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Pimco’s El-Erian Warns of Central Bank Put Bubble

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Mohamed El-Erian, the CEO of Pimco, often acts as the saner and more analytical counter to the often hyperbolic Bill Gross. (Aside: Gross’s latest rant on how the US “pleasures itself on budgetary crystal meth” looks to be off in several respects. I believe meth is a longstanding bathhouse favorite and hence is used for the kind of sex you have with other people, since it increases duration. And the last time Gross made Big Noise, about how Treasuries were going to fall in price when the S&P downgraded them from AAA, he proved to be 180 degrees wrong. Gross’s salvo looked more to more about pumping for Simpson Bowles than investment advice).

Earlier today, El-Erian in the Financial Times released a short and apt note on the limits of the central bank put. It’s richly ironic that an aggressive promoter of unbridled capitalism, Ayn Rand acolyte Alan Greenspan, spawned the innovation that is the biggest market intervention of all time: the Greenspan put, which gave way to the Bernanke puts of the crisis and its aftermath, and have been emulated by apt students at the ECB, in the form of its Securities Markets Program, which has been tweaked, rebranded, and relaunched as the Outright Monetary Transactions, or OMT.

Yet as much as Rule Number One of investors is “don’t fight the Fed,” it’s hard not to notice that the effectiveness of central bank interventions is waning. Admittedly, the half life of pretty much any Eurocrat initiative seems to have collapsed, but even so, the initial celebration of the announcement of the OMT fizzled quickly. Similarly, after months of eager anticipation, the launch of QE3 produced a mere one day stock market rally, and key commodities and Treasuries gave up much of their initial move with surprising speed.

El-Erian warns that monetary authorities are deep into uncharted territory, and their efforts are a deliberate effort to divorce the prices of certain assets from their fundamental values. These are the key sections of his piece:

• The assets likely to be impacted the most and longest are those under the immediate influence of central bank measures – namely the securities they buy directly.

• The more investors venture beyond these assets (and the larger and more illiquid their risk positions), the greater their conviction that unconventional central bank policies will eventually succeed in engineering more robust economic and financial fundamentals…

• The longer this persists, the higher the risk that policy benefits will be offset by collateral damage and unintended consequences; and the greater the political heat on central banks.

• If the critical hand-off to fundamentals does not materialise, the reaction of markets will not be pleasant. Positioning on the basis of the “central banks’ put” is a particularly crowded trade. Also, it involves some investors being overconfident in the powerful omnipresence of these institutions, some believing in immaculate economic recoveries, and some feeling they can wait for markets to peak decisively and then exit smoothly.

El-Erian’s discussion of investor overconfidence is particularly important. While things could actually work out, the market feels a lot like early 2007 to me. While the consensus forecast range is admittedly a lot more sober, there still seems to be a discounting of tail risks, when those looked troubling large then and now. And El-Erian correctly highlights big investor faith that there will be ample liquidity when they need it, when after being burned in the crisis, they should know better.

Reader Scott sent this message, a full week before the El-Erian piece, on an obvious reason why, despite the Fed’s tender ministrations, we might not have a happy ending:

My sense is that QE Now and Forever, focusing on the MBS market, is designed not so much to send people out the risk curve, as it is to allow the big banks to replace those MBS with Treasuries on their balance sheets. There might be a twofold reason for that. First, to insure continued buyers of Treasury debt; that’s the Fed conducting fiscal policy through the backdoor. And perhaps more importantly, to get the banks stuffed with good collateral, so that when the proverbial stuff hits the fan again, they’ve got some cushions. The problem with Bowles Simpson, aside from all its other problems, is that corporate profitability is the flip side of the deficit, and will get crushed if there’s any serious attempt to rein in government spending.

The bigger takeaway may be that that one of the big channels by which all this central hocus pocus works is confidence boosting. And if not enough people clap, Tinkerbell, erm, the Confidence Fairy, really might die. But the longer it takes for the economy to reach liftoff, the more people will correctly question the efficacy of central bank intervention. In other words, while the central banks might really believe they have the ability to implement QE Now and Forever (Ambrose Evans-Pritchard points out Japan is on QE8), investor apostasy could prove to be more of a powerful offset than they anticipate.

