Are The Bond Market Vigilantes Back?

A WSJ article Saturday questions whether the bond market could derail the government's plans for healthcare and energy reform as it did back in the early years of the Clinton administration when the "bond market vigilantes" forced the government to sacrifice its healthcare project and instead address deficits.
For the sake of the economy and the millions of American's looking for jobs - not to mention the global outlook - one would sincerely hope not. The days when markets dictated policy are hopefully behind us once and for all; had we been a little less subservient to market demands (for unfettered trading, light regulation to avoid stiffling innovation, low taxes etc etc) in the first place, we may not have found ourselves in quite such dire straits.
That's not to say that the Treasury market jitters are unreasonable. The U.S. is after all embarked on a once-in-a-lifetime experiment that involves not just massive spending to get the economy out of a recession and restore an embattled banking sector to health. Officials are also attempting to rebalance growth so that it's less consumer-dependent even as demand in the rest of the world is weaker than it's been in a long time, while restoring the flow of credit to the economy without reviving the heavy dependence on leverage and the shadow banking system that was ultimately the root cause of the credit crisis. There's no blue print, no model for what policy makers are doing - from the Fed's many innovative liquidity programs to the Treasury's Auto Task Force. Hence the Treasury market's jitters - in fact, we should all be apprehensive: there are no guarantees that this will work. But equally - and the cooler heads in the bond market will agree - there isn't a palatable alternative.
The bond market is looking for guidance from the Fed as it contemplates the risky path policy makers are taking. Right or wrong, it saw a subtle signal in the Fed's mortgage bonds and agency debt purchases Thursday and Friday, when the bank bought larger amounts than in the prior rounds. It'll be looking for another signal on Wednesday, when the Fed buys Treasurys in the seven to 10-year maturities, just ahead of Thursday's announcement by Treasury of the next round of auctions which include reopenings of existing 10- and 30-year maturities - the ones where all the worries about inflation, unsustainable deficits, and ratings downgrades crystalize. There's one more opportunity for the Fed to send a signal to markets before that announcement: Early Thursday, New York Fed President Bill Dudley addresses a SIFMA conference (though how receptive markets might be remains to be seen - many still remember his March 6 speech when he indicated that Treasury purchases weren't on the table, only for the March 18 FOMC meeting to announce the immediate start of such purchases.).
Central bankers are probably hoping to be able to keep the market on an even keel until the June 23-24 FOMC meeting when they will have the opportunity to discuss the future of the Treasury purchase plan, which runs out in September, and perhaps even more importantly, start addressing in specific their exit strategy. They might just succeed, though it won't be smooth sailing.

Fed & ECB - A Study In Contrast

This week is jam-packed with events that will keep markets on their toes, but the two to focus on are the testimony to the Joint Economic Committee by Fed Chairman Ben Bernanke on Tuesday and the European Central Bank meeting on Thursday (the bank stress tests will be released on Thursday after the markets close. But given all the leaks, there might not be much left to release come the time.). Bernanke and Trichet will be far more interesting, highlighting the difference in approach to the crisis resolution - and reminding us at the same time of the limitations of central banks.

Bernanke will with no little pride be able to point to some hopeful developments, the slowdown in orders, including export orders, abating in the manufacturing sector - still a weathervane for the broader economy despite the service sector's weight - consumer confidence picking up, even house prices, while still falling, no longer setting record declines. Plus, there have been more signs of healing in the financial markets - risk gauges like Libor/OIS are narrowing - 3-month Libor is headed below 1% - and one Fed facility, at least - the one that supports commercial paper- is seeing less usage (though that's in part a reflection of the lower demand for corporate borrowing due to the recession). Sure, he'll be crossing his fingers behind his back as he speaks, given testing times ahead in the auto industry and the continued worsening in the jobless rate (a 9% unemployment rate for April is not out of the question). He will do his utmost to calm any fears that the Fed is in over its head with its ballooning balance sheet by outlining the exit strategies, the groundwork for which was laid in the March joint statement by the Fed and Treasury. And he will have soothing words for those worried about record debt levels. Demand? No sign it's waning massively, plus never underestimate the power of a determined central bank. Inflation? Conscious of the danger, believes the Fed has it under control. And the administration, he will note, is determined to reduce the deficit in the years ahead.

