Fed Exit Strategy: Can Stocks Survive the Bailout Party Hangover?

The Federal Reserve balance sheet has reached beyond $2 trillion during the crisis, requiring temporary liquidity programs and longer-term asset purchases.

As the U.S. economy claws its way towards recovery, we find ourselves in $9.7 trillion debt, stubbornly rising unemployment rates approaching 10%, stagnate home equity markets and increasing loan defaults accelerating bank failures.

In comparison, we find China now the largest producer of gold (300 tons) and 11% volume increases annually, low debt with a $2 trillion cash surplus to invest, unemployment rates of 4.5%, GDP 6% growth and solid long-term prospects.

For Wall Street investors, it is prudent to remain cautious as governments and central banks start to withdraw their unprecedented stimulus measures that have destroyed U.S. dollar values. The green shoots are certainly out there but the big question that remains is whether the current types of stimulus being applied have created a world economy stable enough to survive independently without artificially inflating asset prices.

For example, mortgage interest rates, which briefly dropped into the 4% range, did so not because of a surge in creditworthy borrowers or eager lenders but rather because the Federal Reserve launched a program of buying $1.25 trillion of mortgage-backed securities. Doing its part, the Treasury has poured billions into Fannie (FNM) and Freddie (FRE) and provides guarantees for their mortgages.

In these and many other instances, the "green shoots" that optimists have spotted are really just the visible manifestations of the massive interventions by an increasingly over-extended government stimulus.

Worldwide, central banks have pumped thousands of billions of dollars of new money into the financial system over the past two years in an effort to prevent a depression. Meanwhile, governments have gone to similar extremes, taking on vast sums of debt to prop up industries from banking to car making.

Where is the $1.1 trillion of U.S. taxpayer funded bailout money?

• Banks $173.41 billion -- bailouts include (BAC), (BBT), (C), (WFC), (CCF), (BK)
• Toxic Asset Purchases $30 billion
• AIG $69.83 billion (AIG)
• Fannie & Freddie $95.6 billion
• Foreclosure Relief $50 billion
• Auto companies $77.83 billion bailouts include (GM), (F), (DCX), (DPHIQ.PK)
• Other commitments $79.07 billion
• Uncommitted $524.25 billion – perhaps to help bankrupt airline industry (DAL), (AMR), (LCC), (UAUA)

Going forward, the issue is how the Fed unwinds the unprecedented support it has provided the economy by cutting benchmark interbank lending rates to near zero percent, lending hundreds of billions of dollars, and buying up government and mortgage-related debt in order to keep interest rates low.

Many of the lending programs have begun to shrink as markets stabilize, and the Fed has already announced the end of the longer-term Treasury buying program. As the economy recovers, however, the Fed will have to carefully time and calibrate an exit strategy of ending its buying and lending programs and eventually raising interest rates.

Some policymakers worry that undue angst over whether the Fed's bloated balanced sheet may spark inflation leading to the central bank tightening policy before a self-sustaining global recovery is solidly off the ground.

The possibility of a hurried exit haunts officials, who are mindful that central banks killed recoveries with premature rate hikes in the United States in the 1930s and in Japan in the 1990s.

These measures may already be inflating a bubble in asset prices, from equities to commodities and there a is risk that inflation would get out of control over the medium term if central banks miss-time their “exit strategies”.

Meanwhile, the underlying problems in the global economy, such as unsustainable trade imbalances between the US, Europe and Asia, have not been resolved. Fed Chief, Ben Bernanke has stated that reserves held by banks at the Fed will to some extent contract automatically. Improving financial conditions have already led to the short-term lending facilities being used less and will eventually lead to their considerable reduction.

Redemptions of the Fed's holdings of agency debt, agency MBS and longer-term Treasury securities are expected to occur at a rate of $100 billion to $200 billion each year over the next few years, according to the Fed’s recent monetary policy report.

Generally speaking, despite continued large holdings of assets, the Federal Reserve will have at its disposal two broad means of tightening monetary policy at the appropriate times. In principle, either of these methods would suffice to raise short-term interest rates; however, to ensure effectiveness, the two methods will most likely be used in combination.

Below are some of the Fed's exit strategy options that were recently outlined in a report to Congress -- alongside are some drawbacks often discussed by analysts:

PAYING INTEREST ON RESERVES:

By setting the interest rate on reserves the Fed essentially creates a magnet for banks to place those reserves with the Fed rather than lend them out into the financial system -- creating a floor under short-term market rates.

This is a result of banks generally will not lending funds in the money market at a rate lower than they can earn risk-free at the Fed.

Raising the interest rate paid on balances that banks hold at the Federal Reserve should provide a powerful upward influence on short-term market interest rates, including the federal funds rate, without the need to drain reserve balances. A number of central banks around the world have effectively used this tool.

Cons: There could be a political backlash if the Fed was paying banks a significant amount of taxpayer money to push up interest rates. That payment might be logical from a monetary policy perspective, but it is a disaster from a public relations perspective.

