(or Treasury Bonds)
June 10, 2011
Stocks have come to the end of a “wonderful journey,” according to PIMCO’s Bill Gross, and are now on their own, like “a baby bird just released from the nest.” The journey Gross spoke of is the multi-decade decline in real interest rates, which have fueled bull markets across “risk assets,” especially in equities and bonds.
Real rates can’t go lower, Gross said, and both stocks and bonds are perilously valued; he advised his audience to diversify outside the US.
Gross, who was the opening keynote speaker at the 2011 Morningstar Investment Conference on Wednesday, said that real interest rates have fallen from 4% to -0.5% since October of 2008, as measured by five-year TIPS yields. Nominal rates fell by approximately 200 basis points over that period, and he called both declines “staggering.”
Gross is a founder, managing director and co-CIO of PIMCO, the California-based money management firm.
Real interest rates were 9% in 1981, Gross said, and their decline since then has contributed to secular bull markets in both stocks and bonds.
Real interest rates are now two standard deviations below their average value from the last 25 years.
It’s not just the bond market that has benefitted from the decline in real rates, Gross said. Equity valuations, based on the Gordon model that discounts future cash flows, have risen.
“It’s the real interest rate that’s the critical determinant of asset prices.”
But real interest rates have nowhere to go but up, according to Gross, and that has alarming implications for valuations. “Risk assets have a cap and are limited,” he said.
As evidence that real rates can’t go lower, Gross cited the example of Japan. Its 10-year government bond rates, he said, are just 80 basis points below those in the US. “It is really hard to understand how yields can be driven much lower if only because of the Japanese comparison,” he said. “It's a relevant comparison to make.” Japan has been mired in a two-decade long period economic stagnation, so it serves as the cautionary tale of how capital markets can evolve, despite the government efforts to revive it.
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