Gundlach, Pimco Sour on Reflation Trade as Price Pressures Peak

They correctly picked last year’s uptick in price growth, but two bond-market heavyweights are now signaling inflation may have seen its zenith.

Pacific Investment Management Co. is scaling back its outlook for U.S. price growth, saying an increase in job-market participation will dent wage growth and oil’s pullback will also be a damper. For DoubleLine Capital LP’s Jeffrey Gundlach, inflation this year has passed its peak, meaning the reflation trade that’s dominated markets in 2017 could peter out.

Both firms made prescient calls last year on consumer-price gains, recommending the profitable trade of buying TIPs, or Treasury Inflation Protected Securities. They’re not the only ones questioning the outlook for inflation, though, with Australia & New Zealand Banking Group Ltd. to BNP Paribas SA flagging the prospect that a halt in the commodity rally could put a lid on inflation over the next few months.

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“Longer-term risks to inflation are skewed to the upside, but at the same time the momentum behind the recent reflation trade is likely to ebb temporarily in the near term,” Pimco’s Global Economic Advisor Joachim Fels and chief investment officer for fixed income Andrew Balls, wrote in a report dispersed via Twitter this week.

In a webcast Tuesday, Gundlach all but called time on the reflation trade, which has seen equities to emerging-market debt and raw materials rally on bets Donald Trump’s presidency will usher in a period of fiscal spending-fueled growth.

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Gundlach has tempered his forecasts for U.S. Treasuries. Read more here.

It’s a view that largely runs counter to the consensus, with U.S. consumer-price growth expected to quicken to 2.5 percent by the end of this year, from 1.3 percent in 2016, according to the median of economists’ forecasts compiled by Bloomberg.

China Factor

Brent crude has rallied more than 7 percent from a 2017 low reached March 23, but remains below this year’s average price after a selloff at the start of last month. Pimco also cited a shift in China’s focus from growth to stability in their reasoning, saying “the strong Chinese credit impulse that supported global reflation in 2016 and into 2017 is likely to wane in the course of this year.”

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Hao Hong, a China markets strategist with Bocom International Holdings Co., last month flagged the prospect of a cyclical slowdown in Asia’s largest economy that would prick inflationary pressures and skewer reflation trades. Consumer-price growth in China may be slower than expectations amid cuts to overcapacity, the Economic Information Daily reported Wednesday, citing Bank of Communications Co.’s chief economist, Lian Ping.

If Pimco and Gundlach are right, it’s bad news for trading in TIPS, which have climbed 1.6 percent over the past year, versus the 1.5 percent loss for nominal Treasuries.

“There’s starting to be some concerns about actually whether the global economy can pick up any more,” Richard Yetsenga, chief economist at ANZ in Sydney, said on Bloomberg TV Tuesday. ”Commodity prices are up a bit but they don’t seem to really be going on with that kind of trend.”

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PIMCO's Gross admits he struck out on bonds this year

In a Special Edition letter posted on PIMCO’s website, Gross, who runs the $242 billion PIMCO Total Return portfolio, wrote that he underestimated the contagion effect from the Europe debt crisis and the U.S. debt ceiling debacle.“As Europe’s crisis and the U.S. debt ceiling debacle turned developed economies toward a potential recession, the Total Return Fund had too little risk off and too much risk on,” said Gross, who also shares the title of co-chief investment officer at Pacific Investment Management Co. with Mohamed El-Erian.Gross, known as the “bond king”, came under heavy criticism earlier this year when he bet heavily against U.S. Treasuries which have turned out to be one of the biggest outperformers of 2011.His fund’s poor performance led Gross to simply call his open letter to investors, “Mea Culpa."It is up only 1.06 percent year to date versus the benchmark BarCap U.S. Aggregate Index which is up 3.99 percent.Gross, who helps manage more than $1.2 trillion at PIMCO, said late Friday the Total Return fund had positions in German bonds and Canadian Treasuries to counter the U.S. underweight position, "but not enough."He added that minor percentages of emerging market corporate and sovereign debt, effectively denominated in their local non-dollar currencies, did not perform well either."The simple fact is that the portfolio at midyear was positioned for what we call a "New Normal” developed world economy - 2.0 percent real growth and 2 percent inflation,“ Gross said.That’s all changed, of course. Gross said PIMCO’s internal growth forecast for developed economies "is now zero percent over the coming several quarters and the portfolio more accurately reflects this posture."Last week, Reuters reported that Gross ramped up buying of mortgage-backed securities in September, albeit by using leverage, on the likelihood the Federal Reserve’s reinvestment program in those securities will boost prices significantly.Gross increased mortgage debt to 38 percent of assets in September, from 32 percent in August, as the U.S. central bank announced last month that it "will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities."His move into mortgage-backed securities also comes as the PIMCO Total Return fund’s cash equivalents and money-market securities fell to negative 19 percent September, from negative 9.0 percent in August.In having a so-called negative position in cash equivalents and money-market securities, it is an indication of using derivatives and short-term securities as collateral in order to boost the fund’s buying power with leverage.Gross’ move to seek more yield by putting more money into mortgage bonds is yet another bold bet which many will be watching after Gross’s call on Treasuries cost his fund’s performance. In doing so, he is effectively extending the average duration of his fund’s investments, making them potentially more exposed to a rise interest rates.Clearly, Gross is betting interest rates will remain low for some time as the world economy continues to struggle.In his "mea culpa” letter, Gross resorted to baseball analogies and metaphors. He closed his letter by saying: “This is big league ball, where your ticket holders come to the park expecting not a circus-Willie Mays-catch but more wins than losses and a year-end performance that places your bond assets near the top of the standings."He added, "Baseball metaphors aside, we know why PIMCO Total Return is arguably the largest and hopefully the greatest bond fund in the world.”