LARGE SCALE REVERSE REPURCHASE AGREEMENTS:

The Fed could arrange large-scale reverse repurchase agreements, or repos, with financial market participants, which would drain reserves from the banking system and reduce excess liquidity at other institutions.

Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date, however this further increases future debt.

THE STIMULUS BAILOUT HANGOVER:

Now that the housing bubble, stock market bubble and commodities bubble have popped, the market is now trying to adjust to "non-bubbly" conditions.

Perhaps, we should move cautiously in implementing new laws, regulations and federal compensation policies that interfere with the natural market correction process which could delay the necessary adjustment and prolong the recession.

For example, if a failing business is artificially propped up, valuable resources are potentially being wasted at this stage, on an unsustainable entity rather than being invested in new innovative ventures that might survive independently.

Although lots of excitement surrounds the billions of dollars in stimulus, inevitably the party always ends when the music stops; unfortunately, there may be no more resources available for the hungover Americans left standing in massive debt. The tab so far is over $9.7 trillion, enough to hand each U.S. household a check for around $92,000, or pay off 90% of all home mortgages in the country.

The borrowed money, of course, will come from taxes in various forms, making it very difficult for U.S. companies to compete worldwide. As history has it, we'll attempt to borrow more from China, the largest foreign holder of Treasury debt, with the promise of paying it back with interest. Some will come from the Federal Reserve printing it, a move that further devalues the greenback and leads to taxation through inflation. However, next time around China and other nations won’t be as enthusiastic but rather will look for “greener” currency or other safer commodity options including gold (universal currency).

The Federal Reserve’s stimulus exit strategy must be implemented now given that U.S. bailout costs are simply too immense to foster any significant GDP growth. We can't keep GM-AIG-Fannie-and-Freddie and every insolvent bank and every rising mortgage default problem afloat. It can't be done. It's not a long-term strategy. It's just desperation to avoid the inevitable pain.

The U.S. is going to have to start allowing the natural market process to take shape, likely to result in several 5%-10% correction type dips of Wall Street stock prices throughout the next 2-years. The sooner we know just where the U.S. economy actually stands independently without any further artificial stimulus, the better. The Federal Reserve has stated that it cannot continue piling on additional borrowed debt that is stunting long-term global economic growth and simply passing the burdens down the road to future generations. It remains to be seen how the "bailout party hangover" affects Wall Street stocks as the Federal Reserve implements the stimulus EXIT strategy.

DISCLOSURE: NONE

Comments

[User 488917:]

The Economy is like a Drug Addict and its addicted to a Golden Flood of Free Money. We still have got to get off the Drugs.

Aly-Khan Satchu
rich.co.ke
Twitter alykhansatchu

Sep 21 04:27 AM

[Roger Knights:]

"The Economy is like a Drug Addict and its addicted to a Golden Flood of Free Money."

And its motto is, Just say mo'

Sep 21 05:10 AM

[alexthen:]

The following "sentence" was in the article. Could you decipher it?

This is results from banks generally will not lending funds in the money market at a rate lower than they can earn risk-free at the Fed.

Sep 21 05:27 AM

[ArtfulDodger:]

Good article, JR.

Let's hope the Fed learned from the last time Greenspan snatched billions of dollars out of the economy, by raising interest rates 17 straight times (from 1 to 5 1/4), because we know what little boondoggle that brought about.

We're still staggering from that harsh blow.

Sep 21 10:49 AM

[Moochacha:]

AIG shares are up almost $6, on the news that the company is proposing the government restructure their loans and lower interest rates etc. This is the company at the heart of the financial crisis. The world has been patient but there is no remorse.

Sep 21 02:18 PM

[Albertarocks:]

On Sep 21 02:18 PM Moochacha wrote:

> AIG shares are up almost $6, on the news that the company is proposing
> the government restructure their loans and lower interest rates etc.
> This is the company at the heart of the financial crisis. The world
> has been patient but there is no remorse.

In a fair world where corruption isn't considered a virtue and a requirement to get a job on Wall Street, the shenanigans and manipulations featured in the trading of AIG shares would result in an entire yacht full of pigs being sent behind bars for life.

Take a look at a 60 minute chart. These thugs manipulate the stock in the most boring easterly direction possible for weeks on end, then when everybody's pretty much asleep... BOOM, they run it up from $12.60 to $30 in one day. Then they do it again from $23 to $33, and still... nobody's in jail. Then again... they manipulate it to run due east for a week, and when everyone's asleep again, they crank it up from $33 to $58 in about 13 seconds. Why is nobody in jail for this theft? Who out there can tell me how AIG improved it's model so much that it's stock is suddenly worth more than 50 cents, let alone these shameless run-ups from a horrendously overvalued $12.50 to $57 in 3 weeks? Why aren't they all in jail?

Sep 22 12:26 AM