Impotent Fed

From an interview of Bill Gross in Barron’s:

You have taken central bankers to task for impotence and ignorance, among other sins. In particular, you have written that Fed Chair Janet Yellen and others are ignorant of the harm done by their policies “to a classical economic model that has driven prosperity.” Just what did you mean, and what sorts of dangers do we face?

The Federal Reserve was created in 1913. President Nixon took the U.S. off the gold standard in 1971. For the past 40-plus years, central banks have been able to print as much money as they wanted, and they have. When I started at Pimco in 1971, the amount of credit outstanding in the U.S., including mortgages, business debt, and government debt, was $1 trillion. Now it’s $58 trillion. Credit growth, at least in its earlier stages, can be very productive. For all the faults of Fannie Mae and Freddie Mac, the securitization of mortgages lowered interest rates and enabled people to buy homes. But when credit reaches the point of satiation, it doesn’t do what it did before.

Think of the old Monty Python movie, The Meaning of Life. A grotesque, rotund guy keeps eating to demonstrate the negatives of gluttony, and finally is offered one last thing, a “wafer-thin mint.” He swallows it and explodes. It’s pretty funny. Is our financial system, with $58 trillion of credit, to the point of a wafer-thin mint? Probably not. But we’re to the point where every bite is less and less fulfilling. Even though credit isn’t being created as rapidly as in the past, it doesn’t do what it did before.

Central banks believe that the historical model of raising interest rates to dampen inflation and lowering rates to invigorate the economy is still a functional model. The experience of the past five years, and maybe the past 15 or 20 in Japan, has shown this isn’t the case.

So where does that leave our economy?

In the developed financial economies, as a bloc, lowering interest rates to near zero has produced negative consequences. The best examples of this include the business models of insurance companies and pension funds. Insurers have long-term liabilities and base their death benefits, and even health benefits, on earning a certain rate of interest on their premium dollars. When that rate is zero or close to it, their model is destroyed.

To use another example, California bases its current and future pension payments to civil workers on an estimated future return of 8% or so from bonds and stocks. But when bonds return 1% or 2%, or nothing in Germany’s case, what happens? We’ve seen the difficulties that Puerto Rico, Detroit, and Illinois have faced paying their debts.

Now consider mom and pop and other people who read Barron’s. They are saving for retirement and to put their kids through college. They might have depended on a historic 8%-like return from stocks and bonds. Well, sorry. When interest rates get to zero—and that isn’t the endpoint; they could go negative—savers are destroyed. And savers are the bedrock of capitalism. Savers allow investment, and investment produces growth.

Are you suggesting a recession looms?

No. I see very slow growth. In the U.S., instead of 3% economic growth, we have 2%. In euroland, instead of 2%, growth is 1%-plus. In Japan, they hope for anything above zero.

What governments want, and what central banks are trying to do, is produce, in addition to minimal growth, a semblance of inflation. Inflating is one way to get out from under all the debt that has been accumulated. It isn’t working, because with interest rates at zero, companies and individual savers sense the futility of taking on risk. In this case, the mint eater doesn’t explode, but the system sort of grinds to a halt.

It doesn’t look like anything is grinding to a halt around here. You can see gorgeous golf courses from one window and a yacht basin from the other.

This isn’t the real economy. It is Disneyland and Hollywood. It is finance-based prosperity, based on money that doesn’t produce anything anymore because yields are so low.

Even in a negative-rate environment, as in Germany or Switzerland, banks and big insurance companies have little choice but to park their money electronically with the central bank and pay 50 basis points. But an individual can say “give me back my money” and keep it in cash. That’s what would make the system implode. I’m not talking about millionaires or Newport Beach–aires, but people with $25,000 or $50,000. Without deposits, banks can’t make loans anymore, so the system starts to collapse.

Let’s say Yellen steps down and President Obama appoints you the new head of the Fed. What would you do differently?

What you’re really asking is: What is the way out? The way out is a little bit of pain over a relatively long period of time. That is a problem for politicians and central bankers who are concerned with their legacy. It means raising interest rates and returning the savings function to normal. The Fed speaks of normalizing the yield curve but knows it can’t go too fast. A 25-basis-point increase [in the federal-funds rate] in December had consequences in terms of strengthening the dollar and hurting emerging markets.

Will the Fed raise rates this year?

Yes, as long as the stock market permits it. They have to normalize interest rates over a period of two, three, four years, or the domestic and global economy won’t function. In today’s world, normalization would mean a 2% fed-funds rate, a 3.5% yield on the 10-year bond, and a 4.5% mortgage rate. Would this create some pain? Of course. Housing prices probably would stop rising, and might fall a bit. The Fed has to move gradually.

What will be the 10-year Treasury yield at the end of 2016?

Close to what it yields now. I expect the Fed to raise rates once or twice this year. That would put the fed-funds rate at 1%. Does the 10-year deserve to yield 1.90% with fed funds at 1%? Yes, so long as inflation is 2% or less. If the Fed raises rates, the euro and yen could weaken. That would mean rates in Europe and Japan don’t have to go negative, or to extreme lows. In a sense, the Fed is driving everything. But it can’t raise rates too much without threatening a country like Brazil, whose corporations have tons of dollar-dominated debt.

