It won't take much for the Federal Reserve to raise short-term interest rates too far, triggering an economic reversal making indebted students, corporations and other borrowers unable to repay loans, according to billionaire bond manager Bill Gross.
"Central bankers and indeed investors should view additional tightening and 'normalizing' of short-term rates with caution," Gross, who runs the $2.1 billion Janus Henderson Global Unconstrained Bond Fund, said in an investment outlook published Thursday.
The Fed has hiked its short-term funds rate four times since December 2015, including twice this year. The implied probability of another rate hike in 2017 was about 40 percent as of late Wednesday, according to data compiled by Bloomberg. The median Fed target rate is 1.375 percent this year, rising to 2.94 percent in 2019.
If short-term rates rise faster than long-term rates, it causes a flattening yield curve, historically often a precursor to recessions, such as the 2007-2009 financial crisis that was underway long before the collapse of Lehman Brothers Holdings Inc. Because rates have been so low for so long, it could take a small move on the short end to trigger an economic reversal, according to Gross.
"Most destructive leverage -- as witnessed with the pre-Lehman subprime mortgages -- occurs at the short end of the yield curve as the cost of monthly interest payments increase significantly to debt holders," he wrote.
Yields have already flattened since the Fed ended its asset purchases under its quantitative easing program, leading to higher short-term rates, he wrote. Post-crisis global quantitative easing has led central banks to "overstuff" their balance sheets by more than $15 trillion, according to Gross.
"My analysis shows me that the current curve has flattened by nearly 300 basis points since the peak of Fed easing in 2011/2012," Gross wrote. "Today's highly levered domestic and global economies, which have 'feasted' on the easy monetary policies of recent years, can likely not stand anywhere close to the flat yield curves witnessed in prior decades."
The go-slow warning marks a subtle shift for Gross, who has repeatedly argued for hikes because persistently low rates harm banks, insurers and individual savers while distorting the economy with inflated asset prices. Now he's warning that borrowers with short-term debt may be among the biggest risks to the economy.
The Janus Henderson Global Unconstrained Bond Fund returned 1.9 percent this year through July 18, trailing 74 percent of its peers, according to Bloomberg data. It has returned 6.3 percent since Gross took over management in October 2014 after leaving Pacific Investment Management Co.