Granted this topic deserves a much more extensive analysis and I hope to readdress it in the near future (but in the mean time welcome any thoughts), today Morgan Stanley is out with a note that brings up relevant good points.
The argument goes as follows: The Fed's version of quantitative easing was initially misunderstood by the market, which assumed a Japanese-type purchasing of Govt Bonds resulting in accelerated private-party bond purchasing. MS claims the Fed is instead trying to lower consumer credit rates, specifically 30 year MBS, rather than adjusting UST rates in hopes that lower yields would pull down the overall credit yields (a marginal contradiction with the latest FOMC statement, which however does not mean much).
The result would be MBS rates that will (should) drop, whereas currently low UST rates are kept there artificially based on faulty market expectations. This does make sense from a use of money point of view as consumers borrow at consumer, not treasury rates. The market result would be, unsurprisingly, a narrowing of the UST - MBS spread. MS expects that once the "market catches on to the likelihood of tighter MBS vs UST spreads, and confidence in this plan is established (ed. big assumption there), we would expect financials to use their leverage to buy MBS and earn significant carry. Getting the private sector to lever up and buy MBS is necessary because the public sector can't do all the heavy lifting by itself." Sequentially, after fixing the MBS market, the argument goes, next up IG, HY and equities would be fixed too... and presto - all is good again.
Three points here:
1) This makes sense but is built on some pretty significant game theory cooperative assumptions which as we have seen since Sept 15, have gone out of the window.
2) Morgan Stanley may very well be pitching its book. Based on prior experience this would not be the least surprising.
3) Soros' little Black Wednesday escapade comes to mind (ah the days when he wasn't acting a tad senile). What happens if someone decides to take other side of the trade.... say someone with a little capital on the side... say someone like Paulson. For this to work there has to be confidence, and confidence can be destroyed by something as simple as a word out of place.
Nonetheless, an interesting topic and potentially reduced to the following philosophical argument: do the wrong thing for near term profit, or do the right thing risking the chance of utter systemic annihilation...
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