Two days later, listen to Jean-Claude Trichet, president of the European Central Bank. He will explain why a 1/4 percentage point cut in the euro zone's key rate to 1.0% and the extension of its refi operations from six months to possibly a year are sufficient to lay the groundwork for recovery, even as these measures pale in contrast to the Fed's actions. He has a point: Structurally, the euro zone depends on banks for lending, in contrast to the U.S., which relies heavily on debt markets - so expanding money supply is one key way of ensuring the supply of credit to the economy. Add the automatic stabilizers such as unemployment benefits, welfare payments, healthcare etc, to the special spending packages, and the euro zone and the U.S. are spending similar amounts. And he too can point to success: Euro zone market rates are in many instances lower than dollar rates, even though the Fed's key rate is much lower. But most importantly, expect Trichet to remind his audience of the stifling impact of ever-rising government deficits: consumers, fearful of higher taxes later, don't spend any additional funds, opting to save them instead; interest rates eventually end up having to be higher than desirable to attract investors; economies lack the resources to tackle the big structural issues, such as pension funding, better education, etc.

So, is the ECB free-riding on the coattails of the Fed's massive intervention? Or is the Fed being reckless, and is it the ECB that should be lauded for its adherence to fiscal discipline? It's probably a bit of both, and a lot of the difference in the approach is based on their history - the Fed and the Great Depression; the ECB and Europe's battle with hyperinflation.
But it's also a moot point in many ways. There's only so much central banks can do; they are after all merely guardians of the economy. It's time to remember that the economic challenges the euro zone and the U.S. face require political solutions. From the big exporters to the finance- and real-estate dependent economies - it's time we recognize the integral part the economy plays in society and reclaim our power to set its course.

Don't Trample The Green Shoots

So the Fed held fire on expanding the Treasury purchase program Wednesday - but there's one thing one shouldn't overlook: the program runs until the fall - ie September. So either at the June or the August FOMC, it'll have to make the decision whether to expand its buying.

In the meantime, there's plenty of bad news lurking that could prevent a full-blown, sustained sell-off in the long end of the Treasury market - even though the 10-year yield could well test the 3.25% mark before all is said and done. Right now, the market is obsessing with supply - no wonder, Treasury said Wednesday it plans to sell some $361 billion in marketable debt this quarter. That's after just over $450 billion or so were sold in the first quarter - $2 trillion is easily in our sights if we continue at this pace.

Among the risks still out there: the fate of the auto makers. The Chrysler negotiations are going down to the wire - and we're only talking $6 billion or so in debt involved. In the battle royal over GM, bondholders have just fired their first shot, according to Reuters. Investors may think that with GM bonds trading at just a couple of cents on the dollar, all the bad news should be already priced in. But last week's swift drop in the dollar against the yen, when the bankruptcy flag was raised for Chrysler, was a healthy warning against complacency.

More uncertainties: the banks. From Goldman Sachs to Deutsche Bank, their first quarter profits came overwhelmingly from trading - fixed income, currencies, commodities. Not even the banks themselves think that's a sustainable model of growth. Not to mention the stress tests, the release of which is turning into a painful farce.

The biggest question mark, though, hangs over the economy, and the consumer in particular. There's a lot stacked up against us (see above) domestically, while the economy slowly wends its way out of recession; the highs in the jobless rate have yet to be seen. Foreign demand won't be much help - the economies in Germany and Japan look likely to have a terrible year.

A closer reading of the Fed statement shows that while policy makers are less downbeat than in March, they remain closely attuned to the risks to the economy. Policy makers are determined to keep long-term rates, so important to consumers and the housing market, low. The consensus that the Fed will expand its Treasury purchases will likely prove right. Now all we need to work out is when they'll tell us.

What To Expect From The Fed On Wednesday

The Federal Reserve's rate setting committee meets on Wednesday - what should we expect from the statement? It's unlikely to be as explosive as the March 18 one (when despite clear signals to the contrary - including a very definitive statement by New York Fed President Bill Dudley 10 days earlier - the FOMC opted to significantly ramp up its mortgage purchase program and to start buying Treasurys to manipulate the yield curve); it could sound a little bit less concerned on the economic front, if the Beige Book and Fed Vice Chair Donald Kohn are anything to go by (but see above, one might want to be careful when reading Fed tea leaves.)

The Treasury market is inclined to push yields higher and test the Fed's mettle - already Friday, the 10-year yield briefly poked its head back above the 3% mark. The thinking is that the Fed will have to buy more than $300 billion worth of government debt to keep long-dated yields in check - and though the consensus seems to be for now that policy makers won't want to announce an expansion of the program, we've learnt our lesson on that (see once again above).

