Pacific Investment Management Company, generally known as PIMCO, is one of the w
ID: 1201484 • Letter: P
Question
Pacific Investment Management Company, generally known as PIMCO, is one of the world's largest investment companies. Among other things, it runs PIMCO Total Return, the world's largest mutual fund. Bill Gross, who heads PIMCO, is legendary for his ability t predict trends in financial markets, especially bond markets, where PIMCO does much of its investing.
In the fall of 2009, Gross decided to put more of PIMCO's assets into long-term U.S. government bonds. This amounted to a bet that long-term interest rates would fall. This bet was especially interesting because it was the opposite of the bet many other investors were making. For example, in November 2009 the investment bank Morgan Stanley told its clients to expect a sharp rise in long-term interest rates.
What lay behind PIMCO's bet? Gross explained the firm's thinking in his September 2009 commentary. He suggested that unemployment was likely to stay high and inflation low. "Global policy rates," he asserted -- meaning the federal funds rate and its equivalents in Europe and elsewhere -- "will remain low for extended periods of time."
PIMCO's view was in sharp contrast to those of other investors: Morgan Stanley expected long-terms rates to rise in part because t expected the Fed to raise the federal funds rate in 2010.
Who was right? PIMCO, mostly. As the figure below shows, the federal funds rate stayed near zero, and long-term interest rates fell through much of 2010, although they rose somewhat very late in the year as investors became somewhat more optimistic about economic recovery. Morgan Stanley, which had bet on rising rates, actually apologized to investors for getting it wrong.
1. Why did PIMCO's view that unemployment would stay high and inflation low lead to a forecast that policy interest rates would remain low for an extended period?
2. Why would low policy rates suggest low long-term interest rates?
3. What might have caused long-term interest rates to rise in late 2010, even though the federal funds rate was still zero?
Explanation / Answer
1. As long as the unemployment rate remains unusually high, the Fed concludes that there is little danger that inflationary pressure will start to build in response to a tight labor market; in that case, it would want to keep interest rates low because the Fed would normally allow interest rates to remain low, which would in turn increase the growth of consumer spending, business investment, and exports, all of which would help increase upward pressure on wages and prices.
2. The primary benefit of low interest rates is their stimulative effect on economic activity. By reducing interest rates, the Fed can help spur business spending on capital goods—which also helps the economy’s long-term performance—and can help spur household expenditures on homes or consumer durables like automobiles. A second benefit of low interest rates is improving bank balance sheets and banks’ capacity to lend. During the financial crisis, many banks, particularly some of the largest banks, were found to have too little capital, which limited their ability to make loans during the initial stages of the recovery. A third benefit of low interest rates is that they can raise asset prices. When the Fed increases the money supply, the public finds itself with more money balances than it wants to hold. In response, people use these excess balances to increase their purchases of goods and services and of assets like houses or corporate equities. Increased demand for these assets, all else equal, raises their price.
3. Even though the federal funds rate stayed near zero in late 2010, investors expected it to rise eventually, once the economy had recovered. Increased optimism meant that investors moved up their expectation of when the federal funds rate might rise, leading to rise in long term rates.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.