Bill Powers is a senior member of PIMCO’s Portfolio Management and Investment Strategy groups, and plays a key role in formulating the firm-wide viewpoints that shape every PIMCO portfolio. These views are shaped by PIMCO’s cyclical Economic Forums, which examine the outlook for the next six- to 12 months, and the annual Secular Forum, which focuses on the three-to-five year outlook. In this interview—the latest in a series of discussions about PIMCO’s cyclical outlook and investment strategy—Mr. Powers provides an update on the firm’s outlook for the next 12 months following the March Economic Forum and discusses how those views are shaping PIMCO’s portfolio strategy.

Q: PIMCO held its latest Economic Forum in March to discuss the cyclical outlook. What were the major conclusions?

Powers: We have been exploring the secular influences of the fragility and the vulnerability of this period of expanding growth as the economy moves away from the post-bubble period into a period of perhaps more durable economic expansion, realizing that there are real risks to the successful implementation of this transition. Long term, these risks create the potential for the economy to tip in either direction, toward reflation or deflation. Near term, the bias is toward reflation.

The U.S.’s need to maintain stimulative monetary, fiscal and currency policy lead to PIMCO’s reflation bias. The long-term risk that we tip to deflation is certainly lower than it was a few years back, when the economy was coming out of the post-bubble period. Near term, deflation is off the RADAR.

Our latest cyclical forum reflected this bias toward reflation, with the group moving our GDP forecast for the U.S. over the next 12 months up from 3.1% to 3.5%. Similarly, growth in Europe was marked up from 1% to 1.3%—nothing spectacular, but, on the margin, indicating that we expected a little bit stronger growth in Europe as well.

Prospects for Europe appear to be improving as a result of the benefits of restructuring and deregulation. These factors have benefited the corporate sector more than the consumer by providing more flexible labour terms and corporate operating conditions that have allowed profits and prospects for profits to increase. Hence, our view is that the risk of a failed handoff, from policy-driven growth to durable and enduring growth, is lower now. Growth in the U.S. and Europe is expected to be marginally higher.

Japan’s economy is still in a saucer bottom trend with the GDP forecast for Japan actually going down slightly. PIMCO is now forecasting 1.2% growth in Japan, down from 1.9% last quarter. Japan has been less successful emerging from the late 2004 economic soft spot. With respect to China, we are expecting continuing trend growth. We are not expecting a hard landing in China, which would be 5% to 6% growth, nor are we expecting overheated growth of 10% or higher.

Q: How has the potential for faster economic growth in the U.S. affected the market’s expectations for Federal Reserve policy, and how does that fit with PIMCO’s outlook?

Powers: With this universally marked-up expectation for GDP growth, eurodollar contracts have discounted higher rates and a more restrictive Fed. In December, when we last had this discussion, the December 2005 eurodollar contract was discounting a Fed Funds rate of 3.25%. Now, that level is up 75 basis points, discounting a Fed Funds level of 4.00%.

In December, we had discussed the possibility of a pause in Fed Funds at a level of 2%, which clearly did not happen. Now, with Fed Funds at 2.75%, and with the economy posting both a solid nonfarm payroll number for February and a stronger producer price index, PIMCO concedes a 3%-plus Fed Funds rate, absent an economic accident. Fed Chairman Alan Greenspan indicated that the current level of the real Fed Funds rate lies, in his opinion, below the neutral level that allows for non-inflationary, sustained growth. The Fed remains on the move to raise rates and again, the likelihood is that it will not pause until a level of above 3%.

Q: Despite the expectations for higher short-term rates, longer-term bonds performed very well in the first quarter. What was behind the outperformance of the long end of the market?

Powers: There were many factors that contributed to the outperformance of the long end. Some of this outperformance came as a result of discussions by pension concerns about changes in regulations affecting pensions in Europe, the U.K. and the U.S. The U.S. Pension Benefit Guarantee Corporation also acquired plan assets of airlines and used them to fund longer duration mandates. Additionally, the release of Fed minutes warning of concern for excessive risk-taking signalled a more hawkish Fed posture. These factors favoured the long end of the curve, causing a tremendous rally in the long end versus the short to intermediate part of the curve.

