In Bill Gross' view, U.S. inflation is becoming a subdued beast and interest rates will drop. That's the contrarian forecast of the chief...

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In Bill Gross’ view, U.S. inflation is becoming a subdued beast and interest rates will drop.

That’s the contrarian forecast of the chief investment officer of Newport Beach, Calif.-based Pacific Investment Management, the world’s largest manager of bonds.

Federal Reserve policy-makers raised short-term interest rates another quarter-point yesterday. But if Gross is right and inflation is declining to the 1 to 1.5 percent range, then the Fed will halt its rate increases this year.

That would create a brave new investment climate for bonds and stocks, and perhaps a scarier scenario for U.S. real estate.

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“Next year, disinflation will ultimately triumph over reflation,” Gross said at a recent Morningstar Mutual Fund conference in Chicago. “That means the 10-year U.S. Treasury note may yield as low as 3 percent.”

Gross is defying conventional wisdom by predicting the Federal Reserve will stop its rate-increase policy and start cutting borrowing costs.

With crude oil hitting $60 a barrel and commodity prices soaring, though, it’s hard to make a convincing argument that inflation is completely under control.

The Dow Jones/AIG Commodity Total Return Index, for example, a basket of commodities from oil to metals, is up 12.6 percent over the past year through June 22, according to Bloomberg data. That compares with an annual increase of 2.2 percent for the U.S. core consumer price index, through May 31.

House prices

The unfettered escalation in U.S. home prices also has raised the cost of living.

During the past five years, residential property alone has increased in value by almost 50 percent, which “surpasses any increase in 25 years,” according to the Federal Deposit Insurance Corp. (FDIC). And during a 12-month period ending in March, home prices in Washington state jumped 12.7 percent, compared with a nationwide figure of 12.5 percent, according to FDIC figures.

Like many economic savants, Gross is concerned that if his lower-rate forecast comes true, home financing will become even cheaper and encourage more buying and speculation in already overheated home markets.

“The leverage frightens me,” Gross candidly said at the Chicago conference. “We need the housing market to stay above water, but 10 percent to 15 percent annual appreciation is not a good thing.”

The economy is “floating because of the housing market when it should be floating because of productivity,” Gross said when asked about the prospect of the real-estate bubble inflating even more if his lower-rate forecast materializes.

Some wild cards

Gross isn’t known for being on the wrong side of interest-rate bets, hence his deserved reputation as a bond czar.

His flagship Pimco Total Return Institutional fund, holding about $82 billion, has beaten 91 percent of peers over the past half-decade through June 21.

The day after Gross spoke in Chicago, the 10-year Treasury note yield dipped below the 4 percent mark. Traders attributed the decline to concerns of lower global growth, higher oil prices and a possible rate cut by the Bank of England.

Part of Gross’ wisdom, though, hinges on the possibility he may be wrong. One wild card includes the chance inflation will accelerate, forcing the Fed to keep raising short-term rates.

Gross also is waiting to see if the Chinese and Japanese governments ease their buying of U.S. Treasury securities and begin selling them. To date, these mega-customers of U.S. debt have kept rates low in this country and have been cited by economists as a factor in fueling the housing boom by providing low-cost capital for financing.

“If these dollars don’t recirculate into Treasuries, we’d best watch out,” Gross added.

The Gross portfolio

Assuming that Gross is right on a pending decline in interest and inflation rates, how would you invest?

You would want to hold a generous basket of stocks and bonds. Yet if interest rates headed north, you wouldn’t want to assume too much risk by owning single bonds or concentrating on long-term maturities.

Two fund suggestions include the iShares Lehman Aggregate Bond Fund (AGG), an exchange-traded fund, or the Vanguard Total Bond Market Index Fund (VBMFX).

Both low-expense funds represent broad-based baskets of the U.S. bond market and can be core holdings for any investor. For non-U.S. bonds, the T. Rowe Price International Bond Fund (RPIBX) is a good choice.

An even more across-the-board income fund is the Pimco All Asset Fund (PASDX), a fund of funds that covers a variety of U.S. and international bonds, commodities and real estate. The fund has beaten 95 percent of its peers over the past year.

For stocks, which may also benefit from lower rates, consider the Vanguard Total Stock Market VIPERS (VTI), an exchange-traded fund that covers most U.S.-listed stocks.

Keep costs low

While bonds, stocks and real estate may continue to rally under Gross’ scenario, he doesn’t see them or hedge funds exceeding single-digit returns. That means investment expenses will play a major role in enhancing total returns.

“In a 4 percent to 5 percent return world, you can’t afford to give away money to fees,” he said. “Cut those fees under the assumption there’s not much out there.”

There’s always the chance Gross and other market seers have foggy crystal balls, and that a pronounced economic slowdown is imminent. In that case, real estate may be hurt the most.

“There is a necessity that the housing market not crash and do half well,” he said.

Yet if the economy enters a recession — a possibility in the next five years in his estimation — he notes the Federal Reserve may have limited ability to revive it through interest-rates cuts again.

Then Federal Reserve Chairman Alan “Greenspan may be out of rabbits,” he said.

Information from FDIC on Washington state home values provided by Seattle Times real-estate reporter Elizabeth Rhodes.