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Bill Gross: Yields to Spike as QE2 Ends

NEWPORT BEACH, CA ( TheStreet) -- Come June, the Federal Reserve's controversial bond buying program, QE2, is widely expected to end.

The withdrawal of a nearly $1.5 trillion monetary stimulus may have dramatic consequences, according to Bill Gross, founder and CIO of the world's largest bond fund, Pimco.

In his latest investment outlook, Gross poses the question that confronts all bond investors -- "Who will buy Treasuries when the Fed doesn't?" Gross notes that private investors, including Pimco and other bond funds, own only 40% of Treasuries, with the remaining held by the Federal Reserve and foreign investors. What's more, the Fed has been buying 70% of all annualized issuances since the beginning of QE2.

Bill Gross, Founder and CIO, Pimco.

Traditional private investors in Treasuries -- banks and bond funds -- may not rush to buy Treasuries once QE2 ends. Banks are stepping up lending, and inflows to bond funds are drying up. But demand for Treasuries may not be the problem.

The question Gross says is really not who will buy Treasuries but "at what yield" the investors will buy them at and "what are the price repercussions if the adjustments are significant?"

Quantitative easing has kept yields artificially low so far. Gross estimates that Treasury yields are perhaps 150 basis points too low when viewed in a historical context and when compared with an expected nominal GDP growth of 5%.

Once the Fed rips off the QE2 band-aid, bond investors will likely demand a higher yield. "25 basis point policy rates for an 'extended period of time' may not be enough to entice arbitrage Treasury buyers, nor bond fund asset allocators to re-enter a Treasury market at today's artificially low yields," argues Gross. "Yields may have to go higher, maybe even much higher to attract buying interest."

If yields rise and spreads widen, that could hurt the outlook for real growth. And it is the successful handoff of public to private debt creation that would be the true test of the success of QE, according to Gross.

"If on June 30, 2011 (the assumed termination date of QE II), the private sector cannot stand on its own two legs -- issuing debt at low yields and narrow credit spreads, creating the jobs necessary to reduce unemployment and instilling global confidence in the sanctity and stability of the U.S. dollar -- then the QEs will have been a colossal flop," wrote Gross.

The fund manager's comments come as Fed Chairman Ben Bernanke testifies before Capitol Hill on monetary policy.

Bernanke told lawmakers under questioning following his testimony Wednesday that he did not expect the end of the asset purchase program to have a big impact on market interest rates, noting that borrowing costs are impacted more by the stock of central bank holdings rather than the flow of purchases.

--Written by Shanthi Bharatwaj in New York



>To contact the writer of this article, click here: Shanthi Bharatwaj.

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Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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