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31 comments

  1. charles sereno

    Once I remarked that Bill Gross blows wind for his own sails, then I found out that he’s a big donor to Doctors Without Borders and needy students and I felt so sorry.
    “No news is good news.” For example, foreclosures are a thing of the past. So it will be with QE. Fairies at work.

  2. yoganmahew

    Well, reader Scott is kind of missing the point. The effectiveness of QE is precisely when CBs swap new bonds for old. Theoretically there is no gain as nominal prices are the same (the replacing asset and the replaced). Where the rear-end has fallen out of the junkier asset, though, by overpaying for it, the Fed reduces the monetary deflation effect by overpaying for the junk assets.

    Any other kind of QE is pointless.

    1. Yves Smith Post author

      The Fed is buying ONLY agency MBS, not subprime. So there is no buying of “junk assets”.

      1. john bougearel

        Scott’s observation appears to be spot on.

        But I do seem to recall that Greenspan once said the Fed could put swine on its balance sheet if it so desired. In more recent weeks, the Fed has explicitly stated that if the economy does not recover hard and fast enough, it is willing to purchase other asset classes beyond MBS. That could include asset classes of the “dreckier” sorts.

        1. craazyman

          I think Greenspan is right. It doesn’t matter how drecky the assets are. What matters is what the new money is, itself, spent on. The Fed balance sheet is purely imaginary money. It doesn’t have any real objective existence, it exists only as money-wave potential that hasn’t collapsed on an observation of property. As a wave it is infinite in inexhaustibility, like time, and physically formless, only possessing the form of a set of potential manifestations.

          If the cash they hand out is used to create what I call “sustainable structures of social cooperation” (i.e. supporting productive lending and imvestment) — then the newly created assets substitute for the failed assets the Fed buys.

          This is not a morally satisfying line of thinking, since it removes the implied financial punishment for poor investment decisions.

          The tension arises in whether a populace will tolerate the implied injustice. It is a contest between sloth and rage. If the newly created assets are productive and sustainable, it’s likely the populace will tolerate this.

          It can go on forever as long as the social structures remain stable. It’s weird to think of it like that. But it can. Will it? That depends on the nature of the social cooperation structures that arise. The money wave collapses on the observation of property and the waveform itself is guided by an intrinsic set of beliefs about the nature of justice in interpersonal interactions. It only blows up when the cooperation structures become widely perceived as “unjust”.

          This is what I’ve figured out while riding the bus staring out the window.

          1. tomk

            Aren’t you being too kind referring to “poor investment decisions” when it was often fraud, thus the “implied injustice” is actual injustice, but financial punishment is all we can realistically hope for, apparently. I love your phrase “sustainable structures of social cooperation”, which should be the prerequisite for the existence of any institution, but, should ain’t is. Stay on the bus, your synthesis of timeless wisdom and financial nuts and bolts is always a treat.

          2. craazyman

            They could call it “The Jekyll Island Diner”

            Didn’t the Big Ben once wait tables at a Mexican Restaurant? I think he could do it.

            booowahahahahahah.

            Jesus, I have to get some work done now. It’s 10:16 am.

          3. Susan the other

            I love your comments Craazy. “A contest between sloth and rage.” But clearly only an imaginary one. Because I was almost thinking the same thing: Investors want returns. Society wants returns. I’m not upset about QE3 at all when I think about it this way – The Fed tweaks interest rates to zirp infinity by exchanging liquid for illiquid (whether junk or not) and in the process creates virtual MMT providing we have good spending policies. And the Fed will do all this through the private banking system (which does need regulation). Here’s the question: how does a country demand good policy with a house full of austerity clowns?

          4. WorldisMorphing

            I think the double-slit experiment is messing with your mind… but tha’s OK — I understand, because it messed with mine too… ;) …plus it makes for an oddly poetic analogy of the “price discovery mechanism” or something like that…

        2. Sy Krass

          Correct, John. I Believe eventually the FED will be buying stocks, state treasuries, municipal bonds, everything. Why? Nothing can fail or the whole thing will fail (and it will fail anyway).

