Tuesday, July 14, 2009

Credit Cycle Breakdown - Exit Plan

There is always two likely outcomes for Monetary Policy.

Policy is completely effective
Policy is horribly ineffective

Unfortunately these are false choices, as the complete breakdown and downward spiral of the credit system has showed us, traditional monetary policy is severely diminished, because of the excess of the issues that brought us to such pain. With this particular crisis, we found out quick that just lowering fed funds rates to restart the economy will have minimal impact. What we have found out to some degree is that non-traditional policy (TARP,TLGP,TALF, and other QE Efforts) have a better chance to be effective in the very short term, but has very counterproductive outcomes in the long run.

The major problem here is the exit plan. Where is it? At this moment, there is no exit plan, as the Treasury is in a cycle of never ending debt issuance. The Treasury has injected Trillions into the system to re liquefy the capital markets, this has had a tremendous effect on pricing and obviously liquidity in these significant markets. The Fed/Treasury's purchases in the MBS/ABS markets have been so large that spreads that were blown apart after Lehman collapsed are almost back to bubble levels. Basically we are back to the point where the excess credit problems took place.

In the first quarter, the banks were able to re mark up agency MBS securities almost 10 points, this allowed them to book huge profits. This quarter, the banks will mark up Non-Agency MBS securities to the tune of about 15 points or so. So Quantitative Easing has worked far more then just lowering fed funds/discount rates.

All of this does have huge mid/long term implications. Its is not clear that inflation expectations are getting better, just take a look at the TIPS (Treasury Inflation Protected Securities), rates are already moving up as investors are doubting whether the Fed will be flexible on monetary policy. Most importantly, investors are seriously pessimistic about how the Treasury can handle the deficit. What most investors are worried about is that the hope of bringing back the status quo will lead to an out of control policy of just printing money. The emphasis on jobs and housing at the expense of inflation and deficits have put long term bond mavens on the defensive, with potentially trillions in Treasury refunding on tap to finance the Bail Out, the question is: How much more ammo does the treasury have?

No comments:

Post a Comment