Bill Gross: Who Will Ultimately Finance Uncle Sam And At What Rate?

If Ben Bernanke had never stepped into the markets via the Fed’s quantitative easing program, where would our level of interest rates currently be? What about equities, commodities, and our greenback? I think the following are easy assumptions to make:

1. Interest rates would be higher.
2. Credit spreads would be wider.
3. Equity markets would be lower.
4. Commodity prices would be lower.
5. The greenback theoretically would be higher but I am less confident of this.

What will happen to our markets and our economy when Ben Bernanke ultimately does pull the punch bowl–that is quantitative easing–away from those utilising the easy money provided by the Fed to prop our markets and our economy?

Bill Gross of Pimco writes extensively on this topic in his monthly commentary, Two-Bits, Four-Bits, Six-Bits, a Dollar,

1. A successful handoff from public to private credit creation has yet to be accomplished, and it is that handoff that ultimately will determine the outlook for real growth and stability.
2. Because quantitative easing has affected all risk spreads, the withdrawal of nearly $1.5 trillion in annualized check writing may have dramatic consequences.
3. Who will buy Treasuries when the Fed doesn’t? The question really is at what yield, and what are the price repercussions if the adjustments are significant.

Speaking of investment tips, no clue or outright signal could have been any clearer than the one given in December 2008, labelled “Quantitative Easing.” While the term was new, the intent was obvious: (1) pump public money into the financial system to replace private credit that was being destroyed in the process of deleveraging; (2) lower interest rates on intermediate and long-term mortgages/Treasury bonds and in the process flush money into risk assets – most visibly the stock market; and (3) forecast publically then hope that higher stock prices would lead to a wealth effect, and in turn generate new private sector lending, job creation and a virtuous circle of economic expansion that would heal the near-fatal wounds of Lehman and its aftermath.

If that was the game plan, then so far, so good, I’d say. Interest rates are artificially low, stocks have nearly doubled since QE I’s first announcement in December of 2008, and the U.S. economy will likely expand by 4% this year, although a $1.5 trillion budget deficit must share QE’s Oscar for most stimulative government policy of 2009/2010.

This quantitative easing stuff worked like a charm, eh? One might wonder if the markets can be manipulated this easily and effectively, why doesn’t the Fed ‘damn the torpedoes, full speed ahead.’

Hold on there, cowboy. As Gross suggests and I agree,

Many critics, though, including yours truly, would wonder whether Quantitative Easing policies actually heal, as opposed to cover up, symptoms of an unhealthy economy. They might at the same time ask simplistically whether it is possible to cure a debt crisis with more debt. As I have discussed in numerous Investment Outlooks, the odds of an ultimate QE success seem critically dependent on several criteria: (1) initial sovereign debt levels that are relatively low. Reinhart and Rogoff in their book “This Time Is Different” have suggested an 80–90% of GDP limit to sovereign debt levels before they become counterproductive; (2) the ability of a country to print globally acceptable scrip – especially enhanced if that nation has the reserve currency status now ascribed to the U.S.; and (3) the willingness of creditors to believe in future real growth as a rebalancing solution to current excessive deficits and debt levels.

Most observers would agree with us at PIMCO that QE I and II programs were initiated and employed under the favourable conditions of (1) and (2). The third criterion (3), however, is more problematic. A successful handoff from public to private credit creation has yet to be accomplished, and it is that handoff that ultimately will determine the outlook for real growth and the potential reversal in our astronomical deficits and escalating debt levels. If on June 30, 2011 (the assumed termination date of QE II), the private sector cannot stand on its own two legs – issuing debt at low yields and narrow credit spreads, creating the jobs necessary to reduce unemployment and instilling global confidence in the sanctity and stability of the U.S. dollar – then the QEs will have been a colossal flop.

Don’t think for a second that Bernanke himself does not lie awake at nights wondering this very same point. Will the QE I and II programs have provided the traction for a successful transition from public to private sector financing? Gross provides further fabulous inquisitive commentary and pictorials on this greatest of all questions.

Washington, Main Street – and importantly from an investment perspective – Wall Street await the outcome. Because QE has affected not only interest rates but stock prices and all risk spreads, the withdrawal of nearly $1.5 trillion in annualized check writing may have dramatic consequences in the reverse direction. To visualise the gaping hole that the Fed’s void might have, PIMCO has produced a set of three pie charts that attempt to point out (1) who owns what percentage of the existing stock of Treasuries, (2) who has been buying the annual supply (which closely parallels the Federal deficit) and (3) who might step up to the plate if and when the Fed and its QE bat are retired. The sequential charts 1, 2 and 3 are illuminating, but not necessarily comforting.

What an unbiased observer must admit is that most of the publically issued $9 trillion of Treasury notes and bonds are now in the hands of foreign sovereigns and the Fed (60%) while private market investors such as bond funds, insurance companies and banks are in the (40%) minority. More striking, however, is the evidence in Chart 2 which points out that nearly 70% of the annualized issuance since the beginning of QE II has been purchased by the Fed, with the balance absorbed by those old standbys – the Chinese, Japanese and other reserve surplus sovereigns. Basically, the recent game plan is as simple as the Ohio State Buckeyes’ “three yards and a cloud of dust” in the 1960s. When applied to the Treasury market it translates to this: The Treasury issues bonds and the Fed buys them. What could be simpler, and who’s to worry? This Sammy Scheme as I’ve described it in recent Outlooks is as foolproof as Ponzi and Madoff until… until… well, until it isn’t. Because like at the end of a typical chain letter, the legitimate corollary question is – Who will buy Treasuries when the Fed doesn’t?


What I would point out is that Treasury yields are perhaps 150 basis points or 1½% too low when viewed on a historical context and when compared with expected nominal GDP growth of 5%.

I personally do not believe the nominal GDP will be that high but we shall see.

Investors should view June 30th, 2011 not as political historians view November 11th, 1918 (Armistice Day – a day of reconciliation and healing) but more like June 6th, 1944 (D-Day – a day fraught with hope for victory, but fuelled with immediate uncertainty and fear as to what would happen in the short term). 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.

The markets clearly enjoy the calm and palliative benefit of Ben’s big checkbook BUT when he stops writing those QE checks, the risks currently beneath the surface will once again bubble to the top. Gross provides great work here highlighting that reality.

Navigate accordingly.

Larry Doyle

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I have no affiliation or business interest with any entity referenced in this commentary. The opinions expressed are my own and not those of Greenwich Investment Management. As President of Greenwich Investment Management, an SEC regulated privately held registered investment adviser, I am merely a proponent of real transparency within our markets so that investor confidence and investor protection can be achieved.

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