Monetary policy exit strategies pick-up momentum

We have the following on the monetary exit front:

Fed talking about exit strategy in WSJ. Officials saying they will have to be as aggressive in the exit as in the easing. The Fed is also closing some of their less active lending programs given there is not a strong market demand. Spreads have tighten so the credit easing programs are less necessary.

ECB cutting some of the longer-term lending programs as an precursor for exit. Although now we are hearing that ECB Trichet is worried about "sharp" currency moves.

BOJ is planning to end their emergency corporate debt-buying program. Corporate bonds have done especially well in Japan. This was a program started last December and extended in July. This action is expected even after the Tankan report which suggests that investment cuts will continue and the recovery in Japan will be slow. This is after an increase in confidence.

The exit plans will be slow but this will start to loosen the high correlation in interest rates within the G10.

The problems with QE and the Bank of England

You can buy bonds but you cannot make banks lend. That is the problem in the UK where the BOE has aggressively eased to solve the recession crisis only to see that the money supply is not growing as fast as expected.

The key issue is now understanding whether the credit crisis was a balance sheet problem or liquidity problem. We have seen spreads decrease in LIBOR and the corporate market as the perceived risk of corporate and financial institutions have declined, but there has been constraints on the amount of new lending. Bank balance sheets have yet to be cleaned up. Increasing the supply of money and cutting rates may not change the desire to lend money.

Watching the BOE is important because it is facing the same problems as the Fed. We are getting a preview of what is in store for the US.

Well-written peice by Kevin Warsh on the Fed

This WSJ editorial is a must read piece on the Fed, well written and thoughtful. The focus is on the exit strategy and that it will require "whatever it takes" focus.

Clear communication is required -

"Judgments made by policy makers in the current period are likely to be as consequential as any made in the depths of the panic. That means policy makers should continue to communicate as clearly as possible the guideposts, conditions and means by which extraordinary monetary accommodation will be unwound, including the removal of excess bank reserves."

Chance of policy error is high -

"It also means that policy makers should acknowledge the heightened costs of policy error. The stakes are high, in part, because the policy accommodation that requires timely removal as the economy rebounds is substantial."

In some cases, policy makers may have waited too long to remove easy-money policies. In other cases, policy makers may have acted too abruptly, normalizing policy before the economy was capable of self-sustaining growth. Errors of each sort are neither uncommon nor unexpected in the normal conduct of monetary policy. And the current period is anything but normal.

No ironclad rules but normalization may have to come sooner than expected -

"In this environment, market participants and policy makers alike should steer clear of ironclad policy prescriptions. Nonetheless, I would hazard the view that prudent risk management indicates that policy likely will need to begin normalization before it is obvious that it is necessary, possibly with greater force than is customary, and taking proper account of the policies being instituted by other authorities."

"Whatever it Takes" required on the exit -

"Whatever it takes" is said by some to be the maxim that marked the battle of the last year. But, it cannot be an asymmetric mantra, trotted out only during times of deep economic and financial distress, and discarded when the cycle turns. If "whatever it takes" was appropriate to arrest the panic, the refrain might turn out to be equally necessary at a stage during the recovery to ensure the Federal Reserve's institutional credibility. The asymmetric application of policy ultimately could cause the innovative policy approaches introduced in the past couple of years to lose their standing as valuable additions in the arsenal of central bankers."


This piece does not tell us when policy will change but it is clear that the Fed is thinking about it and is contemplating strong action. Let the market be aware that they may do what is necessary to control money when they think the easing should be curtailed. Nevertheless, for the trader this can only make you nervous while you wait for the Fed to change directions.

Perfect debt conditions

I was at a recent Futures Industry Association Treasury Market Forum in New York and heard a fine presentation from Treasury on the success of their debt program. It was impressive. The Treasury has done a good job of engaging the street on determining what is the best way to minimize the impact of new debt on interest rates. The Treasury has been both lucky and good at their job. Unfortunately, it is the lucky part which should give pause for most investors.

What is scary is that the OMB is now projecting debt to GDP which will be higher than CBO. There is little wonder why the curve has remained steep and got steeper this year from the long-end going up especially outside the range where the Fed was active. (Of course, there was no room for the short-end to go down.)

The uncertainty about deficit is not a problem for today but in the future. The Treasury has hit a perfect spot of higher saving in the US, less corporate borrowing, less consumer borrowing, constraints on municipals, a better current account, strong official interest from central banks, and good interest from abroad. A great time to issue Treasury debt. But the fear is that the environment will change.

As risk aversion declines there will a greater demand for risky assets. This is already happening. The TIC data suggests that private flows are slowing into the US. The rates are low and the US is now thought of as a carry lender. Money will be moving into equities to capture the stock rally.

If the recovery takes hold, savings will decline and there will be more private borrowing. There will be competition for funds. Look for this to pick up in 2010.

Solving the global imbalance issue is not good for Treasuries. If consumer spending increases from foreign buyers, rates will have to rise.

Hard to be Treasury bull over longer term if you have any recovery story.