In his January commentary, uber-bond manager Bill Gross shows a favorite chart he uses as a bond market timing tool:
This series of graphs is used by PIMCO to indicate when enough is enough – "the point at which adjustable short rates rise sufficiently to make the economy, cry "no más!" That point comes in this example when Fed Funds rise to meet the average cost of intermediate Treasury financing issued over the past 5 years and the spread between the two disappears."
Note the distinction between this chart and the yield curve:
"For sophisticates, please note that this is not the same thing as a flat yield curve. A flat yield curve is a concept comparing current short rates to current 5- and 10-year rates.
What my chart does is to compare current short rates to the Treasury’s average intermediate term "coupon," a more reliable and indicative indicator of economic pain or restrictiveness since it uses an average embedded cost of debt concept instead of a current cost. The standard flatness as measured by current market rates in early 1995 (not shown here) never led to a recession, only a slowdown, just as Chart I would have indicated. In other words, this indicator called for a mild slowdown in 1995 which is what we got.
The standard flat curve theory called for something more extreme which is something we never got. The embedded cost of debt indicator, therefore, shown in Chart I, has been more reliable."
Gross’ conclusion? A US recession and a Bond market rally:
"The current data point in Chart I
is not only calling for an end to the bear bond market, but a recession
at some point 12-18 months hence. . . Hopefully you can take solace from a new timing indicator that says the
worst is over for bonds"
That’s consistent with my own views on the matters, but via a very different methodology . . .
A Gift That Should Keep on Giving
Bill Gross | January 2006