Biggest bond investors bet on rate cut

By Jennifer Ablan

NEW YORK (Reuters) - Welcome to the dawn of a new credit cycle, with tighter bank lending, rising costs for riskier borrowers and a slowing economy.

That's the message from three of the biggest names in U.S. bond investing, Bill Gross, Dan Fuss and Jeffrey Gundlach. The trio have made big bets on U.S. government bonds and expect a tightening in financial and economic conditions will likely force the Federal Reserve to cut interest rates by the middle of the year, if not sooner.

"The linear uptrend in risk-taking was broken this week," said Gundlach, chief investment officer at the TCW Group in Los Angeles, which manages assets worth $145 billion. "We are sitting here at our biggest Treasury position in 10 years. We are double the market weighting in Treasuries."

After three years of abundant liquidity and muted volatility, this week's plunge in stocks and lower-rated debt have triggered a sudden pullback in risk-taking.

Indeed, punctuating that pullback is the unwinding of the global carry trade by leveraged players. For the better part of this decade, investors have borrowed in low-yielding Japanese yen to buy high-yielding emerging market stocks, bonds and currencies.

As investors undo their carry positions, the yen has risen about 3 percent this week, while emerging market currencies were broadly down.

"When you get an upset as big as this in the so-called carry trade, you will see an initial cutback in risk appetite in various markets," added Fuss, co-manager of the $8.7 billion Loomis Sayles Bond Fund. "This week's events were very significant and have led to a change in psychology."

The break in risk appetite not only goes for financial markets, but the economy as well.