Last week Bill Gross, who runs the world’s largest bond fund at Pacific Investment Management Co., sold all government related U.S. debt from PIMCO’s $237 billion Total Return Fund. You may be thinking, “Why is this tidbit of news important to us?” Good question. When someone who is as knowledgeable about the bond market as Mr. Gross decides to get out of U.S. bonds there’s a good chance that something significant is about to happen. Gross is betting that the discontinuation of the Federal Reserve’s Quantitative Easing program (QE2) in June will have a negative overall impact on the bond market.
That’s back up for a minute and explain some things. QE2 is the Federal Reserve program of buying U.S. government debt instruments for the purpose of stimulating the economy. In a period of only 28 months the Federal Reserve has become the largest owner of U.S. Treasury Bonds ($972 billion as of December) surpassing both China and Japan who took decades to accumulate their bond holdings. Yesterday, Mr. Bernanke, Chairman of the Federal Reserve confirmed that the Fed will discontinue QE2 as planned by the end of June.
Bill Gross wonders when the Fed stops buying bonds who will take their place? The Federal Reserve is currently buying $75 billion in U.S. bonds a month. That’s a huge amount. So what will be the impact when the Fed stops buying? It all goes back to the law of supply and demand. If the supply of U.S. treasuries remains the same but the #1 buyer of bonds is no longer buying, in order to get others to absorb the excess supply the market will demand a higher rate of return. It’s as simple as that. Gross believes that the current interest rate on 10 year treasuries is at least 100 basis points below the historical average.
If Mr. Gross is correct the logical result will be a significant rise in interest rates and it should happen before the end of this year. If true this could have a dramatic impact on the commercial real estate market. Rising rates would require a re-adjustment in cap rates upward to offset the decline in investment returns due to higher interest rates.
Years ago there was a TV ad by investment banking firm E.F. Hutton. The ad shows an E.F. Hutton fiancial advisor about to give confidential investment advice to his client in a crowded, noisy room. Before the advisor speaks the crowd stops talking and leans their ear to hear what he has to say. The ad ends with the slogan, “When E.F. Hutton speaks people listen.” Mr. Gross has just spoken and his actions speak loud and clear. Are we wise enough to follow his lead is the only question?
On a totally different note, treasury rates have plunged in the last few days. The 10 Year Treasury rate at this moment is 3.20%, down 55 basis points since January. On the surface this flies in the face of what is being predicted by Mr. Gross. In reality this substantial dip in rates is being caused by the crisis in Japan. Japan’s stock market, has plunged 16% in the last couple of days and investors are taking their money out of their stock market and putting it into the safest investment they know: U.S. Treasury’s. How ironic.
This article was written by Doug Marshall, Principal, of Marshall Commercial Funding.