El-Erian Sees Market Correction Ahead

by John M. Curtis
(310) 204-8700

Copyright Feb. 16, 2013
All Rights Reserved.                                         

           Meeting at the G20 in Moscow on the subject of “currency wars,” the G7 disputed the idea there’s any organized attempt to devalue a variety of currencies.  Some economists have warned that the Federal Reserve Board’s QE3—the third round of Treasury bond buy-backs—devalues currencies by flooding the market with paper money.  While loosely correlated, today’s central bank intervention in the United State and Europe has cost currencies significant value.  “It’s important to understand that,” said 55- year-old Mohammed El-Erian, CEO and co-CIO of PIMCO, the world’s largest bond fund.  “Because that means it’s not going away, it’s going to get worse,” referring to continued central bank intervention causing more currency devaluation.  Because of central bank action, El-Erian believes that it’s only a matter of time before Wall Street discounts share prices.

             El-Erian blames policymakers in the U.S. and Europe for too much artificial intervention causing currency depreciation.  If elected officials could agree on more austere fiscal policies, El-Erian speculates that central bank intervention would be unnecessary if politicians would control spending more responsibly.   Central bank intervention causes currencies to drop, making imports more costly and exports more affordable.  Federal Reserve Board Chairman Ben. S. Bernanke believes that keeping banks flush with cash is more important than tightening the purse strings.  Putting more liquidity into the system has caused Wall Street to rise to its current inflated levels inviting a significant correction.   El-Erian sees central bank intervention causing a “wealth effect,” where consumers feel more inclined to spend discretionary capital into the consumer economy.

             Since over two-thirds of a nation’s Gross Domestic Product comes from consumer spending, Fed intervention keeps everyone happy by driving down interest rates to their current artificially low levels.  Too much central bank intervention risks “breaking” the economy by devaluing currency and triggering a currency war.  “High-risk, high-reward and no one can tell for sure which way it’s going to tip,” said El-Erian.  He would like to see less Fed intervention and more genuine growth promoted from better bipartisan economic management by Congress.  Given today’s divided government, it’s doubtful that President Barack Obama can get an obstructionist Republican Party to agree on anything, especially compromising on the so-called “sequester” that triggers automatic government spending cuts.  Neither side agrees on what’s best for the U.S. economy in terms of budget priorities.

             Bernanke has engineered a soft landing after the worst recession started in 2007 since the Great Depression.  Former President Bush’s economic policies left the biggest U.S. banks bankrupt, largely from the collapse of the Housing and derivatives’ market.  When homeowners began defaulting on adjustable rate mortgages, the investment value of synthetic collateralized debt obligations or CDOs also began defaulting, forcing payment of “credit default swaps,” a kind of insurance or bond on the risky derivative investments.  Many of the nation’s largest bank-owned investment houses were wheeling-and-dealing with CDOs and credit default swaps during the height of the last real estate bubble in 2007-08.  When the value of such investments went to zero, insurance companies like American International Group [AIG] went under paying off on bankrupt derivative investments.

             El-Erian sees problems ahead for an inflated stock market based on such hedging strategies.  When Obama signed Wall Street reform into law July 21, 2010, it didn’t include restrictions on banks letting brokerage houses continue to trade in derivatives.   “The key issue is for politicians to exploit the window being bought for them by the central banks,” said El-Erian, referring to the cheap money coming at historically low interest rates.  While El-Erian hopes that the Fed succeeds in engineering the non-inflationary target growth, he sees problems with long-term bond investors.  Current Fed policies have played havoc with El-Erian and PIMCO founder Bill Gross’ bond fund.  El-Erian would like to see less Fed intervention and more market forces dictate borrowing costs and bond prices.  Fed’s cheap money policy, keeping interests at zero-to-0.25%, have hurt the bond market.

             Expecting a market correction, El-Erian believes that the Fed’s QE3 is not sustainable.  “We think that prices are artificially high, that maintaining them here is going to be hard as central banks become less effective, and that it’s time to book some profits and to wait for some better entry points,” said El-Erian, making his case for a market correction.  Whether anyone at the nation’s biggest investment bank and market-maker Goldman Sachs listens is anyone’s guess.  Stocks and bonds historically compete for investors capital with stocks currently winning out.  Only the Fed has jumped back into the low returns from the Treasury Bond market.  Most investors—including PIMCO—have been pulled out of the bond market because of abysmal returns.  If Bernanke sees fit to bump up interest rates, El-Erian’s PIMCO would be a very happy customer.

 John M. Curtis writes politically neutral commentary analyzing spin in national and global news.  He's editor of OnlineColumnist.com.and author of Dodging the Bullet and Operation Charisma.