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09-26-06, 10:27 AM
Investment Outlook - Empty Nesting/Successful Investing (http://www.pimco.com/LeftNav/Late+Breaking+Commentary/IO/2006/IO+October+2006.htm)
October 2006 (Bill Gross - PIMCO)

Currently, PIMCO’s best 60/40 bet is a cyclical one that proposes that the Fed is done and ultimately will have to lower interest rates in order to restimulate an asset based/housing led economy that has been its primary growth hormone in recent years. With inflation leveling off at admittedly unacceptable levels and the domestic economy moving towards a 2% real growth rate or less in the next year or so, the Fed at some point in 2007 will be forced to cut short rates. Don’t ask us when or by how much yet. A lot will depend on the evolution of the domestic housing market and the equally important maturation of the global economy sans U.S. consumer imports and perhaps sans hyper investment spending in Asia. We will monitor daily. But with the ongoing uncertainty of why 10-year Treasuries should yield 4.65% in a 5.25% Fed Funds world, we feel more comfortable with the observation that the front-end of the U.S. Curve is only valuing a 40 basis point cut in FF by September of 2007. Like I suggested above, we’re not sure how much it should be but we’re comforted by the fact that in effect we’re only paying a 40 basis point premium in the form of a lower 4.85% yield in order to find out what’s behind Monte Hall’s/Ben Bernanke’s door #2. The U.S. bond bull market, which began almost two months ago, remains in its infancy but the best way to play it is via durations above index and concentrated in the front-end of the curve. Importantly, although other central banks remain focused on raising short rates another 25 or 50 basis points, global bond markets usually follow the U.S. lead and we expect the same pattern this time as well with a mild exception in Japan, and slightly different curve dynamics in Euroland.

AntiSpin: Bill rarely requires iTulip AntiSpin. He has consistently conveyed the facts of the oddity that is the US economy with wit and originality for years.

Gross coined the phrase "Asset-based Economy" to refer to the perculiar and unsustainable engine of US economic growth–the inflating of assets, from houses to public companies, and generation of economic "output" reported as GDP growth resulting from the profits that are made by trading these assets back and forth as they inflate. Bill also talks about "The Last Bond Market," which correlates to our prediction of a period of disinflation– the "Ka" of Ka-Poom–that will attend the decline in the price of inflated assets as the impact of liquidity withdrawn by world central banks takes hold. So far, the signs of this disinflation appear to be showing up in the US bond market, where the Wall Street Journal today points out the strong rally in bonds that has gripped the market recently. "Slowing Economy Spurs Bond Rally: U.S. Treasury-bond yields are at their lowest levels in months. A sense that growth is slowing and inflation receding may help to shape the outlook for the economy and investments."

While Gross projects an ongoing rise in bond prices and Fed rate cuts next year, gold and silver rise and Bloomberg reports "Volcker, Corrigan Warn of Inflation 'Creeping' Higher (http://www.bloomberg.com/apps/news?pid=20601087&sid=aYnJF7iLrZn8&refer=home)."

"I am a little bit more worried about inflation,'' said Volcker, 79, speaking at a discussion sponsored by the Women's Economic Round Table in New York today. Gerald Corrigan, who served as New York Fed president from 1985 to 1993, said he shared Volcker's concerns.

While the inflation rate isn't "high" or "running away," Volcker said, "it is kind of creeping up, and I am impressed by the degree of pressure, if that is the right word, psychological pressure, political pressure, there is not to do anything about it.'"
The apparent paradox can be explained by an increase in the volatility of bonds and PMs as we head into the Ka-Poom period. The cross-currents and contradictory price movements present opportunities but will also challenge standard risk models commonly used by banks and hedge funds; standard relationships will not hold through the period. 2007 will be the year of the reckoning for many hedge funds.