Now For The Hard Part...

The past couple of weeks have felt vaguely comforting: stocks rose, some economic data, both here and abroad, seemed a bit less dire than it could have been, the government appeared to be getting a handle on the banks and - more importantly - came up with a plan for regulation of derivatives that finally showed leadership, ditching the fiction in place since 2005 that industry-led efforts would be sufficient to ensure proper market functioning. After the ravages of the post-Lehman months, the global economy heaved a sigh of relief.

But the relief won't last. Already, the first signs of problems (slowing Chinese exports, plunging U.S. retail sales, desperately bad numbers from the euro zone, not to mention a realization that the banks remain a possible source of more instability) are hurting sentiment. We're now finding out that the landscape at the bottom of the cliff is not exactly a hospitable place. It's strewn with large rocks, and it's very hard to see what lies behind those boulders. It's not at all what we are used to - as citizens, investors and policy makers. It's one thing to see a slow, gradual recovery - that at least implies progress, even if only at snail's pace - and devise policy accordingly. It's another to plot policy for a course that goes round in circles at times, heads up, then down again, and occasionally runs into dead ends.

But critics of the massive deficits and the Federal Reserve's monstrously inflated balance sheet have smelled blood. It's true the Fed and the government are taking a massive gamble, and if things don't pan out, the fallout could be extremely painful for many, many generations to come. But those who want the Fed to start shrinking its balance sheet and the government to cut spending now live in cloud cuckoo land. They fail to understand how much leverage still has to come out of the U.S. system - not just at banks and households, but also at corporations (remember, the years preceding the crisis saw massive LBO activity, shareholders clamoring for buybacks, and several mergers - not just in the auto industry - that shouldn't have happened.) The global economy is showing extreme strains as it tries to adapt to U.S. consumers' new-found frugality. The tried and trusted method of exiting a recession through exports doesn't work in a world where financing is scarce and demand even scarcer.

We must not forget that this is a financial and an economic crisis - on a global scale. In this case, the past is really no guide to the future. Storm clouds are already gathering once again - it's another two weeks to June 1, the deadline for GM. Even if the U.S. economy manages to weather that event, it would be premature to think that our problems are over. The inflection point spied by some policy makers could yet turn out to be but a short-lived reprieve.

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.