What's more, there are good reasons why the Fed might want to announce an expansion of its purchases now: if policy makers do see some kind of stabilization in the economy, why not double down and make sure the 10-year yield stays below 3% to ensure it stays that way? That's particularly as the consumer remains the weakest link: job losses will continue to rise - April's unemployment rate could touch 9% (it was 5% in April 2008, just for comparison) - and don't be fooled by those who say jobs are a "lagging indicator". That's only a comfort when there's another source of demand (typically exports) that can help get the economy growing again - but remember, this time, we're in a synchronized downturn so that historical leg of recovery won't be of much help.

A freaked-out consumer, terrified of losing his/her job, a global economy mired in a lack of demand - maybe adding another $750 billion to its Treasury purchase program might not be the worst thing the Fed could do.

Bank Stress Tests - What Took The Regulators So Long?

Treasury Secretary Timothy Geithner must be having a sense of deja vu when it comes to the stress tests that regulators are currently conducting on the 19 major banks in the U.S. Take a look at his speeches as New York Fed president from early 2005 onwards and one can't help but wonder why regulators didn't act earlier to rein in the banking sector.

Geithner didn't hold many speeches as Fed president, but when he did, from 2005 onwards, he was constantly - a bit like a Greek chorus - urging financial institutions to make sure their stress tests were based on sufficiently negative parameters (the tail risk) and that the tests were conducted across all asset classes, not just on a business by business line (contagion risk). Capital and liquidity cushions - he said time and again - should be appropriate to the most negative outcomes ("adverse scenarios where uncertainty is the highest") rather than just meet minimal regulatory standards. One presumes that if he said it publicly, he was saying something similar in private, both to his fellow regulators and the firms he oversaw.

Roll forward to 2009 and his recommendations four years ago look very much like the blue print for the Federal Reserve's stress tests - and while there's little point now in bashing the regulators - who clearly saw cause for concern even when the good times were still rolling in the credit markets - we should learn the lessons of the past and remember that leaving it to the banks, or any group of private sector agents (same would be true for energy companies or health insurers) to self-regulate and do the right thing out of enlightened self interest and an obligation to their shareholders is foolhardy and invites abuse.

There's no telling what would have happened had the Fed forced the banks in 2005 or 2006 to raise capital and liquidity cushions significantly above the regulatory requirements and conduct far more stringent stress tests. The investment banks would have remained outside this net, unless the SEC had joined in, so Bear Stearns and Lehman might still have gone under. But humans are by nature prone not to do what's best for them and easily swayed by short-term considerations. Which is why we have civil laws and which is also why regulators and politicians should not shirk their duty and institute tough rules for industries that have the power to sink our economy.

Spring Blandishments

Spring's here and with it comes talk of "green shoots" and "small signs of hopes" when it comes to the economic data - February brought the second month in a row of rising retail sales and personal spending, durable goods orders were up as were existing and new home sales. And bank chiefs talked about a good start to the year for the first two months.

But it pays to remember that the on-month gains came after the economy well and truly tanked in the fourth quarter - it fell so steeply, there had to be some kind of leveling off in the pace of decline. That's no doubt a good sign; a continuation of the fourth quarter's precipitous drop across all sectors of the economy would have been highly alarming. But when things stabilize, there's still a possibility they could resume their decline - it's in no way a given that the only path from here is upward. And in a worrying sign, some bank chiefs, including JPMorgan's Jamie Dimon, are warning that March was a tough month.

The coming week brings the first inklings of this month's data in the form of the ISM's national reports on the manufacturing and non-manufacturing sectors. The headline numbers will show more stability, but it's the components such as inventories, shipments and orders - particularly export orders - that will be the most insightful. Global demand outside the U.S. has collapsed - the major export nations, from Japan to Germany to China, have all reported dire export numbers. Chinese officials believe they have averted crisis with their stimulus package and that the vital signs of their economy - such as bank lending - have improved. Germany says it has done enough to stimulate its economy and that given its high debt levels - left over from the country's reunification in the 1990s - it doesn't have the fiscal flexibility to spend more.

But demand will have to come from somewhere for the U.S. economy to start growing and not just bump along the bottom of the trough for an extended period. The domestic stimulus package is one source - but that won't come into full force until 2010. Foreign demand will take even longer to surface - China's recovery will to some degree depend on a recovery in the U.S. as one of its largest trading partners; Germany needs the rest of the world to recover so it can start exporting again, and Japan's economy remains in a blue funk. A hopefully more immediate source of demand will come from the funds that the Fed is creating and throwing by the armload at financial markets to revive gun-shy capitalist spirits and the broader economy.

Spring crocuses notwithstanding, the economic outlook continues to hang in the balance. It will take longer than one season for the rescue efforts to work their way through the economy.

Is The PPIP Pure Piffle?

