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Investment Outlook
Bill Gross | January 2006

A Gift That Should Keep on Giving

Santa was good to me this year - too good to tell you the truth. While that’s not possible for a 6-year-
old tot, it’s more understandable for a 61-year-old man who is in the process of simplifying as
opposed to complicating his life. Why it was only 5 years ago on these Outlook pages where I swore
that any friend who invited me to another dreaded Christmas party was no friend of mine. A year or
so later I tried to send a message to my family via the Outlook that all I wanted for Christmas was to
keep my two front teeth and maybe a comb or two. Combs, that’s what I needed, not shirts, sport
coats, or books that I would never read. Who cares if they cost only 50¢ - I needed to comb my hair
more than dressing up for next year’s Christmas gala that I would never attend. Ah, but no - they
never listen. Package after package, ribbon upon ribbon - Santa, Frosty, and reindeer wrapping
paper in endless gobs all over the living room floor. And when it was all over, what was the one
present I raved about? An ordinary pair of reading glasses. "My God, I can read the newspaper," I
screamed. And so it was that I had a merry Christmas after all, despite the plethoric overload of
wrapping paper and redundant gifts. Next year I have decided to implement a one-gift maximum,
hoping for more combs, reading glasses, and maybe a pair of socks. Sue keeps pointing out that the
ones I wear to work have holes in the heels.

During the Christmas/New Years interlude there was considerable press and discussion about the
coming of the flat/inverted U.S. yield curve and what it meant for the economy and financial markets.
Five of the past 6 recessions have been preceded by flat yield curves or was it 5 of the past 6 flat
yield curves have led to recessions? No matter, there’s a connection there that’s reflective of
substantial Fed tightening that tends to inhibit future growth via an increased cost of borrowing -
more on the short-term portion of the yield curve, but generally everywhere along it. During this
cycle, however, with the "conundrum" and all, soothsayers point out that 5- and 10-year yields
haven’t gone up very much and therefore the flat curve is not as restrictive as in prior cycles. In last
month’s Outlook I divulged my/PIMCO’s "secret" which hoped to contradict that theory. I argued that
today’s 4¼% Fed Funds rate, and in turn, today’s % longer dated yields almost everywhere on
the curve were much more restrictive than they appeared. PIMCO’s "lack of global aggregate
demand" and Bernanke’s "global savings glut" were the primary explanations, suggesting that it took
these lower yields to generate even anemic domestic investment spending as well as to keep the
housing asset bubble afloat which in turn was pumping consumption. Since higher yields worked
with a 12-18 month lag in terms of their economic impact, it seemed clear to me that 2006 would be
a year of slower growth, perhaps 2%, and that the Fed and indeed the yield curve was about to
reach a plateau around 4½%.

This historical 12-18 month lag between a tightening cycle/flat yield curve is what fools many
analysts into thinking that yields are still stimulative and that the Fed has more wood to chop. It takes
that long for higher yields to affect the housing market, mortgage equitization, and corporate
investment cycles, whereas many economists feel it should work more like an anesthetic in the
operating room where the patient counts backwards from 10 to 1 and is out before he reaches 5. It
doesn’t work that fast. The Fed knows this, but often is willing to risk an overshoot and a curve
inversion in order to insure benign inflation and sufficient economic slack over the foreseeable future.
Short rates can always be lowered quickly (and they are - within an average 6 months after the last
hike) if the economy seems to be slowing too rapidly.

Not only the time lag but the level of interest rates is the critical question for bondholders, and while
last month’s Outlook argued that they were now sufficiently restrictive, it acknowledged that there
was considerable disagreement with that view because of the "conundrum." Let me introduce,
therefore, another market "timing" tool, my holiday gift to you, that will hopefully add weight to my
arguments that the current bear market in bonds is over.

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Imagine, if you will, purchasing (receiving) a 5-year interest rate swap at some time over the past few
years. For those of you who don’t spend 12 hours a day in bond trading rooms, that means owning a
5-year fixed rate bond and financing it (paying) with 3-month Libor which increases in yield every
time the Fed raises its benchmark. Instead of mark to market changes in the 5-year swap price, what
I would like to promote here is the concept of an increasingly more expensive "cost" to owning this 5-
year swap as its financing rate (3-month Libor) increases. A 5-year swap purchased when short
rates were much lower and the yield curve more positive, produced positive carry and therefore
generated "profits" for anyone holding this longer dated maturity when viewed from an income
statement perspective. But if you narrow or eliminate that carry via higher short rates (and a flat yield
curve) those "profits" disappear.

This 5-year swap concept is important because the U.S. economy operates in much the same way.
With close to a 5-year average life, the entire U.S. bond market can be compared to a 5-year fixed
swap. That means that companies, homeowners, and consumers that have borrowed money in
recent years - (and purchased assets such as a home that are akin in my example to a 5-year swap)
- are now being squeezed in a flat yield curve environment. Visualize a real life example in which you
have "financed" a home with an adjustable rate mortgage (in my example you finance a 5-year swap
with floating 3-month Libor). As the cost of the ARM increases with higher short rates, your excess
income available to spend on discretionary items begins to shrink. If that ARM rate goes too high,
you hunker down even more by not eating out, going to movies, or taking a vacation to exotic
destinations. The economy in other words slows down.

How does this translate into a bond market timing tool? Chart I shows but one of a series of graphs
PIMCO uses to indicate when enough is enough - the point at which adjustable short rates rise
sufficiently to make the owner of a home or a 5-year swap, or more importantly 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.

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

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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.

For those of you whose heads are turning, simply accept the fact that by the time the line in Chart I
bottoms or hits 0, bond market yields have already peaked - in other words the bear market is over.
Bear market ending dates of 1/00, 12/94, 3/89, and 5/84 can all be compared to 0-line or near 0-line
bottom points indicating sufficiently onerous Fed Funds levels to slow the economy and end a bond
bear market. Data points from the early 1980s backwards tell a similar story but are much more
extreme since it was necessary for the Volcker Fed to go to super tightness in order to knock out
accelerating inflation.

The sum total of last month’s Investment Outlook’s "secret" and this month’s Investment Outlook’s
"gift that should keep on giving" is that yields have peaked in the bond market and will soon peak in
Fed Funds producing an economic slowdown in 2006. If the Fed goes beyond 4½% and inverts the
yield curve, the possibility of recession will increase. Observant readers will have already noted that
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. Perhaps. Much will depend on the future condition of
the U.S. housing market and of course global economies - primarily of the Asian variety. We shall
see. But for now, hopefully you can take solace from a new timing indicator that says the worst is
over for bonds and an indicator that should keep on giving in terms of its reliability for years and
years to come. Enjoy and Happy New Year…for bonds!

William H. Gross
Managing Director

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