Bernanke and the Fed vs. Buffett, El-Erian, Gross and the Investor

On March 2nd aiCIO reported in its Daily News, Following PIMCO’s El-Erian, Warren Buffet Discourages QE2, “Echoing statements made by Pacific Investment Management Co.’s Mohamed El-Erian and Bill Gross, Berkshire Hathaway’s Warren Buffett has said the US does not currently need an economic stimulus.

“The sentiments by the financial heavyweights reflect waning public support for the Federal Reserve’s effort to stimulate the economy as well as fears that the US cannot continue with the stimulus.

“In an interview with CNBC, Buffett explained that despite his respect for Federal Reserve chairman Ben Bernanke, he believes the US does need to continue its quantitative easing program, dubbed QE2, as there has been a tremendous amount of government stimulus since the beginning of the financial crisis….Previously, El-Erian has said that the cost of the Federal Reserve’s actions is starting to outweigh the benefits. In an interview with CNBC, El-Erian said the central bank should calculate how it can exit from its multi-trillion dollar quantitative easing program.”

Several days later Bill Gross of PIMCO weighed in, “Speaking of investment tips, no clue or outright signal could have been any clearer than the one given in December 2008, labeled ‘Quantitative Easing.’ While the term was new, the intent was obvious: (1) pump public money into the financial system to replace private credit that was being destroyed in the process of deleveraging; (2) lower interest rates on intermediate and long term-mortgages/Treasury bonds and in the process flush money into risk assets - most visibly the stock market; and (3) forecast publically then hope that higher stock prices would lead to a wealth effect, and in turn generate new private sector lending, job creation and a virtuous circle of economic expansion that would heal the near-fatal wounds of Lehman and its aftermath. If that was the game plan, then so far, so good, I’d say. Interest rates are artificially low, stocks have nearly doubled since QE1’s first announcement in December of 2008, and the U.S. economy will likely expand by 4% this year, although a $1.5 trillion budget deficit must share QE’s Oscar for most stimulative government policy of 2009/2010.

“Many critics, though, including yours truly, would wonder whether Quantitative Easing policies actually heal, as opposed to cover up, symptoms of an unhealthy economy.” (PIMCO, Investment Outlook, Two-Bits, Four-Bits, Six-Bits, a Dollar)

From an investment standpoint, PIMCO has determined that the spread is too low on Treasury notes and answered their own question, “Who will buy Treasuries when the Fed doesn’t?,” by announcing that they had exited U.S. government debt and liquidated their holdings in PIMCO’s heavyweight Total Return Fund.

Some have questioned how long PIMCO, the leading bond fund investor, will stay out of the U.S. bond market. Michael Mackenzie weighed in, “But this move away from Treasuries could prove costly for Pimco…To say no to Treasuries, the most liquid of bonds, means you are dismissing a haven that warrants being part of your portfolio. It is an interesting stance at a time of Middle East turmoil and the unresolved debt woes in the eurozone.” “There is much to be said for not following the herd, but as traders warn, the reward of being first to a new investment opportunity must be weighed against the risk of being eaten by an unforeseen foe,” he concluded. (FT, March 11, 2011, Bond king’s Lear-like Treasuries renunciation)

In the interim, Ben Bernanke has not changed course in response to public calls by Buffett, El-Erian and Gross on behalf of the investor. As the week wound down, we saw how difficult it is to predict when a central bank will make a change in direction. Alen Mattich in The Wall Street Journal wrote, “Yet again, the Bank of England delayed the inevitable, holding interest rates steady at the latest monthly meeting of its Monetary Policy Committee. So far, the MPC has managed to keep the market on its side, despite interest rates at historic lows and still-climbing inflation. But bond investors’ willingness to accept negative real yields is likely to be wearing thin…Europe’s bond markets are broadly divided into three groups. There are the untouchables, like Greece, Portugal and Ireland. There are the high-quality issuers, like Germany, France and the U.K. And there’s an intermediate purgatory, in which Italy and Spain sit, where yields are painfully high but still serviceable. It’s unlikely to take much to push the U.K. into a purgatory of 5% to 6% yields on 10-year debt, Mr. Jeffrey says [Richard Jeffrey, chief investment officer at Cazenove Capital Management]. That may not be much above inflation, but it would be enough to inflict serious pain on an economy as heavily indebted as the U.K.’s. And serious pain for the U.K.’s bond holders as they watch the value of their assets fall.” (WSJ, March 11, 2011, BOE Doves Living on Borrowed Time)

This debate will go on in both countries against the backdrop of rising oil prices caused by the continuing chaos and struggle in Libya and the other Middle East oil-producing nations. We all woke up on Friday to the horror of the massive earthquake and tsunami in Japan, whose shear size and deadly impact rattled the global markets. Humanitarian rescue and support efforts have begun, while the world anxiously watches for potential meltdowns of several nuclear reactors. This island nation and its people have shown before that they are resilient and I trust that they will start to rebuild their lives and their country in the coming months.