(Adds quotes on Operation Twist, background, paragraphs 6-14)
By Jennifer Ablan
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, stunting growth in U.S. corporate profits.
Gross, who oversees the $1.4 billion Janus Global Unconstrained Bond Fund, said in his latest Investment Outlook that 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, saying zero-bound levels are harming the real economy and destroying insurance company balance sheets and pension funds.
Gross said a steeper yield curve, indicating 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 even if the Fed decides to tighten.
He suggests the Fed should sell longer-term Treasuries and buy shorter-term notes to achieve a positively sloped curve.
"I propose an 'Operation Switch'," Gross said. "Instead of 2012's 'Operation Twist,' which sold 2-5 year notes and reinvested the proceeds in longer dated Treasuries now resting in their portfolio, the Fed should do just the reverse."
Gross said "Operation Twist" did nothing to improve year-over-year gross domestic product growth. It may, in fact, have lowered it, dropping GDP in the 4th quarter of 2013 to 0.9 percent year-over-year, following the 'Twist' in 2012.
"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," Gross said.
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.
Gross has been in the spotlight in recent weeks.
On Monday, Soros Fund Management LLC, which billionaire investor George Soros chairs, pulled its roughly $500 million from an account run by Gross at Denver-based Janus Capital Group Inc, according to a source familiar with the matter.
Last month, Gross sued Pimco and its parent Allianz SE for $200 million, claiming he was wrongfully ousted as chief investment officer by a "cabal" of executives who wanted his share of the bonus pool.
In the complaint filed in the California Superior Court, Gross said Pimco managing directors were "driven by a lust for power, greed, and a desire to improve their own financial position and reputation" in their ultimately successful effort to drive him out. (Reporting By Jennifer Ablan; Editing by Chizu Nomiyama and David Gregorio)