What will the global economy look like in five or 10 years?

Structurally, demographics are a problem for global growth. The developed world is aging, with Japan the best example. Italy is another good example, and Germany is a good, old society, too. As baby boomers get older, they spend less and less. But capitalism has been based on an ever-expanding number of people. It needs consumers.

Another thing happening is deglobalization, whether it’s Donald Trump building a wall to keep out Mexicans, or European nations putting up fences to keep out migrants. Larry Summers [former secretary of the Treasury] has talked about secular stagnation, or a condition of little or no economic growth. At Pimco, I used the term “the new normal” to refer to this condition. It all adds up, again, to very slow growth. The days of 3% and 4% annual growth are gone.


Fed Gambles

images …with your future.  From the WSJ:

In Going Long, the Fed Is Short-Sighted

The Fed is clearly doing everything it can, at the expense of small savers, to provide the U.S. Treasury with minimal borrowing costs to help it finance a profligate administration and Congress.

Stock and bond traders spent most of last year in a state of high anxiety over what would happen when the Federal Reserve began “tapering” its monthly $85 billion purchases of Treasurys and mortgage-backed securities. But when the tapering was actually announced in December, the Dow Jones Industrial Average rose sharply, apparently out of relief from all the suspense. Today, after various fluctuations including last week’s swoon, the Dow is pretty much where it was back then.

The taper this month will take the purchases down to $55 billion, $30 billion in Treasurys and $25 billion in the tainted mortgage-backed securities that were the product of Uncle Sam’s “affordable housing” fiasco of the 2000s. So far, the worst fears of the markets haven’t happened.

Why not? One reason may be that the Fed isn’t tapering as much as the numbers might indicate.

While the Fed is buying fewer securities, those it is buying have longer maturities. So the Fed’s purchases, though shrinking, are relieving banks and the Treasury from a higher proportion of their risks.

Numbers compiled by the Federal Reserve bank of St. Louis record the lengthening of Treasury maturities in the Fed’s ballooning portfolio. The face value of that portfolio now stands at something over $2.3 trillion, of which bonds with maturities of more than 10 years account for 26%, compared with 18% only four years ago. Maturities between five and 10 years now account for 37%, versus 26% in 2010. But maturities from one to five years have dropped to 37% from 42%. Short-term notes, 91 days to a year, ran around 23% of holdings in the pre-2008 years. Today, they are zero.

This might all sound rather arcane, but longer maturities mean that the Fed is buying more risk. That mitigates whatever tightening effect tapering might have on the markets.

John Butler, a fund manager for Amphora Commodities in London, has commented that by buying a greater proportion of longer-dated securities from the banking system and thus relieving bankers of risk means that monetary policy may be no more tighter than it was before tapering. That would be debatable considering the substantial $10 billion increments the Fed is removing from the “buy” side of the Treasury and MBS side of the market each month. But it certainly can be said that by relieving banks and the Treasury of some of their long-term risk, the Fed is softening the market impact of tapering.

Long bonds normally return greater yields than shorter-term securities because in a fiat money system subject to bouts of inflation, they carry greater risk. Thanks in part to the Fed’s purchases, the 10-year Treasury is currently yielding less than 3%, which doesn’t offer much protection against a future inflation loss.

At the Fed’s target of 2% annual inflation (which the CPI is currently undershooting if you believe those numbers), a 10-year Treasury with a 2.75% coupon would net less than 1% at maturity. If inflation rises above 3% it becomes a loser and from 5% inflation on up it becomes a big loser. Even a one-year spike of 10% in a decade of otherwise modest inflation could produce a loss at maturity for bonds with the remarkably low coupons Treasurys carry today.

The Fed has made no secret of its plans to go long, but the whole concept of “quantitative easing,” including the term itself, is shrouded in obfuscation. While the Fed says its policies are a form of economic stimulus, any such effect is far less obvious than what is plainly visible. The Fed is clearly doing everything it can, at the expense of small savers, to provide the U.S. Treasury with minimal borrowing costs to help it finance a profligate administration and Congress.

Banks, especially the big ones, aren’t doing so badly either. According to the Federal Deposit Insurance Corp., the banking industry had record earnings of $154.7 billion in 2013. The largest, “systemically important” giants have an added fillip in that their too-big-to-fail designation and close connections with the Fed reduce their borrowing costs versus their less-favored brethren. The Fed pays a quarter of a percentage point to borrow from the banks the money it uses for supporting the Treasury and the mortgage market under “quantitative easing.” That pads bank earnings as well.

So everyone wins, right? Well, except maybe for the Fed itself, and of course savers.

The Fed has put itself in a position that offers no easy way out. If credit demand rises and that huge holding of excess bank reserves finds its way into the global economy, it could trigger inflation in excess of the Fed’s strange 2% target, and it could happen fast. The Fed could find itself sitting on a lot of devalued Treasury and mortgage-backed debt that would lose money even if held to maturity.

Who knows what the world will look like 10 years from now, or even next week? At least the Fed has an incentive to try to contain inflation. But given the size of the bank reserves already exploded by the Fed, maybe it already has failed in that task.