    2. Richard Kline

      On the subject of “a deliberate effort to divorce the prices of certain assets from their fundamental values,” prices diverged from fundamentals in the Bubble of the 1990s. Prices divorced from fundamentals in the Bubble of the 2000s. From the Panic Buy of 2008, prices at the market level have no intrinsic relation to fundamentals; that is, we are in in an asset ‘price command economy,’ where the government targets asset prices by inventing money to purchase said assets _completely OUT of relation_ to valuation of those assets.

      That’s not to say that prices at the retail level are unreal; fundamentals do have significant sway there. Nor necessarily are prices at the wholesale level incredible in their formation and movements. But market prices for asset classes as a whole walk on air, not on fundamental ground. And that is the real problem for the Fed and its co-demigods of money. The economy’s fundamentals have not cooperated, and will not cooperate, with invented prices, so those prices will go in wild directions most of them down anytime the Fed stops inventing money to maintain the unreality. I concur with reader Scott on that point.

      One has to see two actor classes in this drama: Feddies and Streeters. What isn’t understood, it seems to me, is that these groups have completely different agendas and preferred realities. Some of the Feddies may seriously think that they are ‘stimulating the economy’ or ‘saving the banking system’ or ‘backstopping employment.’ Whereas the Streeters don’t believe a syllable about that or care because their angle is _to game the Feddies out of the nation’s eyeteeth_. Y’all know, “smart guys making money off of dumb ones.” To the Streeters, it doesn’t matter if at the market level prices are bizarro, because money can be made on the motion. Fundamentals don’t matter as long as you know the rules and who sets them. And yes, the Streeters goal is to get as may Treasuries backed by full faith and credit onto their ledgers as possible, ideally by exchanging unreal assets for them, or better being given them outright as money gifts. The illusions of the marks who are the Feddies conform perfectly to, as invented and manipulated by, the Streeters’ extractive program.

      The real economy? That’s for voters and other schmucks, and left for dead like them. I have no idea what the precise endgame looks like, or when, but command economies run into real trouble when the material resources run short or out. The Feddies think fundamentals will rise to their designs before then. I don’t.

  3. Conscience of a Conservative

    The Fed’s focus on mortgages has been a huge boon to banks, much more so than borrowers and responsible for a disproportionate amount of the big four banks profitability and have served as a huge cushion to the other non-so profitable businesses the banks are in. It’s not just the ability to profit from mortage underwrititing or being the conduit by which the smaller originators funnel mortages into Fannie Mae but in the ever increasing spreads between where mortgages are originated and the price they are sold to Fannie(geeks may wish to look at the historical spread between mortgage rates, committment rates and tba’s).

    1. Cynthia

      Since the Fed is monetizing the mortgage market, why not just “originate” a mortgage for everyone? It doesn’t matter whether the mortgagee qualifies or has any income, since the Fed is simply monetizing every debt instrument in sight anyway.

      Needless to say, this whole QE thingy has taken on an air of insanity! This is going to go down as the largest bubble in history! Historians will fault us for not seeing it coming!

  4. vlade

    Fed & co fail to understand (or don’t want to show) that what we need to get out of this is at least wage inflation, at best real wage growth.

    That is NOT going to happen if companies sit on their piles of cash, which they will regardless of how many RBMSes Fed buys.

    Bringing down the mortgage rates is, at best, a temporary relief which in an environment of stagnating real wages and growing inflation of essentials (food, fuel) disappears pretty quickly (who cares that “holidays and travel” component of the RPI in the UK went down – of course it did when people can’t afford it, but if utilities, food and fuel (as a total) go up, even if RPI is unchanged the real impact on living standard is down).

    Central Banks have no way of forcing the companies to get off their piles of cash if they didn’t manage to do so by superlow rates so far. It’s an entirely fiscal problem.

