By Bill Gross via PIMCO  I’ve spun a few yarns in recent years about my days as a naval officer; not, thank goodness, tales told by dead men, but certainly echoes from the depths of Davy Jones’ Locker. A few years ago I wrote about the time that our ship (on my watch) was almost cut in half by an auto-piloted tanker at midnight, but never have I divulged the day that the USS Diachenko came within one degree of heeling over during a typhoon in the South China Sea. “Engage emergency ballast,” the Captain roared at yours truly – the one and only chief engineer. Little did he know that Ensign Gross had slept through his classes at Philadelphia’s damage control school and had no idea what he was talking about. I could hardly find the oil dipstick on my car back in San Diego, let alone conceive of emergency ballast procedures in 50 foot seas. And so…the ship rolled to starboard, the ship rolled to port, the ship heeled at the extreme to 36 degrees (within 1 degree, as I later read in the ship’s manual, of the ultimate tipping point). One hundred sailors at risk, because of one twenty-three-year-old mechanically challenged officer, and a Captain who should have known better than to trust him.
Bill Gross

We survived, and a year later I exited – the Diachenko and the Navy for good – theirs and mine. I think I heard a sigh of relief as I saluted the Captain for the last time, but in memory of those nearly tragic moments, let me reprint an article posted on wikiHow, outlining exactly how to go about abandoning ship should you ever venture into the South China Sea or anywhere close to Davy’s infamous locker. The article is a bona fide and serious attempt to instruct would be passengers in a Titanic-like disaster. I found it, however, as comical as yours truly pretending to be a chief engineer in 1969. Judge for yourself…

wikiHow: the how to manual you can edit

How to Escape a Sinking Ship

The Basics: Before Setting Sail

1. Understand the mechanics of a sinking ship. Water usually enters the lowest point of a ship first, the bilge area.

2. As more and more water enters the ship, it will start to heel significantly. From this point on, sinking will occur quickly. Abandon ship.

If Sinking is Imminent

1. Think about your sense of etiquette. What will you do if push comes to shove?

2. If you’re in charge of the sinking ship learn how to send a Mayday. Read “How to call Mayday from a marine vessel” on the attached internet link.

3. Stay calm and don’t panic.

4. If you see someone with fear, yell at them.

5. While still on deck, watch for catapulting objects coming your way. Large items can kill you.

Abandoning Ship

6. Find a lifeboat. The best scenario is to enter a lifeboat without getting wet.

7. If jumping off the ship, always look first.

8. If you survive, be ready for the reality that others may have perished. Seek counseling.

Counseling indeed! If only I knew then what I know now: wikiHow, not experience or damage control school, is the best teacher. So, should bond investors abandon ship? And who to believe? The captain of the Fed, the co-captains of the USS PIMCO, or just trust your instincts? Well there is no wikiHow moment to guide you in this case, although it’s true that yours truly, PIMCO, and the bond market have sailed some rough seas over the past few years. So has Chairman Bernanke. We’re all in this one together it seems.

Immediate analysis of the past 6 weeks’ market action would argue that in late April, both the Fed and PIMCO observed that bond markets were approaching a tipping point. Yields were too low, prices too high, both for investors’ and the economy’s own good. The Fed’s Jeremy Stein had written a research paper outlining the risk. I, in fact, had written a MarchInvestment Outlook outlining Governor Stein’s paper, and to be fair, PIMCO had been warning of high seas for what seems like an eternity. “Never,” I tweeted, “have investors reached so high for so little return. Never have investors stooped so low for so much risk.” True enough, history will likely record.

It will also record however, that the risk was not only in narrow credit spreads and emerging market debt/equity markets but at the heart of the credit system itself: U.S. Treasuries. What supposedly old salts like yours truly didn’t suspect was that all bonds, and yes, equities too were at risk of heeling over based upon a rather perfect storm, one that forecasters everywhere found difficult to fathom.

The forecast for bad weather as I’ve mentioned was becoming more rational with every increase in asset prices. If all markets were being artificially supported as PIMCO claimed and the Fed confirmed, then somedaysomeday that support via quantitative easing would have to be withdrawn. But the dark clouds seemed to be far off on the horizon. Investors worldwide piled on the leverage – not just in high yield or equity space – but in Treasuries as well. If the Fed (and BOJ) were going to keep writing checks at one trillion per year, then these two central banks alone might be buying 70-80% of all developed market future supply. The fear was that there might not be enough for others, not that there was too much leverage.

Well, that started to change with the May 22nd taper talk and, of course, with the Fed’s June 19th statement and Chairman Bernanke’s press conference. In trying to be specific about which conditions would prompt a tapering of QE, the Fed tilted overrisked investors to one side of an overloaded and overlevered boat. Everyone was looking for lifeboats on the starboard side of the ship, and selling begat more selling, even in Treasuries. While the Fed’s move may ultimately be better understood or even praised, it no doubt induced market panic. Without the presence of a “Bernanke Put” or the promise of a continuing program of QE check writing, investors found the lifeboats dysfunctional. They could only sell to themselves and almost all of them had too much risk. A band somewhere on the upper deck began to play “Nearer, My God, to Thee.”

Well I go too far in my sinking ship metaphor, but you get the point, I hope. The U.S. economy is not sinking, nor are the majority of global economies. Their markets just had too much risk,and in PIMCO’s opinion, too much hope for a constant QE and for the growth that it would produce. In effect, the ship was top heavy with too little ballast. Guess I should have known, huh?

Well where does the ship go from here? Should you as a bond investor jump overboard and risk the cold money market Atlantic Ocean at near zero degrees? We don’t think so – and not because we want to keep you on board – we just don’t think so. Why not?

1) The Fed’s forecast of the economy which prompted tapering panic is far too optimistic. If 7% unemployment is tapering’s final port of

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