PIMCO

Are the markets already front running a potential announcement of a third round of Quantitative Easing (QE 3)?   Maybe so.  We had expected QE3 at the end of last summer as the economy weakened substantially from the impact of the Japanese earthquake/debt ceiling debate/Eurozone crisis trifecta.  However, with political pressures running high due to the raging battle in Congress raising the debt ceiling there was little support from the public for further intervention.  Furthermore, with inflation, as measured by CPI, already outside of the Fed's comfort zone, the Fed opted to institute "Operation Twist" (O.T.) instead. With the Euro-Crisis on the broiler, another debt ceiling debate approaching, the U.S. economy struggling along as Europe slips into a recession and corporate earnings being revised down there are plenty of reasons for stocks to decline in price.  Yet, they have continued to inch up.  With short interest on stocks having plunged in recent weeks it certainly sounds like the markets are betting on something happening and soon.

Imagine pensions not paying retiree funds, insurers not paying claims, and banks collapsing everywhere. Sounds like fun? I will be discussing this live on RT's Capital Account with the lusciously locquacious Lauryn Lyster at 4:30pm.

All you need to read.

When back in December we observed that Pimco's Total Return Fund (which contrary to rumors actually closed the year at $244 billion, or $4 billion more than in the beginning) had a $60 billion margin "cash" position, the proceeds of which were used to purchase a near record $103 billion in Mortgage Backed Securities we thought this is about as far as Bill Gross would go betting the ranch on QE3, and specifically that kind of QE3 that assumes at least a big portion is used to buys MBS (the same instrument that SocGen believes, along with gold, will benefit the most from an imminent QE3 announcement). It turns out we were wrong, and in December the fund doubled down on its QE3 all in bet, by "borrowing" even more cash, or a record $78 billion, using the proceeds to buy even more MBS, as well as Treasurys, which hit a combined 31% of the TRF's holdings. In other words, between MBS and USTs, Pimco holds a whopping 79% of total, mostly in very long duration exposure. In fact, this combination of long duration and pre-QE exposure has not been seen at PIMCO since late 2008, early 2009, meaning that as many banks have been suggesting, Gross is convinced that the Fed will announce if not outright QE3 this January, then at least intimate it is coming.

One of the recurring analogues we have used in the past to describe the centrally planned farce that capital markets have become and the global economy in general has been one of a increasingly chaotic sine wave with ever greater amplitude and ever higher frequency (shorter wavelength). By definition, the greater the central intervention, the bigger the dampening or promoting effect, as central banks attempt to mute or enhance a given wave leg. As a result, each oscillation becomes ever more acute, ever more chaotic, and increasingly more unpredictable. And with "Austrian" analytics becoming increasingly dominant, i.e., how much money on the margin is entering or leaving the closed monetary system at any given moment, the same analysis can be drawn out to the primary driver of virtually everything: the inflation-vs-deflation debate. This in turn is why we are increasingly convinced that as the system gets caught in an ever more rapid round trip scramble peak deflation to peak inflation (and vice versa) so the ever more desperate central planners will have no choice but to ultimately throw the kitchen sink at the massive deflationary problem - because after all it is their prerogative to spur inflation, and will do as at any cost - a process which will culminate with the only possible outcome: terminal currency debasement as the Chaotic monetary swings finally become uncontrollable. Ironically, the reason why bring this up is an essay by Pimco's Neel Kashkari titled simply enough: "Chaos Theory" which looks at unfolding events precisely in the very same light, and whose observations we agree with entirely. Furthermore, since he lays it out more coherently, we present it in its entirety below. His conclusion, especially as pertains to the ubiquitous inflation-deflation debate however, is worth nothing upfront: "I believe societies will in the end choose inflation because it is the less painful option for the largest number of its citizens. I am hopeful central banks will be effective in preventing runaway inflation. But it is going to be a long, bumpy journey until the destination becomes clear. This equity market is best for long-term investors who can withstand extended volatility. Day traders beware: chaos is here to stay for the foreseeable future." Unfortunately, we are far less optimistic that the very same central bankers who have blundered in virtually everything, will succeed this one time. But, for the sake of the status quo, one can hope...

