The Financial Times has a fascinating story about how Bill Gross and John Paulson, both the managers of large financial firms (Pimco and Paulson & Co. respectively) expected the United States to enter a period of inflation, planned accordingly, and got their bets completely wrong.
Paulson and Gross both made an error in judgement: they assumed that the Federal Reserve’s policy of quantitative easing would engineer inflation.
The FT reports on how this has affected their firms’ standing:
Mr Paulson’s flagship Advantage Plus fund was down 39 per cent for the year by mid-August, according to investors. Mr Gross, trailing his benchmark, slipped to 501st among his 584 bond manager peers, his status as a bond guru under threat.
In Paulson’s case, he not only got this judgement wrong, he got it wrong on the advice and consultation of former Federal Reserve Chairman Alan Greenspan:
According to a person familiar with Mr Paulson’s thinking, he was also exceptionally keen on gold. When the Fed began to buy bonds in 2009 in an attempt to stimulate the economy, he was advised by Alan Greenspan, former Fed chairman, that this would ultimately lead to higher inflation as the economy recovered. So his $35bn hedge fund decided to allow its investors worried about inflation to transfer their holdings from US dollars into gold, using derivatives that track the price of the precious metal.
Paulson is also notable for being profiled in a BusinessWeek article in July of 2010 where he was–as hindsight now shows us–excessively confident about the US economic recovery:
Paulson has a simpler view [thank Krugman]: Americans are starting to spend again, in ways not terribly dissimilar to the ways we did before, buying suburban homes and stuffing our Social Security checks into slot machines. There are pitfalls. As we work our way back to the old normal and demand picks up, the years of superlow interest rates will come back to smack us, fueling inflation that Paulson sees possibly reaching into the double digits within a few years. That’s why, in addition to Florida property, Paulson is heavily invested in gold.
Bill Gross to his credit is aware that the economy is weaker. He knows that the real reason that economy is doing poorly is because of low aggregate demand and has even argued that this is a bigger problem then America’s debt. Yet he also expected quantitative easing to be followed by inflation:
The value of a Treasury’s fixed interest payments is eroded by inflation. Mr Gross expected interest rates to rise when the Fed stopped buying bonds as part of its quantitative easing stimulus programme at the end of June, which would cause their price to fall.
Another person who got this call wrong is majority leader Eric Cantor, who famously invested with a fund that goes short on long-term government bonds on the expectation that the US will enter a period of higher inflation.
Instead, against the expectations of Johnson, Gross, and Cantor interest rates have been pegged low till the middle of 2013.
To be sure, core inflation is a little higher than expected. Yet as of this posting, the two-year “breakeven rate” (the difference between inflation indexed and non-inflation indexed treasury bonds) shows an inflation expectation of a little over 1% for two years and around 2% over ten years.
Markets rise and fall and August has been an exceptionally rough month. The psychodrama over the debt ceiling, the reduced GDP growth figures, and the renewed fear of a European debt crisis all did their part to make US debt seem like the safest possible investment, even in a post S&P downgrade world.
Inflation will return at some point, but not as soon as some on Wall Street expected it to.
Update: The description of Eric Cantor’s investment has been clarified.