All That Glitters / The Great POMO Bubble Alert

Why your analyst is urging you to buy more and more bonds, and why you could get badly burnt.

Do you know POMO?

It’s the acronym for Permanent Open Market Operation, or, daily purchases of United States government bonds by the U.S. Federal Reserve Bank, with money it conjures out of nowhere.

The main question at the moment on the global economic agenda is whether the Fed should stop, or buy even more.

This isn't a question that concerns only central bankers. It concerns you very directly.

The markets retreated last week, all week long. The reason: The traders fear that the Fed will reduce or stop its POMO activity.

Every month the Fed streams new money into the market to the tune of $85 billion – an activity known as for quantitative easing, or QE for short. It is doing so by purchasing government bonds.

Many suspect this flow of money is the main reason why bond prices have soared in recent months. The injection of $85 million a month is very significant, even for the vast American market. This is more than $1 trillion a year in demand, which flows into the bond market on a daily basis. That keeps bond prices high and yields low, spurring investors who want more than 0% returns in real terms, to put their money into stocks.

When big money like this is flowing into the markets, stocks go up: The S&P 500 index has gained 6.3% this year, and under its inspiration, the benchmark Tel Aviv index, the TA-100, has gained 5.3%.

But what will happen if this flow of money slows down or stops?

Drug addict, needs fix

Some liken the markets today to a drug addict: They need to have their daily fix and they need this fix to get bigger all the time – otherwise they will crash.

Last week the U.S. central bank’s Federal Open Market Committee (the body that sets monetary policy) published its minutes. These indicated that several FOMC members are worried that this massive bond buying could hamstring American financial stability in the future.

This is understandable. In essence, there is something very strange about a central bank purchasing its governments’ bonds.

Here is an example: Ten days ago the American Treasury held a routine offering of 30-year bonds, as part of its annual plan for financing the deficit. But in the Monday’s POMO – that is, only four days after the bonds were issued – the Fed came along and bought up the bonds.

For many observers this isn't how responsible monetary policy is conducted. It is like directly financing the deficit by printing money.

In economic theory, there is a fundamental difference between financing a government’s deficit by printing money and buying government bonds by the central bank.

Printing money is to create new money in a routine way, with all the dangers of inflation that go along with it. Now, the Fed is being careful to purchase bonds only on the secondary market (that is, from the public and not directly from the government).

The difference is in the expectations the Fed is creating. By buying on the secondary market, the bank is implying that it will sell those same bonds in the future. Therefore, this is no routine printing of money, and the public needs to realize it will stop at some point.

But when the central bank buys bonds on Monday that the government had issued four days earlier, the claim that it isn’t a matter of routine printing of money doesn’t hold water very well.

Disturbing signs

What's the problem with routine printing of money, or even the public’s belief that money is being printed?

The first problem is concern about inflation. It looks low now but is liable to climb in the future.

The second problem is more serious: Printing money, or the public’s belief concerning it, is liable to create financial bubbles – and these, as everyone knows, can easily cause crises.

The crisis of 2008, from which the world has not yet recovered, was indeed caused by a bubble of cheap credit together with a bubble in real estate prices, both in the United States and in many European countries.

We know what happened: The bubbles burst with a bang, the money vanished from the markets – and the whole world sank into a slump.

It turns out that there are already signs, some of them disturbing, that the cheap credit and the printing of money are inflating new bubbles.

Issues of corporate bonds, especially junk bonds (bonds of companies in dodgy financial shape), rose to historic levels in the last year, as did their prices.

In some property markets, too, for example agricultural lands, prices have skyrocketed at a pace that doesn't inspire confidence.

When the members of the FOMC talk about the risks in the Fed's bond purchase plan, what they mean – is bubbles, and how they end.

Bernanke shrugs

In the meantime, Fed chairman Ben Bernanke is dismissing the concerns. In an internal meeting with private investors earlier this month, say people who were there, Bernanke argued that there is no clear research evidence showing the federal bank’s effect on financial bubbles.

“There's a lot of disagreement about what role monetary policy plays in creating asset bubbles. It is not a settled issue," Bernanke said on January 14, at the University of Michigan's Gerald Ford School of Public Policy. "Our attitude is that we need to be open-minded about it and to pay close attention to what’s happening. And to the extent that we can identify problems, you know we need to address that.”

Moreover, added Bernake, the “first line of defense” if bubbles emerge “needs to be regulatory and supervisory” actions rather than changes in monetary policy.

Since even people within the Fed now whimpering about the risks did not vote against his policy, a policy change at the bank seems unlikely. It could be, even, that this analysis is what drove the markets back up Friday, after two days of steep drops.

As of now, nobody in Washington seems about to question or put a stop to Bernanke’s unique monetary experiment. Moreover, in recent weeks support has been increasing for similar money-printing schemes in places like Great Britain and Japan.

Britain, for example, has lost its perfect credit rating from Moody’s. This will strengthen the hands of those who are demanding that “something be done” to stimulate the local economy.

A political matter

The money supply is also a political matter. Many don't see Bernanke changing policy before the end of his term in January 2014. Bernanke himself argues that stopping the asset purchases and the printing of money could drag the U.S. back into recession.

What will happen next? That is for the President of the United States, Barack Obama, to decide.

He could offer Bernanke another term as chairman of the Fed. In political circles they're are that depends on the state of the economy. If the United States blossoms within a year, Bernanke could decide to “retire at the pinnacle” and go down in history as the man who rescued America from the biggest crisis since 1929. Or, he could stay on for another term in order “to finish the job.”

Obama could of course offer the job to someone else, for example Bernanke’s deputy, Janet Yellin, the Vice Chair of the Board of Governors of the Federal Reserve or even our own outgoing Bank of Israel Governor Stanley Fischer. Both see the world through Bernanke’s eyes, support his policy and are likely to keep printing money as a useful and practical tool for supporting the economy.

And this, dear reader, is why most analysts and economists at the banks and investment houses are continue to urge their clients to buy more and more bonds.

Bloomberg
Bloomberg