In his typical forthright manner, the moustachioed maestro appeared on Bloomberg TV today discussing Europe's crisis and the US economy. While we (ZH) wonder what (or who) the 'we' El-Erian is speaking for, he notes that the Fed "doesn't have enough policy instruments to deal with the challenges facing the economy" and that QE3 will not work (a possibility we discussed last week). From investing in a fat-tailed environment to the Fed's liquidity trap and why Europe needs to 'refound' the euro-zone, his fragile hope is that crises remain 'contained' yet prefers the USD's 'safety' for now and worries on the US stocks 'cleanest dirty shirt' bullish argument, suggesting defense is the better play currently.

Europe has opened a new week with a modestly schizophrenic session: after hitting a multi year low against the USD and an 11 year low against the Yen, the Euro has seen a constant rise and traded nearly 100 pips higher last at 1.2770 on renewed hopes that today's Merkozy meeting would finally yield success. While that is clearly an utter delusion, with the abosolute record of shorts in the EUR as we pointed out last Friday, the smallest move higher can generate an avalanche of covering, and as we said previously a "potential" margin hike by the CME at any point in Euro contracts would leads to a QE-like surge higher in the EUR. If only briefly. Elsewhere, bond yields were mostly unchanged with the 10-yr Italian yield -3bps to 7.1% after rising as much as 4bps to 7.17% earlier; the 10-yr Spanish yield -5bps to 5.66%; was +1bp to 5.72% earlier; the 10-yr bund yield +2bps to 1.88%, first rise in 3 days. Most importantly, but no longer surprisingly, the ECB Deposit Facility usage soared to a new all time high of €464 billion, an increase of €199 billion since the LTRO hit the bank balance sheets on December 21, which accounts for virtually all the non-rolled cash. Simply said, Europe remains in suspended animation with hopes that a deus ex (now that the aliens have been downgraded from "possible" to "interference") will materalize preventing an allout spread collapse.

The folks at Religare Capital Markets have put together one of the better cheat sheets on a region that most of the big banks largely ignore: the Middle East, where day after day we get new and more troubling headlines of escalation, usually involving Iran and Israel. And since at the end of the day, in a resource-strapped world, the bottom line is always about energy, and oil, what happens in the MENA region is arguably far more important at the end of the day than who prints how much electronic paper/linen. But most important is probably the following analysis charting the probability of an attack of Iran by either Israel or the US. We were quite surprised to find that in Religare's opinion the probability of an Israeli-sourced attack on Iran hits a high of 50% sometime in early February, with the US contributing about 20% with a peak in May and just before the presidential elections. This is how they explain it: "The probability of an attack on Iran is now higher than ever. The only solution to the current crisis, diplomacy, is off the table due to politics and the focus is now shifting to regime change. We see the probability dropping mid-year, although US elections could increase the probability of a US attack significantly (unless Ron Paul steams ahead), as will Iran’s likely decision to move their centrifuges to reinforced facilities in Qom if not handled correctly (likely mid-year). We reiterate our view that the fallout may not be as bad as expected from an Israeli strike, horrendous from a US one." And if they are right, what happens to oil will likely be the biggest catalyst of events in 2012 - a topic PIMCO has already had some extended observations on.

