Tuesday, June 21, 2011

Monetary Psy-Ops With a "Twist"

Bill Gross just loves to manufacture heavily publicized comments about the U.S. Treasury market every now and again. At first glance, they may even come off as his deeply personal opinions about Treasury bonds and the future of U.S. fiscal and monetary policy. Take more than a glance, though, and it becomes easy to see that men like that, in such lofty positions of financial power, never make any "public statements" very lightly. In fact, they are usually calculated to several decimal places in a room full of financial vultures, political hawks and public relations wizards before they ever see the light of day.

That was the subject of a piece I wrote about two months ago, found here at TAE, which argued that Pimco's net short position on Treasuries in its flagship fund was very little more than a magician performing a misleading sleight of hand on stage. It was certainly not an unconditional bet against the U.S. Treasury market, the Fed and the entire debt-dollar system of corollary bonds and derivative instruments, as some had began to claim when the position was made public. It is very well known that Gross has an all-access VIP pass to the Fed's monetary nightclub, but that level of inside connect is exactly why we should be skeptical of his public actions or statements.

[Bill Gross, Master of Monetary Psy-Ops]: "Now, the TRF is net short treasuries and many people are convinced that its short position is, in fact, nothing short of a prediction by Gross that the treasury market will soon collapse. Indeed, he seems to be at least betting that rates will increase significantly in the short-term. Perhaps that is true or perhaps he is making a bad bet, but perhaps we should also be wary of such plainly advertised convictions. After all, the insider "beltway" encompassing Wall Street and Washington has two lanes running in both directions.

...An unexpected end to QE operations will send the dollar soaring, and as mentioned before, all asset markets plunging except for the U.S. treasury market. Bill Gross may have dumped all of his treasury exposure for now, but has any other major financial institution or money manager followed suit? Has the Fed announced any plans to sell its treasury holdings back into the primary or secondary markets?

I suspect that, by that time [when the rush to Treasuries as a "safe haven" really gets underway], there would have been a significant reversal in the treasury holdings of TRF and the superficial justifications for the investment decisions of the omniscient Bill Gross. Perhaps he will continue to have minimal exposure to U.S. treasuries throughout the year, as a partial hedge to his fund's enormous cash holdings, but that certainly should not be taken as an absolute bet against the treasury market."

The record cash holdings were obviously a bet on dollar-based deflationary pressures, and the value of the entire Treasury curve really doesn't have that much distance from the value of the dollar. Indeed, it didn't take very long before Gross made another statement to lay the foundation for justifying such a reversal in his fund's position on Treasuries:

Gross: “Treasury yields are currently yielding substantially less than historical averages when compared with inflation. Perhaps the only justification for a further rally would be weak economic growth or a future recession that substantially lowered inflation and inflationary expectations.[Bill Gross: Only a Recession Will Change Short Bets on Treasuries].

You mean the type of weak economic growth and low inflation evidenced by significantly declining or decelerating home prices, consumer spending, retail sales, consumer/business confidence, manufacturing strength and PPI/CPI levels, Mr. Gross? Well, I know the man doesn't need me to tell him this, but that kind of "justification for a further rally" is quite easy to stumble upon these days, and it turns out we already have. Add in the entirely predictable worsening sovereign debt situation across Europe, and a Treasury rally becomes all but inevitable. Perhaps its time for those short bets to change?

Of course, no self-respecting financial shark would just give up the guaranteed extra value he could gain from buying bonds at even lower prices, so Gross may have to stretch out the role of "bad cop" for a bit longer:

[Bill Gross, Master of Monetary Psy-Ops]: "(Gross is) The bad cop who beats the suspect over the head and tells him he has one last minute to confess before the entire case is blown wide open, followed by the good cop [UST/Fed] who enters the room and promises they will go easy on the suspect and recommend leniency to the judge, as long as he just tells them where all the money is hidden. Once again, it is not about enforcing the law or finding justice, it's only about using deception to drive all of that money out of its hole and into their hands."

Recently, Gross has made another stir about how further QE operations by the Fed may come in the form of "interest rate caps" on 2-3 year Treasury notes.  []. The comment came over Twitter as a "tweet", so I guess we can be certain that it was strictly intended as his informal and personal opinion about monetary policy. Zero Hedge commented that this tweet was "troubling" because it also seemed to back up what David Rosenberg had predicted earlier, when he wrote that the Fed may engage in "Operation Twist 2". The initial "Operation Twist" occurred in the 1960s when the Fed began buying the long-bond and selling the short-bond to flatten the rate curve. [].

This time around, Rosenberg believes that it may only start buying up 10-year Treasury bonds on the open market to clear them at a targeted interest rate, instead of targeting a specific increase on it's balance sheet like it did with QE2. Therefore, the amount monetized (and added to the Fed's balance sheet) would ultimately depend on how much supply was being issued by the UST and how much demand existed for that supply from other investors. Rosenberg surmises that the potential upside for the Fed in capping long-term rates would greatly exceed the downside, "since just about everything that has to do with the economy is either directly or indirectly priced off the 10-year part of the curve" (such as variable mortgage rates).

