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U.S. Treasury Bonds, Suddenly Unloved

The biggest hitter in the bond business these days is Pimco's Bill Gross, who is happy to share his common-sense reasoning with all of us little guys. If you own bond funds, you might want to pick up on what he's putting down, because Pimco is selling its Treasury bonds. The reason? The end of Quantitative Easing, and the market vacuum that could result when the Fed stops buying so much of the Treasury's issuance of bonds. And Gross is backing up the theory, selling Treasury bonds out of the Pimco Total Return Fund, and holding almost a quarter of the portfolio in cash.

Bill Gross has been a fan of quantitative easing, seeing it as a necessary means to recovery from the credit crisis. As a refresher, under QE the Treasury issues bonds, and the Fed buys them, to provide a jump-start to the money supply. (I wrote about this Tuesday.)

The aim was to to replace the missing supply of private credit by pumping public money into the financial system, and thereby reduce interest rates to give the housing market and business in general a fighting chance and make everyone feel richer through higher stock prices.

Gross writes in his March 2011 strategy report:

If that was the game plan, then so far, so good, I'd say. Interest rates are artificially low, stocks have nearly doubled since QE I's first announcement in December of 2008, and the U.S. economy will likely expand by 4% this year...
Gross looks at the end of QE2, and wonders about the effects on the Treasury market. Will the end of Fed buying simply slow the momentum of the market, which will be restored in an orderly way when the usual buyers, such as foreign governments, step back in? Or will the end of QE2 create a vacuum of buying in the market, requiring the Treasury to pay much higher yields to attract the non-Fed purchases?

Since QE2, the Fed has bought 70 percent of Treasury bond issuance, and the rest is going to foreign governments. Who will pick up that slack? Gross observes:

I don't know. Reserve surplus sovereigns are likely good for their standard $500 billion annually but the banks are now making loans instead of buying Treasuries, and bond funds are not receiving generous inflows like they were as late as November of 2010. Who's left? Well, let me not go too far. Temporary voids in demand are not exactly a buyers' strike. Someone will buy them, and we at PIMCO may even be among them. The question really is at what yield and what are the price repercussions if the adjustments are significant.
He shows how low today's yields are compared to history, and reckons that the 10-year should be about 1.5 percent higher, given nominal growth in GDP of 5 percent. The short end is even more suppressed:
Fed funds policy rates for the past 40 years have averaged 75 basis points less than nominal GDP and now rest at 475 basis points under that historical waterline.
Then comes today's news, as noted in the Financial Times, that the behemoth Pimco Total Return Fund has sold all its Treasuries. (Bloomberg covers it as well.) It continues to hold U.S. mortgage bonds, corporates, high yield and emerging market bonds, and 23 percent in cash.

Time to think about all those bond funds we own.

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