    1. James Cole

      Sure they do–central banks could go and buy used cars, iphones, and houses from the actual citizens, and thereby give them the cash and the confidence to go spend the money on new cars, iphones and houses, at which point prosperity trickles up. It’s entirely a problem of aggregate demand.

      1. Ed

        Pretty sure they tried this with Cash for Clunkers. The problem is that buying everyone’s used iPhone is a tedious and inefficient process. And the spread between used price values and new price costs means that people would still have to go back into debt.

        I think a lot of the ‘aggregate demand’ isn’t ever coming back. How many stupid plastic bullshit things do people really need? If the fed offered to buy everyone’s old shit, people would simply horde the money like the banks are. They’d repair their balance sheets. 5 years of horrid economic conditions have trained people to learn to live simpler, less complex, cheaper lives.

        remember how your grandparents would repair everything and never throw anything away? A great depression will psychologically change attitudes. The thing that kickstarted aggregate demand after the depression was the baby boomers coming home. Large household formation, demographic shifts. That isn’t going to happen now. Families are smaller and people are moving back in with their parents. Couple that with lack of faith in the political process, and you have a recipe for stunted demand for a long time. Aggregate demand in Japan has been down despite gobs and gobs of money printed by its central bank.

      2. djrichard

        How about if we just have the Fed Reserve employ people? They could even sell bonds to sterilize the operation. If they run out of bonds to sell, they can print them up out of thin air, just like the money they print to employ people.

    2. Cynthia

      When the Federal Reserve purchases bonds and/or distressed assets, it does so to lower interest rates – to stimulate more lending and borrowing. As you know, our economy is fueled by debt. Over 70% of U.S. GDP derives from debt-based consumer spending.

      And so when the U.S. economy is in recession, the U.S. government and the Federal Reserve initiate policies that they hope will compel middle class Americans to borrow more money. And as more money is “printed”, speculative investing pushes the cost of such commodities as food and energy upward. This then is the squeeze on the middle class to which pundits and political mouthpieces refer: Stagnant wages + rising prices + increasing debt to service = a falling standard of living for the American middle class.

      But while both sides of the political aisle trade ideological barbs about who’s to blame for our disappearing middle class, no one appears willing to admit that the only honest solution to this ongoing crisis – a crisis in which private banks reap outrageous profits because our economy only grows when more credit and debt are contracted, and a crisis in which middle class purchasing power continues to slip away – is to have the government, not private institutions called banks, create the money.

      The bottom line is this: if we continue to live in a world in which banks create money through the extension of credit, the gap between rich and “not-rich” will continue to widen and the real wealth of middle class will continue to shrink.

  5. Cynthia

    QE3 is an exceedingly painful and pernicious thing, and by no means appropriate. Its intent is to inflate the banking problem away. The result is that the people that lived within their means are punished, whereas those that did not are rewarded. Risk taking is rewarded, responsibility is punished.

    Further, those that are punished most harshly are the poor and middle class. These are the people that can least afford inflation. My personal cost of living, namely food, clothing, and utilities, is up $12,000 in the past 5 years. That represents a major portion of my income. To the rich, not so much.

  6. BrettMankey

    I think the true intention is to try to prop up the otherwise insolvent TBTF. Check out this amicus brief in the GMAC bankruptcy here: http://mattweidnerlaw.com/blog/wp-content/uploads/2012/10/gmacbankruptcyamicusbrief.pdf. The actual market value of GMAC delinquent firsts is $0.14 on the dollar(see pages 18-20 for discussion). As we already know, if forced to mark to market their 2nds instead of holding them at $0.80 on the dollar as they are now, the TBTF and and the remainder of the top ten are toast(particularly when considered in conjunction with the true market value of delinquent firsts). The plan is to try to replace this dreck at 100 cents on the dollar with Treasurys via the Fed balance sheet under the guise of boosting employment. If more of the general populace become aware of this plan, the Fed will most likely be forced to curtail these efforts. Thus, they are making hay while the sun is still shining…I think that mark to market in conjunction with the reestablishment of the rule of law for all will go a long way to restoring confidence and the American economy. Otherwise we will continue with what appears to in the biggest banana republic since United Fruit, John Foster Dulles et. al. in the 1950s.