Pity Timothy Geithner - it seems that no plan that bears his imprint will ever meet the approval of the nattering nabobs. At least today, he has the comfort of having won the blessing - albeit temporary - of the markets.

But is his plan as bad as the critics claim? Does it really fail to address the key issue, as some say -namely that it's the state of the banks as a whole, not that of certain groups of assets (home loans, commercial real estate etc.) that needs to be addressed? That some banks are just in such bad shape that they need to be nationalized, then wound down - and that the Treasury's public-private investment program is just postponing the day of reckoning?

What the critics overlook is that the financial markets are still a train wreck. True, the stock market is up. Also true, investment-grade bond issuance is at a record for the current quarter. But equally true is that Asian investors have packed up and left the mortgage-backed securities market - and they aren't about to return. Private label mortgages - ones not guaranteed by the government in the form of Fannie Mae or Freddie Mac guarantees - are moribund, commercial real estate is in dire state - and a lot of those loans and securities sit on bank balance sheets. We aren't out of the woods yet; it's just that the markets that are visible have picked up some. And let's not forget the reason for that wasn't pontificating, it was vigorous government and central bank action. Meantime, starved of the oxygen of finance, the global economy is heading toward a full-scale recession this year.

So the Geithner plan is first and foremost a plan to help restart markets that, more than 18 months into the crisis, are still not working (remember, it was the early August 2007 admission by BNP that it was temporarily freezing three investment vehicles because it wasn't possible to value the asset-backed securities these vehicles held that got the ball rolling) and are doing untold harm to the economy. The key goal is to get private capital moving again.

Certainly, the signs are auspicious for the one leg of the Treasury's plan, the auction process for wholesale loans held by banks. As to the other leg, the one dealing with securities backed by home loans and commercial real estate loans, that will take a while to get going. But what the plan does do is get the credit machine rolling again. It will help the banks too, chiefly by buying them time to get their house in order.

Some banks could still fail - we are still in the thick of the woods. It's to be hoped that Congress makes good use of the room that Treasury has created to come up with a legislative framework for the bankruptcy and unwinding of a large financial institutions. It's been a year since Bear Stearns hit the skids - and the absence of such a framework became painfully obvious.

Enron, Bear Stearns & Treasury's Financial Stability Plan

The government is set to present the heart of its financial stability plan - how to deal with the toxic assets clogging up banks' balance sheets - a stark reminder how little progress has been made in dealing with the root of the financial crisis a year after the Bear Stearns bailout.
There's no harm in thrashing out the pros and cons of this plan yet again. But what is urgently needed - and what we are highly unlikely to get - is a sober debate of the big picture, the plan's framework. Transparency will once again fall by the wayside. The taxpayer will be asked to pay up, without being told what it is that we're taking on all this debt for, let alone being involved in the debate whether this is the best solution.

The arguments against the Financial Stability plan are easy to list and most involve practicalities. Private investors will be reluctant to lend because they fear arbitrary changes to the ground rules by populist lawmakers, no matter how cheap the funds are the government will offer them. Valuing these assets so that banks will be willing to sell them without overpaying for them remains a tricky issue. The mood right now is for solutions that work immediately - yet this plan is nothing if not complex and will take time to implement.

But of far greater importance is an issue that we seem to have lost sight of as the crisis has progressed: the need for transparency. We as taxpayers, whose full faith and credit are on the line, have a right to know what these purchases are that we are funding. The Treasury has a web site www.financialstability.gov. It should post the assets that are going up for sale there, including the prospectuses that the government will send out to investors. And please, spare me the "nobody would understand them, they are so complex" argument. It's irrelevant - all that matters is that anyone who is interested has the option to find out more.
What we can't have is a replay of Maiden Lane I - remember the $30 billion facility set up in June last year to take over Bear assets that JPMorgan's Dimon washed his hands off? It's faded into the mist of the financial crisis, but it's still there - just a bit diminished: at the end of 2008, the $30 billion - of which JPMorgan had put up $1 billion - had shrunk to $26 billion. Yet nobody except the New York Fed, JPMorgan and the portfolio manager Blackrock have any idea what's in that portfolio. What harm could come of making these assets public?

This insistence on obscurity is the biggest problem we face. The taxpayer must be treated as equal partner in the resolution of the financial crisis. Officials have decided that the best way to rescue the banking system and the economy is by reviving the shadow banking system - those obscure markets that allowed lenders to repackage loans and sell them on to third parties. But they have yet to explain how they arrived at this decision; they have yet to involve us, the taxpayers, in their discussions.

