Wednesday, March 30, 2011

The Coming End of Quantitative Easing

For the past few weeks there has been talk in the press that QE II will pause at the end of June, and last week several Federal Reserve Bank Presidents made statements supportive of this view. As we will see below, there is good reason to believe that the government's extraordinary programs of support are coming to an end. We should seriously consider this, because the implications appear to be serious for market liquidity, rate expectations, and the dollar.

Accommodation Is Already Being Removed

Recent Fed pronouncements about ending QE should not be unexpected, because both the Fed and the Treasury have been cutting back for some time on other programs of financial and economic support. In "Crisis Era Props Are Fading Away" the Wall Street Journal last week reported on other support programs that both Treasury and the Federal Reserve have already started to roll back.

The Treasury Department has already announced plans to sell its $142 billion portfolio of federal agency mortgage-backed securities bought at the worst of the crisis. The Federal Reserve moved to the next stage of a plan to drain liquidity from the financial system through reverse repurchase agreements, or "reverse repos." Some of these moves have been going on for months. The Fed started testing reverse repos in the fall of 2009, and it has been some time since the Treasury ended several emergency-lending programs that eased the credit markets through the crisis.

More moves are being contemplated. The Fed is considering an auction for some of the subprime-mortgage securities acquired in the bailout of American International Group Inc.

Reasons for Policy Change at This Time

As pointed out by Glenview Capital in the blog Pragmatic Capitalism, there are some fundamental reasons for QE to pause: (1) the economy has rebounded (at least by some accounts), (2) the risk of immediate deflation has receded, (3) rapidly rising prices of oil, food, and other commodities provide some indication of incipient price inflation, and (4) Fed commentary has grown more cognizant of the risks of inflation.

In addition to the reasons cited in that article, the Fed probably wants to normalize policy so as to leave some "dry powder" ready to counteract the next recession or financial panic. Also, private financial institutions have stabilized to some extent, although much of their problems are being hidden at present by Treasury and Fed programs and by official tolerance of mark-to-fantasy accounting.

Recent Federal Reserve Comments

Based on recent statements, the Fed appears now to be in favor of putting an end of QE, if conditions continue stable or improve. Not long ago, St. Louis Federal Reserve Bank President Bullard said this quite plainly: "If the economy is as strong as I think it is then I think it may be reasonable to send a signal to markets that we're going to start withdrawing our stimulus, and I'd start by pulling up a little bit short on the QE2 program." Then last Friday a parade of Federal Reserve Bank Presidents made well-coordinated statements like these:

Speaking at a conference in Marseilles, Bullard said “The economy is looking pretty good. It is still reasonable to review QE2 in the coming meetings, especially this April meeting, and see if we want to decide to finish the program or to stop a little bit short.”

Speaking at the same conference, Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said: "If the economy evolves the way I've forecast, I would not foresee us doing further accommodation." He added that the U.S. economy would need to worsen “materially” for the bank to consider further bond-buying.

Atlanta Fed President Dennis Lockhart said in a speech last Friday that "it's a high bar" for the Fed to pursue more QE. He told reporters after his speech that he favors completing the present round of asset purchases as scheduled but opposes additional moves based on his current economic forecast.

At a speech in New York a speech in New York last Friday, Charles Plosser, President of the Philadelphia Fed, said: "If this forecast is broadly accurate, then monetary policy will have to reverse course in the not-too-distant future and begin to remove the massive amount of accommodation it has supplied to the economy." He suggested selling $125 billion for every 0.25 percentage-point rise in the benchmark rate to almost eliminate $1.5 trillion in bank reserves.

Charles Evans, President of the Federal Reserve Bank of Chicago, said to reporters at a meeting at the bank that the current program of QE was enough: "Following through on that to the tune of $600 billion, like we've said, I think is appropriate. I personally don't see as many needs for a further amount, as I probably thought last fall."

