- By Bill Gross
- The New Normal, previously believed to be bell-shaped and thin-tailed in its depiction of growth probability and financial market outcomes, appears to be morphing into a world of fat-tailed, almost bimodal outcomes.
- A new duality – credit and zero-bound interest rate risk – characterizes the financial markets of 2012, offering the fat left-tailed possibility of unforeseen policy delevering or the fat right-tailed possibility of central bank inflationary expansion.
- Until the outcome becomes clear, investors should consider ways to hedge their bets, including: maximizing durations, U.S. Treasury bonds that may potentially offer capital gains, long-term Treasury Inflation Protected Securities (TIPS), high quality corporates and senior bank debt, and select U.S. municipal bonds.
But before ringing in the New Year with a rather grim foreboding, let me at least describe what financial markets came to know as the “old normal.” It actually began with early 20th century fractional reserve banking, but came into its adulthood in 1971 when the U.S. and the world departed from gold to a debt-based credit foundation. Some called it a dollar standard but it was really a credit standard based on dollars and unlike gold with its scarcity and hard money character, the new credit-based standard had no anchor – dollar or otherwise. All developed economies from 1971 and beyond learned to use credit and the expansion of debt to drive growth and prosperity. Almost all developed and some emerging economies became hooked on credit as a substitution for investment in tangible real things – plant, equipment and an educated labor force. They made paper, not things, so much of it it seems, that they debased it. Interest rates were lowered and assets securitized to the point where they could go no further and in the aftermath of Lehman 2008 markets substituted sovereign for private credit until it appears that that trend can go no further either. Now we are left with zero-bound yields and creditors that trust no one and very few countries. The financial markets are slowly imploding – delevering – because there’s too much paper and too little trust. Goodbye “Old Normal,” standby to redefine “New Normal,” and welcome to 2012’s “paranormal.”
This process of delevering has consistently been a part of PIMCO’s secular thesis but “implosion” and “bimodal fat tailed” outcomes are New Age and very “2012ish.” Perhaps the first observation to be made is that most developed economies have not, in fact, delevered since 2008. Certain portions of them – yes: U.S. and Euroland households; southern peripheral Euroland countries. But credit as a whole remains resilient or at least static because of a multitude of quantitative easings (QEs) in the U.S., U.K., and Japan. Now it seems a gigantic tidal wave of QE is being generated in Euroland, thinly disguised as an LTRO (three-year long term refinancing operation) which in effect can and will be used by banks to support sovereign bond issuance. Amazingly, Italian banks are now issuing state guaranteed paper to obtain funds from the European Central Bank (ECB) and then reinvesting the proceeds into Italian bonds, which is QE by any definition and near Ponzi by another.