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PIMCO: What's Happening to Bonds and Why?


History will regard the ongoing phase of dislocations as a transitional period of adjustment triggered by changing expectations about policy, the economy, and asset preferences.

In all likelihood, the Fed will taper for a mix of reasons. Specifically, it will likely be comforted by the notion that the American economy continues to heal, but also frustrated by the gradualism of the recovery and the threat of collateral damage. Meanwhile, look for the Fed to try to compensate the potential contractionary impact of tapering by evolving its forward guidance policy.

The most difficult call relates to technicals. Given their behavioral finance dimension, they have a bad (though understandable) habit of surprising even the most experienced and astute investors. And as much as they may be discounted by some long-term investors, bad technicals can contaminate fundamentals due to their path-dependency dynamic (that is to say, rather than immediate mean reversion, the tendency of one disruptive move increasing the probability of additional ones).

These different considerations reinforce the investment conclusions set out by Bill Gross in his Investment Outlook of last week. Specifically, fixed income investors should respect the technicals for now, emphasize the front end of curves on the basis of the policy pivot (from QE to forward guidance), and consider TIPS as a source of endogenous portfolio hedging. They should look to exploit large technical dislocations that are anchored by upcoming maturities and other self-liquidating characteristics. And, given that the bad technicals will run their course eventually, they should prepare to take advantage of broader overshoots that provide both attractive valuations and solid carry.

The greater the movements in fixed income fueled by changes in the Fed's policy paradigm and investor asset preferences, the more the investor community needs to pay attention to an asset class that inevitably impacts the attractiveness of other asset classes, covariances and the robustness of overall asset allocations. And investors should guard in particular against the potentially disruptive element of fixed income technical overshoots – meaning interest rate spikes that cannot be validated by an economic recovery, policy rate increases or sustainable asset shifts.

Concluding remark

Similar to prior periods, history will regard the ongoing phase of dislocations in the bond market as a transitional period of adjustment triggered by changing expectations about policy, the economy and asset preferences – all of which have been significantly turbocharged by a set of temporary and ultimately reversible technical factors. By contrast, history is unlikely to record a change in the important role that fixed income plays over time in prudent asset allocations and diversified investment portfolios – in generating returns, reducing volatility and lowering the risk of severe capital loss.

This article by Mohamed A. El-Erian originally appeared on PIMCO.
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