The Fed's Last Stand: Lower Spreads vs. Default Risk

"I don’t think the Fed is done,” former Fed governor Laurence Meyer warned when asked to comment on the minutes of the December 16 Federal Open Market Committee meeting. Though the minutes (released earlier this week) are marked by a series of vague statements, the undertone is clear: the most potent weapon now in the Fed’s arsenal is the ability to force an across-the-board reduction in yield spreads, and the Fed is poised to put that weapon to use shortly. In brief, the Fed is ready to enter uncharted territory.

There is no disputing the Fed’s immediate focus. Aggressive purchases of mortgage-backed securities issued by Fannie Mae (FNM), Freddie Mac (FRE) and Ginnie Mae will bring 30-year mortgage rates down into the 4.25-4.75% range. But additional (negative) data on the economy, starting with today’s jobs report, may well result in the Fed entering the market to buy paper which investors simply don’t want to hold: i.e. debt securities based on consumer loans and commercial property, and, most importantly, corporate loans.

The Fed is certainly not done, despite a whopping $1.34 trillion increase in assets on its balance sheet last year. The problem is that the strategy of engineering lower credit spreads in the economy at large does not qualify as monetary policy, by any standards. On the contrary, by implication, the Fed’s target for consumer and corporate spreads is tantamount to a direct verdict on the measurement of business risk. Cutting benchmark rate to almost zero has not resulted in the thawing of the credit markets. But will the forced reduction in mortgage and consumer rates do the job?

If the recent indicators are any guide, the Fed is poised to take the biggest financial gamble in modern history, with tax-payer dollars. And, on present indications, they will be assisted in that task by the credit default swap market. CDS price-makers, who themselves are in the midst of an unprecedented pricing environment, are still not realizing that, with the exception of financials being supported by the government, lower spreads may just not mean lower default risk. The CDX North American investment grade index [CDX.NA.IG] is hovering around 200 basis points, a 30% improvement since late November. CDS spreads for government-backed banks have also narrowed substantially in recent weeks, with Citigroup (C) leading the pack at 190 bps today vis-à-vis 485 bps on November 21, 2008.

More significantly for investors, CDS spreads in the corporate sector have displayed a tightening since mid-December, obviously in anticipation of the Fed’s last stand in the credit markets. A recommendation to go long corporate and municipal bond exchange-traded funds (BND, HYG, PHB, PWZ) flies in the face of this writer’s 2009 perspective on the credit matrix; but, a reading of the FOMC minutes dictates that such a recommendation must be made today, though certain bond ETFs have recorded appreciable gains of late.

However, long-bond-ETF positions will need to be monitored closely as we enter the second quarter of this year. The Fed’s forthcoming intervention will not remove the default risks arising from declining earnings and worsening economic fundamentals. As CDS spreads begin to properly reflect default risks, the notion of a “thaw” in the credit markets will prove to be illusory; logically, the only way to generate a flow of credit is to reduce the risk of debt default. That risk, in turn, is going to be shaped by the intensity of the global recession (or depression, at some point), not by the Fed buying debt to shape credit spreads.

It is not clear if the Fed is looking over its own shoulders and checking market perceptions of the “full faith and credit” of the US government. The 10-year CDS spread on US treasuries has risen from less than 2 bps (yes 0.02%) in July 2007 to 65 bps today; and since concerns regarding the sheer size and range of government intervention in business are growing with each passing day, 10-year CDS spreads should move beyond 100 bps within the next 8-12 weeks. There is no historical parallel to tell us if the Fed’s “not-done-yet” initiatives will actually sustain lower yields on structured and straight debt within the context of a rapid deterioration in its own credibility. In fact, such initiatives might well magnify the same systemic risks the Fed is seeking to counter.

Disclosure: no positions

Comments

[bosun.j:]

"the Fed is poised to take the biggest financial gamble in modern history, with tax-payer dollars" Sums up the whole problem pretty well. Give a drunk some money to use in Vegas and what does he care whether he wins or loses....its not his money! Damn sure gonna have a good time though won't he!

