In his latest monthly outlook Bill Gross calls June 30th the equivalent of the market’s D-Day. Of course, that is when the Fed’s QE2 program ends. And Mr. Gross might be right. After all, the Fed has injected our blind school child with the belief that he is going to become the world’s greatest archer. No, the Fed hasn’t changed anything fundamentally about the US economy via its purchase of long-term bonds. In fact, given the drop in housing prices, surge in commodity prices, billions reallocated due to gasoline prices, surging mortgage costs, continued lack of borrowing, etc you could actually make the argument that this program has been counterproductive. The one thing it has done is boost risk assets and give market speculators an almost Superman-like feel. Our poor little archer is convinced that Papa Fed has given him superhuman powers. I guess the end of QE2 can be seen as their Kryptonite and our blind school child is still…blind.
But that is not what Bill Gross is worried about. No, he is concerned that the US government might not be able to fund itself when QE2 ends. That is to say that QE2 filled some void that wasn’t going to be there. Naturally, he doesn’t explain how the lack of QE2 would have resulted in its own D-Day (because it wouldn’t have – the Federal government would have continued spending with or without QE2), but the truth doesn’t make for nearly as interesting story telling. He says:
“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.”
Yes, you will buy them. And so will the rest of America because no matter what the Fed does they cannot eliminate the public’s desire to net save. They can make other assets less attractive on a relative basis, but they cannot eliminate a savers desire to net save. And during a balance sheet recession that desire to save is quite high so wise savers naturally choose risk-free interest bearing bonds over cash. Luckily, the Federal government is running a 10% budget deficit so the private sector is able to save in excess of 7% of GDP (we are running a -3% Current Account (CA) deficit so the math can be no other way). Naturally, some of this savings is flowing into government bonds.
The crucial point here is that this concept of “government funding” is really an inflation debate. If inflation remains low then the demand for bonds will remain high. If inflation soars then bonds will be re-priced lower as their demand wanes. But you have to connect the dots here – will large deficits offset the many other deflationary forces in the coming years? If you think so then demand for government bonds could be problematic. If, like me, you believe inflation is likely to remain low then this isn’t a worry and people will continue to gobble up government bonds because they want a risk free return that beats cash.
Further, if one were to review the bond auction data you can see this strong demand for yourself. Where will the buyers come from? They will come from the same place they always come from. Although he acknowledges that some of these buyers are foreign governments he appears oblivious to the simple reality of the current account (CA) deficit. Those dollars may leave our shores, but they come back in the form of UST purchases. The alternative is for these foreign nations to purchase other dollar denominated goods. If you recall, most foreign governments have a pretty poor record of buying our resources, ports or oil companies. So what do they do? They buy the safest yielding paper on the planet – UST’s. This is expected to continue so long as inflation remains under control (which, in this environment looks like a high probability outcome).
Most importantly, it’s likely that QE has not had a substantive impact on the US economy to begin with. That is, interest rates likely would have fallen with or without QE because the US economy has remained weak leading to low inflation. So the demand for US T-bonds was never in doubt. It would have been strong regardless of QE because US government bonds remain the safe haven in an environment where the only safe low interest bearing assets are all slowly being driven to lower interest rates. Without a hike in the Fed Funds rate due to high inflation fears there is a very low probability that interest rates will surge at the end of QE.