Economy May Reverse Course When Fed Buying Ends: Gross

The expected end of the Federal Reserve's Treasury-buying in June may not bode well for the US economy, with "dramatic consequences in the reverse direction" likely, according to Pimco managing director Bill Gross.

The Federal Reserve headquarters in Washington, DC.
The Federal Reserve headquarters in Washington, DC.

Among the likely outcomes when the Fed walks away from the second leg of quantitative easing (QE 2) will be substantially higher interest rates and an economy that may not be able to stand on its own, Gross wrote in his monthly analysis.

"A successful handoff from public to private credit creation has yet to be accomplished, and it is that handoff that ultimately will determine the outlook for real growth and the potential reversal in our astronomical deficits and escalating debt levels," he wrote.

If the economy cannot manage after the Fed's expected end to Treasury purchases on June 30, "then the QEs will have been a colossal flop," he added.

The comments come as Fed officials weigh the proper exit strategyfrom the nearly $2 trillion money-printing program the central bank embarked on following the global financial crisis.

Recent indications from Fed governors are that the central bank may consider extending the date for the end of QE 2, though it will keep the amount of purchases the same. Expectations are low for now that the Fed would add a third leg, with that likely changing only in the case of a severe adverse reaction from the financial markets.

At its core, the buying of Treasurys from financial institutions aimed to cut interest rates and pump cash into the economy, preferably in risk assets such as stocks. The result, in Chairman Ben Bernanke's words, would be a "wealth effect" that would instill confidence in the economy and propel growth.

But the program has achieved only partial success.

While the stock market has soared during both legs of QE, unemployment has remained stubbornly high and the housing market has displayed few signs of recovery. At the same time, the soaring debt and deficits have increased inflation expectationsas commodity prices have surged.

Gross said critics of the Fed easing programs legitimately could ask whether the "policies actually heal, as opposed to cover up, symptoms of an unhealthy economy."

Interest rates, he said, are probably 1.50 percentage points too low—based on the benchmark 10-year Treasury yield compared to expected economic growth—and will gain once the Fed walks away.

The central bank, along with other sovereign entities in China, Japan and elsewhere, account for 60 percent of Treasury ownership. Since QE 2 has begun, the Fed has been responsible for 70 percent of all Treasury buys, Gross said.

"Who will buy Treasuries when the Fed doesn't?" he asked. "I don't know."

He called the Treasury-buying a "Sammy Scheme" (apparently after Uncle Sam) and said it "is as foolproof as Ponzi and Madoff until...until...well, until it isn't."