The rhetoric has continued this week. Richard Fisher, President of the Dallas Fed, said today in an interview on Fox Business that he would vote against any further monetary easing by the central bank after the current program is finished in June. He was definite about this: "I cannot foresee a circumstance where I can support any further liquidity in the economy."

Pressures on the Fed to End QE

A stabilizing economy and a stable financial system have been cited as reasons for taking a pause in QE soon. These are not the only reasons why the Fed might end QE -- or say that it is going to end QE. There are other possible motives that include both real-world finances and Washington politics.

Another reason to consider ending QE in the future, if not right now, is the dollar. The ability of this country to remain solvent depends on maintaining at least some value for the dollar. So far, the dollar has declined only gradually in reaction to the government's extraordinary support for the financial system and the economy, but many of our creditors have complained about the trend. Naturally, dollar weakness is a big issue with the Fed, and they need to do something about it before heretofore modest dollar weakness turns into panic.

Partly, the problem can be seen in the continuing flow of dollars into commodities. When consumers and investors see commodity prices rising suddenly, they try to preserve wealth by exchanging dollars for commodities. This is not what the Fed wants. They want you to hold dollars and other US financial assets, not barrels of oil or gold ingots. A related view is that the Fed needs to forestall the incipient inflation seen in rising commodity prices. In addition, all of this speculation is destabilizing to the markets.

Many observers (such as Bill Gross of PIMCO) worry that the Fed is taking a big risk by tightening policy while it has been buying one-third of all US Treasury issuance. This may be a risk, but others point out that the Fed may already have enough securities on its balance sheet to control rates, and that it doesn't have to depend on incremental purchases.

Maybe the most persuasive explanation for the Fed's recent statements is that it needs to placate the fiscal hawks in Congress. According to this point of view, the Fed is just biding its time until forecasts of robust economic growth are proven wrong. At signs of a faltering economy, the Fed can rein in talk of pursuing QE and start preparing the markets for QE III. Signs of a faltering economy may not be long in coming, considering that the most recent economic data are not uniformly encouraging, and many economic forecasts are being cut back.

Problems with Pausing QE

Unfortunately, a pause in QE would happen at a time when overall economic and financial conditions are hardly conducive to monetary tightening. As Glenview Capital wrote in the blog Pragmatic Capitalism, "a renewed emphasis on deficit reduction in Congress ... will likely slow the growth of both Federal and State/Local spending that has played a key role in reinforcing the economy to prevent a double-dip recession." This austerity-induced fiscal drag seems likely to add its own burden on the weak economy.

If they come to pass, these domestic drags on the economy will happen against a global backdrop of economic negatives. These include high oil prices induced by fears of continuing political unrest in the Middle East, financial instabilities induced by the continuing debt crises on the periphery of the European Union, and the possibility of tightening by China to rein in inflation pressures and rein in an unbalanced and overheated economy.

Pausing QE would tend to raise interest rates, which is a situation that the financial system may not be ready to face. As Bill Gross asked: "Who will buy Treasuries when the Fed doesn't?" This raises the additional question of how high rates might go when the artificial foundation of QE II credit is removed. There is also the question of how well the economy and the financial system can withstand higher rates. The economy hardly seems robust enough to withstand sharply higher borrowing costs. The financial system gives appearances of having stabilized to some extent, but that leaves the question of how dependent is has become on the continuance of rock-bottom interest rates.

There is also a risk that fiscal austerity, induced by fears about government deficits, might actually worsen that situation. This is because the stabilization of the economy has been dependent on stimulus through growth in Federal expenditures. With reductions in Federal, state, and local budgets, there is a higher risk that growth will falter, and that lower economic growth will reduce tax revenues and increase the deficit.

                               Barbara Stevenson, Apple Vendor, 1933-1934.

All of this paints a picture of a financial and economic environment that is hardly appropriate for monetary tightening in the US. As noted above, recent economic news is not encouraging, and continuing signs of weakness could easily raise new fears of another recession.  We have to wonder if QE would not need to be quickly resumed if this uncertain economic climate resumes a downward course.

