Pimco's Observations As The US "Reaches The Keynesian Endpoint" - The QE2 Ponzi Scheme Is "Nothing But A Profit Illusion"

Tyler Durden's picture

Once again, it is the world's biggest bond manager which either is really tempting fate by telling the truth in an increasingly more aggressive manner day after day, or is engaging in the most acute case of reverse psychology ever seen, coming out with the most critical opinion of the Fed's actions on the verge of the Fed's historic first press conference. And this one is truly a stunner, far more real than anything even Bill Gross has said in the past: "Just as Charles Ponzi needed donuts to turn back a suspicious crowd
of investors, the Fed needs “donuts” in order to fill the bellies of
the literally millions of investors worldwide who worry about the
alarmingly large U.S. budget deficit and the impact that the U.S. debt
dilemma could have on their Treasury holdings...
Their
collective buying has created what we believe to be a profit illusion
with many investors mistakenly believing they can continuously reap
profits from perpetually falling bond yields and rising bond prices,
just as they have had opportunity to do over the past 30 years, amid the
great secular bull market for Treasuries and the bond market more
generally...
For many reasons, this “duration tailwind” for Treasuries can’t
last, particularly because the United States has reached the Keynesian
Endpoint, where the last balance sheet has been tapped
."

Must read

Summary of "The End of QEII: It’s Time to Make the Donuts"

  • ?With quantitative easing the Federal Reserve has in essence picked the pockets of Treasury bond investors throughout the world.
  • Ultimately, the U.S. must own up to its past sins and let the deleveraging process play itself out.
  • The U.S. must invest in its people, its land, and its
    infrastructure, as well as promote free trade, to achieve economic
    growth rates fast enough to justify consumption levels previously
    supported by debt.

In 1920 the Boston Post contacted Clarence Barron, the founder of
Barron’s, to investigate a man who claimed to be racking up remarkable
gains for investors in an arbitrage involving the purchase and sale of
postal-reply coupons. Charles Ponzi, the developer of the scheme, sought
to convince investors that differentials in inflation rates between
countries had created an opportunity for investors to purchase the
postal-reply coupons on the cheap in one country and redeem them in the
United States, an arbitrage that Ponzi said would enable investors to
grow their money by several fold if they invested with him.

In fact, there were indeed differences between the prices of
postal-reply coupons postage bought in foreign countries and their
redemption value in the United States. But there were also substantial
barriers preventing any actual arbitrage, including enormous logistical
challenges having to redeem the coupons, which were of low
denominational value. Ponzi nonetheless started and then perpetuated the
scheme.

Barron sought to expose Ponzi’s scheme, noting in articles that
eventually brought the Post a Pulitzer Prize, that to support the
investments Ponzi had supposedly made there would have to be 160 million
postal-reply coupons in circulation. There were only 27,000 of them.
These and other questions led an angry and suspicious crowd to gather
outside of Ponzi’s Securities Exchange Company, which was located in
Boston on School Street.
 
Ponzi, who was famous for his deceptions, convinced many in the
angry crowd to stay calm and leave their money with him, enticing them
with little more than his charm, donuts and coffee. It wasn’t the first
time that investors would be misled by the potential for future profits
and simple trappings, but donuts and coffee? Really? Is it this easy to
get investors to part with their money? In many cases yes,
unfortunately.
 
From Donuts to QEI and QEII: The New Profit Illusion
Just as Charles Ponzi needed donuts to turn back a suspicious crowd
of investors, the Fed needs “donuts” in order to fill the bellies of
the literally millions of investors worldwide who worry about the
alarmingly large U.S. budget deficit and the impact that the U.S. debt
dilemma could have on their Treasury holdings.
Investors are no doubt
worried they may have bought into an unsustainable scheme: the creation
of a scourge of debt so large that the Fed itself has had to purchase
the debt to keep the game going.
 
