Hey Bill Gross, Why So Serious?

October 9, 2012

We like to pick on Bill Gross every once in a while. He is a billionaire who loves to “talk to his book” — i.e. tout Pimco’s trading positions — so he can certainly take it.

An example from last year, “The Bond King Gets Desperate,” is newly relevant given the bond king’s latest commentary.

In last year’s write-up, we took Gross to task for saying America is like Greece. He’s saying it again – that America is comparable to Greece – and it’s still just as silly.

The latest Pimco Investment Outlook (Gross’ monthly commentary vehicle) is called “Damages.”

It is full of quotable soundbites, like ready-to-dip chicken McNuggets, such as stating Uncle Sam is addicted to ‘budgetary crystal meth.”

Here is the Greece part (which got a lot of armageddon types excited):

How can the U.S. not be considered the first destination of global capital in search of safe (although historically low) returns? Easy answer: It will not be if we continue down the current road and don’t address our “fiscal gap.” IF we continue to close our eyes to existing 8% of GDP deficits, which when including Social Security, Medicaid and Medicare liabilities compose an average estimated 11% annual “fiscal gap,” then we will begin to resemble Greece before the turn of the next decade.

No, no, no. America will NEVER resemble Greece. The situations are just too different. This isn’t apples and oranges, it’s apples and wildebeests.

Here is an excerpt of what we said more than a year ago (which still holds):

To even imply that the United States is worse off than Greece is pretty amusing — especially now that Greece is splattered all over trader’s screens like roadkill on a windshield.

So how does the United States differ from Greece in ways that materially affect the bond situation? Let us count the ways:

  • The United States is a military and agrarian superpower.
  • The United States accounts for roughly 25% of global GDP.
  • The United States is the issuer and printer of the world’s reserve currency.
  • The United States owes in its own paper.
  • In the eyes of massive creditors such as China, Japan and a majority of global central banks, the United States is “too big to fail.”

Are we trying to write off America’s long-term fiscal problems? Absolutely not!

But suggesting that the U.S. is in worse fiscal shape than Greece, from a logistical / tactical perspective, is like comparing J.P. Morgan to the Bumbershoot Bank of Topeka Kansas. Greece is screwed, but the only reason we care is because of deeply embedded systemic risk. Were America to be screwed, so would the world. The comparison is more hyperbole than fact.

Further, re, “too big to fail:” As goes America, so goes the globe — still. Guess what happens in the aftermath of a true U.S. economic collapse?

The price of oil collapses, which means the Middle East goes haywire. (Saudi Arabia and other nations can no longer afford sustained pricing below $80 or $90 a barrel.)

The value of exports and world trade collapses (America is ~25% of GDP, remember, and a very important “vendor finance” customer) at a time when China is nowhere near ready to stand on its own two feet — which means Asia goes down too.

Not only is the U.S. genuinely “Too Big To Fail” in many respects — with the important advantage of a still dominant military and agrarian position — Uncle Sam also has the ability to buy bonds with dollars. This activity risks serious inflation in the long run, but as Keynes liked to say, “In the long run we are all dead.”

We have argued forcefully in the past that bad U.S. policies ultimately pose serious inflation risk, as the cost of unproductive spending is ultimately born out through inflation / reflation (distributing the hidden costs of debt).

And yet, have you seen the trajectory of the price of oil lately? It collapsed 4% in one day this week. Does the market seem genuinely worried about inflation to you?

Funny thing. Oil was dropping when we last broached this topic, and it  is dropping once again.

Check out continuous contract crude oil futures as of October 2012:

click to enlarge

Before going into his “USA as Greece / budgetary crystal meth” bit, Gross is careful to remove any semblance of timeline from his comments with the following:

Well, Armageddon is not around the corner. I don’t believe in the imminent demise of the U.S. economy and its financial markets. But I’m afraid for them.

One could perhaps rephrase that as “Look, don’t put a timeline on my prediction, because all the guys who did that with Japan are looking pretty sheepish and a lot poorer if they bet on it, but hey it makes sense to be worried in your heart of hearts and eventually I will be right!”

Yeah… okay… It is hard to see how this is helpful. Yes it is true that unrestrained spending eventually leads to severe problems. Key phrase being “eventually,” case in point Japan (an eventuality for which we still wait).

But the focus on the United States’ problems, to the exclusion of other potentially far more serious problems in the world, is so simplistic and moralistic it drives us nuts! 

Consider China’s black box, for example. If estimates are correct, China could be facing a shortfall in the trillions… and don’t even get us started on Europe…

Is this a case of trying to deflect attention from one problem by pointing to others? No, not at all because the fiscal attractiveness of U.S. assets (and U.S. debt) cannot be viewed in a vacuum. Such has to be considered against the merits of other alternatives.

