NEW YORK, Nov 3 (Reuters) - Bill Gross, the closely watched bond investor, on Tuesday warned that the flatness of the Treasury yield curve could have harmful effects on lending across all credit markets, resulting in stunted profit growth in the United States.
In his latest Investment Outlook, Gross, who oversees the $1.4 billion Janus Global Unconstrained Bond Fund, said the Federal Reserve's historical models fail to recognize that over the past 25 years, capitalism has increasingly morphed into a finance-dominated system as opposed to one that produces goods and services.
"Capitalism would not work well if fed funds and 30-year Treasuries co-existed at the same yield, nor if commercial paper and 30-year corporates did as well," Gross said. "Investors would have no incentive to invest long-term."
The slope of the yield curve continues to flatten, with short-term rates rising faster than longer-bond yields. This typically happens when monetary policy is tightened. Gross has urged the Fed to raise interest rates to "more normal levels" since early this year as he argues that zero-bound levels are harming the real economy and destroying insurance company balance sheets and pension funds.
Gross said a steeper yield curve, which indicates that yields on long-term bonds are rising faster than those on short-term bonds or, occasionally, that short-term bond yields are falling even as longer-term yields are rising, can be achieved despite the Fed's tightening cycle.
Gross said a much steeper yield curve and a higher policy rate allow banks, financially oriented businesses, as well as household savers themselves to increase margins and restore profit and disposable income growth.
He suggests two ideas to achieve a positively sloped curve.
"Central banks could raise their inflation targets," Gross said. "Japan has done so over the past few years, avoided deflation/recession and actually benefited bond and equity markets."
Gross said targeting 3 percent inflation worldwide should raise 10-30 year yields more than short rates, resulting in a steeper curve at slightly higher yield levels. "San Francisco Fed President John Williams recently brought up the possibility of raising inflation targets in the absence of more stimulative fiscal policy," Gross noted.
Gross also proposed an "Operation Switch" by the Fed as opposed to 2012's "Operation Twist," which sold 2-5 year notes and reinvested the proceeds in longer-dated Treasuries, in an effort to push down long-term interest rates and therefore boost the economy. "The Fed now holds upwards of $2 trillion longer-dated Treasuries and mortgages that can be 'switched' into 2-5 year paper, steepening the yield curve and benefiting savers, liability based businesses, and the economy itself." (Reporting By Jennifer Ablan; Editing by Chizu Nomiyama)