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By Shannon Zimmerman | 10-05-2012 12:00 PM

Today's Most Dominant Risk Factor

All asset classes are currently being driven by central bank policy measures, and understanding the risks are critical for portfolio construction, says PIMCO's Vineer Bhansali.

Shannon Zimmerman: It's a very political season, so let's backup a little bit and talk about monetary policy and policy in general. You think of that as a risk exposure. How do you go about analyzing that and having a view into something that can be so remarkably unpredictable?

Vineer Bhansali: It's very interesting. Over the last four years, the policy risk factor has evolved from just being monetary policy to just policy in general. Four years ago you could have looked at what the federal-funds rate was or what the pricing of eurodollar contracts was, and say, what is the Federal Reserve supposed to do? And quantitatively you could have proxied the policy risk factor with, let's say, the fourth or eighth eurodollar futures contract implied rate.

Now, since then rates have come down to zero-bound and they are very low, and the policy that the central banks are using is not just monetary policy, but they're also buying assets like mortgages. They're also out in the public space talking about managing expectations about inflation. So, the evolution of analysis for policy risk factors has had to move into those dimensions. And what we have done is really tried to build a framework within which the policy risk factor can be more broadly interpreted. There also has been a lot of great research from researchers from Stanford and other places who've looked at quantifying the policy risk factor by the mentioning of policy risk in news items. So, doing a Google search, for example. That's a very interesting area of research. And to your question, we believe that the policy risk factor today is probably the most dominant risk factor in terms of both asset-class returns and risk, and really getting it right is of paramount importance for any robust portfolio construction. All assets are being driven by it.

Zimmerman: Is that particularly true of monetary policy in the Fed because I know you talk about policy broadly, and obviously, if you're thinking of health-care bonds, for instance, it's an interesting time, though maybe the question is settled by now. But over the last 12 to 18 months there was a lot of uncertainty around that. Is that the kind of thing that you would factor into your assessment of whether or not to increase your exposure to health-care bonds?

Bhansali: Yes, it would, but it's a little bit more indirect, like you mentioned. To see what health-care reform might do to health-care bonds and health-care equities requires a lot more interpretation. Monetary policy on the other hand is relatively more straightforward. It's not easy, but straightforward because you can know that once the rate-cutting process has been exhausted, the next step for the Federal Reserve is to do outright purchases of securities. And what you have to find is what is the area in which they are likely to deploy their capital, and what is it likely to do to the rest of the market. For example, as TIPS yields become significantly negative, what does it do to things like gold, what does it do to things like index equities, et cetera? And that's an evolving area of research, both for myself and for a lot of the industry.

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