PIMCO, the largest bond manager in the world, is reducing its exposure to US and UK bonds:

“Managing Director Paul McCulley said the supply/demand balance for U.S. and British government debt was likely to suffer as governments stepped up borrowing, and as buying by central banks eventually declined. “We’re probably going to have a $1.4 trillion deficit this year without the Fed on the buy side of the market for duration,” he said of U.S. Treasuries, in a report on Pimco’s website. “There is major uncertainty about how the supply/demand equation for duration will resolve itself when the Fed is out of the picture.” (cnbc.com Jan 4, 2010).

When the largest bond manager in the world is selling US bonds, its telling us, indirectly, that they believe the US fiscal mismanagement will lead to higher interest rates. Higher interest rates are bad for bonds (and stocks as well).

John Hussman, who I follow closely, puts out a weekly comment, and this week he is discussing the US Treasury’s decision to provide “unlimited financial support for the next three years”. (up to $300 Billion ) Essentially, the US Treasury continues to effectively buy dilinquent or bad mortgages from Fannie Mae and Freddie Mac, as a way to absorb these bad debts. John explains:

“This policy is likely to lead to far more delinquencies. ……. What is likely in my view, is that we will observe far greater issuance of government liabilities, which will predictably create a near doubling of the consumer price index in the coming decade. It is notable that he massive expansion of government liabilities beginning in the late-1960’s eventually exploded into uncontrollable inflation by the late 1970’s. There are lags between the creation of government liabilities and their inflationary effects. But to expand these liabilities as recklessly as the Fed and Treasury are now doing, is to undermine the long-term foundations of the economy”.

Implications for the financial markets

“What we do know is that stocks are overvalued even on the basis of normalized earnings, to an extent that exceeds nearly every pre-1995 level except 1929. Intermediate term conditions are strenuously overbought, investors (with advisory sentiment now down to 15.6% bearishness) are clearly overbullish, and interest rate trends are pushing higher. This situation does not always resolve itself into market declines, and indeed, given that market internals remain reasonably firm, we may continue to observe marginal new highs for some amount of time. But the statistical regularity from overvalued, overbought, overbullish, rising yield environments is one of steep, abrupt market losses generally within a period of about 10-12 weeks. ”

2010 will provide some excellent investment opportunities for the patient investor. Stay tuned.

Happy New Year !

Mike