All that the Fed has had to do thus far to keep the game going is
press the “on” button to its virtual printing press, crediting the
account of the U.S. Treasury. In the process, the Fed has kept the
demand for U.S. Treasuries high, perhaps deceptively so, attracting with
its redolence many classes of buyers, including households, banks,
pension funds, insurance companies and foreign investors. Their
collective buying has created what we believe to be a profit illusion
with many investors mistakenly believing they can continuously reap
profits from perpetually falling bond yields and rising bond prices,
just as they have had opportunity to do over the past 30 years, amid the
great secular bull market for Treasuries and the bond market more
generally.
 
For many reasons, this “duration tailwind” for Treasuries can’t
last, particularly because the United States has reached the Keynesian
Endpoint, where the last balance sheet has been tapped
. In addition,
with inflation expectations rising in the context of low levels of
initial jobless claims, and with Federal Reserve officials themselves
expressing reluctance to go beyond Quantitative Easing (QE) II, the
Fed’s Treasury buying is expected to end in June, leaving others to
carry the Treasury’s heavy load.
 
The Federal Reserve’s colossal bond purchases therefore will
likely, to the chagrin of millions of unsuspecting Treasury bond
investors, be one of the markers for the latter stages of the bull
market for Treasuries. For now, however, the Fed’s purchases have the
sweet aroma of freshly baked jelly donuts and many a Treasury bond
investor has been drawn to their savory, sugary, scrumptious taste.
 
What they should instead smell is the whiff of rotten eggs. But
this is easily hidden with a nose pin, which the Fed through QEII places
on the noses of each investor, with the goal of creating perpetual
serendipitous moments that in the eyes of investors transform the rotten
stench into something far more delectable. Ultimately, however, the
stench of the Federal Reserve’s bond purchases will seep into the
nostrils of investors all around the world when it becomes glaringly
obvious to them that the Fed can’t possibly continue as the Treasury’s
main source of demand.
 
Treasury investors will also realize that not only has QE
suppressed the rates they earn on their Treasury holdings, QE promotes
financial and economic conditions that hurt Treasury bond holders,
primarily because it boosts economic growth and inflation, resulting in
confiscation of the skimpy Treasury yields they earn.
Foreign investors
have the added discomfort of a decline in the foreign-exchange value of
the U.S. dollar. To top it off, Treasury investors face the potential
for capital losses for having bought into the Fed’s scheme at prices
inflated by QE, sort of like playing a game of hot potato and getting
stuck with the potato when the Fed abruptly leaves the game.
 
House of Pain
With QEI and QEII the Federal Reserve has in essence picked the
pockets of Treasury bond investors throughout the world. To be sure, QE
fattened the bellies of many Treasury investors, owing to substantial
price gains.
 
The problem, however, is that the Fed essentially
robbed Peter to pay Paul by pushing yields below inflation and by
undermining the value of the U.S. dollar. Peter was the unsuspecting
investor in Treasury securities drawn into the Fed’s scheme by the
allure of ever-rising Treasury prices; Paul was everyone else invested
in everything else.
 
The movement into this “everything else” that was prompted by QEI
and QEII can be visualized by looking at concentric circles, with the
riskiest assets at the perimeter of the circles. The migration toward
the perimeter was encouraged through not only a decrease in term premia
for longer-term bonds resulting from the Fed’s large-scale asset
purchases, but also by the Fed’s zero interest rate policy, or ZIRP. It
created a “house of pain,” an investment climate in the money market so
punishing that it drove investors to seek refuge in other assets. No
wonder $1 trillion of money has flowed out of money market funds over
the past 2 ½ years.
 
 
 

 
It’s Time to Make the Donuts
QEI and QEII were necessary solutions at a time when the U.S.
financial system was on the brink, but they are unsustainable means of
funding the U.S. government. Ultimately, the U.S. must own up to its
past sins and let the deleveraging process play itself out. It can’t
pretend that previous levels of demand for goods and services can be
restored simply by turning on the Fed’s printing press.
 
The United States instead must recognize that only by increasing
investment in its people, its land, and its infrastructure, as well as
promoting free trade, can it achieve economic growth rates fast enough
to justify consumption levels previously supported by a wing and a
prayer – by debt.
 