In that light, rather than worrying about the United States’ fiscal position at some point well off in future – on a timeline Gross refuses to even cite – it seems more sensible to us to ask the following hypotheticals:

What happens if recession in Europe – including Germany – places further pressure on China, hastening a “recession with Chinese characteristics” (growth so low it feels like collapse)?  

What happens if one or more of Europe’s growing separatist movements gain traction? Or if Spain refuses a bailout?

What happens if the Federal Reserve fails in its unemployment mandate (as it almost certainly will…) and the US economy slips back into recession?

What happens if a chain reaction of events tying together Iran, Israel, Syria, Saudi Arabia etc. causes the Middle East to implode, sending oil prices rocketing higher and delivering the equivalent of a massive economic coronary via deflationary (not inflationary) shock?  

Rather than worry about what could happen “some day” with the U.S. — sorta like the constant worry over what will happen “some day” with Japan — it seems far more sensible to pay attention to here-and-now developments like this:

 CATALONIA may be the catalyst for a renewed wave of separatism in the European Union, with Scotland and Flanders not far behind. The great paradox of the European Union, which is built on the concept of shared sovereignty, is that it lowers the stakes for regions to push for independence.While a post-national European Union may be emerging out of the euro zone crisis, with a drive for more fiscal union and more centralized control over national budgets and banks, the crisis has accelerated calls for independence from member countries’ richer regions, angry at having to finance poorer neighbors.

Anyone sweating a breakup of the 50 states? Didn’t think so…

Or how about this, via the American Security Council, which reputedly has crude spiking nearly 4% as we write:

In a report issued Monday, the Institute for Science and International Security (ISIS) said Iran has the capacity to produce 25 kilograms of highly enriched uranium needed for the core of a nuclear warhead in two to four months. Iran has thousands of centrifuges enriching uranium at its main plant in Natanz and hundreds of other centrifuges operating at its Fordo facility, located under a mountain to shield it from air attacks.

Considering Iran’s currency is collapsing, that sounds pretty timely.

Or this, which is our candidate for “low level diplomatic conflict most likely to develop into full-blown Smoot Hawley style protectionist trade war” – via Reuters:

U.S. telecommunications operators should not do business with China’s top network equipment makers because potential Chinese state influence on the companies poses a security threat, the U.S. House of Representatives Intelligence Committee said in a report on Monday.

The report follows an 11-month investigation by the committee into Huawei Technologies Co Ltd and its smaller rival, ZTE Corp.The companies have been fighting an uphill battle to overcome U.S. lawmakers’ suspicions and expand in the United States after becoming key players in the worldwide market.

The House Intelligence Committee’s bipartisan concerns are bound to set back the companies’ U.S. prospects and may also lead to new strains in trade ties between the United States and China, the world’s two biggest economies…

Broader point being, there is a lot to worry about right here and now… as the IMF’s “alarmingly high” global growth downgrade confirms… without focusing on long-term concerns as to the US fiscal situation, which realistically should probably be the least of investor worries right now… and at minimum for the foreseeable future…

Here is another distinct irony in respect to the whole bond vigilante stance:

Picture the global economy as a jumbo jet powered by four engines — the United States, Europe, China, and Japan.

Right now the United States is the main engine… sputtering a bit, but the only one not shooting out smoke and flames (Europe, China, Japan in seriously bad shape).

Were the price of treasury bonds to fall sharply, then, U.S. interest rates would rise sharply. 

Were interest rates to rise sharply, any semblance of U.S. economic recovery would be stopped in its tracks.

Were U.S. recovery stopped in its tracks, the rest of the world would nosedive as well (the plane already flirting with ‘stall speed’).

Such an environment would be extremely deflationary…

And thus supportive of US treasuries…

Causing long bond prices to rise again (and interest rates to fall).

This feedback loop scenario is not original to our thinking. It was laid out by Andres Drobny some years ago in Invisible Hands.

But it makes sense. To assess the credit quality of the United States in a vacuum is to think myopically and to erringly exclude multiple key variables. As a primary driver of the global economy, a military and agrarian superpower, a key trading partner, and so on, with many trillions of dollars in embedded intellectual property, real estate, and hydrocarbon assets on the balance sheet (think fracking revolution), the United States is a country that will virtually always have preferable lending status in situations of last resort… and any situation in which the global economy is in danger of collapse, which is exactly what we would have were U.S. rates to spike and threaten to kill off U.S. recovery, is by definition  “last resort.”

Again, is this an apologetic meant to wave off the long-term fiscal issues the United States faces?

No, not at all. Instead it is a recognition of the fact that

  1. The global economy has many moving parts
  2. The fiscal attractiveness of US obligations cannot be determined in a vacuum, and
  3. Indulging in U.S.-centric doom and gloom predictions is inaccurate and irresponsible.

