You Missed $1 Trillion Return Agreeing With Fed Naysayers

Former U.S. Federal Reserve Chairman Ben S. Bernanke
On Nov. 15, 2010, after then-Fed Chairman Ben S. Bernanke announced a second round of bond buying in that became known as QE2, a group of economists, investors and political strategists published a letter to him saying it would “risk currency debasement and inflation” and do little to promote jobs growth. Photographer: Andrew Harrer/Bloomberg

If you agreed with all the academics, billionaires and politicians who denounced Federal Reserve monetary policy since the financial crisis, you missed $1 trillion of investment returns from buying and holding U.S. Treasuries.

That’s how much the government bonds have earned for investors since the end of 2008, when the Fed dropped interest rates close to zero and embarked on the first of three rounds of debt purchases to resuscitate an economy crippled by the worst recession since the Great Depression.

The resilience of Treasuries represents a rebuke to the chorus of skeptics from Stanford University’s John Taylor to billionaire hedge fund manager Paul Singer and U.S. House Speaker John Boehner, who predicted the Fed’s unprecedented stimulus would lead to runaway inflation and spell doom for the bond market. It also suggests investors see few signs the five-year-old expansion will produce the kind of price pressures that would compel Fed Chair Janet Yellen to side with the central bank’s hawkish officials as they consider when to raise rates.

“The doves continue to have the upper hand,” Scott Minerd, who oversees $210 billion as the global chief investment officer at Guggenheim Partners LLC, said in a telephone interview on Sept. 4 from New York. “There is a bias in the market that interest rates need to be higher. But that just isn’t based on sound analysis. Betting against the consensus on Treasuries has been a winning strategy.”

Inflation Risk

Minerd is buying Treasuries due in 10 years or more, which typically appreciate when inflation expectations weaken.

Since the end of 2008, interest-bearing Treasuries of all maturities have returned 14.6 percent, index data compiled by Bank of America Merrill Lynch show. That’s equal to $1 trillion in price gains and interest from the securities over that span.

This year alone, longer-dated U.S. bonds have rallied 14.2 percent, beating the 10.2 percent return for the Standard & Poor’s 500 Index of American stocks. They have almost tripled the gain in gold, which some investors buy to preserve wealth when they foresee rising costs eroding the dollar’s value.

While the Fed’s most-aggressive measures in its 100-year history helped to restore the world’s largest economy and reduced joblessness from a peak of 10 percent, the stimulus has yet to generate the price pressures that some have warned about since the central bank began quantitative easing in 2008.

Open Letters

On Nov. 15, 2010, after then-Fed Chairman Ben S. Bernanke announced a second round of bond buying in that became known as QE2, a group of economists, investors and political strategists published a letter to him saying it would “risk currency debasement and inflation” and do little to promote jobs growth.

Stanford’s Taylor, a former Treasury Department official best known of his interest-rate formula known as the Taylor Rule, and Singer, who runs the New York-based hedge fund Elliott Management Corp., were among the 23 signees.

Also signing were Niall Ferguson, the Harvard University historian and author of “The Ascent of Money: A Financial History of the World”; Seth Klarman, who runs the Boston-based hedge fund Baupost Group LLC and wrote the preface to the sixth edition of “Security Analysis,” the landmark 1934 book by Benjamin Graham on value investing; economist Doug Holtz-Eakin, a former head of the Congressional Budget Office; and Jim Chanos, the founder of the short-selling firm Kynikos Associates LP, who rose to fame betting against Enron Corp.

Not Recognized

Taylor wrote in an e-mail that he wasn’t available for comment while traveling in Hong Kong.

Singer, who declined to comment on the Fed’s policies through spokesman Michael O’Looney, said in his firm’s July investor letter that “substantial inflation” is occurring in areas the Fed hasn’t “recognized or captured” in its analysis.

Ferguson, who referred to his blog post in December titled “Quantitative Teasing,” and Holtz-Eakin both said today the risks of inflation wrought by the Fed’s stimulus remain.

Holtz-Eakin also said QE has failed to produce enough growth to justify the potential costs to the economy. Since the recession ended in 2009, the U.S. has grown less annually than the post-World War II average of about 3 percent.

“Beginning with QE2, I have always felt that the additional easing flunked the benefit-cost test,” said Holtz-Eakin, who now leads the American Action Forum, a Washington-based advocacy group. “The growth merit was little and there were substantial potential costs. Time will tell.”

Diana DeSocio, a spokeswoman at Baupost, said Klarman still agreed with the letter’s content. He declined to comment further. Chanos didn’t respond to requests for comment.

‘Clueless’ Criticism

Top Republicans in Congress including Boehner weighed in on Nov. 17, 2010, with their own letter to Bernanke, which questioned the need for more stimulus after the Fed’s first round of bond buying pumped $1.7 trillion into the economy and expressed concern any additional purchases could result in “hard-to-control, long-term inflation.”

