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Bill Gross: Flat Yield Curve Detrimental To Economy; Fed Should Raise Rates
Aspire, Thought Leaders | 20 November 2015
By: Lim Si Jie
Articles (169) Profile

Renowned bond investor Bill Gross issued a warning to the Fed and the market that the flatness of the Treasury yield curve could have harmful effects on lending across all credit markets, resulting in stunted corporate profit growth.

In his latest Investment Outlook, Bill Gross said that the Federal Reserve’s historical models fail to recognize that over the past 25 years, capitalism has increasingly morphed into a finance-dominated system as opposed to one that produces goods and services.

Flattening Yield Curve Lowers Incentive for Long-term Investment

In the build-up to the Fed’s first interest rate tightening, the slope of the yield curve continues to flatten, with short-term rates rising faster than longer-bond yields.

Bill Gross stated that capitalism would not work well if fed funds and 30-year Treasuries co-existed at the same yield, nor if commercial paper and 30-year corporates had the same rates. This is because investors would have no incentive to invest in the long run.

Bill Gross to Fed: Time to Raise Interest Rates

Gross has urged the Fed to raise interest rates to “more normal levels”, arguing that zero-bound levels are harming the real economy and destroying insurance company balance sheets and pension funds in the long run.

Gross believes that a much steeper yield curve and a higher policy rate allow banks, financially oriented businesses, as well as household savers themselves to increase margins and restore profit and disposable income growth.

Two Ways to A Positive Yield Curve

Gross suggests two possible ways to achieve a positively sloped yield curve:

1. Raising Inflation Targets

Bill Gross believes that central banks could raise their inflation targets. By targeting 3 percent inflation worldwide, it should raise 10 to 30 year yields more than short rates, resulting in a steeper curve at slightly higher yield levels. Citing Japan as a case study, Bill Gross says that Japan has done so over the past few years, avoiding deflation, recession and actually benefited its bond and equity markets.

2. Operation Switch

Instead of 2012′s ‘Operation Twist,’ which sold 2-5 year notes and reinvested the proceeds in longer dated Treasuries now resting in the Fed’s portfolio, Bill suggests that the Fed should do just the reverse. Bill Gross is confident that $2 trillion longer-dated Treasuries and mortgages which the Fed now holds that can be ‘switched’ into two to five year bonds to steepen the yield curve and benefit savers, liability based businesses, and the economy itself.

Investors Takeaway: Look Out For Low Forward P/E

If the Fed decides to leave rates as it is for 2015, investors can expect future profit growth of companies to be stunted. This will lead to a rise in forward Price to Earnings (P/E). In the event of such a situation, companies that continue to boast a low forward P/E against its peers will be much better investment targets for long term investments. Long term investors can screen for stocks with low forward P/E as possible additions into their portfolios.

Si Jie is no stranger to investing having started his journey at a young age. He is heavily influenced by acclaimed investors such as Benjamin Graham, Peter Lynch, and John Rothchild.

Please click here for more information about this author.

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