Wednesday, 6 January 2010

Deciphering the current thinking of PIMCO's Bill Gross

Bill Gross, head of PIMCO, makes some intriguing, and sometimes surprisingly radical, points in his most recent newsletter . His comments ranging from an observation that "What amazes me most of all is that politicians can be bought so cheaply" to a rather sobering assessment of what consequences are likely to follow for some G7 sovereign debt markets (especially the US and UK) when their central banks begin their exit strategy.
The chart below taken from Gross's January 2010 Outlook shows just how dramatically the Fed and the Bank of England are currently propping up their respective economies.

Gross underlines the severity of this degree of public sector support for two major world economies with what appears to be his most outspoken critique of quantitative easing and the fact that it is unsustainable and has run its course.

Public debt is soaring and most of it has come from G7 countries intent on stimulating their respective economies. Over the past two years their sovereign debt has climbed by roughly 20% of respective GDPs, yet that is not the full story. Some of governments’ mystery money showed up in sovereign budgets funded by debt sold to investors, but more of it showed up on central bank balance sheets as a result of check writing that required no money at all. The latter was 2009’s global innovation known as “quantitative easing,” where central banks and fiscal agents bought Treasuries, Gilts, and Euroland corporate “covered” bonds approaching two trillion dollars. It was the least understood, most surreptitious government bailout of all, far exceeding the U.S. TARP in magnitude In the process, as shown in (the chart above), the Fed and the Bank of England (BOE) alone expanded their balance sheets (bought and guaranteed bonds) up to depressionary 1930s levels of nearly 20% of GDP. Theoretically, this could go on for some time, but the check writing is ultimately inflationary and central bankers don’t like to get saddled with collateral such as 30-year mortgages that reduce their maneuverability and represent potential maturity mismatches if interest rates go up.

The key part of the commentary comes in the very next sentence and somewhat runs counter to the notion that PIMCO's stance is one of favoring more stimulus measures to counter a further retreat into recession.

So if something can’t keep going, it stops – to paraphrase Herbert Stein – and 2010 will likely witness an attempted exit by the Fed at the end of March, and perhaps even the BOE later in the year.

When someone as well connected as Gross sticks his neck out and suggests that March could be the beginning of the end for US easy monetary policy, one should not dismiss this as pure armchair speculation. Interestingly the qualification added by using the word "attempted" next to "exit" suggests that Gross thinks that the Fed may be making a misjudgment which will then need to be reversed with a new policy of more accommodation.

But the next quoted section from the newsletter highlights just how much of a bind Chairman Bernanke is in, given the magnitude of the public deficit and the eventual impact that this will have on interest rate policy.

Here’s the problem that the U.S. Fed’s “exit” poses in simple English: Our fiscal 2009 deficit totaled nearly 12% of GDP and required over $1.5 trillion of new debt to finance it. The Chinese bought a little ($100 billion) of that, other sovereign wealth funds bought some more, but as shown in Chart 2, foreign investors as a group bought only 20% of the total – perhaps $300 billion or so. The balance over the past 12 months was substantially purchased by the Federal Reserve. Of course they purchased more 30-year Agency mortgages than Treasuries, but PIMCO and others sold them those mortgages and bought – you guessed it – Treasuries with the proceeds. The conclusion of this fairytale is that the government got to run up a 1.5 trillion dollar deficit, didn’t have to sell much of it to private investors, and lived happily ever – ever – well, not ever after, but certainly in 2009. Now, however, the Fed tells us that they’re “fed up,” or that they think the economy is strong enough for them to gracefully “exit,” or that they’re confident that private investors are capable of absorbing the balance. Not likely. Various studies by the IMF, the Fed itself, and one in particular by Thomas Laubach, a former Fed economist, suggest that increases in budget deficits ultimately have interest rate consequences and that those countries with the highest current and projected deficits as a percentage of GDP will suffer the highest increases – perhaps as much as 25 basis points per 1% increase in projected deficits five years forward. If that calculation is anywhere close to reality, investors can guesstimate the potential consequences by using impartial IMF projections for major G7 country deficits as shown in the chart below.

The reference to Laubach's notion of anticipating future interest rates from projected deficits seems somewhat gratuitous in that the methodology seems hard to follow and largely dependent on what baseline one chooses. Just to play with this technique for a moment, if one was to take 2007 as the starting point and look forward 5 years from that base, that would then suggest that rates in a year or two will be about 200 basis points from where they were in 2007, or at about 7%. Does Gross believe that? If not, then it is hard to see what the point of applying the technique is starting from from the artificially low levels of today of 0.5% especially since the projected deficit for the US will (according to the table which, in my opinion, is almost certainly suspect) actually decline from current levels.

Although the methodology seems spurious the underlying sentiment seems clear enough, and this was echoed in Paul McCulley's recent comments, and that is that PIMCO is turning bearish on long term government debt for the US and the UK.
Reading between the lines of Mr. Gross's comments it is hard to resist the conclusion that PIMCO now believes that there are serious consequences to pay for the degree of public debt that has been created and that there is both an expectation that the economy may well remain weak (and possibly in need of another round of virtually zero interest rates) but that this will not be supportive of higher bond prices.

The reasoning differs from the often cited stagflation argument as Gross does not dwell on inflationary concerns but rather seems more concerned about the magnitudes of the deficit, the duration of the Fed's holdings and fiscal rectitude issues. All of this underlines the fact that these are unusual times and not susceptible to any of the archetypal macro-economic interpretations/explanations.

Clever writers such as Gross will often leave a lot unsaid and use innuendo to make their ultimate points. Which is why the final remark in his newsletter has a sting in the tail which seems to be suggesting more than that the customary warning that it would be prudent to be cautious in 2010.

Additionally, if exit strategies proceed as planned, all U.S. and U.K. asset markets may suffer from the absence of the near $2 trillion of government checks written in 2009. It seems no coincidence that stocks, high yield bonds, and other risk assets have thrived since early March, just as this “juice” was being squeezed into financial markets. If so, then most “carry” trades in credit, duration, and currency space may be at risk in the first half of 2010 as the markets readjust to the absence of their “sugar daddy.” There’s no tellin’ where the money went? Not exactly, but it’s left a suspicious trail. Market returns may not be “so fine” in 2010.

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