Bill Gross Asks The $64,000 Question: "Who Will Buy Treasuries When The Fed Doesn’t?" His Answer: "I Don't Know"; Gross Is Getting Out Of Risk

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After serving as the inspiration for the Chairsatan's latest appellation with his February missive, Bill Gross now goes for the jugular with the $64,000 question: with "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?" Bingo, we have a winner. This is precisely the issue that Zero Hedge has been exposing over the past 6 months, and is the reason why the Fed is now locked in a QEasing corner from which there is no exit. To his credit, Gross attempts to provide an answer: "Someone
will buy them, and we at PIMCO may even be among them. The question
really is at what yield and what are the price repercussions if the
adjustments are significant... 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%."
And the stunner: "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
. 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." Translation: Pimco just issued a "sell" rating on everything.

From Bill Gross March Outlook.

Two-Bits, Four-Bits, Six-Bits, a Dollar

  • 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.
  • Because quantitative easing has affected all risk spreads, the
    withdrawal of nearly $1.5 trillion in annualized check writing may have
    dramatic consequences.
  • 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.

The
Gross family legend is rather full of Paul Bunyan tall tales passed
down over the years but none perhaps more self- revealing than “The Day
When I Gave the Waitress a Negative Tip.” Admittedly I was young and
full of testosterone but the service was terribly sloooww and I was
in a big hurrrryyy! Finally presented with a $2.00 bill, I took two
bucks and wrote the following on a nearby napkin: “Thanks for the sh…ty
service, negative tip – you owe me 25 cents.” I didn’t stick around to
see the reaction, but I’m sure it was a unique experience for the young
lady. I was, of course, like any 21-year-old, in the business of
establishing a repertoire of “unique” experiences and this was but one
notch on my Paul Bunyan Axe.

These days, my negative two-bit tip would hardly leave a dent in the
estimated $25 billion annual pool of tips left at American restaurants.
No matter. What was revealing at the moment back in 1965 was what it
said about me: impatient, willing to disappoint people (at least
strangers) and a little inconsiderate of some people. Maybe a little
imaginative too. In any case, social scientists have recently confirmed
that tipping does send a message and that it is more about
the man or the woman in the mirror than the quality of the service. The
primary reason for tipping appears to be social approval. Theoretically
it is a power tool, a financial weapon that commands “treat or trick,”
but studies since the 1940s have shown that most people do not have the
requisite nerve to stiff a waitress even for unreasonable service. And
too, William Grimes, in The New York Times, pointed out a
decade ago that a waitress who touched her customers when asking if the
meal was OK, raised her tip from 11 to 14% of the tab. Waiters’ personal
introductions, as well as crouching at the table when taking an order,
also worked famously. And here’s an interesting tidbit: Solo diners
leave an average tip of 19.7% while a five-some drops all the way to
13.2%. Evidently, the size of the tip is a factor, and a reason why
restaurants charge 16%+ for groups of six or more. That surely would
have enraged Leo Crespi, who at the turn of the 20th century proposed
the formation of a National Anti-Tipping League. While ahead of his
time, he would likely play second fiddle to yours truly 65 years later
who invented the “negative tip.” Recently my 22-year-old son, Nick,
carved a notch on his own Paul Bunyan Axe with a negative $1.00 tip
adjusted for 45 years of inflation. Tip off the old block, I’d say!

Speaking of investment tips, no clue or outright signal could
have been any clearer than the one given in December 2008, labeled
“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.

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 favorable 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. If so, there will be no 15%+ tip for
the American economy and its citizen waiters. An inflation-adjusted “negative buck” might be more likely.

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 visualize 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?

I don’t know. Reserve surplus sovereigns are likely good for their
standard $500 billion annually but the banks are now making loans
instead of buying Treasuries, and bond funds are not receiving generous
inflows like they were as late as November of 2010. Who’s left? Well,
let me not go too far. Temporary voids in demand are not exactly a buyers’ strike. Someone
will buy them, and we at PIMCO may even be among them. The question
really is at what yield and what are the price repercussions if the
adjustments are significant. Fed Vice Chairman Janet Yellen in a speech
just last week confirmed the theoretical rationale that Treasury yields
are directly linked to the outstanding quantity of longer-term assets in
the hands of the public. If that quantity is suddenly increased in one
year as the charts imply, what are the yield consequences? 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%.
This conclusion can
be validated with numerous examples: (1) 10-year Treasury yields, while
volatile, typically mimic nominal GDP growth and by that standard are
150 basis points too low, (2) real 5-year Treasury interest rates over a century’s
time have averaged 1½% and now rest at a negative 0.15%! (3) Fed funds
policy rates for the past 40 years have averaged 75 basis points less
than nominal GDP and now rest at 475 basis points under that historical
waterline.

As a counter, one would argue (and I would partially agree) that
the U.S. and indeed developed global economies must keep yields
artificially low for some time if post Lehman healing is to take place.
But that of course is the point. By eliminating QE II, the Fed would be
ripping a Band-Aid off a partially healed scab. Ouch! 
25 basis
point policy rates for an “extended period of time” may not be enough
to entice arbitrage Treasury buyers, nor bond fund asset allocators to
reenter a Treasury market at today’s artificially low yields. Yields may
have to go higher, maybe even much higher to attract buying interest.

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 fueled 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. 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.