Tuesday, November 2, 2010

Interest Rate Watch and Credit Market Insights

QE2—Actually QE 0.5

Hype takes a hike. The hype of $2 trillion was fun but completely misleading. The guidance from Bill Dudley, president of the New York Federal Reserve Bank, of $500 billion and the institutional history of the Fed suggests that a gradual injection of reserves was the likely path.

Jon Hilsenrath’s essay in The Wall Street Journal earlier this week caught the “shock & awe” end of the expectations distribution for Fed policy off-guard. First, from the institutional history of the Fed, shock and awe is the rare action, the major exception being Paul Volker’s Saturday surprise in 1979. Instead, Fed policymakers appear to appreciate that they are moving into uncertain territory. Comments by regional presidents Hoenig, Plosser and Fisher suggest some concern about the quantitative easing approach and they certainly would object to a shock treatment for the economy. A “shock” treatment for the economy would likely have been met with several dissents at the FOMC meeting coming up, and certainly, the Federal Reserve would want to appear to avoid the appearance of division as the Fed moves into new policy territory.

Second, as an economic matter, the gradual approach is better suited for an economy that is showing moderate growth with low inflation and very limited signs of deflation. The Fed may be concerned about the possibility of deflation, but as of yet, there are no signs of that deflation. Moreover, a gradual pattern of buying Treasury securities and injecting reserves into the financial system will allow the Fed to ease and watch the results without the risk of doing too much and trying to pull it all back later. As President Hoenig of the Kansas City Fed said in a recent speech, the Fed simply does not have the knowledge or even the capabilities to fine-tune the economy such that just a little more inflation would be the precise outcome of a quantitative easing move.

The Outlook
Our view is that short rates remain low, while longer-term Treasury rates drift up with stronger growth and higher inflation.

Credit Market Insights

A Savings Bubble?
The past decade could easily be thought of as the decade of bubbles. From oil, food and commodities to housing, stocks and bonds, it feels like we’ve been following the bubble trail for years, trying in desperation to figure out when the next “big one” will pop. Generally speaking, whenever a bubble pops, it is not good news, unless you are on the short side of the trade, of course. But, there may be yet another bubble brewing out there, one which could not only be beneficial when it pops, but could fuel a very strong period of growth down the road…a savings bubble.

Everyone knows that credit across the economy is on a downward trajectory. But while this has been happening, consumer spending has been on an upward trend since the end of the recession. In an era of stubbornly high unemployment and little in the way of job growth, what has propelled consumer spending? The answer is savings. During the recession, consumers pulled way back, building up a war chest of savings. Since the beginning of the recession in December 2007, personal savings have nearly tripled, and are currently nearly twice as high as the average seen during the prior 50 years on an inflation-adjusted basis. Like water seeping through a failing dam, little trickles have come out of savings here and there to support spending despite a weak labor market. But, when consumers finally start to feel confident again, the bursting of the savings bubble could be a powerful tailwind for the economy…and tinder for inflation.

Full report: Interest Rate Watch and Credit Market Insights

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