Gross: hold short duration bonds to avoid 'inflation dragon'

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Investors should only buy short duration bonds supported by the Fed's easing measures as inflation remains a risk in the years that are not safeguarded by the central bank's promises, according to PIMCO bond star Bill Gross.

In his most recent investment note, the manager of the world's biggest mutual fund - the $285 billion PIMCO Total Return - referred to the monetary policies of central banks as bubble-like.

'Well ultimately government financing schemes such as today’s QE’s or England’s early 1700s South Sea Bubble end badly,' said Gross.

While it may appear like we are getting 'money for nothing and debt for free', Gross warns these measures will soon bite back.

'Investors should be alert to the long-term inflationary thrust of such check writing. While they are not likely to breathe fire in 2013, the inflationary dragons lurk in the “out” years towards which long-term bond yields are measured,' he said.

'You should avoid them and confine your maturities and bond durations to short/intermediate targets supported by Fed policies.'

At the December meeting, the Fed pledged to keep interest rates at near-zero levels so long as the unemployment rate is above 6.5% and inflation remained below 2.5% for the next year or two.

Just one month before that meeting, Gross had upped exposure to treasuries from a 20% position to a 24% exposure in the fund despite a track record of criticising Fed policies as a danger to the stability of the monetary system.

QE to threaten economic growth

At a time when equities are seen as increasingly attractive for investors disappointed by low risk-return in fixed income, Gross reiterated the view that monetary policy would not impact the wider economy and as such would also not support growth assets in the long term.

'Zero-bound interest rates, QE maneuvering, and “essentially costless” check writing destroy financial business models and stunt investment decisions which offer increasingly lower ROIs and ROEs,' he wrote.

'Purchases of “paper” shares as opposed to investments in tangible productive investment assets become the likely preferred corporate choice. Those purchases may be initially supportive of stock prices but ultimately constraining of true wealth creation and real economic growth.'

'At some future point, risk assets – stocks, corporate and high yield bonds – must recognize the difference.'

'Japan we are not, nor is Euroland or the U.K. – just yet. But “costless” check writing does indeed have a cost and checks cannot perpetually be written for free.'

At the end of 2012, Gross wrote an investment outlook where he said that he favoured US inflation-protected bonds and high-quality municipal bonds.

Financial stocks of banks and insurance companies, high yield bonds and long-dated developed country bonds in the US, UK and Germany are the assets Gross said he recommended as a sell.