Pimco's bet on deflation, debt deflation and depression

Posted on 30 September 2009 with no comments from readers

It is interesting to hear that the Bond King Bill Gross of Pimco is now buying longer maturity treasury bonds as a protection against deflation.

Mr. Gross expects a ‘new normal’ in the global economy that will include heightened government regulation, lower consumption and slower growth of two to three per cent.

This is a rather less dramatic outlook than those who predict hyperinflation from government bailouts and stimulus packages, or those who see a reverse Armageddon of debt deflation and depression. It is not quite the Goldilock’s economy as higher growth rates have gone but it is no disaster either.

Bonds set to soar?

On the other hand, this is not the vibrant V-shaped recovery that financial markets have priced in either. And if stock markets take a tumble the easy-to-predict winner is the bond market and its King Bill Gross.

So this announcement from Bill Gross is well timed. The long bear market rally has been faltering over the past week and a reversal will send the bond market back up and yields tumbling.

Indeed, earlier this year when things were really bad in the stock market Mr. Gross pulled back from buying as yields got so low he was worried about a fall in bond prices when they recovered. That happened and Pimco’ Total Return Fund has delivered an 18 per cent return out performing 94 per cent of its peers, according to Bloomberg.

Will he get his timing right again? Past performance does not guarantee future performance but what other measure do we have to guide us?

Well, I suppose we can look around and ask where the evidence of inflation is to be found? I can not think of a single thing that is more expensive than a year ago. Indeed, the reverse is true, almost everything can be found at a discount if you look.

That is deflation, not inflation. There is even evidence of a debt deflation trap in some economies like Ireland and Spain as debt burdens are growing in real terms as the economy shrinks. This leads to bankruptcies, redundancies and ultimately depression as incomes decline and further hit spending in a downward spiral.

Central bank policy

Central banks have kept interest rates super low to support the banks, indebted companies and individuals, and to allow economies to recover enough to bear this burden. But at best this leaves economies heavily burdened with debt to repay and therefore unable to achieve higher growth rates.

Pimco is placing its investors money on this scenario. But it is far from certain that this is how things will pan out. Central banks have already shown a penchant for money printing with quantitative easing. Using inflation to undermine debt and spread the burden might yet prove an irresistable alternative for the authorities, particular with democratic governments anxious to stay popular with their electors.

It could yet be that Pimco is proven right in the short term as the stock market crashes again, but that longer term the inflationists will have the last laugh.