For the Federal Reserve and the U.S. Treasury, it is time to make
the donuts. There is a crowd standing outside and, although there is no
wrongdoing to make them as angry as the crowd that stood outside of
Charles Ponzi’s office before he was busted, they are just as anxious,
and it is going to take a lot of convincing to get them to show up at
the next Treasury auction and the one after that, and the one after
that, and….
Across the Pond and Around the World
Now, let’s turn to Ben Emons for a walk through the evolution of
QE, its goals, its effects, and its upcoming end, before turning to
other PIMCO colleagues for discussions on central banking in Europe and
the emerging markets. Comments from PIMCO experts throughout the world
are a regular feature of the Global Central Bank Focus.
 

 
The Evolution and Ending of QEII
Ben Emons
 
The Fed’s long-term securities asset purchases – dubbed
“quantitative easing,” or QE, for short – link asset prices to the
economy. The Fed engineered such a linkage via a sequence of signals
that were met with anticipation in the financial markets for an
aggressive style of monetary easing.
 
The sequence began in the fall of 2008 when the federal funds rate
moved toward the zero bound, resulting in November 2008 in the
announcement of the Fed’s first asset purchase program consisting of
agency securities and agency mortgage-backed securities. At the time,
the purchase of Treasury securities was being evaluated for their
potential benefits.
 
The Fed had two initial intentions for its asset purchases: to
address distressed credit markets and to support the housing sector.
Both goals were facilitated largely by liquidity support programs such
as the Term Asset-Backed Securities Loan Facility. Anticipation of
additional action grew when in December 2008 Fed Chairman Ben Bernanke
made a stronger case for quantitative easing, driving Treasury yields
sharply lower.
 
This occurred in a similar fashion with QEII when Bernanke in
August 2010 spoke to the effectiveness of asset purchases at the Fed’s
annual summit in Jackson Hole. The intention of quantitative easing
however was different from credit easing; it was a rebalancing effect.
By signaling quantitative easing, investors’ anticipation drove
portfolio allocations into Treasuries.
 
When Treasury yields became very negative in real terms, it pushed
investors into equities, corporate bonds and other assets that had
positive real rates. The premise of this strategy was that portfolio
assets are imperfect substitutes. By changing drastically the yield of
‘risk-free’ assets, a domino change occurred in other assets, which is
the portfolio rebalancing effect. As a result, the expansion of the
Fed’s balance sheet became very positively correlated with returns on
the S&P 500 index during QEI & QEII, as shown in Figure 3.
 
 
 
The true intention of QE therefore was to generate a self-feeding
mechanism of expectations building on expectations in a way similar to
the money multiplier. During QEI as well as QEII, the Fed succeeded with
this strategy as the portfolio balance had a knock-on effect on its
favorite gauge of inflation expectations, the 5-year/5-year forward
break-even derived from Treasury inflation-indexed securities. This is a
market-based measure where investors believe inflation will be in five
years looking five years out.
 
The positive correlation between the change in the Fed’s balance
sheet and forward break-even inflation shows a direct connection with
the rise in asset prices (Figure 3). Hence the Fed has created a
transmission channel it can call upon if it wishes to utilize QE in the
future. The success of this transmission hinges on several associated
costs. There is the stock effect represented by assets on the balance
sheet and a flow effect from the Fed’s daily purchases. Fed research has
shown that the impact on interest rates from the flow effect is
relatively small (~3 basis points) mainly because operations are
preannounced, but the stock effect can be larger when either announced
(~70 basis points) or signaled (~30 bps). Other Fed research has
estimated projected deficits (flow) and debt (stock) can be worth 25
basis points in terms of risk premium.
 
QEI saw essentially two ends when the Treasury and MBS programs
finished respectively on 10/29/09 and 3/31/10. As Figure 4 shows, the
premium in forward rates was then relatively small (10 to 25 basis
points), and it consisted in part of premiums for liquidity, term to
maturity, and future rates on top of expectations for QE’s end. For the
period ending when the Fed is scheduled to end QEII in June, there is
only a small premium in the forwards, but through December 31, 2011 the
premium is larger (40 to 70 basis points) partially because interest
rate hike expectations have increased.  
 
