Bill Gross: Here's what could trigger a 'run on the shadow banks'

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Bill Gross expects gradual hike

Bill Gross thinks conditions are ripe for a significant liquidity crisis in the markets, and he points a finger at his old firm for its potential to be at the center of the storm.

In his monthly note to investors, the Janus Capital Group fund manager said there are six specific triggers for such an event in which there would not be enough buyers to accommodate sellers in a panicked bond market. (Tweet This)

"Long used to the inevitability of capital gains, investors and markets have not been tested during a stretch of time when prices go down and policymakers' hands are tied to perform their historical function of buyer of last resort," Gross wrote. "It's then that liquidity will be tested."

The comments come as fixed income investors face challenges on multiple fronts: Looming debt defaults from both Puerto Rico and Greece, and the latter's potential exit from the euro zone, along with the likelihood of a Federal Reserve rate hike later this year.

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The conditions Gross cited for a market meltdown are:

1) A central bank mistake leading to lower bond prices and a stronger dollar.

2) Greece, and if so, the inevitable aftermath of default/restructuring leading to additional concerns for euro zone peripherals.

3) China— "a riddle wrapped in a mystery, inside an enigma." It is the "mystery meat" of economic sandwiches—you never know what's in there. Credit has expanded more rapidly in recent years than any major economy in history, a sure warning sign.

4) Emerging market crisis—dollar denominated debt/overinvestment/commodity orientation—take your pick of potential culprits.

5) Geopolitical risks—too numerous to mention and too sensitive to print.

6) A butterfly's wing—chaos theory suggests that a small change in "non-linear systems" could result in large changes elsewhere. Call this kooky, but in a levered financial system, small changes can upset the status quo. Keep that butterfly net handy.

Unlike the financial crisis, where Wall Street's largest investment banks came under duress when liquidity dried up, Gross said the next wave will involve nonbank institutions like Pimco, the Newport Beach, California-based firm he co-founded more than 40 years but left in 2014.