Thursday, September 8, 2011

Wonky: Bill Gross on QE is credit destruction

This piece is so wonky, I actually needed a full day to wrap my head around the concepts and only after a long discussion (more listening then talking) with someone who knows a lot more about the term structure of credit (as in is a professional) did I finally reach some sort of synthesis.

The piece is by Bill Gross, the head of Pimco, one of the largest buyers of credit and bonds out there. You can find the piece here. There are too many money shots but if I had to boil it down the claims are

1- QE flattens the yield curve and that is bad for investors
2- by removing the transformation of maturity premium, banks have little to no incentive to lend
3- Liquidity by the FED results in less liquidity by the banks because the banks lower their leverage.
4- what is supposed to stop a minsky negative dynamic in fact exacerbates it. By killing broader liquidity while expanding base liquidity.

Let me try and address the points in order see if I can steady my thoughts on these points.

On 1. It is clear that QE flattens the yield curve. That is the whole point. By using QE the FED effectively targets a very low interest rate in the broad economy to stimulate it. This is the intended and stated target. The conflict between offer wanting a higher rate of return in times of crisis and demand wanting lower is partly settled in the markets but mostly influenced by the FED cost of money to member banks which is now close to zero. This is a spread point, not a curve point.

Obviously the offer (capital holders) do not like this situation. In fact for the same or increased risk (there is recession, there will be default) you get less compensation so it goes counter to the mathematical logic of the buy side on bonds. Clearly Gross is talking up his book here and has already issued public calls "to boycott expensive bonds". As a personal aside I do relate to this having largely shunned the muni market for these very reasons. The risk/return doesn't look right to me (and I am pretty low in terms of risk profile). So the net-net is I pursue options strategies in broad equity markets.

And again, herein is also another justification of QE: to smoke investors out of cash and bonds and into risk asset. The flight to safety is really a risk tilting towards cash (cash preference) as opposed to bond/equities. The buy side of bonds may not like it but that is the point. So yeah investors don't like it but there it is.

So the primitive conclusion is that there is less offer on the buy side. Liquidity in the market because private investors don't like the risk profile. First paradox is "more liquidity by the FED imposes LESS liquidity by the private sector" a 'crowding out' argument as it were on the yield.

1'/ I am not sure the crowding out argument is valid. True I have moved up the risk profile, effectively being smoked out of my cash hole, but because that position in the market has been flooded with cheap FED money. The market is akin to electron orbitals around a nucleus: the lower orbits (more stable) get filled first and the 'bathtub" gets filled as all lower positions get filled. In other words, the effective rate in the market is still a MARKET rate and so the market has CLEARED it is not like there is no liquidity there. THERE IS CHEAP CASH, JUST NOT MINE OR PIMCOs. True the money that is sitting there is bank money sitting on top of high powered FED money and not private money but liquidity is still there by definition of a market clearance at that rate. In other words TOTAL liquidity has increased, at least in theory.

2/ but not so fast says Bill Gross, that is not the whole story. We have focuses on yield, you also need to focus on the yield CURVE. Banking theory tells you that maturity transformation by the banking system (what Gross alludes to in the beginning) is its raison d'etre. Essentially banks borrow short term (overnight) and lend long term to an econ that wants longer maturities to plan, the 8year 'compromise' bill alludes to in the beginning. Maturity transformation IS THE MAIN FUNCTION performed by the banking sector. Banks lever up and multiply the credit in the economy. So the first point is that banks will make less profit because the yield curve is flattened. In fact they would rather shorten their maturity since it doesn't pay more to go long and take more risk. This Bill says means there is less offer on longer maturities. I understand the point, which is essentially the same point as above (but around maturities, the slope of the curve as opposed to just the absolute return). The corrolary , that banks would lend less, seems iffy by the same clearing logic used in yield. Yeah you need to move out but the MARKET CLEARS. Again, I have this cash, it doesn't pay as well as before but what am I to do? sit on it? no, I lend it and take the return it gives me, again the bathtub will fill in order and markets will clear. I just make less because the whole "energy level" as it were has been lowered by QE: again the stated goal of QE for obvious macro economic reasons of stimulus and avoiding death spirals. So jumping to the conclusion that banks don't lend seems specious. They don't lend for other reasons, a prevalent view is that we may be witnessing depressed demand by the larger corporations who don't see the need to invest and that the smaller concerns are just not addressed by the banks because they shun that risk. This is orthogonal to the base levels of corporate bonds.

3/ Ah but that is STILL not the full story says Bill. The LEVERAGE in the banking system will also go down. I really have a tough time understanding that one. Basically it says that banks lower their leverage because the returns are so low. It seems counter intuitive on the surface of things. In case there is little return people in fact tend to lever to multiply their return on capital. That is the whole point of leverage. It seems that leverage would in fact be need in order to maintain profit levels at the banks. If not it says MMT will effectively screw the profit levels at the banks in direct contradiction with most MMT tenents that profits come out of investments. In fact the person I was talking to works for a bank in exactly these products and says that argument doesn't hold water on the surface of things, I must admit to not having followed that logic at this point.

4/ The link to minsky is tenuous by now but goes as such: if there less leverage we are cyclically contributing to the decrease of liquidity in the system. There is less debt available. In other words, if you have followed the logic so far the claim is a flat yield curve gives you this paradoxical result: MORE liquidity results in LESS liquidity (FED liquidity UP-> banks leverage DOWN-> econ in minsky/fisher spiral) THERE IS NO HELICOPTER. Because the banks reduce the liquidity as the FED increases its liquidity because QE flattens the yield curve.

That paradoxical result is very interesting

1- Gross may be simply talking his book and maybe full of it when he says "and banks, poor banks, lower their leverage".
2- in case he is not full of it, it may be an explanation of why more FED lending lowers bank lending. The usual arguments or "banks don't lend, econ doesn't borrow, pushing on a string etc" may in fact find some justification in the arcane logic of modern monetary theory.
3- a more likely picture, as with any complex system like the banking network, is that too much of one thing is bad. QE1 stabilized the fisher capsizing boat (smoke cash out). QE2 propped balance sheets and played currency wars, QE3 will be counter productive. Too much of a good thing?

I just don't know. Thoughts very welcome.

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