Fitch downgrades Greece - now what?

We are down to BBB- from BBB+ with a negative outlook. Still there is uncertainty on what the EU will do to help Greece. Germany is willing to provide help but only at market rates. It is unusual that we have not even seen Greece go to below investment grade yet there is strong opposition to paying the market spread. You have to ask all of the below investment grade countries what they think about this situation.

There is something absurd about the link between the action of ratings agencies, spreads and sovereign risk. The market is pricing in a hefty spread on these bonds relative to a year ago., but 400 bps is not out of sigh for a junk credit. Investors do not believe that Greece will make good on their plans. The rating agencies have been slow to react, so they are saying this is an investment grade credit. It is hard to argue that we are in a crisis if the ratings agencies cannot even come to the point of saying that Greece is below investment grade. Why should they get a discount?

If you have to handicap this process, you should expect some bail-out at good rates and spread tightening.

Yuan fix is in - Treasury Geithner trip must have some take-away

The yuan has been pegged to the dollar at around 6.83 per dollar since 2008, but the visit by Treasury secretary Geithner suggests that a deal may be in the offering to see an appreciation. The Treasury will delay any report on calling China a currency manipulator so it seems likely that there will be some yuan change to ease the political pressure. This would be the deal. The forward point suggest a deal. The yen appreciation is another sign.

Of course, economics can overtake the situation. China exports have declined for 13 months. This shrunk the trade surplus by 34 percent. This was expected since the US and the rest of the world was in a global trade recession, but it is harder to argue for an appreciation when trade is declining. Now we have a China trade deficit reported for March. The change in exports YOY was half of what occurred for imports. China reported a trade deficit.

The internal politics in China makes it hard to have anything other then a token increase.

The Fed and fiscal deficits - stuck in a box

From NYT-

“The arithmetic is, unfortunately, quite clear,” Mr. Bernanke said. “To avoid large and unsustainable budget deficits, the nation will ultimately have to choose among higher taxes, modifications to entitlement programs such as Social Security and Medicare, less spending on everything else from education to defense, or some combination of the above. These choices are difficult, and it always seems easier to put them off — until the day they cannot be put off any more.”

He said a “sharp near-term reduction in our fiscal deficit is probably neither practical nor advisable,” but that a long-term plan for fiscal sustainability could help to lower interest rates and borrowing costs, and even stimulate economic growth.

I heard Niall Ferguson give a talk in Boston the other week with an illuminating story. He argued that the current fiscal situation is like, "War financing without the war". Go back to WWII and you see massive increases in debt to GDP to finance the war effort. The impact was extraordinary and required the Fed to have an Accord with the Treasury to keep rates low. Unfortunately, we know what happens when war financing gets out of control, defaults and inflation.

Chairman Bernanke may know realize that he is in a box. He cannot follow a normal monetary policy of raising rates given the size of the deficits. we usually expect a tightening within 6-9 months after employment starts to turn positive. Can we expect a tightening policy while the structural deficits are still rising? This will be a test of independence.

A focus on speculative bubbles - A change in Fed behavior

From NYT

a member of the Federal Reserve’s policy-making board challenged the notion that financial markets were self-correcting, saying that asset bubbles existed and that central banks could do more to prevent them.

William C. Dudley, president and chief executive of the Federal Reserve Bank of New York, called on policy makers to more aggressively speak out against prevailing wisdom when asset prices fluctuated wildly.

“The costs of waiting to respond to an asset bubble until after it has burst can be very high,” Mr. Dudley said in prepared remarks to the Economic Club of New York. “A proactive approach is appropriate.”

Comments like this make the Fed look like it will more closely follow the views of the ECB. Greenspan was never a fan of trying to prick asset bubbles. The same could be said of Chairman Bernanke. European central bankers have been more willing to look for bubbles; however, it is less clear that they did much with real estate excesses in Ireland or Spain.

Dudley makes a strong case that even if bubbles are hard to identify this is not enough reason to do nothing. There are tools both monetary and regulatory which can be used to slow bubble growth. It takes a willingness to track markets and act if prices move from fundamentals.

Unfortunately everyone knows about the bubble after the fact. It would be helpful if the Fed provides some working rules for how they assess valuation in markets.