Wednesday, October 22, 2008

Let me spell it out T-I-G-H-T-E-N-I-N-G

That's right.

The Fed is pumping in tons, gallons, cubic meters, miles, square yards, light-years of liquidity- however you want to measure it. But it's still as if the Fed is tightening. Yes, I said 'tightening'.

Am I out of my mind?

Perhaps, but I think not.

Are you ready for a FOOOTBALLL? - an example
Dallas just lost its starting QB to an injury. It is starting a 40-Yr old as a back up QB. Why aren't Dallas fans HAPPY? They now have a QB again - problem solved.

Fail to see the parallel?

I thought so.

You don't have to be a Dallas Cowboy fan or a knowledgeable football fan to see it. When your front line guy goes down -in any sport or endeavor- and you replace him, there is a fall off in what you can do.

Ah...I know what you are thinking...BUT THIS IS THE FED! It is the Fed, THE BEST OF THE BEST, not some past-his-prime over-the-hill substitute. THIS IS THE FED, stepping in to close the gap in the financial markets. The GOVERNMENT is now backstopping things. It's like taking down a chicken wire fence and replacing it with concrete. It's like turning to Superman as a 'last resort.' THIS IS BETTER THAN IT WAS? Whoa? Who thinks THAT? BETTER? Anyone?

Yeah, on closer thought, not quite.

Never metaphor I didn't like...
(1)It's a bit more like getting babe Ruth to fill in at quarterback (QB). I use 'The Babe' because he is so well known. He is (was) great. But he did not play pro football. Who knows if he is any good (or would have been) as a QB? It's the same thing with the Fed. The Fed is filling in. Yes it is a brute as a as a central bank. But now it is wading into markets providing some 'sporadic and limited ' backstop services.
(2) It's a bit more like getting an official who knows the game so well to take off the stripped shirt and put on a jersey. Will he be as good as a number one draft choice?
(3) The Fed is not barging into markets aggressively to replace commercial bank lending or to coup CP issues. It's there, but so are the usual principals. And they are as wary as you were calling your (hoped for) girl friend for a first date with your Mom listening in over your shoulder.

It's all about the rates and END -USER credit!
To get more specific, junk bonds are spread - SPREAD - at 1,000bps (or more) over treasuries...Spread? I never heard of a spread like that. It's like saying I'm going to SPREAD some toast on my butter. Isn't that backwards" Isn't the base rate usually large and rate spread small instead of versa vice? Developing economies are seeing their cost of credit rise. Burger King warns that its franchisees are having trouble getting loans to refurbish their stores. Credit is tighter on all venues.

DO NOT THINK that the Fed has pumped all this NET liquidity into markets. The Fed has swapped more-liquid for less-liquid paper in many cases. That is more liquidity by definition, but no net new credit. There is some direct net liquidlty provision. But, because the private sector has drawn back so sharply, there is actually little if any stimulus even from that. In fact, look at rates in financial markets and tell me -WITH A STRAIGHT FACE- that this does not look like a tightening? Do not look at the Fed balance sheet or at Fed funds levels; look at market interest rates being paid in the US and being paid around the world.

If the Fed and other central banks have pumped in all that liquidity, why isn't anything acting like it is WET?

The real baseline...
Some are gratified and reassured that central banks are so active. And it is better that they are involved now than not. But the comparative counterfactual is not 'what if they were not involved' but 'what if they were not needed?' Then markets and lending would be quite different. But rest assured this is not their thing. Central banks are backstopping and they are not as good as the frontliners they are replacing. The Phillies or Rays will win the World Series this year but neither would do well in the super bowl. Different sport. Different skills. Central bank ≠ Commerical bank. As for investment bank... (please see 'Funk and Wagnalls' under 'extinct').

We would be much better off if we did not need the central banks. People forget that. THAT is the baseline. Relative to that we are much worse off even with the special assistance.

Looking ahead to...
So while some are very worried about inflation and think that the economy is poised to react after being drown in liquidity I say look instead at conventional credit market measures. The credit the Fed gives to the banks counts for naught if the banks don't pass that credit (and capital) on in the form of lending. And the market rates are telling us that they are not doing that.

Credit is hard to get, not easy. It is NOT YET like the Fed is easing. It just may have to push a lot harder on that string.

Much better to count from 'this date' forward expecting the economy to react as if the Fed had raised rates than to expect the economy in the period ahead to act as if the Fed had cut them. This is why the recession is going to get deeper and darker.

I'm not just a pessimist. I am simply looking at the right facts in the right way and not blindly assuming how things will turn out because the Fed has showed its hand. The more you think the less happy you will be too. Sorry for that.

Think and believe.


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