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Bond guru predicts continuing asset bubbles, inflation and declining U.S. dollar

by Wayne Cheveldayoff, 2004-11-11

If U.S. bond guru Bill Gross is correct about the future, the U.S. dollar will continue to slide and U.S. inflation will continue to move higher – both carrying important implications for Canadian investors.

It is a prediction Gross bases on the one thing he feels fairly certain about: the U.S. economy is so addicted to debt that the Federal Reserve will not raise short-term interest rates much above the inflation rate.

This view goes directly against the expectations of many economists who cite the historical long-term average of 2 per cent for U.S. real short-term interest rates.

Using this rule of thumb, some economists predict that as the U.S. economy strengthens, the Fed, to contain inflation, can be expected to push short-term rates up to a level 2 percentage points above the inflation rate. If the inflation rate is 2 per cent, the Fed’s overnight rate, the fed funds rate, should be at 4 per cent.

This kind of thinking is behind predictions that the U.S. fed funds rate, currently 2 per cent, will jump to the range of 3 to 5 per cent in 2005 and such significantly higher rates would attract needed capital to the U.S., thereby stabilizing the U.S. dollar which is being undermined by a ballooning current account trade deficit that requires close to US$2 billion a day in financing inflows.

But this is not the scenario expected by Gross, who, as chief investment officer of California-based Pacific Investment Management Co. (PIMCO), manages $415 billion in State of California and other retirement funds and the largest U.S. bond mutual fund.

In his November Investment Outlook (available at www.pimco.com), Gross predicts that real U.S. rates will have to be kept low, possibly only a half point above inflation, by a Fed that will “raise nominal short rates just enough to contain prices but not kill the economy.”

He believes that “too much debt in a finance-based economy precludes raising interest rates like we have in the past and while that keeps the patient/economy breathing, it leads to asset bubbles, potential inflation, and a declining currency.”

In an interview broadcast after the election on November 3, Gross said it is uncertain how quickly his prediction will play out. It could depend on a variety of factors including how long Japan and China will continue to buy U.S. dollars and possibly who will be chosen as the next Fed Chairman and what the dollar policy will be of the next U.S. Treasury Secretary.

To exploit the situation he believes is unfolding, Gross says investors should “buy the assets being bubbled, investment in bonds that are protected against inflation…and short the (U.S.) dollar.”

For Canadian investors, this probably means sticking with inflation-geared investments in real estate and commodities like oil and gas and metals, buying real return bonds, and staying away from both U.S.-dollar securities and stocks of Canadian companies that will be hurt by the high Canadian dollar.

The weak U.S. dollar has been a prime reason why the Canadian dollar has risen so much and has cut into the returns Canadian investors were expecting from U.S. stocks. For example, the S&P500 index rose 28 per cent last year but this translated into a Canadian-dollar gain of only 6.2 per cent. From the first of this year to November 4, the U.S. index rose 4.5 per cent but was down 2.8 per cent in Canadian-dollar terms.

A lot will depend on what the Bank of Canada will do as events unfold. The rise in the Canadian dollar so far this year is likely to take a bite out of manufacturing profits and job creation and the probable response will be to raise Canadian interest rates by a lesser amount than U.S. rates in order to take some of the pressure off the Canadian dollar.

But if our economy continues strong in the face of the high Canadian dollar, the Bank of Canada may take the view that it needs sizeable real short-term interest rates to contain inflation and Canada could end up with a different situation – one where the combined restraint of a high Canadian dollar and high interest rates cools inflation and asset bubbles.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.





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©2004 Wayne Cheveldayoff