Kyle Bass, QE, and Japanese Pension Funds (Settle 1591.9)

As I perused the blogs this morning, I saw that Zero Hedge had a link to a Kyle Bass case study on Japan. I decided to take a look, and as tends to happen when reading  about Bass' work,  became captivated. The link is available here (http://www.zerohedge.com/news/presenting-kyle-bass-harvard-business-school-case-study#comments) for anyone interested in reading. I wanted to point out one particular passage at the bottom of page 9 which reads as follows.

"The mechanism Bass had in mind was that as a country attempted to "monetize" the debt, the resulting increase in inflation expectations would push up nominal interest rates, as well as increasing the interest rate risk premium. When this happened, interest payments on debt would have to increase, creating further need for monetization, and ultimately, a restructuring. In arguing this view, Bass cited work by economists Carmen Reinhart and Kenneth Rogoff, who had shown that soverign debt crises often precipitated inflation, exchange rate crashes, and banking crises".

On Wednesday June 20th, at 12:30 we will get the next FOMC announcement, followed by a press conference by Chairman Bernanke at 2:15. The decisions made at that meeting will certainly be based on events yet to come. If we are to see some stabilization in Europe over the next few weeks, one can reasonably assume that nothing except for maybe a few phrases (that we will all overanalyze) in their minutes will change. So is Goldman's call that more quantitative easing will be announced on this day a bet that the next few weeks will be painful? I think so.

I suggested to a colleague that the mere fact that Goldman's Hatzius went public with this call a few weeks back, meant we certainly wouldn't be getting QE anytime soon. Knowing what we do about Goldman, if they were really anticipating such policy action, would they tell all of us? Unless the new "mea culpa" public relations shift among banks is real (Dimon/Blankfein admitting faults and mistakes), it is safe to assume Goldman would be better served to position its own trades according to this thesis. But hey, perhaps they already have the trades on, and are thus already in front of the trade. This call seemed just so surprising at the time, that I felt I had to pay attention to it. Things have since played out in a way that makes me think this call may be real.

 Hatzius has said the following for with regard to the potential for a QE announcement at the June meeting.

"After June the probability goes down. June is the time that Operation Twist is scheduled to end, and that's a natural time to decide whether you want to have a successive program," he says. 

"Our baseline is still that we will see something in the second quarter by the June meeting."
(http://www.newsmax.com/StreetTalk/Fed-easing-1940census-hatzius/2012/04/03/id/434703)

It makes sense that the end of the twist would be a natural time to bring back QE. Still, this reasoning seems too simple. The Fed is running out of policy options. Hatzius knows that. "The end of the twist" does not seem to be a good enough reason for the Fed to enter back into another round of quantitative easing UNLESS it is amidst a backdrop of economic frailty. Namely, a weak stock market. Bernanke has said that the first thing he thinks about when he wakes up is where the stock market stands. It is well known that Bernanke thinks that a robust or at least stable stock market is vital to the recovery. Recent price action has shown a stock market with very little fight in it. Is it possible that the Goldman call was really a bearish call on the stock market? While June 20 is a month (eternity) away, the way the tape has behaved, and the dramatic sentiment shifts (hard to believe consumer confidence was at a multi-year high just a few weeks ago) we have seen set up perfectly for a scenario grave enough in which Bernanke's all in "growth" bet will require some candy (QE) to give the stock market a sugar rush.

It is hard to envision a scenario in which institutions don't buy the stock market on a QE announcement, but that pop might be short in duration. The Bass commentary offers food for thought about what really happens when a debt laden nation engages in QE. The government issues money to buy its own debt. As such, there is more money in the system. More money in the system gives at least two reasons to buy stocks. More money in the system, in theory, will cause money pass through the system at an accelerated rate, promoting growth. Additionally, in a more inflationary environment (which money printing promotes) bond holders will see erosion in the real value of their bond holdings, causing them to reach for growth opportunities (ie equities). The second reason is clearly not going to cause people to buy stocks, as currently the 10 year note yields less than the "2%" inflation rate. But whatever the reason, its QE! Buy! Buy! Buy!

Bass' case study points out a more economically fundamental reason why this should not work. If investors really did leave the bond market, the lack of demand would push interest rates higher.

" The mechanism Bass had in mind was that as a country attempted to "monetize" the debt, the resulting increase in inflation expectations would push up nominal interest rates".

As interest rates rise, the cost of funding our (American government debt) debt increases. If the Fed wants people to allocate their money to the stock market over time, it will have to pick up the slack in demand by continuing to buy treasuries ad infinitum. In our kick the can down the road world, QE will simply drive us further into the misunderstood government martingale strategy inwhich we are all unfortunately investors.

To be fair, Bass' case study relates to Japan, but I believe that the general underlying thesis applies. Interestingly, last week, Okayama Metal and Machinery, became the first Japanese pension fund to invest in gold. (https://www.kitcomm.com/showthread.php?t=104768) Perhaps  government monetization of its debt is a downward spiral for governments as discussed. Regardless, its implementation becomes freakishly bullish for gold. When you see a previously absent player in the gold market decide to get its feet wet to hedge its sovereign risk, especially at a time where gold held support above 1522 last week, it looks more and more like a buy. Incredibly, following what pundits were calling "the end of the gold trade", gold closed up on the week. The volumes and resiliency on COMEX futures contracts shows the metals strength. The aforementioned economics behind likely central bank actions support the bullish case as well.