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Thursday, January 07, 2016 3:40 PM

Bill Gross on China, Secular Stagnation, and the Highly Leveraged "Negative Carry" Environment

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In a Bloomberg TV Interview, Bill Gross of Janus Capital spoke with Bloomberg's Tom Keene about the state of the global economy.

The interview and transcript below are well worth the time. Gross' thoughts on negative carry are particularly interesting. I offer my comments beneath the transcript.

Partial Transcript

TOM KEENE: Bill, good morning to you, thrilled to speak to you tomorrow on the jobs report. Let's talk about the more urgent matters of this market. First of all, Bill, China is the topic. Is this about China and their stock market? Or is there more going on on this January afternoon?

BILL GROSS: Yes, it is about China specifically, Tom. But there's a lot more going on and we've talked about it in past months.

The global economy is still highly levered and central banks are artificially elevating prices and keeping interest rates low.

It's a highly levered world and when something gets out of whack like the Chinese currency or in terms of the oil price, then you see these movements everywhere.

KEENE: Within a highly levered world, do you see any sense of an immediate catharsis to clear markets? Or is the theme for early 2016 that we slog along with this rolling pain in search of an abrupt move to clear markets?

GROSS: Well, China announced this morning that they are going to let markets clear. They haven't.

KEENE: What will we see tomorrow morning? Bill, what will we see out of Australia and into China tomorrow? They're going to go longer than seven or 12 minutes. What would you predict we will observe?

GROSS: Well, based upon the ETF in the United States, China is predicted to be down 5 percent or 6 percent. It depends upon whether the Chinese are good to their word in terms of letting markets clear. They haven't. And to the extent that it goes down more than 5 percent or 6 percent, who knows?

But China is an artificial market. All global markets are artificially based.  And to the extent that we have a catharsis, I think, depends upon central banks basically giving up in terms of what they do. I don't think they're -- that's going to happen.

Draghi is in it, whatever it takes. The U.S. Fed will stop raising interest rates if the see a problem. China will get back into the markets if they have a catharsis and the Japanese, of course, buy stocks and bonds like they are going out of style.

So it's up to the central banks basically to save the day or prevent a catharsis.  And I think they will. But ultimately, to my way of thinking, that's not a good thing but it allows for zombie corporations and zombie production that we are now seeing in terms of the oil market.

KEENE: Just so you don't call it zombie surveillance. Bill Gross, with what you just stated, of the responsibility of central banks, given the market turmoil and if we see more tomorrow and after the jobs report, will there be a responsibility of Chair Yellen to say we're one and done, that's all we're going to do with our rate rises?

GROSS:  Well, I don't think she'll say that. They've been on this track of raising interest rates for so long that she's not going to come out with one or done. She may come out there -- someone may come out -- Fischer perhaps -- will come out and acknowledge the fact that global markets and that global financial conditions are an important consideration in terms of future policy.

But I don't think they're going to divulge that they are not raising interest rates for times as Stan Fischer said a few days ago.

KEENE: You know, I look here at the bond market, Bill, and you got to convince our less sophisticated viewers and listeners, the idea that they can be protected by being diversified or buying unconstrained in that. There's a real sweat out there that this is like '98 or this is like -- frame this within the history that you worked in at your previous employer and now at Janus. Where are we in terms of level of crisis?

GROSS: Yes and that's a great question and if you got a minute.  I will go through it as quickly as I can.

KEENE: Please. 

GROSS: Basically ever since -- ever since I began my career in the early '70s and the Fed basically relaxed and was off the gold standard, it has been a function of a carried trade for investors, not just unlevered investors but levered investors and hedge funds.

In other words, they tried to capture carry, carry in the form of duration, meaning longer maturity bonds, carry in the form of credit spreads, meaning lower quality instruments, carry in the form of volatility, carry, carry, carry. And ultimately that produced substantial bull markets, not just in bond markets but equity markets as well.

They captured basically carry relative to overnight financing and to Treasury bills.

Now when interest rates are so low and, in some cases, negative, it sets up the situation in which carry is not positive but negative. And you see in terms of the inner correlations, you see a market -- and this happened with hedge funds last year -- where the returns for hedge funds and other levered investors are basically zero or negative because the carry has collapsed and there's no carry to capture.

And so what we see on days like today, when markets go down and oil prices go down and currencies fluctuate is a negative carry in which investors start to lose money and that ultimately is what the financial markets have taken us from the early '70s in terms of high carry to now lower or negative carry.

KEENE: Well, that was beautifully explained but it also suggests we have got to get to an idea where we get back to normal.

Do you suggest, as Lawrence Summers suggests, that we are not going to get back to the normal where carry works because we are within a new terminal value, and we're within some form of secular stagnation?

I mean, is something that what we've seen the last 24 hours, is it something we need to get used to?

GROSS: Well, I have been saying that for years, not to preempt Larry Summers, who's a smart guy and secular stagnation, as he's suggested, was not even his original idea. But the new normal from the old PIMCO days, basically said the same thing, that growth will be low, that interest rates will be even lower and that we have to get used to a world of low returns.

Now we didn't really see that, did we, because of quantitative easing and the dropping of interest rates over the past three or four years.  It has taken a while for that to take place. 

But yes, secular stagnation in terms of demography, secular stagnation in terms of low interest rates, secular stagnation in terms of technology, all of that is producing a situation in which growth is low, interest rates are low, stock prices are relatively high and returns suffer.

Negative Carry, Negative Interest Rates, Piles of Debt

Central banks have attempted to fight price deflation with low interest rates. When that failed, we saw negative interest rates.

Corporations leveraged up with more debt, even though the problem is debt. Now equities and bonds are in even bigger bubbles than ever before.

The Fed bailed out the banks, but home prices are more unaffordable than ever. 

Former Dallas Fed president Richard Fisher admitted as such. He specifically stated in a Squawk Box interview, "We Frontloaded a Tremendous Market Rally".

He also admitted the Fed created bubbles on purpose for the "wealth effect".
Click on that link for a transcript of an amazing video confession.

Like Bill Gross, I expected low growth, low interest rates, and low returns. It was the forecast for low returns that led to Gross' ouster at PIMCO, and caused a huge amount of grief for value investors.

Now, in search of yield, in a decreasing yield environment, hedge funds, pension plans, and others are more leveraged than ever.

Pension plans need 8% returns in a 1% world. That no problem if they use 8-10 time leverage, until of course prices decline.

Please note the counter-productive actions of central banks. Negative interest rates and huge equity bubbles have all but guaranteed negative carry.

Unwind of China

China has stepped in to defend its markets three times recently, and three times to no avail. Capital flight from China is massive.

For discussion, please see China's Use of Derivatives to Hide Capital Flight Comes Unglued; Reserves Fall by Record Amount; "Worthless" Certificates of Confiscation.

Currency Wars

The currency wars and volatility we see today are a direct result of central bank attempts to force their will on the markets.

I have said this before, wrongly for the past few years, but gold will eventually be a big winner in this economic madness.

Mike "Mish" Shedlock

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