The Fed’s Dilemma
by Doug Noland, Prudent Bear
April 8, 2005
prudentbear.com
I believe the coming weeks in the markets – and perhaps next week in particular – will be decisive. I sense a lot of “hoping” by market participants. And markets are not typically accommodative to those clinging to hopes and prayers. There is hope that a slowing U.S. and global economy will stem escalating global inflationary pressures and bail out the highly leveraged and speculative U.S. bond market. There is hope that the darkening clouds of financial scandal and systemic fragility will spook the Fed, state attorneys general, OFHEO, the regulatory community and Congress into forbearance and passivism. There’s also a lot of hope that U.S. equities will be able to muster the much anticipated rally. There is similarly much hope that the recent shallow decline in yields is not the best the bond bear has to offer. There is, as well, hope that the dollar has stabilized.
All the complacency and hopefulness has left curiously little room for fear. I’ve always appreciated the old adage, “You know you’re in a bear market when people are losing money but feeling pretty good about it.” It seems especially pertinent today in various markets. After all, acute market vulnerability manifests most forcefully from an environment where the fanatical crowd has begun to part with its money yet clutches to the notion that fundamentals are sound and the worst has passed. And when the crowd is highly leveraged with bets in myriad markets – as it is to unparalleled extremes these days - it is appropriate to think in terms of systemic fragility and instability. Sensing a high degree of concerted hoping in various markets leads me to believe that the next bout of selling may prove decisive. If a series of (seemingly vulnerable) bets falter simultaneously – say, rates rise, stocks drop, the currencies and commodities break big one way or the other, and spreads widen – the big loser would be systemic liquidity.
I am not comforted by the general perception of the underlying soundness of the U.S. economy and financial system, while the markets’ complacency with regard to the scandal unfolding throughout the U.S. financial sector is rather amazing. Yesterday’s discussion between CNBC’s Ron Insana and the astute Jim Chanos regarding the similarities of AIG to Enron should have been good enough for a few hundred points down on the Dow – at least.
Taking a step back for a moment and contemplating the financial world, one is left with a sense that “contemporary finance,” as we have come to know it, has commenced a radical shakeout. The scope of the problem is staggering. There is Fannie and Freddie, with their combined books of business of $3.8 Trillion backed (hopefully) by a little sliver of shareholder’s equity. Troubled GM and Ford have total liabilities of $740 billion, with equity stated at $45 billion and absolutely dismal prospects. AIG has total liabilities of almost $700 billion (SH Equity of $83bn). Combined, these five companies’ exposure of almost $5.3 Trillion is in the neighborhood of 30 times reported equity. In the best of times, there was no room for error or chicanery. These may be the worst. And one does not want to forget MBIA. This troubled risk guarantor has written insurance – “Net Debt Service Outstanding” - to the tune of $890 billion, with shareholder’s equity of $6.6 billion. To witness such a massive and pervasive Credit system problem at this pinnacle stage of system excess and asset inflation portends a devastating down cycle.
Now, I am the first to admit that the Credit system, immersed in Bubble “blow-off” excess, for now still packs sufficient punch to adequately finance the Bubble Economy and the Bubble Asset Markets. But this endeavor will become increasingly untenable. Underneath the Bubble façade, the New Age Risk Intermediation Scheme is increasingly impaired and susceptible to crisis. This has future ramifications for both Credit Availability and Marketplace Liquidity, something the stock market should increasingly begin to discount. And there is still the specter of the loss of U.S. financial sector integrity inciting a run on the dollar and U.S. securities. The indomitable GSE’s “backstop bid” has simply vanished for the interest rate markets; how dependable is the foreign central bank dollar “backstop bid” going forward in the currency markets?
And there is the important issue of a very serious dilemma developing for the Fed, as well as for the markets as they grapple with how the Fed may choose to deal with its predicament. One the one hand, a critical segment of the U.S. Credit system has been defiled and the systemic contagion risk is high. “Structured finance” is increasingly suspect. Yet, past experience provides marketplace solace that the Fed will err on the side of caution. On the other hand, the Mortgage Finance Bubble is running white hot in a precarious textbook speculative blow-off. The Fed, at this point, should be feeling the heat to raise rates sufficiently to rein in conspicuous and destabilizing Credit and speculative excess. Bonds are cheering (praying?) for Fed restraint, while the dollar is desperate for some real tightening of Credit conditions. My hunch is that the Fed may actually believe all its talk of “resiliency” and be ready to ratchet up rates and initially downplay signs of systemic stress. It is not easy for me to envisage a scenario that is supportive of inflated equity prices. |
