the list.” And worse, “I’ve seen no willingness to tackle the difficult problem of entitlements from any political party.”

This is exactly the problem, really. Our national conversation about deficits is about politics—about ideology—not math. It’s a proxy war in our eternal battle over how much to tax and spend. Republicans care about deficits when spending is on the table, but as soon as they get a chance to pass some tax cuts, they forget they ever cared. Meanwhile, Democrats, who were outraged—outraged!—when the deficit averaged less than 3 percent of GDP under George W. Bush, are now silent about deficits that are running three times as high, and that are projected to stay above Bush’s even after Obama has left office. Very few true deficit hawks are left in America—only deficit vultures.

Unfortunately, no matter which ideological path we head down, we still must ultimately persuade people like Bill Gross to come along for the journey. I asked Gross whether it matters to him how we close the deficit. He shrugged and said that obviously we need to raise taxes on the rich by quite a bit. But he doesn’t really have any particular political prescription other than doing whatever it takes—tax hikes or spending cuts or both—to bring the budget back in line. “In the developed world,” he said, “the credit bubble is at an end, and investors are calling ‘Game over.’”

Yet he’s not bearish on America. “We own U.S. corporates, Fannie and Freddie mortgages—we haven’t left the country, we’ve just left Treasuries.” It would be one thing, he told me, if this were 1943 and we were in World War II; but we’re not, and he has a fiduciary duty to his investors that he can’t violate just because his country doesn’t want to make hard choices about taxes and spending.

And would he have bought the Victory Bonds that the government sold to fund the war effort? For the first time in the interview, Gross obviously tried to hedge. “Well, I’d like to think that the government wouldn’t have picked the pockets of its savers.”

But it did then, just like it is doing now, I pointed out; the government inflated away the value of the bonds so that they yielded negative real returns. Gross smiled.

“Maybe if they framed it as a ‘Victory in Afghanistan’ thing, I might be more favorably disposed.” So the people worried about the bond vigilantes have at least one ray of hope after all. The leader of the gang may be tough—but at heart, he’s still a bit of a patriot. That may not be enough to save us. But perhaps it will buy us some time to clean up our act.

Megan McArdle is an Atlantic senior editor.
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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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