Gyroscopic Investing

Can they do that? How can an quasi-government entity dictate interest rate ceilings?
Bottom line - would it matter to HB investment theme?

Here is the full article

By Jennifer Ablan
NEW YORK | Wed Jun 15, 2011 5:03pm EDT
http://www.reuters.com/article/2011/06/ ... XC20110615

The world's largest bond fund manager said on Twitter late Tuesday: "QE3 likely to take form of 'extended period' language or interest rate caps on 2-3-year Treasuries."

Gross, the co-chief investment officer of PIMCO, the world's top bond manager, also said on Twitter: "Next week's Fed statement will likely stress 'extended period of time' language or even a period of interest rate caps."

The Fed will hold its next policy meeting on Tuesday and Wednesday, and will issue its policy statement after the close of the meeting.

The recent soft patch of economic data has increased speculation over whether U.S. policymakers will perform a third round of bond purchases, an unconventional monetary measure known as "quantitative easing," or QE2. The second round of QE2's $600 billion in purchases will conclude on June 30.

But Gross tweeted that the Fed could signal a cap on interest rates as a form of QE3.

Mark Porterfield, spokesman for PIMCO, confirmed to Reuters the content of the tweets. Pacific Investment Management Co. oversees more than $1.2 trillion in assets.

While the 10-year Treasury bond is one of the most widely watched securities as it sets the benchmark for almost every other interest rate in the U.S. economy, Fed Chairman Ben Bernanke has long considered the two-year Treasury note as an effective tool.

In a November 2002 speech, entitled "Deflation: Making Sure 'It' Doesn't Happen Here," Bernanke said: "Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates."

Bernanke, who at the time was a Federal Reserve governor, went on to say that the two-year Treasury note is a long-term maturity and that 10-year notes are "longer" maturing securities.

Bernanke said: "A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years).

"The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well."

They could cap yields by purchasing as many bonds on the secondary market as required to decrease supply and lower the yield to some target level.  It seems like a dangerous game to play because all of the smart money will front-run the fed.  On the other hand, just by having the smart money try to front run them, lower bond yields could be a self-fulfilling prophecy.

We are getting to the level of market manipulation where it is tough to predict what will happen.  I would say it's a good time to be holding long bonds, but it's hard to say.  QE3 could just as easily have the opposite effect.

edit:  One other thing to say here - we need to keep in mind what is the goal here - it seems clear that the #1 drag on the economy is the deflating housing market.  The goal here is to keep yields as low as possible to drop financing charges and artificially sustain high house prices.  There is an inverse correlation between bond yields and house prices.  As bond yields rise, house prices fall, because in the end, a house price is based on a mortgage payment and the higher the financing charge, the lower the house price must be.

It will all be for naught in the end - money is cheap right now and I don't see anyone rushing out to get a $500,000 mortgage.

The Fed can only influence rates. They don't control them. If the markets think there is too much money causing inflation the rates are going to go way up whether the Fed wants it or not.

Also with these big money managers you never know if they have hidden motives for their public statements. In particular, I never trust public statements from people like Gross, Soros, Buffet, etc. You never know what bets they have out there to make money from saying certain things publicly.

As usual, I continue to ignore market predictions like this.

craigr wrote: The Fed can only influence rates. They don't control them. If the markets think there is too much money causing inflation the rates are going to go way up whether the Fed wants it or not.

Is that really true? Couldn't the Fed (and other sovereign central banks) in theory buy all of the bonds and have zero rates all the way up the yield curve? Having negative real interest rates across all the trusted currencies would only leave commodities as a refuge and taxes/regulations could be attempted to keep savers out of them?
Also Japan seems to show that too much money doesn't cause inflation if no one spends it.

Let's also not forget that Bill Gross has made some disastrous calls this year. He's probably the last person you'd want to get a prediction from.