Sometimes Mike O'Rourke pins the events of the prior day just that little bit better than anyone else. Today is a case in point. We present his letter to clients in all its unadulterated glory and hope he won't sue... One can only hide behind the whole DMCA thing so long...
It was another terrible Tuesday. Financial unrest in global markets over the past few days weighed upon the U.S. market today. The weakness has sparked another flight to quality in the Dollar, Treasuries and Gold. As usual in such environments, buyers go on strike and move into self-preservation mode. The fact that an $800 billion Stimulus is ushered in with heavy selling sums up the malaise in this market. The recession has helped uncover yet another financial fraud. To the SEC’s credit, they have been investigating the case since the summer. This is another example of one of the few silver linings in a recession. They expose our weaknesses and help strengthen the underlying structure of the economy. To wrap the day’s trading, less than an hour after the new TARP salary caps were signed into law, we had the first high level, Wall Street executive departure.
It was also reported today that regulators are descending upon the banks to begin collecting data for Treasury’s “stress test.” During his House Financial Services Committee testimony last Tuesday, the Fed Chairman paralleled the Treasury Secretary’s stress test to FDR’s bank holiday. The Chairman explained, “An interesting historical example is the bank holiday of 1933 when Roosevelt shut down the banks for a week, and said we are just going to check the books and open them up only when we think they are solvent. And a lot of the banks opened up pretty quick. So, it's not really clear that how much they really looked through the books, but when they opened them up again, people felt much more comfortable, and more confident in the bank. And part of the proposal that Secretary Geithner put out this morning is to have a supervisory review, not only of the quality of assets reserving and the potential future losses, but also to ask a very important question: How well would the banks do in a very -- even more severe scenario?” The Chairman answered his own question by describing the stress test. “A stress test. Are they able -- do they have enough capital that, even putting aside whether they're solvent today, that they could survive an even worse scenario? And to get confidence that they could survive that scenario, put enough capital in that, that they can survive that scenario, should help restore confidence that they are, in fact, solvent and that would in turn attract private capital.” The current market action is similar to the information vacuum of early January. The problems and challenges are well known, and now investors are awaiting a path forward. Tomorrow, the Fed Chairman has a speech on the Fed’s programs and its balance sheet.
On the subject of the Fed’s balance sheet, St. Louis Fed President James Bullard gave a speech today. Bullard is the latest in a line of officials who have publicly acknowledged that the economy is at risk of being caught in a deflationary trap. The core of Bullard’s speech contrasts the monetary base in ordinary (persistent) conditions versus exceptional (temporary) conditions. Hence, Central Bank expansion of its balance sheet in exceptional conditions is common throughout history. In the case of the Fed and its balance sheet, the Fed has increased the monetary base from $873 Billion in August to its current level of $1.73 Trillion. The expansion consists mostly of temporary programs that run off as the need for them subsides and therefore, they do not pose an inflationary risk. Bullard goes a step further to note that if the market stresses eased and the programs ran off to zero, the monetary base would be smaller than its pre-crisis July 2007 levels. Bullard explained, “It would be as if the FOMC had reacted to the financial crisis by shrinking the monetary base. From the perspective of maintaining an expansion of the monetary base to ward off a deflationary risk, these programs seem to be a thin reed on which to balance medium-term inflation objectives.” Bullard notes that the purchase of Agency MBS will partially offset the Fed’s previous sale of Treasuries but when completed will lead to an approximately $275 Billion expansion to the ordinary/persistent monetary base. The questions investors should be asking are whether or not that is enough to prevent deflation and should the rate of purchases be accelerated?
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