Many plan sponsors are evaluating their asset-liability mismatch, which has been short of duration because of expectations for continued reflation and expectations for a steepening of the curve. Before this recent sponsorship of the long end of the curve, the long end lacked a sponsor. The realization of heightened focus by the pension industry on reducing their duration risk—being underweight in duration—changed the dynamics of support for the long end of the curve.

Another factor is the Bretton Woods II regime. The Asian central banks’ funding of the U.S. current account deficit significantly reduces pressure on either the dollar or interest rates. The market’s confidence in the ability of this dynamic to maintain the status quo of rates and dollar ranges leads to a view that inflation levels will be more benign than what would be the case if the dollar were to weaken dramatically in adjusting to the large current account and fiscal deficit. With the bond market trading in a range, as proxied by 10-year Treasuries, and with the Fed Funds rate on the rise and prospects for higher inflation diminished as a result of a forecast of a more aggressive Fed relative to prior expectations, the long end of the curve became relatively more attractive. Despite the recent back-up in rates, the long end of the curve has not given up its gains relative to intermediate issues.

Q: In prior discussions, you have said PIMCO believes real interest rates need to remain lower than in previous Fed tightening cycles because of the economy’s reliance on financing. Is today’s rate structure what PIMCO expected? Or is it a "conundrum," as Alan Greenspan recently called it?

Powers: PIMCO is indeed forecasting a low real rate environment. The conundrum is really the lack of term and interest rate risk premiums that would normally be associated with an economy that is developing signs of increasing growth. The Fed’s forecast was spot-on when they characterized the slowdown in the second half of last year as a "soft patch," indicating they had confidence that the economy would move through that. That forecast turned out to be exactly right.

The conundrum for the Fed is that moving the Fed Funds rate up 175 basis points from 1% to 2.75% is not typically an environment where intermediate to long rates rally as they have. With expectations that the Fed finishes tightening with Fed Funds above 3% in this cycle, the configuration of intermediate and long rates at the time Chairman Greenspan made that comment was such that the flatness of the curve really denied the usual risk premiums that the market usually demands. The conundrum expressed by Chairman Greenspan was the lack of adequate risk premiums in the market. We agreed with that outlook despite the view that real rates should remain historically lower, certainly than in the period from 1980 to 2000.

Q: If U.S. interest rates are artificially low because of all the factors we’ve discussed, how is this affecting interest rates in other parts of the world?

Powers: There are three facets to that issue. First, relative value managers like PIMCO are constantly looking for value in the market and opportunities to move in and out of sectors of the market that are relatively expensive and into those that are relatively cheap. The goal is to identify assets likely to perform better on a risk-adjusted basis. When we believe, as we currently do, that the prospects are excellent for long European rates to decline from 75 basis points below the U.S. to 100 basis points below the U.S., we will move out of the relatively expensive long U.S. sector into a relatively cheaper long Europe sector. We recognize that our trades, and those of others like ourselves who are expressing these relative-value macroeconomic judgments, will create relatively more demand for European bonds than would have been the case had the U.S. market been significantly cheaper.

If long U.S. rates were significantly cheaper than long European rates, U.S. managers would not be departing U.S. bonds for Europe, and long European rates would obviously be higher as a result.

Second, while the U.S. Fed Funds rate has moved from 1% to 2.75% on the way to 3% and beyond, policy rates in Japan and Europe have not changed. The currency-hedged carry differential between the U.S. and Europe has changed significantly from when the Fed Funds rate was at 1% and the European Central Bank rate was at 2% versus current levels, with the Fed at 2.75% and the ECB still at 2%. For European investors buying U.S. fixed income and hedging the currency exposure, what was attractive additional carry is now an expensive additional cost. Similarly, this enhances the return of U.S. investors buying European fixed income on a currency-hedged basis.