There are a lot of valid points made in Rosenberg's "OT2" analysis, and I would be the first to support the argument that the Fed is focused on maintaining the integrity of the Treasury market above all else (especially the long-end). At the same time, it's hard not to notice the fact that so many people are talking about QE3 and it's arrival on the monetary scene any day now, in whatever form it may happen to take. Perhaps these people are actually over-estimating the need for the Fed to intervene this year, as deflationary pressures set in and natural investment in "safe haven" Treasuries starts to pick up some major steam.

Does it really make sense for the Fed to risk the potential downsides of a balance sheet ex(im)plosion at this stage of the financial crisis, when equity and commodity markets have barely lost any value back from QE2? That question brings us back to Bill Gross, who has also recently stated that the banks do not have excess capital waiting to buy Treasury bonds when QE2 ends, in another example of his righteous and very public indignation with the bond market. Just as a reminder, though, we are talking about THE bond market that has kept Pimco, Gross and El-Erian filthy rich for many years now.

[Bill Gross, Master of Monetary Psy-Ops]: "Besides, did anyone really think that the world's biggest bond fund was about to unconditionally give up on the world's biggest bond market (which just so happens to support every other U.S. bond market, and foreign ones as well)? Personally, I think Bill Gross is going to continue doing what he does best - speaking in half-truths and pretending like he cares about day-to-day developments in the U.S. fiscal situation, while carting his millions in compensation to undisclosed personal bank accounts around the world. That is one financial shark who cannot survive outside of the deep waters, and his next feast of flesh will be no less filling than the last."

Zero Hedge reported on June 12, after conducting a solid analysis of bank reserves data, that almost the entirety of QE2 funds to date (~$600B) has gone to European Banks, and concluded that this revelation provided support for Gross' contention that the funds would not be available for re-investment in Treasury bonds. Here is a simple graph indicating strong evidence of the Fed-European transfer and the relevant quote from the ZH report (emphasis mine):

Tyler Durden: "Recall that Bill Gross has long been asking where the cash to purchase bonds come the end of QE 2 would come from. Well, the punditry, in its parroting groupthink stupidity (validated by precisely zero actual research), immediately set forth the thesis that there is no problem: after all banks would simply reverse the process of reserve expansion and use the $750 billion in Cash that will be accumulated by the end of QE 2 on June 30 to purchase US Treasurys. 


The above data destroys this thesis completely: since the bulk of the reserve induced bank cash has long since departed US shores and is now being used to ratably fill European bank balance sheet voids, and since US banks have benefited precisely not at all from any of the reserves generated by QE 2, there is exactly zero dry powder for the US Primary Dealers to purchase Treasurys starting July 1."

From my point of view, that conclusion makes no sense whatsoever, unless we assume that European-owned banks listed as Primary Dealers for the Fed are no longer allowed to show up at Treasury auctions. The Treasury bills and notes purchased with U.S. dollars could essentially perform the same "re-capitalization" function as the cash itself (theoretically, of course). There is really no credible reason to think that at least some of that cash won't find its way back into the Treasury market in the near future. Of course, that train of thought does not sit well with those consistently trumpeting the imminent collapse of the Treasury and USD markets, which happens to be something ZH is quite fond of doing.

Which also may be why it continues to take Bill Gross' tweets at face value, and expects more details of "Operation Twist 2" on the short-end to be revealed quite soon (perhaps when the FOMC minutes of its June 22 meeting are released). []. I still suspect that we are not going to hear anything about further monetization in the next few months, at least not from the Fed itself. A few bold statements from Gross and the speculative rumors that naturally accompany such statements should do the trick just fine. Indeed, what better way is there to support a naturally forming Treasury market rally without opening yourself up to the political and/or financial risks of actual monetization?

The latest Treasury International Capital (TIC) report shows that net inflows into Treasuries increased for the month of April, mainly due to foreign government purchases. So when can we expect all of those "private accounts" to get with the program?

"Outside of equities, official accounts, which include foreign central banks, were the biggest buyers in the month with net inflow into Treasuries of $24.4 billion vs a net outflow from private accounts of $1.0 billion.  

A look at Treasury holdings by nations shows a $7.6 billion rise in mainland China, which is also a positive, to $1.15 trillion and a small decline in Japan to $906.9 billion. UK-based accounts, which are the third largest holders of US Treasuries, shows a $7.8 billion increase to $333.0 billion."

Well, with the rapidly progressing financial troubles of Europe and Japan, I suspect it will not be very long from now. In the meantime, as discussed in Bailing Out the Thimble with the Titanic, the Fed can continue to exert some influence over longer-term rates by selling insurance (IR swaps) on Treasury bonds through primary dealer banks, without any explicit monetization or anyone being the wiser (major investors). Eventually, the time will come when some form of QE3 is necessary, but that time will likely be sometime next year after asset prices have come down significantly. As for Gross, well, I still expect that financial shark to be well-positioned for the long-bond rally when it occurs, and in no small part because of his immensely public fear-mongering tactics.

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