Tightening to fight inflation runs the risk of undercutting the recovering economy, a situation which would place the Fed and Congress between a rock and a hard place with respect to policy choices. This could lead to a real dilemma for policy, that perhaps deficits cannot be reduced without further weakening the economy.  Perhaps we should not be surprised to see such a dilemma, given that this country has seen decades of Fed policies and national budgets sending false signals to the markets that induced economic participants to misallocate resources into consumption rather than productive investment.

QE and the Markets

One of the best discussions about pausing QE that I have read was John Hussman's March 28 commentary. His argument is based on the fact that "the primary factor behind the market's recent advance has been speculation based on the belief, explicitly encouraged by Bernanke, that the Fed would provide a backstop for risk-taking." The implication for the markets is clear. If the Fed does not enter into another round of QE (and certainly if the Fed unwinds past QE), it risks an "an increase in risk aversion" and "a decline in speculative enthusiasm."

Given the momentum-like behavior of the markets, Hussman believes that investors have not priced in "the extent to which this [the market advance] has been reliant on various stimulus measures that are now drawing to a close." In fact, low market returns were almost guaranteed by the nature of QE. This is because by "increasing the stock of non-interest bearing money in the economy toward $2.4 trillion, all of which has to be held by somebody, the Fed has created a market environment that has raised the prices and lowered the returns on all competing assets." [My emphasis]

There is no way of knowing where the market will go in the short-term, but poor long-term returns are indicated by present market valuations. This is borne out by Hussman's quantitative models, which are definitely long-term and fundamental in their valuation approach. These models assume that "long-term growth in GDP and earnings will persist at the same roughly 6.3% peak-to-peak growth rate across economic cycles," which is the average rate observed over nearly the past century. Based on the level of stock valuations to normalized earnings, "our present 10-year total return estimate for the S&P 500 is only about 3.4% annually," and "the historical skew to these returns easily includes zero in the confidence interval."

Bill Gross's has warned that the end of QE will mean the end of the bull market in bonds and, as we discussed above, there is good reason to worry that the removal of extraordinary monetary accommodation may also drive down the prices riskier asset classes, like stocks and commodities. Whether we agree with all of these arguments or not, it is always a good time to review the asset allocations in our portfolios.

Tuesday, March 22, 2011

Not Yet the End of the Bull Market in Bonds

PIMCO Total Return Eliminates Government Bonds

A couple of weeks ago there was considerable angst in the press over the announcement that the PIMCO Total Return Fund had totally eliminated its exposure to US government bonds during the month of January. Total Return raised its cash position by a corresponding amount.

In an interview on Yahoo Tech Ticker, PIMCO guru Bill Gross advised investors to stay clear of “bonds in dollar denominated terms” and to be “wary of higher interest rates going forward.” Bloomberg reported: "Gross believes that interest rates on U.S. Treasuries are way too low right now and that they will start going up when the Federal Reserve ends the current round of quantitative easing in June."

Should We Be Worried?

Well, if you believe that rates will rise precipitously when QE II ends, I don't blame you for selling bonds and going to cash. You might even believe, as Zero Hedge wrote, that the "cost of capital could go up by at least 150bps while input costs are rising, margins are compressing and liquidity drying up." In that situation, it might even make sense to "get the hell out of Dodge in all asset classes."

But is there reason to be so greatly worried about rising rates, especially at the end of QE II in June? I certainly agree that the US faces persistent, multi-year problems with interest rates and the dollar. However, it isn't exactly clear that we should have a particularly elevated level of worry about the purported forthcoming event "when the Federal Reserve ends the current round of quantitative easing in June," as Gross says we should. There are differing opinions about the market impact that the end of QE II may have, if it does end then, and we might profit by at least listening to some other opinions.

What Happened to Bond Yields the Last Time?

