Because quantitative easing has affected all risk spreads, the withdrawal of nearly $1.5 trillion in annualized check writing may have dramatic consequences.
~ Bill Gross
The Ides of March will soon be upon us, but it’s not the 15th of this month that has PIMCO’s Bill Gross a little concerned. He’s more worried about June 30th, the date on which the Federal Reserve’s latest Quantitative Easing program is set to end. His latest Investment Outlook extends the concerns about U.S. Treasuries which he outlined in last month’s missive.
Gross, like many others, has been a critic of the Fed’s Quantitative Easing programs, wondering “whether [they] actually heal, as opposed to cover up, symptoms of an unhealthy economy.” Among a couple of other factors, its success, according to Gross, depends on “the willingness of creditors to believe in future real growth as a rebalancing solution to current excessive deficits and debt levels.” In the past, Treasury buyers have been 50% foreigners, and 40% public institutions and individual savers, with the Fed purchasing the remaining 10%.
Who Will Buy Treasuries?
Recently, however, the Fed has accounted for 70% of the buying while foreign entities comprise about 30% of the purchases. So the big question after June 30th, 2011 is who will fill in the hole left by Fed when they exit QE? Gross answers simply “I don’t know.”
But, as you might expect, his answer doesn’t end there. He goes on to point out that, by various metrics, Treasury yields are about 1.5% (150 bps) too low. No doubt there will still be buyers, but “at what yield and what are the price repercussions if the adjustments are significant?” He doesn’t think bond funds will want to buy at artificially discounted (and negative) real yields, so the market may bid up yields to compensate for this.
Mr. Gross seems to think there’s a chance that the Fed may be able to successfully pass the credit creation baton to the private sector, but he doesn’t seem to feel all that confident about that scenario given that he compares June 30th, 2011 to June 6th, 1944 (D-Day). He concludes that “bond yields and stock prices are resting on an artificial foundation of QE II credit that may or may not lead to a successful private market handoff and stability in currency and financial markets.” Either way, it doesn’t seem like PIMCO wants to be in the risk game as this unfolds.
What About QE3?
I share most of the sentiments Mr. Gross expresses, but I couldn’t help but note that he didn’t really mention the prospects for QE3. He talks about the pain of ripping off the QE2 band-aid, but makes no mention of the likelihood that the Fed could keep the band-aid on as long as they like, whether it’s a good idea or not.
He refers again to the Federal Reserve buying Treasuries as a Ponzi scheme which, like all of them, can continue for quite some time – until it can’t. He seems to be saying that if they choose to enact QE3, QE4, and who knows how many others, that something will crack eventually. Yet if they withhold the morphine from the addict, terrible withdrawal symptoms may ensue.
In spite of the implications above, I wouldn’t take QE3 off the table as a possibility at all. The Fed has shown time and time again that they are more than willing to turn on the spigots regardless of the consequences. In fact, the asset price appreciation that’s followed each installment of quantitative easing only serves as positive reinforcement for this behaviour. Further, the Fed seems impervious to accusations that the same policy that has juiced equity markets could possibly have lifted grains, metals and oil, thereby resulting in the civil unrest now unfolding globally.
Is Gross the Anti-Tepper?
It sounds to me like Gross is making an argument that is opposite to the one made by hedge fund executive David Tepper last September. At the time, Tepper said that government intervention in the markets made stocks a win-win proposition. If the economy improved, stocks would go up. If the economy slowed down, the Fed would come in with more QE, and stocks would go up. Of course, his prediction has been right on the money so far.
Bill Gross seems to be saying that if the Fed continues with the QE policy, it may work for a while longer, but will eventually go the way of all Ponzi schemes and blow up, taking markets with it. If they terminate QE this June, markets may not like that either, especially if geopolitical unrest continues or escalates. Either way, it doesn’t look good for stock or bond markets from his perch.
Besides Tepper’s no-lose position, and PIMCO’s no-win proposition, a few alternative scenarios occur to me: What if equities do pull back on fears of QE2 ending, but the dip in equity markets causes a rise in bond prices as the herd shifts to perceived safe havens? This would fill at least some of the demand for Treasuries created by the Fed exiting QE.
This is pretty much what happened last summer as QE1 wound down. Equities fell and bonds rose from April through the summer of 2010 until Bernanke telegraphed QE2 in August, and those trades subsequently reversed hard. Interestingly, the U.S. dollar has not maintained its traditional safe haven role during the past couple of equity market dips and this has folks like Simon Black saying that this means the dollar is finished.
Recently, however, some have also questioned whether the U.S. fiscal situation has deteriorated to the point where investors will no longer choose U.S. assets like Treasuries or the dollar for cover. Each crisis is different, but the recent upheaval in Libya hasn’t provided much support for the greenback either. Treasury prices, however, did firm over the past few weeks.
Sitting on the Bench
Although Bill Gross took a negative tone in his latest piece, perhaps it would be more accurate to say that PIMCO sees an investment environment that’s fraught with so many uncertainties that they just want to keep lots of powder dry until we see how all of this shakes out. Referring to an earlier anecdote about leaving a waitress a negative tip at a restaurant in his youth, he finishes the letter like this: “15% gratuities may lie ahead, but more than likely there is a negative two-bit or even eight-bit tip lying on the investment table. Like I did 45 years ago, PIMCO’s not sticking around to see the waitress’s reaction.”
How do you think stocks and bonds will fare as June 30th approaches? Will we see QE3?
(Photo Credit: Ronen Boidek)