"Investors should view June 30th, 2011 ... like June 6th, 1944 (D-Day -- a day fraught with hope for victory, but fueled with immediate uncertainty and fear as to what would happen in the short term)."
It'd be easy to brush off that kind of talk as rambling hyperbole if it came from almost anyone other than the man who said it -- Bill Gross, the head of PIMCO, the world's largest bond manager. He knows what he's talking about, and he puts his money where his mouth is.
June 30 is when the Federal Reserve is set to finish its $600 billion campaign of buying U.S. Treasury bonds. The program's known as QE2, for the second round of quantitative easing. What happens when it ends is anyone's guess. It's always that way with this stuff. We do, however, know what happened when the Fed's first bond-buying program, QE1, ended last year. And it wasn't pretty.
Gross first puts the size of QE2 in perspective. The Fed has bought roughly 70% of the Treasuries issued by the government over the past several months. The Fed buys Treasuries even in normal times, but the weight it's throwing around today is simply awesome:
Who buys Treasuries?
Understanding this chart is key to piecing together the QE programs' impact. One of the funny things about both QE programs is how counterintuitive the results have been. The Fed's goal in buying Treasuries is to push bond yields down, which should spur economic growth. It may have achieved growth, but bond yields have done just the opposite of what was expected. After the Fed stopped buying bonds when QE1 ended last spring, yields plunged. When it started the printing presses back up for QE2 last summer, yields rose.
None of that should make sense unless you realize the importance of this chart. It's pretty simple: The Fed's extra bond buying will push down yields only if other buyers -- either foreign sovereigns, or private investors like hedge funds, pension funds, and banks like Bank of America
Factor that in, and rising yields in the face of massive Fed buying could actually make sense. If the Fed's $600 billion QE2 program drove, say, $1 trillion worth of private buyers out of the Treasury market, rising yields is exactly what you'd expect. And that looks about like what happened.
But where did that private money go? Money that used to chase Treasuries began chasing something else. Stocks. Gold. Oil. Junk bonds. You name it. Nearly everything expect Treasuries has been rising, or did rise, during QE1 and QE2. Assuming private money was chased out of the Treasury market, that's exactly what you'd expect to happen. The cash has to go somewhere.
So what happens when QE2 ends in June? Again, who knows. Weird things happen. But I don't think rising interest rates is the biggest risk, as so many assume. I don't think you have to worry about who's going to buy Treasuries. Someone will. Private buyers will line up for them in the Fed's absence. It's what they did after QE1. They may form such a long line that yields actually fall.
The real risk is what happens to other assets when that happens. Private money that over the past six months chased stocks and commodities might run to its old home, the Treasury market. If it does, you can guess what happens. Just remember what markets did last summer. It isn't an enjoyable experience.
The silver lining is that all of this is just short-term rattling noise. Whatever the Fed does, or doesn't do, has no impact on the long-term value of businesses. Good, high-quality companies with strong brands and high returns on capital, like Coca-Cola