Cullen Roche, the author of the blog Pragmatic Capitalism, looked at Gross's track record and concluded: "I am not sure there is much, if anything, that we can read into this move by Mr. Gross. He has been talking about some form of bear market in bonds for over 10 years now." For example, ten years ago Gross wrote in 2001 "We are at the end of the secular bull market in bonds," which hardly turned out to be the case then.

Roche also pointed out that Federal Reserve history is against Gross's pronouncement that QE II will lead to a rise in bond rates. When QE I ended last year, and the Fed contracted its balance sheet, interest rates did the opposite of what Gross expected, that is, they dropped.

Of course, the Fed's move was advertised in advance, and bond yields did rise during much of the lead-up to the event.  Also, the context is different this time. There is more public awareness now of the risks of a declining dollar, and attention to the growing US government debt has also increased in the past year. Perhaps it is best to admit that argument from a single anecdote is impossible, and not dismiss Gross's worries simply on that basis.

What Else Happened Last Time?

If we want to use historical analogies, the only time that the Fed previously cut back on a program of quantitative easing was last year. Interest rates fell after that cutback, but what else happened? A full examination of the historical record shouldn't be restricted to a single dimension, bond yields, even if that is the issue that Bill Gross focused on.

In John Maldin's latest column, he quoted from a list that was originally published by David Rosenberg. To quote those two, during the period from late April to late August last year, when the Fed contracted its balance sheet by 12 percent, the markets saw asset price changes that included the following:

The S&P 500 sagged from 1,217 to 1,064….

The S&P 600 small caps fell from 394 to 330….

Baa spreads widened +56bps from 237bps to 296bps…

CRB futures dropped from 279 to 267….

Oil went from $84.30 a barrel to $75.20….

The VIX index jumped from 16.6 to 24.5….

The trade-weighted dollar index (major currencies) firmed to 76.5 from 75.5….

The yield on the 10-year U.S. Treasury note plunged to 2.66% from 3.84%…

Among commodities, the exception to the overall decline was gold which "acted as a refuge at a time of intensifying economic and financial uncertainty" by rising to $1,235 an ounce from $1,140.

If the end of QE II follows the same pattern as the end of QE I, perhaps there is reason to worry about the short-term impact, because there were price drops across a wide range of asset classes. But the price declines last time did not include the one that Gross identified, namely a drop in bond prices.

The Difficulty of Interpreting History and Statistics

In his Yahoo Tech Ticker interview, Gross said that America's debt level is nearing a breaking point after years of reckless spending, and that we can no longer depend on foreigners for funding. A critical question, of course, is when the breaking point will arrive. Gross cited the work of Ken Rogoff and Carmen Reinhart in This Time Is Different when he said: “When a country reaches a certain debt level, confidence in that country’s ability to repay that debt becomes jeopardized.”

Now, we must be careful here, because timing is everything in investing. Certainly, high national debt levels can be dangerous, but has the US reached a critical level of debt?  Do we expect the US to experience a major bond market dislocation this year, as Gross seems to imply?

The really big problem with Gross's appeal to Rogoff and Reinhart is of course that, when he refers to "a certain debt level," he is referring to average results over a sample of national experiences. Referring a a sample average is misleading. The outstanding aspect of the data used by Rogoff and Reinhart is the variability in the experiences of different nations with respect to the conditions under which they had difficulties paying their debts. There is no way of saying that a nation will default when it reaches a given level of debt, however one defines the debt.

Also, it is myopic to focus attention on only a single variable, the nation's level of debt (presumably as a fraction of gross economic product). Other factors are also critical in determining a nation's ability to pay its debts, including its level of economic activity, prospects for growth, currency convertibility, trade relationships with creditors, and many others. There are good reasons that US creditors are willing to tolerate present debt levels and that the US currently experiences interest rates that are low to moderate in historical terms over the maturity span of the yield curve.

In fact, predicting a nation's ability to repay its debt is not a matter than anyone can achieve with any certainty. Is there risk to the US dollar? You bet. Could the dollar fall more this year? Sure. But will American's ability to repay its debt suddenly end this year? There are risks, but QE II does not seem especially likely to be the trigger for a massive event.