Off-balance sheet vehicles were instrumental in allowing banks to circumvent capital rules and take on far more risk than they should have - in a replay of what brought down Enron. They should have been banned in 2002, we are now paying for regulators' inability to act forcefully seven years on (we won't even ask where Congress was all those years. Those Congressmen baying for bonus recipients' blood should take a long, hard look at their own record.) These same regulators have now embarked on a strategy that revives those markets that allowed us to live beyond our means, borrow more than we could afford.

Is that the best plan we can come up with?

Business As Usual Is Not An Option

Ben Bernanke, our unruffled Federal Reserve chairman, was asked today whether spending trillions of dollars is the right answer given that it was overspending that got us into trouble in the first place. And his answer was clear - but also goes to the heart of the widespread unease that many feel right now: We cannot afford not to spend. Without aggressive measures, the downturn will become much worse. We need to get through this crisis, then only can we start talking about being fiscally responsible. For sure, there has to be a plan to address the ballooning budget deficit; but now is not the time to be prudent - and he cited St. Augustine's famous "God let me be moral - only not just right now."


The rub with this though is that St. Augustine knew what he had to achieve, and more importantly, what he had to do to fulfill God's demands. It was more or less in his own hands. But it's far from obvious that any of the world's governments have any coherent notion of how to get to the blessed state of sustainable deficits, both external and internal. We need to rethink the premise of a global economy that is driven chiefly by consumer spending in the largest economy, the U.S. Rebalancing the global economy will require the U.S. to curb consumption and invest more in education, transportation, clean technology and many other areas that have been neglected in the past decades. Japan, China and Germany (numbers 2-4 of the global economy) must wean themselves off the exporting fix - these economies must find a way to stimulate private consumption. None of this will be achieved overnight; the scale of the challenge we are facing is daunting.

Conventional wisdom says that the housing market in the U.S. lies at the root of the current crisis - that is partly true. But a different statement would also be correct: it was the massive global imbalances that created the havoc we are now struggling to contain. The G7's conciliatory tone toward China - rather than the usual yuan bashing - was a first step; but the forum that will prove decisive in outlining the post-crisis economic order should ideally be the G20 - where emerging and developed nations come together - which next gathers in London in early April. It has been mostly a talking shop, a handy place for national grandstanding. But under the new U.S. leadership, it has to be hoped that this will change, because we cannot emerge on the other side of the crisis with the same or similar imbalances in the world economy. We cannot afford business as usual.

Groundhog Day - Or Why Change Is Not What We Need At the Federal Reserve

It's like Groundhog Day: one major bank's stock price is falling like a stone, another banking behemoth is getting money and/or guarantees for toxic loans from the Treasury, investors are piling into super-safe Treasurys, the euro is getting pummeled against the dollar and the yen. It's Jan. 14, 2009, but it feels like any day in September or early October 2008. Or late-June 2008. Or March 2008. Or August 2007. It's clear we're stuck in the depths of the woods and there's very little light shining through the mountains of bad loans sitting on bank balance sheets to show us the way out. And that is why, amid all the many pressing issues he has to deal with, President-elect Barack Obama should announce now that he plans to re-nominate Ben Bernanke as Federal Reserve chairman when his term expires next year. There are several reasons why he should do this so far in advance:

-There's enough uncertainty in financial markets and the broader economy to keep us all awake at night for the next couple of years - the last things these markets need are jitters, rumours and chatter about who will lead the central bank as it attempts to steer us out of this mess without causing greater problems down the line. And you can bet your bottom dollar that sometime in the summer, the guessing game will start.

-Let the best man (or woman) win: Bernanke is hands down the best choice for this job. He's the foremost scholar of the Great Depression. His communication skills are impeccable and inspire trust (take a look at the speech he gave this week in London - chockablock full of information, expressed so clearly that the text could double as the basis of an introductory course on financial crises at any college).

-It's the Bernanke Fed's programs and actions that have helped pull credit markets back from the brink - just look at the impact of the mortgage bond purchase plan; it was the Fed's announcement of this plan that finally got mortgage rates to budge. They were well above 6% for a 30-year fixed rate mortgage at that point back in November, now they're just above 5%, thanks to the boldness of the program; a committment to buy $500 billion - equivalent to an entire year's worth of net new supply - within six months.

-Given the depth and intractability of the financial system's problems, come next year, the Fed will very likely still be the main counterparty and risk-taker in the credit markets. Confirming Bernanke now means stability at the helm of the markets lifeline provider - a great help in the current chaotic times. No central bank has ever attempted what the Fed is currently aiming for. There is no upside to switching drivers mid-race in this case.

Obama was elected on the wings of change. But for the sake of the U.S. economy - and with it, the global economy - he should seek not change, but continuity, at the Federal Reserve.