Take Five: Mohamed El-Erian on the perilous perch of bond funds

Pimco's CEO talks turkey about Cyprus, America's credit rating and the threat of rising rates

Mar 26, 2013 @ 12:01 am

By Jeff Benjamin

Mohamed El-Erian, chief executive and co-chief investment officer at Pacific Investment Management Co. LLC, addresses congressional “dysfunction,” untested Fed policies and Europe's latest “botched” attempt to bail out Cyprus.

Question #1: Regarding the latest efforts to bail out the Cyprus financial system, what implications might there be for the U.S.?

Mohamed El-Erian: Another botched attempt by Europe to rescue Cyprus would have few direct effects on the U.S. but carries the risk of some indirect ones. By “botched,” I refer to the possibility that in addition to failing in its primary objective of avoiding a Cypriot bankruptcy, Europe would end up undermining the integrity of bank deposit insurance, the free flow of capital and the power of its central bank.

Fortunately, there are no meaningful parallels between the crumpling Cypriot banks and a U.S .banking system that has made progress — though not complete — in reforming itself. Also, the irresponsible and excessive growth of the Cypriot banking system to eight times the country's [gross domestic product] is a huge differentiator, especially since it occurred on the back of foreign deposits, including from dubious sources.

Because of all this, it would be utterly wrong to draw any implications from Cyprus for the soundness of [Federal Deposit Insurance Corp.] deposit insurance here in the U.S.

The indirect effects, however, cannot be so easily dismissed.

If Europeans do not get a quick and proper handle on the Cyprus crisis, the country could risk the type of social disorder and political breakdown that could even force it out of the eurozone. If this occurs, we would expect the European economy to contract even more in 2013, financial dislocations to return to other vulnerable peripheral economies and market risk aversion to spike. This would translate into stronger external head winds for the ongoing process of U.S. economic healing. And it would place an even greater onus on the effectiveness of Federal Reserve policies.

Question #2: How significant is it that — at least since February — the U.S. dollar has been strengthening in stride with the stock market rally?

El-Erian: Because of America's role as the provider of global public goods, the hyperactive policies of the Federal Reserve have been forcing other central banks to adopt more expansionary measures. The resulting gradual convergence in monetary policy towards a generally more stimulative stance translates into a stronger dollar, as well as provides significant support to the stock market.

Also, the improving data out of the U.S. — in absolute terms and relative to other major Western currency blocs — confirm the country's superior mix of resilience and agility. As such, this attracts greater foreign capital into the U.S., serving also to strengthen the dollar and boost equity prices.

Question #3: As the pace of government spending continues pushing debt levels higher, how much risk is there of another U.S. credit downgrade?

El-Erian: There is a risk, especially as Congress' failure to address medium-term fiscal issues is not the only issue. Congress is also failing to act on measures that would lift the structural impediments to faster economic growth. It seems to have fallen into the trap of creating periodic and unnecessary potholes for the country — the debacles over the debt limit, the fiscal cliff and the sequester being examples.

Question #4: When and how do you think the U.S. economy will be able to stand on its own without such extreme support from the Federal Reserve?

El-Erian: This is an extremely complex question, involving a series of tricky judgments for which there are no historical precedents or reliable models. Exceptional Fed support is now serving a number of purposes, all of which facilitate over time the safe deleveraging of excessively indebted segments of the economy. Specifically, it provides a subsidy for debtors by taxing savers through negative real interest rates, it buys time for Congress to overcome its dysfunction, it provides a better context for engaging in the real economy, it limits the adverse impact of politics on endogenous economic healing, and it serves as a counter to head winds from abroad.

The twist is that the Fed's experimental approach involves not just benefits but also — to use Chairman Ben Bernanke's phrase from his influential August 2010 Jackson Hole [Wyo.] speech — "costs and risks." Like a pharmaceutical company forced to roll out new drugs that have not been clinically tested, the Fed is risking both collateral damage and unintended consequences.

Question #5: When interest rates start rising, how vulnerable is the mutual fund industry to a sell-off in bonds?

El-Erian: A lot depends on the nature of the possible sell-off, its timing and how the industry positioned its clients' assets ahead of all this. Indeed, the question speaks to a more general point that we believe is extremely important in a world facing, to use another Bernanke phrase, "an unusually uncertain outlook."

The vast majority of asset prices have been driven to artificial levels by the direct and sizable involvements of central banks in markets. Traditional asset class correlations have become less stable. And the information content of the industry's conventional labels, benchmarks and guidelines is less meaningful.

All this explains why Pimco and others should be spending — and we are spending — a lot of time analyzing not only what we do to enhance clients' assets but also how we do it.

It involves exploring a broader investment universe and having more-realistic expectations about the likely distribution of returns. It is about thinking analytically about forward-looking benchmarks rather than being hostage to those that capture a past that is undergoing major national and global realignments. And it is about supplementing traditional asset class assessments with innovative risk factor analyses.


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