Gross on the Financial System's "Breaking Point"

Bond guru Bill Gross says the monetary system that the world has used for the past four decades is in danger of hitting a “breaking point” amid a sea of sovereign debt that is of questionable quality and offering low yields — which would have wide-ranging impacts on the entire “Wall Street food chain”.

“Policy responses by fiscal and monetary authorities have managed to prevent substantial haircutting of the $200 trillion or so of financial assets that comprise our global monetary system, yet in the process have increased the risk and lowered the return of sovereign securities which represent its core,” Gross writes in his latest commentary on PIMCO’s site. “Soaring debt/GDP ratios in previously sacrosanct AAA countries have made low cost funding increasingly a function of central banks as opposed to private market investors. QEs and LTROs totaling trillions have been publically spawned in recent years. In the process, however, yields and future returns have plunged, presenting not a warm Pacific Ocean of positive real interest rates, but a frigid, Arctic ice-ladened sea when compared to 2-3% inflation now commonplace in developed economies.”

Gross says the danger is that lenders will either perceive too much risk or not be satisfied with the returns available. A variety of factors will prevent them from profiting from the yield spread that has helped lever financial markets for so long, and they will cut back on the lending that has driven our system. “As they question the value of much of the $200 trillion which comprises our current system, they move marginally elsewhere — to real assets such as land, gold and tangible things, or to cash and a figurative mattress where at least their money is readily accessible,” he says in discussing what could happen.

Gross says the inability to lever financial markets through the yield spread means lower returns for both bonds and stocks. His advice: “Bond investors should favor quality and ‘clean dirty shirt’ sovereigns (U.S., Mexico and Brazil), for example, as well as emphasize intermediate maturities that gradually shorten over the next few years. Equity investors should likewise favor stable cash flow global companies and ones exposed to high growth markets.”