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 July 2009 Right On Target
There's plenty of blame to go around for this mess. It starts with the Congress whose democrat-led majority not only fought off stronger regulation of the government sponsored entities Fannie Mae and Freddie Mac, but also pushed them to make more loans to sub-prime borrowers. Efforts at fiscal stimulus degenerated into a free-for-all of pent up pork barrel spending, so its failure to create new jobs should come at no surprise. For their part, the republicans have offered few alternatives. In the meantime, unemployment rises and the toxic assets which led to the crisis remain on banks' books. So with all these failed attempts to right the economy and the finger pointing that goes with them, it's worth noting when somebody gets something right. That's precisely what happened on June 23-24 when the Federal Open Market Committee met and crafted a statement on the economy. To put it bluntly, they were right on target.
The Run Up The so-called "bond vigilantes" were already training their sights on the inflation that is sure to come. With all the government's deficit spending -- and possibly more on the way with nationalized healthcare -- printing money with 0% interest rates can only increase the threat of soaring inflation. Acting on this fear, the bond vigilantes sold long-term Treasuries to reduce their exposure. On June 10, the 10-year Treasury yield briefly poked over 4%, but soon fell back when the Fed stepped up the purchase of longer-term bonds. This was a short-term victory for the Fed, and the bond vigilantes saw it as just that -- short-term. Once the Fed stops trimming supply, the flood of new debt to finance the government's spending binge will quickly drive rates up and bond values, which move in the opposite direction, down. They wondered if the Fed would at least signal when the current program would end.
At the other end of the spectrum, some analysts wondered if the Fed's message would hint at any additional efforts to jump-start the credit markets. Perhaps an increase in the funds committed to repurchase Treasuries and asset-backed securities, or maybe a commitment to hold rates short-term at 0% for a prolonged period of time? Without such assurances, the nascent recovery could be jeopardized. Both camps pointed out the negative implications of the other's preferred outcome. If the Fed raised interest rates, even just a quarter of a point, just the perception of reduced liquidity would undo any progress in the credit market. While most agreed this was unlikely, a stronger stance in the communication following the meeting would signal the current monetary stimulus was ending with almost the same effect on the markets as an actual rate increase. Although this might be good for inflation in the long-term, it would risk sending the economy (and financial markets) back toward their March lows. On the other hand, a commitment to hold rates at current levels might send the signal that the Fed believed the economy was still in need of serious help. That would be a strong argument against those who felt it turned the corner in April and May and suggest conditions were worse than most believed. So against this backdrop, the Federal Open Market Committee sat down for their two-day meeting. Stocks were flat for the day and a half leading up to the announcement and when it finally came out on the afternoon of June 23, shares jumped. The Fed's carefully crafted statement nailed it.
A Blunt Assessment In the prior two months, the credit markets showed signs of thawing. Large banks were able to offer equity to investors as a way of raising capital to pay off government bailout dollars. Most offerings went well and the issuers' balance sheets were strengthened. Even lenders with less than stellar credit ratings were able to bring new junk bonds to the market, some were even oversubscribed. Less government support, improving balance sheets, and even an uptick in the high-yield market are all positive signs for recovery. The stock market's run from the March 9 low was even more dramatic. At it's highest point on June 12, the S&P 500 was up just a hair under 40%. On that same day, the Dow Jones Industrials poked into positive territory for the first time since the first week of the year. Investors were starting to think in terms of a "v-shaped" recover with stocks rising so far so fast.
But Federal Reserve Governor Kevin Warsh put it all into perspective in a mid-June speech, "The economy's rather indiscriminate bounce off the bottom is not evidence that the U.S. is close to a strong rebound. The panic's hasty retreat should not be confused with robust recovery." Many parts of the economy -- particularly stocks and commodity prices -- were reacting to the first signs of stabilization. As June came to a close, crude oil was trading over $70 a barrel, more than twice it's price earlier this year.
Even so, the inflation fearing bond vigilantes overreacted in driving down the prices of long-term Treasuries. In the calming words of the FOMC statement, "The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time." While the government's deficit spending adds to inflationary pressures, the economy is still sluggish enough to contain them. Ultimately this will be an issue, but not until the economy is back on track. A sustained recovery must have something more than hope and anticipation to drive it. In this particular instance, there must be so tangible evidence that economic fundamentals are improving along with corporate balance sheets. Positive earnings growth would also be a welcome development. So far, none of this has really been sited, only as the Fed pointed out, conditions are simply getting worse at a slower pace.
A Sober Outlook On the other hand, there's no need to shut off the liquidity spigot. Corporate borrowing is just now coming around, and any impediment may nip it in the bud. The spread between corporate bonds and Treasuries is still quite large, so there's still much more work to be done. When all's said and done, the government's efforts to get non-performing assets off financials' books hasn't been very successful. Many firms are still holding on in hopes that an improving economy may breathe some life back into them. For that to happen, the credit market needs just about all the liquidity the Fed can afford. Once again, the Fed's decision to hold the line on interest rates was the right response. In the words of the FOMC, "The Committee continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period." That "extended period" will be required to get earnings back on track and repair financial balance sheets. Bear in mind, the FOMC statement is not the minutes of the entire two-day meeting. Odds are, the Fed governors discussed potential impediments to the current course as well as an exit strategy when it's time to tighten policy. Keeping these discussions out of the official statement avoided sending jittery markets the wrong signal in either direction. Here again, the Fed was right on target. Much of the fiscal and monetary policy that's been put in place since the beginning of the sub-prime crisis has been created on the fly. Some of it's been misdirected (the TARP fund and the stimulus package), some of it's been questionable (the GM bailout, the forced marriage of Merrill Lynch and Bank of America), and a little of it has been on target. The Fed's recent actions fall into the latter category. Let's hope that continues. Search this site! Just enter you key word or words:
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S THE SECOND HALF of the year gets underway, the world economy continues to struggle. Despite a few signs of improvement, a definitive turnaround has yet to occur. Congress' exorbitantly expensive stimulus package has not as yet, created any jobs. The unemployment rate it was supposed to hold under 8% is now approaching 10%. That's left most of the recession fighting to the Federal Reserve. With short-term rates holding around 0%, the Fed has sought other, less traditional sources to spark the economy. Special government-backed lending facilities and open market purchases of Treasury and mortgage-backed securities have been able to stabilize longer-term interest rates for at least short periods of time. However, at some point these efforts will have to be reversed and the economy will have to fly on its own.