It used to be the case that Japanese investors buying U.S. Treasuries and hedging the currency risk used to pick up yield. Now, because of the change in interest rate differentials, not only on the front end but also out the curve, there is no benefit for Japanese investors to invest in U.S. fixed income for relative yield purposes, because the cost of hedging is so expensive. Now, from a simple yield analysis, it actually benefits U.S. investors to buy Japanese government bonds because, when the currency risk is hedged, one is left with positive carry.

Hence, what had been an attraction to U.S. fixed income for European and Japanese investors as a result of the Fed at 1%, now, with the Fed at 2.75% and moving higher and unchanged central bank rates in Japan and Europe, U.S. fixed income has become much less attractive on a currency-hedged yield basis. As a result, we are seeing flows out of the expensive, poor-carrying U.S. market into other bond markets, which transfers some of the expensiveness of the U.S. market into those markets.

The third element of interest rate externalities of an expensive U.S. bond market affects the income sectors. There has been tremendous liquidity flowing into the U.S. fixed income market, generated by the holders of current account surpluses who are looking to prevent their currencies from appreciating relative to the dollar—namely the dirty float in Japan and the pegged rate in China—recycling these current account deficits from the U.S. back into the U.S. fixed income market. As Fed Governor Ben Bernanke spoke about in a speech on March 10, there are also very significant surpluses or reserves in the emerging market economies, which are lending money to the mature and developed economies, especially the U.S.

As these sources of reserves have grown over time as a result of trade, these pools of wealth have gone beyond providing the minimum liquidity needs for which reserves are typically held, to creating large sources of wealth that motivate trading out of the most liquid Treasury sector, and to a lesser extent the agency sector, to considering other sources of investment, including mortgage-backed securities, asset-backed securities, corporates and TIPS. Quite rationally, these alternatives are being considered to increase the income of these new, large policy-driven holdings of U.S. fixed income.

Therefore, as U.S. interest rates have become expensive due to the Bretton Woods II alignment, other yield curves in Europe and Japan have also become more expensive. In addition, the income sectors of the U.S. fixed income market have also become expensive. Other income sectors, including emerging markets, have benefited from this as well.

Q: What is the risk that foreign central banks will reduce their exposure to U.S. fixed income in an effort to diversify away from the dollar?

Powers: These pools of money are looking for diversification but only a few are publicly discussing diversification away from the dollar. When South Korea mentioned dollar diversification, it caused a sharp drop in the dollar. To reverse unwanted dollar weakness, the South Koreans had to come back and "clarify" their communication.

Even though many large dollar holders might want to diversify because of the dollar’s vulnerability, they face the same issue as South Korea. If the alignment of self-interest leads major Asian or petrol financing to diversify out of the dollar, the Bretton Woods II alignment is undermined. For large central bank holders of dollars, faith that the twin deficits—the U.S. current account and fiscal deficit—will be addressed successfully in the future, preventing or reducing a dollar sell-off, is the backbone of the pact.

Q: A breakdown in the Bretton Woods II pact would clearly have significant implications for fixed income. How is this possibility affecting PIMCO’s portfolio strategy?

Powers: Our secular view puts the risks of the Bretton Woods II alignment front and centre. Unlike Bretton Woods I, which was an explicit policy, there is not a global buy-in to Bretton Woods II. The current regime is motivated more by aligned self-interests than by an explicit pact to maintain this arrangement.

Clearly, there are a number of different elements that could change in the global economy that would reduce any country’s desire to continue the alignment. We have identified some of them and are going to great lengths trying to analyze these potential sources and probabilities of disruption.

One potential source of disruption is excessive Fed tightening, causing the economy to tip into a recession. That would disengage the U.S. consumer as the engine of growth for the mercantile exporting countries—Japan, China and others. The alignment relies on an engaged U.S. consumer who is well financed to buy overseas (largely Asian) goods, creating employment and growth in these countries.