Years, Not Months

Setting a time for a bond blowup is impossible, but the real problem is probably more likely to lie sometime in the next decade, not over the next few months. That is because the big problem is the current high level of US government debt and the likely future growth of that debt, seemingly without limit. Current budgets are heavily in deficit, and entitlement programs —Social Security, Medicare and Medicaid—are set to add ever-increasing burdens that will throw the budget even more into the red. Given the reluctance of politicians to raise taxes to pay for these programs, or to cut entitlements, the national debt seems fixed on a doomsday trajectory that will grow without bound until disaster strikes.

A chart at The Economist is a good place to see the proportion of GDP spent on entitlements and interest, compared with the proportion of GDP that the government is expected to raise in the form of revenues. The data come from the Congressional Budget Office's "alternative fiscal scenario", which is based on today's underlying fiscal policy but also incorporates some widely expected changes, such as an increase in the threshold for the alternative minimum tax rate.  The expansion of entitlements to take up an ever-expanding proportion of the US budget is very striking.

The Economist pointed out that, according to this graph, entitlements and interest will absorb all government spending by 2025. Of course, a crisis will arise well before we reach that point. Not only will there be resistance to letting entitlements crowd other government programs, but the government budget will expand well before that time to comprise an unacceptably large percentage of our GDP. Other economic activity would be crowded out, but markets are certain to react well before that point to demand higher interest rates and pernicious currency exchange rates from the US. As confidence is lost in the US, the point will be reached where the economy falls into depression and the national debt cannot be serviced.

Clearly, the government debt situation poses a very big risk for bonds, interest rates, and the dollar.  In this respect Gross and PIMCO seem perfectly on track in their warnings, although that still leaves the question of timing.

When will the crisis be seen in the markets? Hard to tell, but it seems more likely that the real trouble will be a few years off, say, in the latter half of this decade, rather than at the end of QE II, if it ends this summer. Of course, there are many uncertainties. Determined political action could lead to meaningful cutbacks in government spending, or unexpected economic growth could bring greater tax revenues to the government to reduce annual deficits. Whether a crisis occurs or not, half a decade seems a more plausible period of uncertainty for an American interest rate crisis than does a restricted period like the few months attending the end of QE II, whenever that event actually comes.

Bill Gross's Argument

Gross's stated position on QE II is much more alarmist than the aforementioned historical interpretations would seem to support. He reminded readers in his March letter that the Fed is currently buying about 70 percent of all new US government debt, and he then asked: "Who will buy Treasuries when the Fed doesn't?"

There is no argument with Gross's recognition that "Bond yields and stock prices are resting on an artificial foundation of QE II credit that may or may not lead to a successful private market handoff and stability in currency and financial markets." Without this "handoff and stability" the private sector may indeed be unable to issue debt at the low yields and narrow credit spreads seen in the markets at present.  It is difficult to disagree that this point.

As for the magnitude of the problem that the financial markets might experience if QE ends, we have Gross's estimate" that Treasury yields are perhaps 150 basis points or 1½% too low when viewed on a historical context and when compared with expected nominal GDP growth of 5%." Of course, in order to be really worried that QE II will end soon, you have to accept Gross's estimate of expected nominal GDP growth. Not everyone would agree that the economic prospect is so rosy.

Perhaps the biggest problem with Gross's alarm is that it posits an event that may not occur. Given the weakness of the economy and the reluctance of Congress engage in fiscal stimulation, it would seem more likely that the Fed will find it necessary to continue a policy of extraordinary monetary easing, rather than discontinue it. Current optimism about the economy seems overdone, and the Fed probably knows that.

There is no denying the existence of near-term risks, but the question is the magnitude of the risk and how it will evolve over time.  Based on this analysis, risks to the dollar and Treasuries should rise as deficit difficulties increase over time.  This isn't exactly the message of Gross's comments, but at least he has stated his arguments publicly, so that we can judge the extent to which we would like to share them.