Happy New Year. I would like to begin by thanking my readers for supporting me in 2009. Let us hope and pray that 2010 will be even better.
That said, the investment grade corporate bond market, the junk bond market, and the bank loan markets can’t have a better year in 2010. Rates would have to go below Treasuries, perhaps even to zero. Also, it will be tough, but not impossible for stocks to manage a gain better than 26.5% gain in 2010. But it would require stellar corporate earnings amid continued low financing rates, with no significant continuation of corporate defaults at a high level.
I don’t hold this view with a ton of confidence, but today’s selloff was supposedly due to the Fed deciding to consider selling some of the bonds that they have bought over the last six months or so. I’ve said before a number of times that it is a lot easier to begin an easing program than end one.
The quantitative easing was a way of buying bonds expensively, which would hold down rates in the process. The bond market ran in front of the Fed, pushing up bond prices, figuring (correctly) that the Fed was a forced buyer. As the end of the process drew near, bond investors sold as the Fed began buying their remaining bonds. Now the Fed thinks of selling. Well, even with the yield curve near record levels of steepness, it could get steeper (though probably not by much, I get the weird feeling that something will break, but I don’t know what). Once it becomes evident that the Fed has shifted from buy to sell mode, some bond investors will start shorting the market. Given the record financing schedule that the Treasury will be doing, there will be a lot of supply hitting the market. The yield curve steepness anticipates much of this, but there will be a very negative tone if the Fed and Treasury are selling bonds at the same time.
This makes the recent actions with Fannie & Freddie more understandable. Fannie and Freddie can take losses on mortgages, and the losses get passed on to the US Government, eventually. Losses on bad housing debt gets turned into additional government debt. (Wonderful, not.) The US Government can use Fannie and Freddie to try to reflate the housing market, at least the lower end of it.
The trouble with all of this is that we are bailing out less productive assets, and taxing more productive assets to do so. We don’t need more housing, banks, or autos. We have too much capacity in those areas. Bailing them out is a recipe for stagnation, a la Japan. Handing over investment decisions to the government is an utter and total waste of resources. The role of government in the economy should be to punish theft and fraud, and prevent them where they can. Assuring prosperity is not possible, so don’t try to promise it, much less attempt it.
I think the Treasury and Fed are trapped. They will have a really hard time removing the stimulus, because they don’t want to raise interest rates. Banks have become more reliant on low rates since quantitative easing started.
Then there is China. Because they own so much of our debt, they are the prisoner of the US. If the US were to default, their financial system would likely fail. China is running a bubble policy of its own, and real estate prices are rising, though the ability to service debt is rising more slowly. As with the Fed, forcing rates down can work for a while. But only for a while. Some of that bubble extends to the US, sucking in our debt to keep their currency cheap. Dumb as a rock, but hey, we get cheap goods, and they get expensive debt.
There is an endgame here, but I do not know the what or the when. The US Government could default only on external debt. Hey, if Argentina can do it, so can we, and don’t think that the US Treasury isn’t drawing up contingency plans for that even now. What could be more a more fitting end to being the world’s reserve currency than to default in the end, but protect their own citizens, and send a large portion of the global banking system into insolvency, aside from that in the US? Truly perverse, after the way the US has gamed the system so far. Who knows, after such a crisis, the new US Dollar might seem to be the best possible global reserve currency, but I doubt that would happen when wounds are fresh.
Anyway, here is to a great 2010. May all of your debtors pay you full value.