Friday, 29 October 2010

QE addiction: exonerating Chairman Bernanke

It has been widely noted this week, including here and also again here, that Bill Gross is on record as describing US current monetary policy as having all of the characteristics of a Ponzi scheme. At the same time Gross also proposes that Chairman Bernanke has really no other options than to implement such a scheme, as he has run out of all other viable policy weapons.

But what about the argument that he could/should do nothing and wean the US economy off a diet of endless asset purchases? In essence the flaw in this argument is that he may not have the option of curtailing QE and, in an ironic sense, this would go a step further in exonerating the Fed Chairman.

Looked at from the perspective of the US government's finances, although the unintended consequences of QE are highly undesirable - e.g. a weaker US dollar, friction with other global trading partners, creation of asset bubbles in emerging markets, booming commodity prices etc. - the US economy is most likely now addicted to QE in the same way that happens in any Ponzi scheme.

There's an old saying that a "rolling loan gathers no loss" and if government's simply roll forward expiring debt with new debt in moderation this does not pose systemic risk. However when the magnitude of the expiring debt is so colossal, and where there is clear evidence that, were it not for the stated aim of the Fed that it is effectively backstopping the Treasury market, non US government buyers (e.g. PIMCO, pension funds, PBOC, BOJ etc) may not participate (at least not at current historically low coupon rates).

There is much talk about the Fed's exit strategy but if the Ponzi scheme is as voracious as it appears to be, due to the over-commitments of US federal debt obligations, it looks as though the Fed is trapped. Not only will it be the lender of last resort it may ultimately become the only lender. Unless the Fed continues to reassure other market players such as other sovereign buyers, banks and pension funds, that they - and this includes PIMCO as well - can turn over their inventory quickly to the Fed if the market becomes illiquid, the absence of bids will create that very same illiquidity and systemic risk.

For many private investors, and this may well include PIMCO, it is not their intention to hold a 10 year bond to maturity. Rather they wish to avail themselves of easy exit possibilities from an accommodating central banker running a public buyback program. This "easy exit" is especially true should interest rates be rising and the value of the bond is declining. Usually it is only very long term asset managers such as pension funds that are committed to such buy and hold strategies - with all of the interest rate risk and duration difficulties that comes along with such an extended holding horizon.

More typically for many private investors their typical holding period may be weeks/months where they are looking to unload the bonds at higher prices each time the Fed steps in with more QE.

If the Fed terminates QE just how easy will it be to keep the Ponzi scheme afloat?

In a nutshell, this is why Chairman Bernanke is "boxed in" and why not only Mr. Gross is turning bearish on US bonds but also so are other major holders such as the People's Bank of China.

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