Bill Gross Investment Outlook Jan_06

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Investment OutlookBill Gross | January 2006

A Gift That Should Keep on Giving

Santa was good to me this year - too good to tell you the truth. While thats not possible for a 6-year-old tot, its more understandable for a 61-year-old man who is in the process of simplifying asopposed to complicating his life. Why it was only 5 years ago on these Outlook pages where I sworethat any friend who invited me to another dreaded Christmas party was no friend of mine. A year orso later I tried to send a message to my family via the Outlook that all I wanted for Christmas was tokeep my two front teeth and maybe a comb or two. Combs, thats what I needed, not shirts, sportcoats, or books that I would never read. Who cares if they cost only 50 - I needed to comb my hairmore than dressing up for next years Christmas gala that I would never attend. Ah, but no - theynever listen. Package after package, ribbon upon ribbon - Santa, Frosty, and reindeer wrappingpaper in endless gobs all over the living room floor. And when it was all over, what was the onepresent I raved about? An ordinary pair of reading glasses. "My God, I can read the newspaper," Iscreamed. And so it was that I had a merry Christmas after all, despite the plethoric overload ofwrapping paper and redundant gifts. Next year I have decided to implement a one-gift maximum,hoping for more combs, reading glasses, and maybe a pair of socks. Sue keeps pointing out that theones I wear to work have holes in the heels.

During the Christmas/New Years interlude there was considerable press and discussion about thecoming of the flat/inverted U.S. yield curve and what it meant for the economy and financial markets.Five of the past 6 recessions have been preceded by flat yield curves or was it 5 of the past 6 flatyield curves have led to recessions? No matter, theres a connection there thats reflective ofsubstantial Fed tightening that tends to inhibit future growth via an increased cost of borrowing -more on the short-term portion of the yield curve, but generally everywhere along it. During thiscycle, however, with the "conundrum" and all, soothsayers point out that 5- and 10-year yieldshavent gone up very much and therefore the flat curve is not as restrictive as in prior cycles. In last

months Outlook I divulged my/PIMCOs "secret" which hoped to contradict that theory. I argued thattodays 4% Fed Funds rate, and in turn, todays % longer dated yields almost everywhere onthe curve were much more restrictive than they appeared. PIMCOs "lack of global aggregatedemand" and Bernankes "global savings glut" were the primary explanations, suggesting that it tookthese lower yields to generate even anemic domestic investment spending as well as to keep thehousing asset bubble afloat which in turn was pumping consumption. Since higher yields workedwith a 12-18 month lag in terms of their economic impact, it seemed clear to me that 2006 would bea year of slower growth, perhaps 2%, and that the Fed and indeed the yield curve was about toreach a plateau around 4%.

This historical 12-18 month lag between a tightening cycle/flat yield curve is what fools manyanalysts into thinking that yields are still stimulative and that the Fed has more wood to chop. It takesthat long for higher yields to affect the housing market, mortgage equitization, and corporateinvestment cycles, whereas many economists feel it should work more like an anesthetic in theoperating room where the patient counts backwards from 10 to 1 and is out before he reaches 5. Itdoesnt work that fast. The Fed knows this, but often is willing to risk an overshoot and a curveinversion in order to insure benign inflation and sufficient economic slack over the foreseeable future.Short rates can always be lowered quickly (and they are - within an average 6 months after the lasthike) if the economy seems to be slowing too rapidly.

Not only the time lag but the level of interest rates is the critical question for bondholders, and whilelast months Outlook argued that they were now sufficiently restrictive, it acknowledged that therewas considerable disagreement with that view because of the "conundrum." Let me introduce,therefore, another market "timing" tool, my holiday gift to you, that will hopefully add weight to myarguments that the current bear market in bonds is over.

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Imagine, if you will, purchasing (receiving) a 5-year interest rate swap at some time over the past fewyears. For those of you who dont spend 12 hours a day in bond trading rooms, that means owning a5-year fixed rate bond and financing it (paying) with 3-month Libor which increases in yield everytime the Fed raises its benchmark. Instead of mark to market changes in the 5-year swap price, whatI would like to promote here is the concept of an increasingly more expensive "cost" to owning this 5-year swap as its financing rate (3-month Libor) increases. A 5-year swap purchased when shortrates were much lower and the yield curve more positive, produced positive carry and thereforegenerated "profits" for anyone holding this longer dated maturity when viewed from an income

statement perspective. But if you narrow or eliminate that carry via higher short rates (and a flat yieldcurve) those "profits" disappear.

This 5-year swap concept is important because the U.S. economy operates in much the same way.With close to a 5-year average life, the entire U.S. bond market can be compared to a 5-year fixedswap. That means that companies, homeowners, and consumers that have borrowed money inrecent years - (and purchased assets such as a home that are akin in my example to a 5-year swap)- are now being squeezed in a flat yield curve environment. Visualize a real life example in which youhave "financed" a home with an adjustable rate mortgage (in my example you finance a 5-year swapwith floating 3-month Libor). As the cost of the ARM increases with higher short rates, your excessincome available to spend on discretionary items begins to shrink. If that ARM rate goes too high,you hunker down even more by not eating out, going to movies, or taking a vacation to exoticdestinations. The economy in other words slows down.

How does this translate into a bond market timing tool? Chart I shows but one of a series of graphsPIMCO uses to indicate when enough is enough - the point at which adjustable short rates risesufficiently to make the owner of a home or a 5-year swap, or more importantly the economy, cry "noms!" That point comes in this example when Fed Funds rise to meet the average cost ofintermediate Treasury financing issued over the past 5 years and the spread between the twodisappears.

For sophisticates, please note that this is not the same thing as a flat yield curve. A flat yield curve isa concept comparing current short rates to current 5- and 10-year rates. What my chart does is tocompare current short rates to the Treasurys average intermediate term "coupon," a more reliableand indicative indicator of economic pain or restrictiveness since it uses an average embedded costof debt concept instead of a current cost. The standard flatness as measured by current market ratesin early 1995 (not shown here) never led to a recession, only a slowdown, just as Chart I would haveindicated. In other words, this indicator called for a mild slowdown in 1995 which is what we got. The


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standard flat curve theory called for something more extreme which is something we never got. Theembedded cost of debt indicator, therefore, shown in Chart I, has been more reliable.

For those of you whose heads are turning, simply accept the fact that by the time the line in Chart Ibottoms or hits 0, bond market yields have already peaked - in other words the bear market is over.Bear market ending dates of 1/00, 12/94, 3/89, and 5/84 can all be compared to 0-line or near 0-linebottom points indicating sufficiently onerous Fed Funds levels to slow the economy and end a bondbear market. Data points from the early 1980s backwards tell a similar story but are much moreextreme since it was necessary for the Volcker Fed to go to super tightness in order to knock outaccelerating inflation.

The sum total of last months Investment Outlooks "secret" and this months Investment Outlooks "gift that should keep on giving" is that yields have peaked in the bond market and will soon peak inFed Funds producing an economic slowdown in 2006. If the Fed goes beyond 4% and inverts theyield curve, the possibility of recession will increase. Observant readers will have already noted thatthe current data point in Chart I is not only calling for an end to the bear bond market, but arecession at some point 12-18 months hence. Perhaps. Much will depend on the future condition ofthe U.S. housing market and of course global economies - primarily of the Asian variety. We shallsee. But for now, hopefully you can take solace from a new timing indicator that says the worst isover for bonds and an indicator that should keep on giving in terms of its reliability for years andyears to come. Enjoy and Happy New Yearfor bonds!

William H. GrossManaging Director

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Bill Gross Investment Outlook Jan_06