Friday, January 9, 2009

Ponzi meets treasuries bubble

Well, Goldman aside, talk of a bubble in US treasuries is gaining pace.

To wit, the latest missive from Bill Gross, managing director of Pimco, the world’s biggest bonds fund. In his investment outlook, Gross accuses everything from Option ARMs to hedge funds to American states to the entire US social security system of being Ponzi schemes. For example:

Municipalities with begging bowls now extended for over a trillion of Federal taxpayer dollars, based their budgets and their own handouts on the perpetual rise in home prices, the inevitable upward slope of sales taxes, and the never-ending increase in employment and personal income taxes. To add injury to insult, they conveniently “balanced” their books with a host of accounting tricks that Bernie Madoff could never have come up with in his wildest imagination. Now, with cash flow insufficient to meet current outflows, they are proving my point that we have met Mr. Ponzi and he is us - all of us: auto companies that siphoned sales dollars to make labor peace instead of research and design expenditures; hedge funds that preposterously billed investors for 2% and 20% of nothing; a President and politicians who thought they could fight a phony war for free and distract the nation’s attention from $40 trillion of future social security and health care liabilities. Ponzi, Ponzi, Ponzi.

And here’s where Ponzi meets treasuries, according to Gross:

There is legitimate concern as to the ultimate destination and outcome of our “bailout nation.” Realistically, quantitative easing, a two-trillion-dollar expansion of the Fed’s balance sheet, and the near certainty of future budget deficits approaching 6-7% of GDP should alert bond investors to once again become vigilant as was the case in the 1980s and 90s. Vigilantes we should be, but that is a battle to be fought in the Treasury market where low yields offer little reward and increasing risk.
Indeed, the latest numbers from the Congressional Budget Office (released on Wednesday) suggest a deficit of $1186bn in fiscal-year 2009 and $703bn in 2010. Bank of America analysts are guessing the US’s financing need will be much larger — more like $2140bn for 2009 and $1018bn for 2010. That would mean a lot more treasury issuance, especially this year (see charts from Bank of America below).

Bank of America - US deficit and issuance

In sum — as Bank of America’s Michael Cloherty notes:

… supply continues to increase dramatically at the same time that trading volume has declined sharply.

Hence the talk of a bubble in treasuries, which, as Gross mentions in his letter, are an increasingly risky asset given America’s ballooning deficit and potentially rampant inflation brought about by quantitative easing. In particular, yields on US debt, currently at record lows, suggest that no one is yet really worried about inflation (which erodes the value of their fixed payments and tends to bring down their price). According to Gross:
2½% real yields cannot possibly be maintained unless deflation as opposed to inflation becomes the odds-on favorite. What bond investors know as “breakeven inflation rates” are currently signaling a future where the U.S. CPI averages -1% for the next 10 years. Possible, but not likely.

That would make inflation-linked Tips a good buy, he says. And, despite all the above, Gross is still aligning himself with the US government. But that’s probably unsurprising given just how much the bond manager has benefitted from the US government’s various bailouts — including, but not limited to, the rescue of AIG and its purchase of GSE MBS. His advice, which seems to us much more easily said than done — especially by Pimco:

PIMCO’s view is simple: shake hands with the government; make them your partner by acknowledging that their checkbook represents the largest and most potent source of buying power in 2009 and beyond. Anticipate, then buy what they buy, only do it first: agency-backed mortgages, bank preferred stocks, and senior bank debt; Aaa asset-backed securities such as credit card, student loan, and auto receivables.

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