Another potential disruption is upside surprises in inflation. The current trading range—4% to perhaps now 4.75% on the U.S. 10-year—is valid if inflation and price stability hold. Risks include the price of oil and other commodities, the pass-through of higher wages into the consumer price index, and other second round effects or upside surprises in growth leading corporations to be more aggressive in hiring and investing. If inflation surprises on the upside, the range will not hold, pushing us into a higher interest rate environment.

So far, Asian central banks have been steadfast continuing to accumulate dollar reserves funding the current account deficit. A change in appetite for dollar assets, for Treasuries or other U.S. fixed income, or a rebalancing away from the dollar, would undermine Bretton Woods II. There are other elements that could marginalize this pact as well. Among those are global turmoil, protectionism, or an increase in regulation on the investing habits of Freddie Mac and Fannie Mae. To that, add potential legislation affecting the investing habits of banks and hedge funds, and potentially successful G-7 pressure on China and Japan to adopt more flexible currency policies. All of these, or some combination of them, could result in discontinuity of the current Bretton Woods II regime.

With that in mind, we have a defensive portfolio bias, remaining underweight in duration and favouring exposures in TIPS, municipal bonds, and Europe versus the U.S.

Q: PIMCO also favoured European exposure when we spoke in December. Has that strategy been successful?

Powers: PIMCO forecast that fixed income markets in Europe would outperform those of the U.S., and they have certainly done that. Like any strategy that works out, we wish we had more Europe in our portfolios.

In European fixed income, both the pension funds and the insurance industry are underweight duration and are considering reducing this risk through adding duration. These entities are increasingly subject to more rigid regulations. As a result, the market is focused on the long end of the European curve. Not only did European rates outperform U.S. rates, long rates in Europe outperformed intermediate rates in Europe. We plan to continue favouring the long end of Europe. Shorter-dated European bonds offer less value due to discounting only modest expectations of European Central Bank tightening.

Q: How is the cyclical outlook affecting PIMCO’s yield curve strategy in the U.S.?

Powers: PIMCO’s view is that the Fed must remain accommodative, even to the point of pausing in its rate hike campaign, in order to engineer steady growth in the U.S. economy. The expected tightening expressed by the market in eurodollar contracts in our view will not come to pass. In the U.S. we are favouring the short-end of the yield curve. We believe the probability of additional flattening of the curve is low.

Q: PIMCO has long favoured inflation-indexed Treasuries (TIPS). Has the strong performance in TIPS raised any concerns about that strategy?

Powers: The TIPS market has certainly performed well, with breakeven inflation levels having risen to above 3% on the 2007 and 2008 issues and all but 3% in the 2025 to 2032 issues. This certainly may not be the high end of what the market is expecting in inflation in this cycle, particularly headline CPI inflation. Hence, TIPS still have an important role not only in fixed income portfolios on a tactical basis but also in strategic asset allocation for investors and sponsors of pensions, insurance and other types of plans. Owning inflation protection in a reflationary world is an important defensive component to any portfolio.

Q: Other sectors PIMCO has favoured include emerging markets and municipal bonds. Can you update us on the strategy for these two sectors following the latest cyclical forum?

Powers: We still favour municipal bonds. We think the current high percentage of yields provided by munis relative to Treasuries, particularly on the long-end issues, represents a very attractive defensive characteristic of munis. In addition, munis are domestic investments not subject to the risks associated with an unwind of the Bretton Woods II arrangement as foreigners do not own munis. Hence, the sector is not over-subscribed by foreign investors.

In emerging markets, there has been some volatility in 2004 and early 2005, but we still expect that selective emerging debt will offer very attractive performance going forward. As long as the shop-‘til-you-drop consumers in the U.S. continue shopping, China will continue to import raw materials from the emerging markets in order to create finished products to send to the U.S. Therefore, the improving fundamentals of the emerging market countries should continue, particularly for those emerging economies that export commodities. We specifically find value in Russia and Brazil.

