Fed needs to prepare donuts like Charles Ponzi…

Pimco’s Global Central Bank Focus research notes are always a fascinating read.

The recent Apr-11 issue is another superb read. It has Anthony Crescenzi and Ben Emons writing on Fed, Andrew Bosomworth on ECB and Lupin Rahman on Emerging economies central banks.

The one on Fed is startling. First some bit on Ponzi scheme:

In 1920 the Boston Post contacted Clarence Barron, the founder of Barron’s, to investigate a man who claimed to be racking up remarkable gains for investors in an arbitrage involving the purchase and sale of postal-reply coupons. Charles Ponzi, the developer of the scheme, sought to convince investors that differentials in inflation rates between countries had created an opportunity for investors to purchase the postal-reply coupons on the cheap in one country and redeem them in the United States, an arbitrage that Ponzi said would enable investors to grow their money by several fold if they invested with him.

In fact, there were indeed differences between the prices of postal-reply coupons postage bought in foreign countries and their redemption value in the United States. But there were also substantial barriers preventing any actual arbitrage, including enormous logistical challenges having to redeem the coupons, which were of low denominational value. Ponzi nonetheless started and then perpetuated the scheme.

Barron sought to expose Ponzi’s scheme, noting in articles that eventually brought the Post a Pulitzer Prize, that to support the investments Ponzi had supposedly made there would have to be 160 million postal-reply coupons in circulation. There were only 27,000 of them. These and other questions led an angry and suspicious crowd to gather outside of Ponzi’s Securities Exchange Company, which was located in Boston on School Street.

 

Ponzi, who was famous for his deceptions, convinced many in the angry crowd to stay calm and leave their money with him, enticing them with little more than his charm, donuts and coffee. It wasn’t the first time that investors would be misled by the potential for future profits and simple trappings, but donuts and coffee? Really? Is it this easy to get investors to part with their money? In many cases yes, unfortunately.

 

He says this just like Ponzi, Fed needs to prepare donuts to calm investors:

 

Just as Charles Ponzi needed donuts to turn back a suspicious crowd of investors, the Fed needs “donuts” in order to fill the bellies of the literally millions of investors worldwide who worry about the alarmingly large U.S. budget deficit and the impact that the U.S. debt dilemma could have on their Treasury holdings. Investors are no doubt worried they may have bought into an unsustainable scheme: the creation of a scourge of debt so large that the Fed itself has had to purchase the debt to keep the game going.

 

All that the Fed has had to do thus far to keep the game going is press the “on” button to its virtual printing press, crediting the account of the U.S. Treasury. In the process, the Fed has kept the demand for U.S. Treasuries high, perhaps deceptively so, attracting with its redolence many classes of buyers, including households, banks, pension funds, insurance companies and foreign investors. Their collective buying has created what we believe to be a profit illusion with many investors mistakenly believing they can continuously reap profits from perpetually falling bond yields and rising bond prices, just as they have had opportunity to do over the past 30 years, amid the great secular bull market for Treasuries and the bond market more generally.

 

For many reasons, this “duration tailwind” for Treasuries can’t last, particularly because the United States has reached the Keynesian Endpoint, where the last balance sheet has been tapped.

 

Fed QE so far has smelt good like fresh donuts but will soon smell of rotten eggs:

 

The Federal Reserve’s colossal bond purchases therefore will likely, to the chagrin of millions of unsuspecting Treasury bond investors, be one of the markers for the latter stages of the bull market for Treasuries. For now, however, the Fed’s purchases have the sweet aroma of freshly baked jelly donuts and many a Treasury bond investor has been drawn to their savory, sugary, scrumptious taste.

 

What they should instead smell is the whiff of rotten eggs. But this is easily hidden with a nose pin, which the Fed through QEII places on the noses of each investor, with the goal of creating perpetual serendipitous moments that in the eyes of investors transform the rotten stench into something far more delectable. Ultimately, however, the stench of the Federal Reserve’s bond purchases will seep into the nostrils of investors all around the world when it becomes glaringly obvious to them that the Fed can’t possibly continue as the Treasury’s main source of demand.

 

Though he does not say QE is a failure:

 

Treasury investors will also realize that not only has QE suppressed the rates they earn on their Treasury holdings, QE promotes financial and economic conditions that hurt Treasury bond holders, primarily because it boosts economic growth and inflation, resulting in confiscation of the skimpy Treasury yields they earn. Foreign investors have the added discomfort of a decline in the foreign-exchange value of the U.S. dollar. To top it off, Treasury investors face the potential for capital losses for having bought into the Fed’s scheme at prices inflated by QE, sort of like playing a game of hot potato and getting stuck with the potato when the Fed abruptly leaves the game.

 

Time has come for Fed to further prepare fresh donuts and convince people all is well:

 

QEI and QEII were necessary solutions at a time when the U.S. financial system was on the brink, but they are unsustainable means of funding the U.S. government. Ultimately, the U.S. must own up to its past sins and let the deleveraging process play itself out. It can’t pretend that previous levels of demand for goods and services can be restored simply by turning on the Fed’s printing press.

 

The United States instead must recognize that only by increasing investment in its people, its land, and its infrastructure, as well as promoting free trade, can it achieve economic growth rates fast enough to justify consumption levels previously supported by a wing and a prayer – by debt.

 

For the Federal Reserve and the U.S. Treasury, it is time to make the donuts. There is a crowd standing outside and, although there is no wrongdoing to make them as angry as the crowd that stood outside of Charles Ponzi’s office before he was busted, they are just as anxious, and it is going to take a lot of convincing to get them to show up at the next Treasury auction and the one after that, and the one after that, and….

 

Hmm. Nice comparison…