The Curious Case of Messrs Gross and Fink

The story so far ..

The Fed has so far purchased $ 2.5 trillion in assets since December 2008 and its balancesheet continues to rapidly balloon in size as, in the third round of bond purchases under the quantitative-easing stimulus strategy, it continues its $ 85 billion monthly purchase of Treasuries and Mortgage-backed bonds. The Fed isnt acting in isolation. Policy makers around the world (including the Fed) have pumped in more than $ 6 trillion into the global economy through asset purchases, increasing their balance sheet assets to $ 14.09 trillion as of June 2012. This is up from $ 4.99 trillion in May 2006!

These asset purchases were largely driven by the Fed’s policies. All policy moves by the Fed so far, ZIRP, QE1, QE2, Operation Twist and ‘Infinite’ QE3, were aimed at stimulating  a sluggish economy.  In the initial phases, fears were rife that the first two rounds of Quantitative Easing were nothing but the Fed trying to ‘monetize its debt’ (Central banks in most developed nations,  like UK, US and Japan for instance, are forbidden by law to buy government debt directly from the government and must instead buy it from the secondary market. Thus a two-step process, where the government sells bonds to private entities which the central bank then buys).  Bernanke has been earnest in his appeals however that the easing was to stimulate the economy and not to finance government spending (and I guess, we will have to take his word for that!).

...Operation Twist

This was followed by Operation Twist - A attempt to flatten the yield curve by selling short term debt and using the proceeds to finance the purchase of longer dated treasuries. While this may be just what the doctor ordered to keeping the balance sheet from ballooning any further, Operation Twist has a severe limitation. To finance the purchase of longer dated securities you need to have an inventory of short dated securities to sell. Unfortunately, the Fed will soon run out of short term bonds to sell. What then?  What do you do when you no longer have 0-3 year bonds to sell? Simple, you start selling the longer dated bonds from your portfolio. The Fed had until now indicated that the plan was to keep the Federal Funds rate at the zero range atleast until mid 2015. Its very likely that the ZIRP will be further extended in time.

The objective of ‘unlimited’ QE3 (While continuing its purchase of $ 40 billion per month of MBS, the Fed will also buy $ 45 billion of Treasury Debt every month; The second part of the plan replaces Operation Twist) was to put downward pressure on long-term interest rates. Much like the two phases of easing announced earlier. On September 7, 2012, the Friday before QE3 was announced, the yield on the 10-year Treasuries was 1.67%. On September 14, the day after the QE3 announcement, it had surged up to 1.88%. This was not the desired effect and it is possible that this may have been due to investors flocking to riskier assets like equities and high yield debt from treasuries.  

Bernanke may rest easy in the fact that the 10 year yield averaged 1.79 percent in 2012. The average in 2011 was 2.77 per cent!The average yield registered in 2012 is still significantly greater than the record low of 1.379 percent on July 25, 2012 at the height of Europe’s sovereign debt crisis.

By late 2012, unprecedented stimulus by the ECB had tempered the sovereign crisis in Europe and curtailed the demand for safe haven assets like Gold and Treasuries.  10 year yields seem to have plateaued at sub-2 levels, so is there really a case for purchasing treasuries at the moment?

.. and onto Messrs Gross and Fink

That brings us to the two gentlemen in the subject of this post. One of them is pugnaciously long on treasuries. Bill Gross, who runs the world’s largest bond fund, raised the percentage of Treasuries held in his flagship Total Return Fund to 26 per cent in December 2012, up from 23 per cent of assets in November. MBS still remains the flagship fund’s largest holding, though its proportion has reduced to 42 percent from 44 percent since October 2011. Gross has stated that he would steer clear from longer-dated treasuries as inflationary effects of the Fed’s massive scale of Quantitative Easing will be felt many years later. PIMCO, with $1.92 trillion in assets under management, is primarily a fixed income manager. So this is one really monstrous bet on treasuries by Gross, who co-founded the firm in 1971 (Gross incidentally is one of the rare few fixed income managers to have got in, more than thirty years ago,  on the ground floor of this spectacular bond rally). But even best laid plans can sometimes go wrong.

Gross had apologized to his investors in 2011 after, earlier in that year, he had sold all his treasury holdings.  Yep. He had reduced his holdings in treasuries to zero by March 2011! Why? It was because he believed then that the Fed would stop buying bonds at the end of June 2011 as its QE2 program wound down. Gross watched his worst nightmare come true as the Fed announced a continuation of its quantitative easing program. A few months later, an extraordinary tail risk emerged, sending shock-waves across the world. The US had lost its prized AAA rating! However, amidst the shock-and-awe, the world didnt end as we thought it would and far from triggering an exodus from Treasuries, investors piled into US Treasuries. As equity markets worldwide crumbled, the US treasuries were perceived as the ultimate safe haven by stunned investors seeking refuge from wealth destruction and increased volatility. Yields tumbled swiftly and Gross was left to rue his short treasury postion. With an approach that can best be categorized as extreme risk-averseness, will things turn out differently for him this time around?

The answer to that question may well lie in the world of extreme risk. In February 2012, Larry Fink, the CEO of BlackRock, made a statement that sounded ludicrous then. He said ‘investors should have 100 percent of investments in equities because of valuations and higher returns than bonds’.

(c) Avinash Menon