Bill Gross answers the question: “Just how overvalued are U.S. Treasuries?”
“Put the proper upside or downside of this outsourcing strategy into perspective. How much do you the client stand to gain by selling Treasuries and buying Bunds or Gilts? The first two exhibits hint at anywhere from a 100 basis point to a 150 basis point overvaluation of Treasuries relative to historical parameters which if rectified is equivalent to a relative loss of 7-10% in price terms. To that should be added the following observation derived from the near century long statistics of Ibbotson Associates (Stocks, Bonds, Bills, and Inflation) and Dimson, Marsh & Staunton (Triumph of the Optimists). Over the past 100 years, which included periods of deflation, double-digit inflation, and government controlled interest rates, the arithmetic average long-term real interest in the U.S. approximated 2.9%.
Today’s 30-year real rate offered in the TIPS market stands at 1.9%. The difference of 100 basis points complements relative analysis discussed above without delving into the complicated guessing game of inflation and inflationary expectations. Whether this overvaluation eventually leads to 10-year Treasury yields of 5% depends importantly on three events: 1) The Fed moving to a more economy-neutral Fed funds rate, 2) The Chinese unpegging their currency to the dollar, and 3) The Japanese ceasing their “dirty float” suppression of the Yen via massive Treasury purchases. As of now, only the third condition has some possibility of immediate market moving impact. Perhaps Friday’s employment report will speak to the first. Until Treasuries adjust, however, bond vigilantes and investors alike are better off following an ABT strategy by reducing Treasuries and investing on foreign shores to get their desired durational exposure.”
Ouch . . .
Anything But Treasuries — and JGBs
(The Last Vigilante, Part III)
Bill Gross, April 2004
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