Gross: Bubbles? No. Lower Returns Ahead? Yes.

PIMCO bond guru Bill Gross says the Federal Reserve is confronted with a big challenge in trying to determine a “neutral” interest rate that will accomplish all its goals — and he says PIMCO and the market have very different estimates of what that neutral rate will be.

“Interest rates have to be lower in a levered economy so that debtors can survive, debt can be reduced as a % of GDP, and economies can avoid recessions/depressions!” Gross writes in his latest Investment Outlook. “In a levered landscape, what is the magical ‘neutral’ policy rate that can do all of that? Hard to know.”

But Gross does say that PIMCO’s expectation for what that neutral rate will be — 2% or so — differs greatly from what markets and “Fed

participants” are pricing in right now — 4%. “At PIMCO, we believe that this focus on the future ‘neutral’ policy rate is the critical key to unlocking value in all asset markets,” he says. “If future cash returns are 2% (our belief) instead of 4%, then other assets such as stocks and real estate must be assumed to be more fairly priced as well. Current fears of asset bubbles would be unfounded. A 2% neutral policy rate, however, is not a ‘win/win’ for investors. It comes at a price — the cost being a financial future where asset returns are much lower than historical levels.” Gross does offer a few suggestions for how investors looking for higher returns in this low return environment can proceed, “most of which involve taking different risks than you may be commonly used to taking.”

Gross also talks about how increasing amounts of leverage in the financial system require a changing of assumptions used in determining interest rates, something that the Fed didn’t take into account when it raised rates during the last bull market. “The Great Recession occurred significantly as a result of central banks raising the price of credit too high in the face of households and levered speculators who eventually could not afford to pay the increasing interest rate tab,” he says. “As defaults on U.S. subprime mortgages and high yield bonds began to mount, lenders not only refused to lend more but were forced to liquidate levered holdings, producing a literal run on the ‘Bank of Credit’ which in the U.S. now totals an estimated 75-85 trillion dollars.”