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.