  7. sierra7

    Brett Mankey:
    “….I think that mark to market in conjunction with the reestablishment of the rule of law for all will go a long way to restoring confidence and the American economy. Otherwise we will continue with what appears to in the biggest banana republic since United Fruit, John Foster Dulles et. al. in the 1950s.”

    The core of our present mess…a derivative (no pun intended; or maybe yes)of the change in MtoM back in 2009. The “market” likes to consider “itself” immune to any “outside” influences but embraces wholeheartedly intervention to save it’s AS$$$!

    We are the “muppets”….the forgotten citizens who are getting crushed by the Fed’s ZIRP policies; we are the ones who are not discussed very much in these posts…..

    Cynthia:
    “….Further, those that are punished most harshly are the poor and middle class. These are the people that can least afford inflation. My personal cost of living, namely food, clothing, and utilities, is up $12,000 in the past 5 years. That represents a major portion of my income. To the rich, not so much.”

    ED:
    “….I think a lot of the ‘aggregate demand’ isn’t ever coming back. How many stupid plastic bullshit things do people really need? If the fed offered to buy everyone’s old shit, people would simply horde the money like the banks are. They’d repair their balance sheets. 5 years of horrid economic conditions have trained people to learn to live simpler, less complex, cheaper lives.”

    Again, we as the “muppets” in our society can only buy so much “bull-shit” items so eloquently stated by “Ed”….

    And, that folks is the nut to crack….

    How to bet the ordinary “muppet” to re-purchase more BS items when his/her wages and jobs have been utterly crushed, they live in a country with a “bowl of stupid” for education on our economic system and how it operates and have been taken advantage on the whole by a bunch of greedy, economicall inept, intellectually stupid financial class that depende most wholey on mathematical (re: Quants) structures to predict social actions……any fool would see that that is utterly impossible even with numbers quantitated to infinity……

    The anwer is painful to the “monied classes”:
    De-leverage; De-leverage; De-leverage.
    Period.

    1. Cynthia

      The Fed buying these mortgages will have the effect of closing out $400 billion a month of derivatives. That is why they won’t get the inflation they desire. The fed actions are actually reducing leverage in the system.

      If they really wanted inflation they should buy these MBS and turn around and refinance every one of them with the actual homeowner. A few hundred dollars a month in the pockets of most Americans would go immediately back into the economy. Investor money would have nowhere to turn except investing in more productive endeavors.

    2. different clue

      Sierra 7,
      Your comment inspires me to go to Steve In Virginia’s most recent blogpost on his Economic Undertow blog and cutpaste this paragraph:

      “Thrift is a form of class warfare against the wealthy … who borrow their fortunes and thereby require circulating money to flow to them so that their stupendous debts might be serviced: the non-wealthy are the support for the tycoons. By saving, the non-wealthy deny the tycoons funds, the tycoons are ruined by their own creditors, the creditors are likewise ruined.”

      Now . . . Steve In Virginia could be called a “Deep Doomer”. Here is the link to his most recent post for those who want the flavor . . http://www.economic-undertow.com/2012/10/08/mother-of-all-free-lunches/
      If he is correct on the point of the paragraph I offered, then what if millions of non-rich people were to read his post and especially that paragraph, internalize its meaning, thrill to the hope it offers, lernnit livvit luvvit, welcome it into their hearts, and figure out how to weaponise it in practice? What if millions of not-yet-disemployed people could understand “thrift” and target it in a focused way against the OverClass? What if they could “exterminate” the OverClass’s revenue streams into functional extinction?

      ” I have a dream. I dream of 50 million pairs of strong blue hands wrapped around the neck of PIMCO, crushing PIMCO’s revenue stream windpipe all the way flat. I have a dream today . . . “

  8. Hugh

    As far as I can see, the mission of our elites (in the White House, the Congress, the Treasury, and the Fed) has always been to arrange conditions so banks can eventually become solvent again.

