THE OLD BILL / THE ECONOMIST BUTTONWOOD COLUMN ( A MUST READ )

Buttonwood

The old Bill

Stopping quantitative easing may be harder than starting it

Mar 17th 2011

.

..
BILL GROSS is the most famous and experienced bond-fund manager in the world. So when he says PIMCO’s Total Return, the $237 billion fund which he manages, is avoiding Treasury bonds, investors should take notice.

Mr Gross is particularly worried about the effect of quantitative easing (QE) by the Federal Reserve, the second round of which is due to expire in June. He has described this process, whereby the Fed creates money to buy both mortgage-backed securities and Treasury bonds, as a form of pyramid or Ponzi scheme.

PIMCO reckons the Fed has been responsible for 70% of recent Treasury purchases, with foreigners buying the other 30%. “Who will buy Treasuries when the Fed doesn’t?” asks Mr Gross, adding that the danger is of a spike in bond yields as private investors demand a higher return to compensate them for the risks of inflation or dollar depreciation.

He cites a number of reasons why yields may be at least 150 basis points (one-and-a-half percentage points) too low. First there is normally a rough relationship between yields, currently 3.3% for ten-year Treasury bonds, and nominal GDP growth projected at around 5% a year.

Second, real five-year Treasury-bond yields have averaged about 1.5% in the past; they are currently slightly negative. Third, the short-term Fed funds rate is around 475 basis points below nominal GDP growth, compared with an historic average of 75 basis points.

To some, this may seem naive. The end of QE2 has been well signalled. Markets have had time to adjust. Mr Gross’s own actions indicate that this is the case: he has sold his Treasury-bond holdings in advance. Indeed, markets don’t seem worried at the moment; Treasury-bond yields have fallen over the past month.

Nevertheless, it is legitimate to worry whether getting out of a QE programme will be as easy as getting into it. (This problem also faces the Bank of England and the European Central Bank.) It is not simply a matter of ceasing to buy bonds. Unless they want to end up with a permanently bigger balance-sheet, central banks must offload those bonds they have already bought.

It is no answer to say that the programme will wind itself up naturally as the bonds mature. Unless the government concerned is running a surplus by that stage (dream on), maturing bonds need to be refinanced. So the private sector will have to absorb not only that year’s financing programme but the surplus offloaded by the central bank. This is no small matter. The Fed has an asset pile of some $2.6 trillion, of which just under half is Treasuries.

Herein lies the rub. In what circumstances would investors be most keen to buy more government bonds? When the economy is struggling. But central banks will be highly unlikely to reverse QE at that stage. In any case, cynics suspect the problem with QE is that there may never be a moment when central banks feel confident enough to unwind it. After all, American GDP grew by a respectable 2.8% last year and growth of more than 3% is forecast for this year. Yet this week’s Fed policy meeting indicated that the second round of QE would still be completed.

As the programme has evolved so have the justifications for QE. In testimony to Congress on March 1st, Ben Bernanke, the Fed’s chairman, cited the evidence of its success: “Equity prices have risen significantly, volatility in the equity market has fallen, corporate-bond spreads have narrowed, and inflation compensation as measured in the market for inflation-indexed securities has risen to historically more normal levels. Yields on five- to ten-year nominal Treasury securities initially declined markedly as markets priced in prospective Fed purchases; these yields subsequently rose, however, as investors became more optimistic about economic growth and as traders scaled back their expectations of future securities purchases.”

Note that Mr Bernanke seems to treat both lower and higher bond yields as evidence for the success of the policy. And note also how his first two references are to the recovery in the stockmarket. His big speech on QE, back in January 2009, did not mention share prices at all.

If it is vital to maintain stockmarket confidence, then equity jitters—whether caused by Japanese earthquakes, European fiscal problems or something else—are a reason to keep QE going. And the bigger the programme, the harder it is to unwind. Mr Gross is right to worry.