Pimco Warns That Central Banks Can't Save the Bond Market

"People are starting to come to a more realistic outlook about both the forward-looking growth prospects, as well as the power of central banks to pump up asset prices."

There's nothing much to disagree with there. The European Central Bank and the Bank of Japan have done virtually nothing to scale back their extraordinary stimulus measures and appear destined to keep current policies indefinitely. The Federal Reserve was at least able to boost interest rates several times and reduce the size of its balance sheet, but it has less room than ever to maneuver in the next downturn. In fact, Bloomberg Opinion did a six-part series just last month that envisioned what the Fed could do to better combat a potential recession.

Some investors will surely say they'd welcome the end of central-bank meddling in markets. With great volatility comes great opportunities, after all. Indeed, Pimco's Fels, Andrew Balls and Dan Ivascyn wrote in their outlook that the firm "will emphasize flexibility to respond to events, keeping some powder dry and emphasizing liquidity over chasing the very highest yields."

Still, active managers' swagger aside, the prospect of weakened central banks raises serious and difficult questions about how the world's leading economies will foster growth in the years ahead. To some, the obvious answer is a boost in fiscal spending, as advocates of Modern Monetary Theory suggest. Others, like BlackRock Inc.'s Rick Rieder, have floated even more unconventional ideas from the monetary policy side, like having the ECB team up with regional governments to buy equities. And then there are those who say that persistently low interest rates have completely backfired because individuals are forced to sock away ever-larger sums of money just to make the same return, rather than spend today.

For now, Pimco's executives simply urged investors to play defense by investing in Treasuries and U.S.-guaranteed mortgage-backed securities. Of course, that would have been a better move seven months ago, when 10-year yields were about 100 basis points higher than they are today. But if their outlook is correct, and central banks can't do much to contain market turbulence, hiding in havens still looks like a good wager.

Of course, there's always the possibility that Pimco is underestimating the Fed, ECB and BOJ. Mario Draghi's pledge to do "whatever it takes" will go down in history as effectively summing up policy making in the post-financial crisis era, as will the mantra of "don't fight the Fed." While it's risky to project the recent past onto the future, it's worth remembering that investors who have gone against central banks have often been burned.

At the very least, Pimco is raising some important red flags and reminding investors that the current fixed-income environment — 8% year-to-date returns on U.S. high-yield, 6.6% on investment-grade corporate bonds, 3.4% on Treasuries — can't go on forever. But with interest rates as low as they are, it can last for quite some time.

Conspicuously, Pimco didn't specify what will bring about the end of the current era, nor precisely when the cycle will turn. Even the riskiest credit market ever is merely a "vulnerability" and "not at the point where it will fall of its own weight." It turns out timing the future is hard, even for a $1.76 trillion asset manager. But the overarching message out of Newport Beach, California, is clear: Bond investors ought to be vigilant.

— Read Legal & General Unit Fund Manager Predicts Credit Slump Will Worsen, on ThinkAdvisor.

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