 
 
 
The cost associated with the end of QEII therefore appears to be
mostly factored into forward rates and so the true exit cost lies in
different areas. At the end of QEI, the Fed’s 5YR/5YR forward inflation
stood near 2.9%, but the European sovereign crisis dampened inflation
worries and reversed those quickly. Today, however, fears of contagion
stemming from Europe’s debt dilemma have fallen, boosting the 5YR/5YR to
about 3.1%, posing a challenge for the Fed to create a smooth exit from
QEII.
 
Coinciding with the end of QEII is the debate on the federal debt
limit. As QEII has kept the real Treasury rate persistently negative and
thus supported the portfolio balance effect, the risk is that real
rates suddenly turn sharply positive on inflation or debt concerns, thus
feeding a negative effect from the link between asset prices and the
economy. This is why the Fed is likely to finish QEII as planned with
sufficient communication to provide as smooth an exit as possible. 
 

 
European Central Bank Focus
Andrew Bosomworth
 
What Next?
Earlier this month the Governing Council of the European Central
Bank (ECB) decided to raise the rate on the main refinancing operation
(MRO), which provides the bulk of liquidity to the banking system, by 25
basis points to 1.25% having left it unchanged for almost 2.5 years.
Investors seeking to comprehend why policy was tightened despite the
dire state of public finances in Europe’s periphery perhaps took comfort
from ECB President Trichet’s response to a question whether more rate
hikes are in store: “We did not decide today that it would be the first of a series of interest rate increases.” Phew.
 
Was that not a signal that Europe’s already steep yield curve
prices in too many hikes: 2% by the end of this year and 2.5% by end
2012? Indeed it likely does, but two things – history and loan growth –
suggest investors should draw little comfort from President Trichet’s
answer.
 
In December 2005, the ECB also raised the MRO rate by 25 basis
points, back then to 2.25%, having left it unchanged at “historically
low levels” for exactly 2.5 years. And in response to a similar question
about whether there were more interest rate hikes to come, President
Trichet said, “There is not an ex ante decision of the Governing
Council at today’s meeting to engage in a series of interest rate
increases.”
Yet three months later the ECB hiked again, to 2.5%,
and it continued doing so in regular two and three month intervals until
reaching 4.25% in June 2007. Upshot: the ECB makes its mind up one step
at a time and what is important is the medium-term direction of the
economy. While history never repeats itself, a similar dynamic may be in
store again.
 
To start with, growth in loans to the private sector is responding
positively to the previous years’ stimulating monetary and fiscal
policies. Within the recent 2.6% year-on-year growth in private sector
loans, loans to non-financial corporations have finally stopped
contracting, and lending for house purchases in the entire eurozone has
picked up to 4%, a rate that masks a very heterogeneous pattern of
credit creation across member states from contraction in Spain to boom
in Slovenia.
 
More troubling for a central bank, however, measures of inflation
expectations continue to rise. The European Commission’s survey of
consumers’ price expectations over the next 12 months, for example, show
they have risen consecutively since autumn 2009 and are back at levels
last seen in the heyday before Lehman Brothers defaulted.
 
A 1.25% policy rate thus appears consistent neither with the
improving health of the eurozone economy nor with the firm anchoring of
inflation expectations. And even if the ECB were to raise the rate to
the level of next year’s forwards at 2.5%, it is important to realize
that even that rate is low by historical standards. Indeed, the policy
rate in modern-day Germany and the eurozone has averaged 4.5% since
1875. So what’s next? Another rate hike, I would presume.
 

 
Emerging Markets Central Bank Focus 
Lupin Rahman
 
Central Banks Get Prudent in Emerging Markets: Is It Enough?
Brazil’s recent increase in the tax on financial transactions
related to foreign  investments, the IOF tax (Imposto sobre Operações
Financeiras),  to limit short-term external borrowing and restrain
consumer credit highlights the increasing use of macroprudential
measures across emerging markets as a key component of monetary policy
(Figure 5). But how effective are such measures likely to be, and what
are the risks?
 
