- The Fed’s announcement of a renewed commitment to Quantitative Easing has been well telegraphed and the market’s reaction is likely to be subdued.
- We are in a “liquidity trap,” where interest rates or trillions in asset purchases may not stimulate borrowing or lending because consumer demand is just not there.
- The Fed’s announcement will likely signify the end of a great 30-year bull market in bonds and the necessity for bond managers and, yes, equity managers to adjust to a new environment.
These three bullet points is how Bill Gross summarizes his Investment Outlook for November 2010. Notable in these bullets is the last part about the bull market in bonds coming to an end. While bonds can rally yet further from the already low yields we see today if disinflation continues into deflation, the risk/reward of that trade is not good.
As for the second bullet, Gross explains much as John Hussman did earlier in the week:
We are, as even some Fed Governors now publically admit, in a “liquidity trap,” where interest rates or trillions in QEII asset purchases may not stimulate borrowing or lending because consumer demand is just not there. Escaping from a liquidity trap may be impossible, much like light trapped in a black hole. Just ask Japan. Ben Bernanke, however, will try – it is, to be honest, all he can do. He can’t raise or lower taxes, he can’t direct a fiscal thrust of infrastructure spending, he can’t change our educational system, he can’t force the Chinese to revalue their currency – it is all he can do, and as he proceeds, the dual questions of “will it work” and “will it create a bond market bubble” will be answered. We at PIMCO are not sure.
So what do you do, if you are the Fed? You print money anyway, even at the risk of creating more bubbles – or at least that was my takeaway from what Fed Vice Chair Janet Yellen recently said. I know that David Blanchflower, formerly of the BoE has been musing about other ways to approach quantitative easing to give it a more ‘fiscal’ aspect, like buying municipal bonds. But I don’t think this will happen unless things get very dire. The Fed still has to worry about the politics of an aggressive policy. Marc Chandler’s comments about a shift in policy tones this morning on ‘QEII-lite’ are more to the point, especially in the wake of comments in the Wall Street Journal in this regard.
Nevertheless, Gross is worried and this is what has him contemplating the end of the bond bull market. He writes:
Bondholders, while immediate beneficiaries, will likely eventually be delivered on a platter to more fortunate celebrants, be they financial asset classes more adaptable to inflation such as stocks or commodities, or perhaps the average American on Main Street who might benefit from a hoped-for rise in job growth or simply a boost in nominal wages, however deceptive the illusion.Check writing in the trillions is not a bondholder’s friend; it is in fact inflationary, and, if truth be told, somewhat of a Ponzi scheme. Public debt, actually, has always had a Ponzi-like characteristic. Granted, the U.S. has, at times, paid down its national debt, but there was always the assumption that as long as creditors could be found to roll over existing loans – and buy new ones – the game could keep going forever. Sovereign countries have always implicitly acknowledged that the existing debt would never be paid off because they would “grow” their way out of the apparent predicament, allowing future’s prosperity to continually pay for today’s finance.
Now, however, with growth in doubt, it seems that the Fed has taken Charles Ponzi one step further. Instead of simply paying for maturing debt with receipts from financial sector creditors – banks, insurance companies, surplus reserve nations and investment managers, to name the most significant – the Fed has joined the party itself. Rather than orchestrating the game from on high, it has jumped into the pond with the other swimmers. One and one-half trillion in checks were written in 2009, and trillions more lie ahead. The Fed, in effect, is telling the markets not to worry about our fiscal deficits, it will be the buyer of first and perhaps last resort. There is no need – as with Charles Ponzi – to find an increasing amount of future gullibles, they will just write the check themselves. I ask you: Has there ever been a Ponzi scheme so brazen? There has not. This one is so unique that it requires a new name. I call it a Sammy scheme, in honor of Uncle Sam and the politicians (as well as its citizens) who have brought us to this critical moment in time. It is not a Bernanke scheme, because this is his only alternative and he shares no responsibility for its origin. It is a Sammy scheme – you and I, and the politicians that we elect every two years – deserve all the blame.
Over the short-term, the Fed is in full control of interest rates, of course. Looking at the Federal Government and the Federal Reserve as one consolidated balance sheet, we know that the Federal Government is the monopoly issuer of the currency and can dictate rates simply by setting the Fed Funds rates. It is ready to defend this rate by buying unlimited quantities of financial assets. If it telegraphs that Fed Funds will essentially be zero for "an extended period," market participants bet against this at their peril (and folly). This is why bondholders are beneficiaries of Fed largesse via capital appreciation (in excess of 11% YTD on Treasuries) over the short-term.
However, there is no guarantee where rates will be after this ‘extended period’ of artificially low rates. This is why the likes of Goldman are issuing 50-year paper now. And this is also why commodity prices are through the roof as the Fed has successfully increased inflation expectations. The Fed’s actions today are predicated on its successfully being able to unwind the stimulus it has created when a more normal economic environment causes the demand for credit to increase. If the economy goes into a Japanese-style malaise for twenty years, this is a moot point; the extended period language will extend. If we do have a real recovery, the Fed will need to orchestrate a good way of reducing its balance sheet in an orderly way despite the illiquid assets it has taken on. Otherwise, inflation will be a problem down the line.
P.S. – also read Gross’ letter for the political commentary. He has taken an increasingly populist stance on American politics of late. In this letter, it is no different; he has some very pointed words.
Source: Run Turkey, Run, Bill Gross