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The last chance saloon

We recommend the analysis of Ask Not Whether Governments Will Default But How? (Mares of Morgan Stanley: Aug 25, 2010) as an important work for those who wish to understand the nature of the problem with global sovereign finance. It proposes the notion of “financial oppression” of citizens (or more broadly holders of capital) as a viable strategic alternative available to central banks and governments in lieu of default. This is bold language for Morgan Stanley, a mainstream global house, to use publicly in our brave new regulatory world. We commend them. The analysis is spot on.

For those with a tolerance of flippancy (if not rude language) but who also appreciate clarity of logic, we also suggest  A Termite Riddled House.  It complements Mares’ line of thought for those who might need to grok differently and also happens to have a link to one of the most instructive graphs, a time series, of the Fed’s balance sheet

The graph demonstrates the back end of the cycle. In the front end, as prelude,

  • Congress manipulates housing market (a chicken in every pot becomes a house & mortgage for all for all courtesy of Fannie & Freddie and the Community Re-investment Act);
  • Wall Street brings analytics, derivative technology, and leverage to the party;
  • the GSE’s (Fannie & Freddie) spend at least $171 million on lobbying Congress;
  • encouraged by $171 million of lobbying funds, Congress encourages regulators go to sleep;
  • CMO’s & CDO’s go global and wild, record issuance;
  • then the catalytic event; 
  • the Fed buys out the AIG counterparty book and the “toxic assets” from the banks;
  • Feds force short rates to zero; and finally, and mutually,
  • the banks buy treasuries and ride the yield curve to profitability.  

That’s where we are. The toxic assets are still there, still hanging around. Look at the balance sheet of the Fed. Look at the increase of federal debt.

The strategy of the Fed is very clear. The nature and magnitude of the macro economic problems are so large and complex that resolution of the problems is not feasible from their perspective as a practical or political matter[1]. Scale, complexity, and time make for diverging rather than converging sets of solutions. The cone of possible outcomes they see gets wider and more chaotic.

So, the strategy of the Fed is not to solve large scale, complex problems but rather to avoid several specific bad outcomes

  • a US$ dollar crisis
  • a US bank liquidity crisis
  • a US Treasury market crisis
  • a systemic crisis of foreign bank liquidity

in favor of inducing controlled, chronic inflation to buy time and stability. Default is off the table. The Fed has no more ideas, options or ammo. That’s it.

What does this all mean?  It means we anticipate the Fed will induce structural inflation, which they hope will be moderate, as a best case outcome. We wouldn't go long duration just right now or anytime soon. Those who follow us know we've been inclined to shorter duration and investment grade credits in fixed income for some time. We concede the spread party is over but are content with investment grade spreads for now. We like TIPs as a segment of fixed income strategy. We have been following the muni market with some concern, noting that capacity to repay declines dramatically when you no longer have either cash or a viable tax base. We'll re-consider when we see the risk premia reset (note Harrisburg defaulted on a payment of a general obligation bond today). If we could buy renminbi bonds, we'd think about it.   

As things currently stand we do not anticipate deflation. However, here we come to the uncertainty part,  the 'as currently stands' part. It's unclear on the margin how much more imprudent policy and uncertainty we can tolerate without setting off a chaotic response. The lack of experience in the executive and leglislative branches now adds risk. They don't understand that if you push it hard enough, it will fall over.

The bi-polar mind sees two ways to hit the reset button: a hard reset to equilibrium by crisis of either inflation or deflation. The temperate and optimistic see that with sensible & timely reform we can fix this. When was the last time you saw sensible & timely out of Congress? November might well be the last chance saloon.

Funny how the equity market goes up when the dividend yield exceeds the 10 yr Treasury rate, isn't it?


[1] We will leave for another day the consideration of the hypothesis that in the main the citizenry lacks the capacity to understand what got us here, and therefore we lack the political capacity to resolve it (c.f. dependency ratio > 50% and failures of the educational system). [2] Also thanks JS for correcting the error of 'grock' to 'grok'.


Reader Comments (1)

Ratings on $55bn muni debt face cut
Financial Times
By Nicole Bullock in New York
Published: September 2 2010 20:33 | Last updated: September 2 2010 20:33

Credit ratings on almost 900 municipal bonds, or $50bn to $55bn of debt, could be cut by up to three notches by Moody’s Investors Service, creating the potential for higher interest rates for some municipalities struggling with budget deficits.

The rating agency is modifying the way it rates certain variable rate demand notes, a corner of the $2,800bn market where US states and municipalities raise money....

September 3, 2010 | Registered Commenterhb

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