Q: PIMCO has also been employing currency strategies based on the view that the dollar will continue to weaken, particularly relative to Asian currencies. Is that still the case?

Powers: On a risk-adjusted basis, we see value in yen exposures, limited perhaps to 1.5% to 2%. In addition, the emerging market currency basket that we have discussed continues to offer very good prospects relative to the dollar. We would have a 1% position in that currency basket, which includes Brazil, Chile, Hong Kong, India, Mexico, Peru, Russia, Singapore, Slovakia, South Africa, South Korea and Taiwan.

Q: PIMCO has long been underweight in corporate bonds because of concerns about expensive valuations. With expectations for stronger U.S. economic growth, does PIMCO see any value in the corporate sector?

Powers: We currently remain underweighted in the corporate sector. We believe that opportunities to add value through Treasury futures, rolling mortgage-backed securities and, to a lesser extent, positions in swaps where we can add alpha with the cash-backing, may provide returns that are more compelling than some of the narrow spreads in the corporate market. There certainly has been, and will be, a place for corporate exposures in the portfolio. We are watching with great interest the recent onset of wider corporate spreads.

Q: With interest rates expected to remain range-bound, volatility seems to be priced relatively cheaply. Is PIMCO still attempting to add value through volatility sales at these levels, either through outright sales or by holding mortgage-backed securities?

Powers: As low as volatility has been, empirical volatility has been lower. Even though the reward for selling volatility has declined, actual volatility has been declining faster, providing enduring profits from volatility sales. There is some likelihood that we will break out of this interest rate range, but the likelihood is low over the next two quarters. We see the Bretton Woods II regime holding in the near term, certainly for the next few quarters, and that means that the current level of the 10-year, just above 4.6%, is towards the high end of the 4% to 4.75% range. Hence, this is a time that selling put and call options at the ends of the ranges is an attractive way to garner extra premium in the portfolio.

Despite the historical expensiveness of the mortgage market, we also believe that the limited prospects for moving outside of this interest rate range mean that volatility sales through holding mortgages with embedded options is attractive as well.

One area of the market where we would be unlikely to sell volatility would be the long end of the curve. The long end trends are likely to be more of a crapshoot because of the uncertain pension and insurance industry dynamics. Front-running activity by hedge funds, real bond managers and proprietary street traders who are making plays in the long end of the curve based on anticipating large purchases by pensions and the insurance industry has increased the volatility and uncertainty of the long end.

Q: To sum all this up, how does the portfolio strategy that we’ve discussed differ from PIMCO’s typical strategy?

Powers: PIMCO’s current portfolio structure is defensive due to respect for the reflationary bias of policy makers and the vulnerability of the Bretton Woods II regime. Our concentrations in European bonds, municipal bonds and TIPS reflect this bias. We also have an unusually low holding of mortgage-backed securities and corporates due to their historically expensive valuation. Some of this lack of income is offset by selected emerging markets holdings, concentrations in front-end eurodollar contracts, and volatility sales.

Q: Bill, thank you for updating us once again on PIMCO’s latest cyclical outlook and portfolio strategy.

Summary of PIMCO’s Cyclical Economic Forecast

	Real GDP		Inflation*
	Current	Q205 – Q106	Current	Q205 – Q106
North America	4.4%	3.25 – 3.75%	1.5%	1.75 – 2.25%
Europe	1.6%	1.0 – 1.5%	2.4%	1.50 – 2.00%
Japan/Asia	-0.7%	1.25 – 1.75%	0.0%	-0.25 – 0.25%

*U.S. inflation is Core Personal Consumption Expenditures (PCE). (Note: Core PCE is usually about 50 bps lower than Core CPI)

Rate Forecast:

4.25% to 4.75% on the 10-year Treasury; more likely to break out by 25 bps on high side (Note: fair value yields may very well be higher, but technical factors keep it in this range)

Fed Forecast:

Fed Funds at 3 to 3.5% over next year.

Source: PIMCO internal forecasts