There is something to be seriously concerned about regarding the US fiscal situation, in our opinion… but it isn’t an eventual bond market collapse, or any “armageddon” prediction relating to the U.S. fiscal situation per se.

The real threat to the health and economic well-being of the US is not some mysterious degrading of competitive advantage that sends America down in flames vis a vis China or Europe or the rest of the developing world.

(For the love of Pete, have you SEEN the state of the competition?)

The real threat instead — in our humble view — is a persistently weak and degraded economic state – a sort of hellish purgatory — that lasts for many years, because toxic fiscal policy is never addressed, leading to rapid societal decay at the margins as more Americans grow destitute and the middle class vanishes.

And as long as congress and all the other idiots in Washington, regardless of political affiliation, continue to believe that monetary policy, i.e. Federal Reserve action, is the main driver of economic recovery, real and meaningful changes to fiscal policy will be lost to porkbarrel gridlock.

And by the way, the potential worst economic situation of all — a Smoot-Hawley style downward spiral into protectionist trade war — is one that could be created by congress… possibly even in the name of deficit reduction… and such would cause U.S. treasury values to go up, not down, as the global economy goes down in Molotov Cocktail flames. 

Irony of ironies, you would want to be long treasuries out the yin-yang if such happened…

But nobody is pounding the table saying “HEY IDIOTS, GET OUT OF THE WAY OF DOMESTIC JOB CREATION” or “HEY IDIOTS, DON’T START A TRADE WAR” because you don’t get as much free publicity for that, or as much satisfying doom-and-gloom traction, as one does peddling “budgetary crystal meth” comparisons and painting pictures of bonds going down in flames…

So, Bill (if we can call you Bill), let’s leave the armageddon scenarios to sandwich-board street preachers and instead focus on the “serious” attendant risks to the global economy here and now, shall we?

JS (jack@mercenarytrader.com)

Recent Themes & Trends (scroll for archives)

5 Responses to Hey Bill Gross, Why So Serious?

    • Jack Sparrow on October 11, 2012 at 12:48 pm

      Not sure how this matters… given the shape and trajectory of current macro trends, it’s possible the US share of global GDP could actually go up, not down in the coming years. This would be a net negative, as it would imply multi-year global contraction, not global growth – a world in which the US had a smaller share because EM had grown would be a better world for all, including the USA – but as far as concerns, risk, etc, such is neither here nor there (as far as I can see)…

  1. Hasan on October 11, 2012 at 5:32 pm

    I think your points are soon to be outdated. The US dollar is losing its reserve currency as china has anounced trade and currency deals with many other countries. This has rendered the USD surplus to require,eats around the world in the next few years bringing massive inflation. Also your point that China and others are a major creditor of the US is no longer true since china has stopped buying US debt and it is only the fed that that is buying every worthless TBond available through QE infinity, OT etc creating the biggest TBond bubble ever. This leads to massive currency debasemant which incentivises nations who hold dollars to dump them causing hyperinflation in the US as the all the dumped dollars will float back there. Once the bond bubble bursts and the Fed can’t get away with printing more money then game is up. Bankruptcy. One cannot be a military super power without money and one cannot be so important to the world if their reserve currency status no longer exists. To suggest that the US is too big to fail is misinformed. Economically if the US fails it would cause major deleveraging of the $1 quadrillion dollars of derivatives debt in the world and will later restart world economic growth as the chinese rnb backed by gold or even a basket of currencies would restart trade and free markets soon will exist by demand from emerging economies such as the BRICS. I could go on but It’s worth reading this article from Dr Paul Craig Roberts who I’m sure you know of. He explains it pretty well.



    • Jack Sparrow on October 12, 2012 at 3:07 pm

      Hi Hasan,

      Here is a stream of consciousness (read: 100% off-the-cuff) reply that came out a little lengthier than expected…

      Different viewpoints are certainly welcome, and it takes all kinds to make a market. With that said, there is a certain “stopped clock” aspect to those who have been declaring the United States to be like the Roman Empire in its last days and predicting the imminent demise of the dollar as the world’s reserve currency. This thesis — that America is doomed — has essentially been in stasis for a decade or more. The thesis that Japan is going to collapse under its own fiscal weight has been around for even longer.

      Simple empirical evidence demands a rethink of aggressive assumptions that have failed to come to pass for years and years on end, especially when the drivers behind the argument have given no indication of adjusting or updating. The title of the Paul Craig Roberts article you cited was “Collapse at Hand.” Really? The trouble is such article titles existed seven years ago. Calls for hyperinflation based on a collapse of the US Treasury bond market are also many years old now. Is it possible the timing was off and “at hand” just means waiting a little while longer? Maybe. Or maybe this view of the global economic puzzle is fundamentally misguided and wrong, via the failure to include some very important pieces…

      In addition to the above observation — all too many instances of “imminent demise” prediction have proven false — evidence is mounting that the China miracle is a fraud at worst and a fizzling bottle rocket at best. Indeed, there is ample and growing evidence that 1) China is the biggest malinvestment case of all time, as we have argued, and that 2) China is in real danger not just of hard landing, but outright economic implosion. It is hard to see China leaping to the fore of the 21st century when the entire country bears resemblance to a growth stock with cooked books that is about to suffer a collapse in confidence and a major restatement of earnings power, even as demographic disaster and the threat of supercycle food, water and energy shortage looms (three areas where the U.S. has a distinct global advantage by the way).

