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Whose Fault Is It Anyway?

Now we know - courtesy of Rolling Stone magazine: it's all Goldman Sachs's fault. The destruction of untold wealth, jobs and all the global economic pain of the past two years? All down to one firm. So let's smash the evil empire and move on. But wait, this isn't a movie. This is real life. And in real life, nothing is simple and straightforward and there's very rarely an single scapegoat.

The financial crisis of 2008 was the culmination of a shift in Western societies toward financially-driven economies; a shift that began with the various Big Bangs of liberalization of financial markets in the 1980s, that was driven forward by central banks' success in taming inflation and that hit several small peaks - the S&L crisis in the U.S., the Russian default/Asian crisis, the dotcom bubble, the Enron/WorldCom collapse, the massive teleco debt accumulated in Europe - before exploding in our faces in late 2008.

At every turn, after every crisis, we as a society - here & abroad - had the chance to put a halt to the economy's inexorable progress toward the cliff's edge. Most recently in 2002 when credit markets froze after the Enron/WorldCom debacle. Had supervisors and regulators then done more than just fret over ratings agency incompetence, taken action instead of twiddle their thumbs over the dangers posed by off-balance-sheet vehicles, perhaps some of the more egregious abuses could have been prevented.

But they didn't and why should they have? We as a society decided that financial markets should rule unfettered, we voted into power the politicians who supported the view, we tuned into CNBC, we wanted to get rich by buying low and selling high - and the devil take the hindmost. Politics boiled down to tax cuts and the demonization of any kind of state action. And even when left-wing parties came to power, the kow-tows to the financial markets continued.

We're all responsible for what happened in the past year - not just the bankers. And getting out of this will the recognition that a stable, balanced economy comes at a price: higher taxes, bigger government involvement in the economy and far smaller profits - for all. Not just the bankers at Goldman Sachs.

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.

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.

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.