What is a worry in Asia? Monetization of Treasury debt

WSJ interview with Richard Fischer, President of Dallas Fed.

He has just returned from a trip to China, where "senior officials of the Chinese government grill[ed] me about whether or not we are going to monetize the actions of our legislature." He adds, "I must have been asked about that a hundred times in China."

He returns to events on his recent trip to Asia, which besides China included stops in Japan, Hong Kong, Singapore and Korea. "I wasn't asked once about mortgage-backed securities. But I was asked at every single meeting about our purchase of Treasurys. That seemed to be the principal preoccupation of those that were invested with their surpluses mostly in the United States. That seems to be the issue people are most worried about."

This is a clear sign that foreign investors are worried that the Fed will use the time-tested solution to big deficits, inflate The economy may not inflate today or this year, but for a holding of 10-year Treasuries there is a demand for an inflation premium. Unfortunately, there is no way out of his situation without a dismantling of the source of the problem, deficit.

Donald Kohn Vice Chairman of the Fed at Princeton University:

"To ensure confidence in our ability to sustain price stability, we need to have a framework for managing our balance sheet when it is time to move to contain inflation pressures," he said.

The Fed has said it is willing to expand extensive purchases of mortgage-related and longer-term Treasury securities to support any nascent recovery.

"The preliminary evidence suggests that our program so far has worked," Kohn said referring to the commitments to buy securities to date.

Kohn said government spending is likely to have a more powerful effect in helping pull the economy out of recession now -- with interest rates near zero -- than it would if the Fed were still in a position to lower interest rates further.

"In this situation, fiscal stimulus could lead to a considerably smaller increase in long-term interest rates and the foreign exchange value of the dollar, and to smaller decreases in asset prices, than under more normal circumstances," he added.

The most important point in the Kohn comments is that the Fed needs a framework for managing its balance sheet. What, it does not have a plan? The only hope is that the multiplier will be higher so that we will grow our way out of this depression. There is little evidence for the high multiplier. We did not see it in Japan. There may be an inflation problem not because this is the plan but because the Fed may not be able to manage its balance sheet.

What are corporate CDS spreads telling us?

The CDR corporate CDS spread indices are now at levels similar to pre-Lehman days. Does this make sense if default rates are higher than what we expected six month ago. Some would argue that this is a technical rally based on short-covering of CDS positions, but we still have to look at the numbers and wonder whether this is a broader signal of confidence. Its is notable that the corporate spread on actual bonds are still higher and while they have also declined there is a marked divergence between corporate spreads and CDS spreads for a negative basis.

CDR Liquid Corporate CDS spread index



CDR Liquid High Yield CDS spread index

Confidence everywhere, but why?

Green shoots are delicate and can easily be destroyed, yet the green shoots are leading to growing confidence across many economic groups.

We have consumer confidence growing positive which may be the most important. The Conference Board consumer confidence number jumped the most in six years beating expectations and going form 39.2 to 54.9; however, you have to go back to 1992 to be at these same levels.

The Merrill Lynch fund manager survey shows a surge in bullishness with 7 of 10 investors predicting that the world economy will improve over the next 12 months. Cash holds have been cut from 4.9% to 4.3%.

The Yale School of Management Stock Market Confidence Indexes are also showing improvement. The one year confidence numbers have turned positive as well as the buy on dips confidence indicator. The valuation confidence indicator as well as the crash confidence numbers are showing more optimism.

Let's hope that this is well placed.

The cash is starting to move

As Keynes put it, “our desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future.”

The signs that money is moving and looking for risk are starting to show up in many markets. Equities are higher. Corporate spreads are tighter. Emerging markets are better. Now we will not see Treasury bills at anything like pre-crisis levels but all of the talk is about the growing risk appetite. Unfortunately, I get uncomfortable when the argument hat there is greater appetite for risk is a fact that risk assets are moving higher in price.Risk appetite should be related to a change in future return expectations. Higher expected returns will lead to changes in portfolio composition. Because we cannot observe expectations directly we can only assume that this is occurring when prices move higher. Is this just another momentum story?