      Then add to the above the fact that those who predict the fiscal demise of the United States have never really given proper consideration to the asset side of the U.S. balance sheet. Looking at treasury bonds in a vacuum and saying “it’s the biggest bubble ever” is like looking at the debt on a company’s books without looking at the scope or extent of the company’s assets, especially if a large portion of those assets are being carried at cost i.e. not marked-to-market. The debt-offsetting value of the United States’ military power, agrarian output, intellectual property, institutional memory, political stability, rule of law longevity, demographic vitality, and extensive corporate / household wealth are virtually never discussed in the “America is doomed” presentations, but they all contribute to reasons why U.S. currency (and safe-haven government debt) have proven much more resilient than the doom predictors might think.

      To better understand why U.S. assets (and strategically important advantages in food security and increasingly energy security) are so important not to leave out of the equation, consider how a run on treasury bonds (a UST implosion) would have to come about. If there were any attempt to sell off treasury bonds outright, the Federal Reserve would step in and begin buying USTs in unlimited qualities with electronically printed dollars. This in turn would keep bonds propped up, but threaten to collapse the US currency market.

      Downward pressure on USTs would cause US interest rates to rise, however, which would in turn jeopardize the entire global economic recovery. Fears of renewed economic meltdown as China and Europe sputter would lead to a recommitment to safe haven assets (like USTs), which in turn would induce buying of the same assets that were previously being sold off.

      In addition, given that the dollar would be the weakness transmission mechanism in any bond collapse (as the Fed can always print dollars with which to buy unlimited amounts of bonds), a rapidly weakening dollar would provide an absolutely compelling asset purchase proposition for desirable US assets. When the US dollar declines, it provides the ability to buy US assets at a discount relative to the alternative currency against which the dollar is falling. Thus, were the USD to show signs of collapsing, how quickly do you think overseas investors would begin to salivate at huge currency-induced in the shares of companies like Apple and Google and Exxon, or the currency-adjusted property values available in U.S. real estate (particularly the major coastal cities)? A flood of opportunistic capital would come in seeking to purchase of trillions and trillions worth of discounted US assets, which in turn would put a floor under the sale of the currency. This dynamic works the same as assets on the balance sheet of a public company putting a floor on the falling share price, because at some point those with the ability to value the balance sheet assets cannot resist the bargains being presented.

      Finally, in order for $USD denominated assets and treasuries to collapse, someone has to explain the alternative destination, i.e. where many trillions in capital and reserves are going to flow. Into Europe? The European Union is on the verge of disintegration. Into China? The China miracle is in large part a smoke-and-mirrors vendor finance job, built on manipulated data foundations that cannot be trusted, with a growing threat of ponzi-style real estate collapse and civil unrest if/when a brittle authoritarian regime loses control of the economic plot. (Not to mention the frightening anti-Japanese nationalism the mandarins may already have lost control of — while populism has long been a useful government tool for massaging viewpoints and distracting the domestic populace, the genie cannot be put back in its bottle when stakes start to grow alarmingly high. Wars have been fought for worse reasons.)

      There has long been a certain moralistic, Calvinistic emphasis on the debt situation of the United States. In keeping with the couuntry’s protestant roots, many have taken the intrinsically appealing view that excessive accumulation of debt is a sin and that too much sin must bear consequences. But this hypothesis driven more by an intuitive sense of morality than observable economic drivers does not fit the actual picture of what is happening, or the relative advantages and disadvantages of the US not just as creditor, but as economic juggernaut with significant built-in advantages that not only show no signs of eroding, but could actually be increasing in worth. Think how much more attractive the United States will be, in relative terms as a destination, if global growth contracts over the next few years.

      This touches on another key reason why the points are so confusing — the value of currencies and the desirability of liquid safe-haven assets are both expressed in relative terms. The dollar as a currency is considered in relation to the value of other currencies. United States’ government debt is considered in relation to the stability and attractiveness of alternative safe haven assets. On both these measures, in the real world the U.S. does far better than one might expect, with relative advantages of the United States vis a vis China and Europe again getting stronger, not weaker.

      Could keep going, but trust the points are reasonably well made…


      • Gary on October 13, 2012 at 7:02 am

        Cheers Jack for that analysis of secondary consequences.

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