PIMCO's Gross: Fed funds headed to 3 pct

NEW YORK (Reuters) - Tuesday's cut to the Federal Reserve's key lending rate is another baby step toward much lower rates in 2008 as the Fed tries to prevent a housing-led recession, Bill Gross, chief investment officer at PIMCO, the world's largest bond fund, said.

The Federal Open Market Committee trimmed the federal funds rate by one-quarter basis point, to 4.25 percent, taking its total easing since mid-September to a full percentage point.

Speaking ahead of the FOMC decision via telephone to the Reuters Investment Outlook 2008 Summit in New York, Gross, manager of the $111 billion Pacific Investment Management Co. Total Return Fund, reiterated the firm's view that fed funds will hit 3 percent in 2008.

The final FOMC meeting of 2007 likely saw the Fed "divided," Gross said, with Chairman Ben Bernanke, Vice Chairman Donald Kohn and influential bank presidents like San Francisco's Janet Yellen opposed by "some significant new hawks" who are wary of inflation.

Ultimately, though, rates must go a lot lower given subpar economic growth created by a lingering slowdown in the housing market and its spillover effect on consumer spending, he said from his Newport Beach, California, office.

"Typically, in past recessions or near-recessions, the Fed has eased to a 1 percent real rate," or the equivalent of a nominal fed funds rate of about 3 percent, Gross said.

Short-term rates should remain at low levels until the Fed sees housing prices leveling off, he said.

MORTGAGE RATES MUST FALL

A revival in housing and the economy will likely not take place until at least 2009, Gross said.

"Stopping a housing decline is something we haven't had a lot of experience with," he said.

Conventional 30-year home mortgage rates need to fall, probably to 5 percent, and be paired with a further decline in home prices, to shore up the housing market, he said.

"Ultimately you need to bring down 30-year conforming and, more importantly, 30-year jumbo mortgage rates, which at the moment are still in the 5-1/2 to 6-1/2 yield camp."

Gross said weakness in the U.S. dollar in 2008 would likely come mostly against Asian and emerging market currencies, as those economies will be forced to allow exchange rate appreciation to combat inflation.

"I think the dollar has had its run to the downside against the euro and its run to the downside against the pound," he said. "The weaker dollar will be an Asian, emerging market, Middle Eastern phenomenon as opposed to a European or Canadian phenomenon."

The recent drop in U.S. Treasury debt yields has left Treasuries "by far the most overvalued part of the fixed income sector," Gross said.

Still, with the subprime mortgage crisis not yet in the rear-view mirror, the manager of the $111 billion Pacific Investment Management Co. Total Return Fund said it was too soon to go back into the high-yield market and was currently favoring high grade bank debt.

The attractive segment of the corporate market right now is in bank capital, including recent offerings by Barclays and HSBC, said Gross. PIMCO is also "very heavy" in Fannie Mae and Freddie Mac mortgage-backed securities maturing in 30 years.

The United Kingdom was Gross's pick among off-shore fixed income markets, in part because of what he termed its similarity to the United States economy.

(For summit blog: summitnotebook.reuters.com/)

(To hear audio of Bill Gross interview: here)

(To access summit stories, click on ID:nN10423195)

(Additional reporting by Steven Johnson and Jennifer Ablan; Editing by Leslie Adler)