 
 
Brazil may be the most visible example, but it is far from the only
one. The People’s Bank of China (PBOC) explicitly adopted the broader
use of quantitative measures, with reserve requirement ratios (RRR)
effectively replacing rate hikes as the main monetary tool. In the last
six months, RRR have been hiked a cumulative 350 bps while the prime
lending rate has been raised 75 bps.
 
In Korea’s case, the focus of recent measures has been on affecting
the composition of capital flows with the central bank (CB) imposing a
bank levy on non-deposit foreign currency liabilities and imposing a
leverage cap on banks’ FX derivatives positions. Meanwhile in the most
unorthodox move so far, Turkey’s CB hiked reserve requirements 800 bps
for short-term deposits while cutting the policy rate by 75 bps to reduce incentives for short-term foreign portfolio flows.
 
A cursory look at the recent measures implemented across emerging
markets points to the broad scope and somewhat undefined nature of
macroprudential policies. It is truly a case of incremental
experimentation.
 
At their most basic, macroprudential measures are
targeted/rule-based techniques implemented to limit the buildup of
financial risks and improve the resilience of the financial system to
shocks. As such they may include capital controls or prudential
regulations on selective flows (e.g. Brazil’s tax on corporate foreign
borrowing with less than two years maturity), reserve requirement ratios
which target the ability of banks to extend credit, and taxes on
specific credit sectors, e.g. auto loans or consumer credits. Broader
definitions include all microprudential measures on financial
institutions as well as broad measures to limit asset market bubbles,
such as via strict lending rules for second mortgages.
 
Underlying this shift in CB policy focus has been the combination
of accelerating capital inflows into emerging markets following the
Fed’s pursuit of QEII and a zero policy rate that results in rising
interest rate differentials. These global factors have not only resulted
in appreciation pressures on currencies, but they have also led to a
rapid increase in short-term inflows into domestic equity and debt markets and concurrently encouraged a surge in short-term foreign exchange liabilities of the private sector.
 
Moreover, rising liquidity in the banking system is driving
interbank rates lower, reducing the efficacy of policy rates in the
monetary transmission mechanism. Emerging markets central bankers are
understandably concerned about these phenomena particularly given the
additional macroeconomic risks posed by rising inflationary pressures as
commodity-price increases feed through and domestic output gaps close.
 
Will the Policies Work?
The extent to which macroprudential measures are likely to be
effective in limiting distortions as well as dampening inflation remains
an open question.
 
There is some evidence suggesting that quantity-based measures can
affect the composition of capital flows as well as broad credit
conditions. Nevertheless, insofar as macroprudential policy frameworks
are less developed and less tested than more orthodox interest-based
policy frameworks, there is good reason for pragmatism in terms of what
they can deliver. There is also the issue of the extent to which they
can be circumvented given their (typically) narrower focus, and the
ability and costs of regulation for supervisory authorities playing
catch-up with the private sector.
 
The challenge for markets is therefore to assess the overall impact
of these measures together with any spillover effects on monetary
conditions, inflation and ultimately policy rates. Macroprudential
measures are most likely to be effective in reducing systemic financial
risks when they are undertaken alongside a traditional, rate-driven
tightening cycle as opposed to being enacted in place of
interest rate hikes. While this has been the case so far in some
emerging markets – e.g. Brazil has hiked a cumulative +325 bps since
2010 as well as putting forward a 0.5% of GDP fiscal consolidation plan –
this has not in others – e.g. Turkey.
 
The risks are many, led by the increasing challenges to emerging
market central banks’ credibility in fighting inflation and achieving
stated inflation-targets. EM policymakers will have no choice but to be
pragmatic, while also pointing fingers at others (in this case, the
U.S.) for the source of their headaches. Meanwhile, investors will need
to adapt, including positioning for rising one-year forward inflation
expectations in emerging markets and local curve steepening.