Bill Gross’s latest diagnosis is that the market’s beating heart is being starved of oxygen as the course of QE and zero interest rates medication central bankers have prescribed is not working.
The beating heart he talks of is the ‘carry’ - or return over and above the fixed yield on an economy’s policy rate – which makes up our financial markets and ultimately our real economy, says PIMCO's bond star and manager of the $280 billion PIMCO Total Return bond fund.
Without the assumption of 'carry', he says, then investors would be unwilling to risk financial capital and a capitalistic economy would die for lack of oxygen and that is exactly what is happening in today’s market with central bankers' check writing.
‘There comes a point when no matter how much blood is being pumped through the system as it is now, with zero-based policy rates and global quantitative easing programs, that the blood itself may become anemic, oxygen-starved, or even leukemic, with white blood cells destroying more productive red cell counterparts.’
‘Our global financial system at the zero-bound is beginning to resemble a leukemia patient with New Age chemotherapy, desperately attempting to cure an economy that requires structural as opposed to monetary solutions. Let me shift from the metaphorical to the specific to make my case.’
‘If “carry” is the oxygen that feeds financial assets then it is clear to all – even to central banks with historical models – that there is a lot less of it now than there used to be.’
Before 2009, the US had never had a policy rate so low, and in the UK short-term rates at 50 basis points are now nearly 2% lower than they have ever been, says Gross.
‘Never (as I tweeted recently) have investors reached so high in price for so low a return. Never have investors stooped so low for so much risk.’
Central banks seem to believe that higher and higher asset prices produced necessarily by more and more QE check writing will inevitably stimulate real economic growth via the spillover wealth effect into consumption and real investment.
‘That theory requires challenge if only because it doesn’t seem to be working very well.‘
‘Why it might not be working is fairly clear at least to your author. Once yields, risk spreads, volatility or liquidity premiums get so low, there is less and less incentive to take risk.’
Five reasons why QE is failing
1. Zero-bound yields deprive savers of their ability to generate income which in turn limits consumption and economic growth.
2. Reduced carry via duration extension or spread actually destroys business models and real economic growth. If banks, insurance and investment management companies can no longer generate sufficient “carry” to support employment infrastructures, then personnel layoffs quickly follow.
3. Zombie corporations are allowed to survive. Reminiscent of the zero-bound carry-less Japanese economy over the past few decades, low interest rates, compressed risk spreads, historically low volatility and ultra-liquidity allow marginal corporations to keep on living.
4. When ROIs or carry in the real economy are too low, corporations resort to financial engineering as opposed to R&D and productive investment. […] Look at it this way: Apple has hundreds of billions of cash that is not being invested in future production, but returned via dividends and stock buybacks. Low ROIs fostered by central bank policies in financial markets seem to have increasingly negative influences on investment and real growth.
5. Credit expansion in the private economy is restricted by an expanding Fed balance sheet and the limits on Treasury “repo.” I have previously suggested that the Fed (and other central banks) are where bad bonds go to die. Low yielding Treasuries fit that description and once there, they expire, being no longer available for credit expansion in the private economy.
In his conclusion Gross said that in addition to a fiscally confused Washington, central bankers policies may be having the opposite desired effect.
'Perhaps the beating heart is pumping anemic, even destructively leukemic blood through the system. Perhaps zero-bound interest rates and quantitative easing programs are becoming as much of the problem as the solution.'
To read the full version of Bill Gross's latest Investment Outlook click here.