Who Are These Guys?

By Daniel Kadlec

Americans struggling to find work, get a decent pay raise or buy a home must marvel at the peculiar worries of Bill Gross. A legendary investor, Gross runs the $76 billion Pimco Total Return bond fund. In recent weeks he has sold $6 billion in Treasury bonds, activity that has contributed to a sharp rise in mortgage interest rates. Gross, though, is more concerned about bad things that might happen in the future, not what's happening now. "Two or three years down the road," he says, "inflation might be a real pressure cooker."

The prospect of a runaway economy complete with nasty inflation is unfathomable to a battered labor force more focused on getting or keeping jobs in the current climate. But Gross and other bond investors get paid to look far ahead, take their best guesses and place their bets accordingly. In the process, they exert near total control over the rate you pay when borrowing to buy a house, car or toaster.

That's because long-term interest rates are set in the bond market, not by the Federal Reserve, which dictates short-term rates. Bond traders sell when they anticipate a pickup in inflation, which usually accompanies economic growth and erodes the value of their fixed interest payments. In the past two months, the selling has been heavy, and as a result the average 30-year fixed-rate mortgage has jumped from 5.25% to 6.37%. That move adds $143 to the monthly principal-and-interest payment on a $200,000 mortgage--all because Gross and his kind have had a change of heart and now figure the economic recovery is firmly on track.

To be sure, some economic indicators have been perking up, including stronger retail sales, corporate profits and manufacturing activity. But these could easily prove to be just a blip on the radar. After all, only weeks ago it was the D word--deflation--that was giving traders nightmares. Even Fed Chairman Alan Greenspan has publicly fretted over the prospect of the country succumbing to a Japan-like malaise with falling prices, though he says the possibility is remote.

Greenspan is clearly worried that the bond mavens' expectations for a solid recovery is premature. Last Tuesday the Fed met and not only held its benchmark Federal Funds short-term rate at 1% (a 45-year low) but also took the unprecedented step of saying it would leave the rate there "for a considerable period." The Fed hates to be boxed in. It desperately wanted bond investors to follow the lead. They didn't. A sell-off in Treasury bonds that began in June persisted, pushing bond prices down and yields up. The yield on the closely watched 10-year T-bond jumped to a 12-month high of 4.66% early Thursday before ending the week at 4.53%. As recently as June 13, the yield was 3.11%.

Of course, it isn't just big guns like Gross who have the power to move markets and cause interest rates to spike. Many bond traders are like Brian Edmonds, head of Treasury-bond trading for Banc of America Securities. Blond, trim and a former Harvard lacrosse player, he sits at his desk all day interpreting economic data and trying to predict what the zig-zagging numbers might mean for the market. When claims for unemployment benefits ticked higher last Thursday, it suggested weakness in the economy. Investors promptly bid up bond prices. But Edmonds saw hidden strength in the news. He sold $100 million of T-bonds, just before the market reversed and proved him right. "Volatility creates opportunity," Edmonds says.

Opportunists like "Edmo," as trading pals call him, sit in the pits at hundreds of firms and move the market in increments every day. But it's the relatively few heavyweights like Gross--others include the Soros hedge funds and institutional managers such as BlackRock--who create sustained moves as they constantly position their portfolios for the unknown. People planning on refinancing or buying a house would do well to listen to what Gross has to say. For one thing, he says the unprecedented interest-rate volatility seen of late is now a permanent bond-market reality because of the nation's mushrooming use of credit. As banks, pension funds, insurers and finance companies trade debt to manage their exposure to interest-rate risk, speculators are encouraged to jump in, heightening volatility.

There may be good news in all this. Much of the recent increase in interest rates has been technical--giant mortgage holders like Pimco, Fannie Mae, Freddie Mac, Chase and J.P. Morgan have been selling T-bonds in a complex strategy that helps to shield their vast mortgage holdings against risk. But despite signs of economic recovery, Gross believes bond yields will settle in at current levels--meaning mortgage rates will settle here as well. "We're done selling," Gross says. At least for now.

--With reporting by Sean Gregory and Jyoti Thottam/New York

With reporting by Sean Gregory and Jyoti Thottam/New York