Jan 09 08:06 AM

[Jason Rines...:]

This is a well written article, thank you.

Jan 09 09:45 AM

[Moon Kil Woong:]

Full faith and credit of the US government is laughable right now. There isn't enough of that to fill a bathtub.

I agree that something needs to be done about the CDS market. It's crooked filled with a shadowy play of off balance sheet shennaniganism.

The US buying them or supporting them by buying the crappy underlying bad bonds won't solve the situation. First and formost the CDS market needs full transparency. And the big CDS gamblers need to face the piper, not the US citizen.

Suss out the muck before you start fixing things...

Jan 09 03:01 PM

[Slick Rick:]

Why is everybody looking for this great depression? Is there an American fascination to watching people suffer? The fact is simple. If our government and the FED were not bigoted and self-conscious about actually appearing to help the middle class, then a financial tragedy could be avoided. Instead what I hear is a complete manufactured overwhelmngly amount of propoganda that is obssesed with their own talking points about how bad things are going to get. I'm starting to think there is a contest for the journalists who can continue to paint the bleakest most dire images of the future. What I don't hear are solutions. What I don't hear is a process of who is accountable. What I don't hear is angry media criticism of President Bush. What I don't hear is about how people who never loaned a dime will make money off of CDS through the settlement rate. To those readers, just let me tell you that there are many beneficiaries to these so called bankruptcies which is why our media is so complacent about this issue and fall of Wall Street.
In addition there are some other ideas and lies that will be promoted by the main stream media around the whole process of foreclosure, zoning, and gentrification that one would think we were a third world country. Frankly I'm selling eurodollars (libor) as far as the eye can see to get ready for another lie about rising inflation.

recommendation: Documentary called MONEY MASTERS on google video. A Must See!


On Jan 09 03:01 PM constructe wrote:

> Full faith and credit of the US government is laughable right now.
> There isn't enough of that to fill a bathtub.
>
> I agree that something needs to be done about the CDS market. It's
> crooked filled with a shadowy play of off balance sheet shennaniganism.
>
>
> The US buying them or supporting them by buying the crappy underlying
> bad bonds won't solve the situation. First and formost the CDS market
> needs full transparency. And the big CDS gamblers need to face the
> piper, not the US citizen.
>
> Suss out the muck before you start fixing things...

Jan 10 06:14 AM

[Rakesh Saxena:]

Dear Slick Rick: You are right about solutions---as you will see in my earlier articles, the solution in my view is a structured, planned and deliberate de-leveraging through those sections of the economy which need to be adjusted (size-wise) in line with the new reality. Anything else opens the window to chaos which, of course, works both ways. Many thanks - Rakesh


On Jan 10 06:14 AM Slick Rick wrote:

> Why is everybody looking for this great depression? Is there an American
> fascination to watching people suffer? The fact is simple. If our
> government and the FED were not bigoted and self-conscious about
> actually appearing to help the middle class, then a financial tragedy
> could be avoided. Instead what I hear is a complete manufactured
> overwhelmngly amount of propoganda that is obssesed with their own
> talking points about how bad things are going to get. I'm starting
> to think there is a contest for the journalists who can continue
> to paint the bleakest most dire images of the future. What I don't
> hear are solutions. What I don't hear is a process of who is accountable.
> What I don't hear is angry media criticism of President Bush. What
> I don't hear is about how people who never loaned a dime will make
> money off of CDS through the settlement rate. To those readers, just
> let me tell you that there are many beneficiaries to these so called
> bankruptcies which is why our media is so complacent about this issue
> and fall of Wall Street.
> In addition there are some other ideas and lies that will be promoted
> by the main stream media around the whole process of foreclosure,
> zoning, and gentrification that one would think we were a third world
> country. Frankly I'm selling eurodollars (libor) as far as the eye
> can see to get ready for another lie about rising inflation.
>
> recommendation: Documentary called MONEY MASTERS on google video.
> A Must See!

Jan 10 11:24 AM