    QE3 is a triple win for banks. Banks get to swap illiquid, overpriced MBS with considerable risk of further value loss at par for highly liquid cash. This supports the inflated pricing of these securities. And they can then take that cash, go out, and gamble/blow asset and commodity bubbles with it. The asset bubbles are air, that is the buyers and sellers are mostly the same whereas the commodity bubbles are real. The sellers are the banks and the buyers are the rest of us who need food to eat and gas for transportation.

  9. bc

    I still prefer the Ponzi analogy. Retirement funds are predicated on 8% annualized gains, municipal government budgets are predicated on similar job growth projections and revenue increases. The naive expectation of continued generous passive income from assets residing in the various ponzi’s (insurers, bond funds, equity funds, etc.) permeates our society. The CB’s are the last bastion of hope for all of us Ponzi investors of the world. Paying the required cash flows out to maintain the illusion that our collective saved capital is in fact “there”, backed by money good collateral is becoming the exclusive province of our central banks. Now even their credibility is fading fast.

  10. different clue

    Here is a tiny article about Forest Gardening/Farming that permaculturists might like. It comes from the Energy Bulletin website. It is called “Goodbye Columbus”.
    http://energybulletin.net/stories/2012-10-11/goodbye-columbus

    Perhaps it points to something that could be shrunken down to the level of suburban yards and neighborhoods? Perhaps it points to something that could also be weaponised and disseminationized to aid in drying up revenue streams to the OverClass.

  11. Fiver

    Yves,

    According to the piece linked below, 1 in 6 FHA-insured loans is delinquent, and large US banks hold roughly $60 billion in look-to-default loans:

    http://www.doctorhousingbubble.com/fha-new-subprime-30x-leverage-fha-insured-loans-bailout/

    While the QE announced means far more money than this again gifted to banks and Wall Street (including PIMCO)I wouldn’t discount the notion that the Fed intends to provide its own “insurance” on the risk associated with these duds as part of this round of offical racketeering.

    While there is obviously a political argument in favour of the Government supporting 100% of 1st to (maybe bottom half of) 4th quintile mortgages, along with all manner of public goods based on sound, reasonable, reality-based projections, the sort of bail-and-subsidize-to-loot approach seen here is fraught – and then some.

    With or without any further Fed “help” the simple fact is that for a large and growing majority of the American people, the value of their work as translated into a life-style basket of goods and services, will inexorably fall. The choice is whether to allow most of the people to be tossed for good into this vicious globalized corporate meatgrinder ordered on the basis of what is good from a short-term, purely mercenary/power perspective, or opt for a different, less consumptive but enormously more just and sustainable future based on maximum respect for clear planetary limits to growth.

    That said, the Fed’s efforts to extend and deepen indebtedness is entirely counter-productive in that it papers over what is not at bottom a financial problem, but an existential economic/ecological verity:

    1) It is quite simply impossible for us to increase or even maintain this level of consumption indefinitely, all techno-fairy tales aside.

    2) Debt is precisely the commitment to create at least “x” value via future activity. That future value becomes ever-more-difficult for most individuals to create as their capability fails to increase at the rate of technological change, i.e., his/her “best” no longer suffices. But even more importantly, that activity utilizes various resources, most of which cannot be replaced and cannot even be produced without wreaking unacceptable damage on the planet.

    3) The further into the future that debt extends, in 2012 as opposed to 1912, the greater the probability of a titanic rupture between physical, economic reality and what our Keepers insist their Numbers signify.

    QE3 was largely “priced in”, as in assets had already received their boost before the long-expected announcement. Now, after Obama is re-elected with a comfortable cushion – 5% in the popular vote and a crusher in the Electoral College – not only will there be no “fiscal cliff”, as Reps instantly become much more “responsive”, there will be a substantial amount of fiscal stimulus coming down the pike.

    The problem is what we see ever single day – an open-ended series of crises all of which are rooted in the very corporate globalization US policy now prohibits anyone from exiting via financial thuggery or overt war. Does anyone really suppose such a system will remake itself rather than smash headlong into the wall?

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