Bill Gross warns of recession risk if highly levered economies hike rates

NEW YORK (Reuters) - Highly levered domestic and global economies including the United States, which have “feasted” on easy monetary policies in recent years, cannot withstand a normalizing of short-term interest rates without running the risk of a recession, influential bond investor Bill Gross of Janus Henderson Investors warned on Thursday.

Bill Gross, Portfolio Manager, Janus Capital Group, listens during the Milken Institute Global Conference in Beverly Hills, California, U.S., May 3, 2017. REUTERS/Lucy Nicholson

In his latest Investment Outlook, Gross, who runs the $2.1 billion Janus Henderson Global Unconstrained Bond Fund, said Federal Reserve Chair Janet Yellen and other global policy makers should not rely on historical models “in an era of extraordinary monetary policy.

“The adherence of Yellen, Bernanke, Draghi, and Kuroda, among others, to standard historical models such as the Taylor Rule and the Phillips curve has distorted capitalism as we once knew it, with unknown consequences lurking in the shadows of future years,” Gross said.

He was referring to Yellen’s predecessor at the Fed, Ben Bernanke, European Central Bank President Mario Draghi and Bank of Japan head Haruhiko Kuroda.

Economists John Taylor and A.W. Phillips devised models for guiding interest-rate policy based, respectively, on inflation and the unemployment rate. Those models disregard the importance of private credit in the economy, according to Gross.

Gross said that over the past 25 years, the three U.S. recessions in 1991, 2000 and 2007-2009 coincided nicely with a flat yield curve between three-month Treasury bills and 10-year Treasuries.

“Since the current spread of 80 basis points is far from the ‘triggering’ spread of 0, economists, and some Fed officials as well, believe a recession can be nowhere in sight,” Gross said.

But monetary policy following the collapse of investment bank Lehman Brothers in 2008 has been abnormal, and global central banks “can’t seem to stop buying bonds, although as compulsive eaters and drinkers frequently promise, sobriety is just around the corner,” he said.

Gross said most destructive leverage occurs at the short end of the yield curve as the cost of monthly interest payments increase significantly to debt holders.

“While governments and the U.S. Treasury can afford the additional expense, levered corporations and individuals in many cases cannot,” he said.

Since the Great Recession, more highly levered corporations, and in many cases, indebted individuals with floating-rate student loans now exceeding $1 trillion, cannot cover the increased expense, resulting in reduced investment, consumption and ultimate default, Gross said.

“Commonsensically, a more highly levered economy is more growth sensitive to using short-term interest rates and a flat yield curve, which historically has coincided with the onset of a recession,” he said.

Reporting by Jennifer Ablan; Editing by Leslie Adler