Eyes on the Fed - but few good choices

The eyes of the market are on the Fed now that the president has spoken and not provided a specific fiscal plan. We note that fiscal policy will be more effective during a liquidity trap, but no one is making that as a strong argument. ( I have commented on the negative impact of a the deficit and the need to be firm about a debt ceiling, but I can sill be in favor of fiscal policy. The trade-off o short-term stimulus in exchange for long-term structural change is necessary.)

The market is expecting more monetary action but there are limited choices.

1. Say policy will be loose for an extended period of time. We have already said that, and it may not work to cause more demand.
2. QE3 with more Treasury buying. This will increase inflation expectations and have a positive impact on stocks.
3. Cut the rate on reserve balances. This never should have been done in the first place, but it will not have a strong effect.

There are no choices except to inflate. This will be be dollar and bond negative. It will boost stock values. If we do not get positive statements for action from the Fed, equities will continue their decline.

Chinese ratng agency - tougher than S&P

Guan Jianzhong, chairman of Dagong Global Credit Rating, said the currency is “gradually discarded by the world,” and the “process will be irreversible.”

Dagong made headlines last week when it became the first rating agency to cut its U.S. credit rating from “A+” to “A” after policymakers in Washington failed to act in a timely manner to lift its debt celing.

The odd part is that the Chinese are the largest holders of Treasuries.

US S&P downgrade house of cards

The downgrade of the US government house of cards is starting to occur even if rates have declined. Clearinghouses are being downgraded. Fannie and Freddie have been downgraded. Collateral demands will increase even if does not happen in one day.

The embarrassment of S&P by the US Treasury from their calculation mistakes means that S&P will have to show that other AAA countries that should be downgraded are also adjusted lower. We should expect further downgrades. Municipal bonds will be next. Should a defeased bond be AAA?

S&P downgrade of US Treasury debt

S&P downgraded US Treasury debt to AA+ with a negative outlook. The short-term rating was held at A-1+. The reaction in Treasuries has been muted because the flow to cash and away from equities continues. It takes years to get back a AAA rating.

It is amazing that the messenger has been shot over this downgrade given they told the markets it would happen if there was not a credible multi-trillion debt reduction plan. Th ratings by Moody's and Fitch were reaffirmed on August 2. S&P further double downed by saying that if there was not further movement on debt reduction, it would look to a further downgrade.

Interest rates for sovereign debt are determined by economic growth and expected inflation and to a lesser degree credit risk. Hence, the bond rally with the downgrade. There are also limits to where investors may go in the short-run. However, the credit risk may not be the main concern. Investors may expect higher inflation as a debt solution.