In his latest letter, Bill Gross, obviously for his own reasons, essentially channels Zero Hedge, and repeats everything we have been saying over the past 3 years. We'll take that as a compliment. Next thing you know he will convert the TRF into a gold-only physical fund in anticipation of the wrong-end of the "fat tail" hitting reality head on at full speed, and sending the entire house of centrally planned cards crashing down. "How many ways can you say “it’s different this time?” There’s “abnormal,” “subnormal,” “paranormal” and of course “new normal.” Mohamed El-Erian’s awakening phrase of several years past has virtually been adopted into the lexicon these days, but now it has an almost antiquated vapor to it that reflected calmer seas in 2011 as opposed to the possibility of a perfect storm in 2012. The New Normal as PIMCO and other economists would describe it was a world of muted western growth, high unemployment and relatively orderly delevering. Now we appear to be morphing into a world with much fatter tails, bordering on bimodal. It’s as if the Earth now has two moons instead of one and both are growing in size like a cancerous tumor that may threaten the financial tides, oceans and economic life as we have known it for the past half century. Welcome to 2012...For 2012, in the face of a delevering zero-bound interest rate world, investors must lower return expectations. 2–5% for stocks, bonds and commodities are expected long term returns for global financial markets that have been pushed to the zero bound, a world where substantial real price appreciation is getting close to mathematically improbable. Adjust your expectations, prepare for bimodal outcomes. It is different this time and will continue to be for a number of years. The New Normal is “Sub,” “Ab,” “Para” and then some. The financial markets and global economies are at great risk."

The "Bond King" can't say he didn't warn you. As for the rhetorical answer to his question, we are confident readers don't need any hints. That said, we are no longer surprised to see that established managers of trillions in AUM agree on a daily basis with the hyper cynical (not to be confused with hyper-rehypothecated) musings of fringe bloggers, and it actually becomes is cool" to express agreement with said managers. How soon before every other member of the Ponzi starts exposing the Ponzi for what it is? Is the biggest Nash Equilibrium collapse in "developed world" history coming?

Pimco's Greg Sharenow has released a white paper on what the Newport Beach company believes are the 4 possible outcomes should Iranian nuclear facilities be struck as increasingly more believe will happen given enough time. The conclusion is sensible enough "Whenever the global economy is in a fragile state, as it is today, geopolitical concerns such as the possibility of a strike on Iran’s nuclear facilities become much more exaggerated. Although we cannot (and will not) predict whether an attack is imminent, or even likely, our experience and research tells us that any major disruption in the supply of oil from Iran could have either subtle or profound global repercussions – especially as excess capacity is virtually exhausted and we doubt that other OPEC nations would be able to compensate for a reduction in Iranian oil production." As for those looking for numbers associated with the 4 scenarios presented by PIMCO here they are: "i) Scenario 1: Exports minimally effected. Concerns would drive initial price response; Oil could spike initially to $130 to $140 per barrel and then settle in a higher range, around $120 to $125; ii) Scenario 2: Iranian exports cut off for one month. In this case, we would expect prices could reach previous all-time highs of $145/bbl or even higher depending on issues with shipping; iii) Scenario 3: Iranian exports are lost for half a year. We think oil prices could probably rally and average $150 for the six months, with notable spikes above that level; iv) Scenario 4: Greater loss of production from around the region, either through subsequent Iranian response or due to lack of ability to move oil through Straits of Hormuz. This is the Armageddon scenario in which oil prices could soar, significantly constraining global growth. Forecasting prices in the prior scenarios is dangerous enough. So, we won’t even begin to forecast a cap or target price in this final Doomsday scenario." Needless to say, even the modest Scenario 1 is enough to collapse global economic growth by several percentage points to the point where not even coordinated global printing will do much.

While it won't say much new to those "stupid enough" to exist in the intersection of the "Retired" and "Alive" Venn circles under the Bernanke central planning regime, we suggest any pensioners who hope to see their life savings generate some...any... return (on capital, or of capital) in their lifetime, to simply skip this article and read some of our cheerier fare. So here is the punchline for pension fund managers which now predict an utterly insane 11% equity return which is the only thing that would make their Pension Plans whole: "In the early nineties, plan sponsors, if biased in their forecast, were generally biased toward conservatism. From 1997 through 2007, expectations, although a bit rosy at times, were largely within the realm of reasonableness. In our view, a long-run equity risk premium of 11% is pure jibber-jabber. It is wishful thinking. I dare not predict the level of the S&P 500 ten years out, but an ERP this high suggests the S&P would have to reach unprecedented levels. If this is what plan sponsors are counting on, I, like Clubber Lang, predict Pain." And "Hope is neither a training plan nor an investment strategy." Uh, wrong. Have you seen the EURUSD these days?