The Fed was also criticized abroad, with German Finance Minister Wolfgang Schaeuble calling the stimulus “clueless” that same month. Boehner and Schaeuble didn’t respond to telephone or e-mail requests for comment.

Although inflation based on the Fed’s preferred measure more than doubled to 2.9 percent within the year after QE2 was announced, consumer-price gains have since eased and risen less than the central bank’s 2 percent target for 27 straight months.

Gold Bug

The slowdown in cost-of-living increases upended billionaire John Paulson, who began amassing gold in 2009 in anticipation the Fed’s extraordinary debt purchases would cause “very high rates of inflation.”

While Paulson & Co., his New York-based hedge fund, made $15 billion in 2007 betting on the collapse of the U.S. housing market, Paulson told clients in November that he personally wouldn’t invest more money in gold as the bullion suffered its biggest annual loss in three decades last year. Paulson didn’t respond to telephone calls or e-mail messages seeking comment.

“The market has learned the lesson that if the Fed wants to keep rates low, it has the tools to do so,” Tanweer Akram, a senior economist at Voya Investment Management, which oversees $213 billion, said in a Sept. 3 telephone interview from Atlanta. “And it’s done it without sparking inflation.”

Now, as the Fed moves to end its latest round of bond buying and considers increasing rates, the debate over the pace of tightening has never been more important.

Purchasing Power

One of the biggest reasons bond investors are so confident that the Fed won’t need to move aggressively to boost rates and trigger a bond-market selloff is because sustained improvement in the U.S. labor market remains elusive.

Employers added just 142,000 jobs last month, according to a Labor Department report, the fewest this year and below even the most pessimistic estimate in a Bloomberg survey. The latest payrolls data halted a six-month streak of employment gains surpassing 200,000, which was the most since 1997.

On an annual basis, growth in hourly earnings in the past five years has been the weakest over the course of any expansion since at least the 1960s, data compiled by Bloomberg show.

Without more jobs and higher wages, there’s little chance Americans will spend enough to spur faster inflation.

Based on bond trading, investors anticipate living expenses to increase an average 1.85 percent over the next five years, in line with the mean since 2009. As recently as March last year, inflation expectations were as high as 2.42 percent.

Less inflation makes fixed income more attractive and means investors can earn more in real terms even as yields fall.

Vigilantes Wanted

Demand for 10-year Treasuries has pushed down yields more than a half-percentage point in 2014 to 2.47 percent today.

“Inflation is in check,” Dan Heckman, a senior fixed-income strategist at U.S. Bank Wealth Management, which oversees $120 billion, said by phone from Kansas City, Missouri, on Sept. 3. That’s “helping keep a cap on Treasuries.”

While inflation hasn’t yet emerged as a problem, investors need to be more vigilant of the possibility the Fed is getting it all wrong, according to John Brynjolfsson, the chief investment officer at Irvine, California-based hedge fund Armored Wolf LLC, which manages $670 million.

“Given the magnitude of the easing, there is a lot of kindling to catch fire when inflation arises and the Fed is more likely to be behind the curve in fighting it,” Brynjolfsson, who ran Pacific Investment Management Co.’s first inflation-linked fund, said by telephone Sept. 5. “Buying Treasuries is like picking up pennies in front of a steamroller.”

‘More Disruptive’

Even as hiring in the U.S. slowed last month, reports from manufacturing to auto sales and construction all suggest the economy is gaining momentum. Economists anticipate 3 percent growth next year, which would be the fastest in a decade, according to data compiled by Bloomberg.

Stan Druckenmiller, the hedge-fund manager with one of the best track records in the past three decades, said in July the Fed’s policy of keeping rates near zero for so long is baffling and risky while the odds are high its “monetary experiment will be more disruptive down the road than the Fed anticipates.”

Some Fed officials have started to reassess their own views on how long the target rate needs to stay between zero and 0.25 percent. Minutes of the central bank’s July meeting released on Aug. 20 showed “many” participants said the Fed might raise borrowing costs sooner than they had expected.

Last month, Philadelphia Fed President Charles Plosser said waiting too long to increase rates risks spurring inflation.

Blowing Smoke

While Yellen faces more pressure within the Fed after Plosser dissented at the central bank’s latest meeting, the bond market is still signaling that policy makers won’t need to boost rates much before stopping.

Traders anticipate the benchmark rate will rise to 0.7 percent by the end of next year, less than the median estimate of 1.13 percent from Fed officials. Meanwhile, the one-year interest-rate swap traded five years forward, a proxy for where rates may peak, fell to 3.17 percent.

That compares with 4.24 percent at the start of 2014, which was close to the historical average for peak interest rates that New York Fed President William Dudley said would be consistent with the central bank’s current target for inflation.

“We aren’t seeing the type of growth that will spur inflation,” Guy Lebas, the Philadelphia-based chief fixed-income strategist at Janney Montgomery Scott LLC, which oversees $61 billion, said by telephone on Sept. 3. “The smoke tendrils of inflation that have popped up from time to time have turned out to be a false alarm.”

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