There is no doubt we live in unprecedented economic times. What is also apparent is that mechanisms available to affect change are wholly inadequate, whether political, regulatory or monetary. Europe tells us all we need to know regarding the shortcomings inherent in the systems we have collectively created.
What may be less apparent is the impact monetary authorities exert, whatever the supposed firepower they wield, has become more ineffective the longer the Debt Crisis has lasted. Indeed, the Crisis has recently gathered momentum, as evidenced by Europe's exacerbated struggles.
Interest rates are undoubtedly impacted, their levels set, and their directions determined, by many factors. Chief among these factors has always been the traditional and time tested mechanisms relied on by monetary auhorities the world over. More recently, the Fed and the ECB have taken unprecedented actions in order to influence the shape of the yield curve, yields on Sovereign bonds and to stimulate lending. Orthodoxy has been shunned in these quests.
Yet, we are finding increasing evidence that the Fed and ECB are losing their grip on their abilities to affect the outcomes they seek. In the face of a supposed comprehensive solution in Europe, Italian 10yr yields hit an all-time high in the Euro era. This, despite a massive announced and well publicized Italian bond purchase program executed by the ECB, beginning in August. So much for holding yields at the original target. Similarly, The Fed's vaunted Operation Twist has had uncertain influence, despite the immediate 'market adjustment' it spurred immediately upon its announcement.
The real risk, which I believe has already started to manifest itself, is the declining influence of these interventions. The ECB, for one, seems to be standing aside in the face of the recent Italian yield spike. The Fed has been coy about the potential for QE3, or other 'weapons' at its disposal crypticly alluded to by Mr. Bernanke in a number of settings. I believe both Agencies are accutely aware of their limitations. The ECB needs to keep its powder dry for the totality of the European 'solution,' whatever it is, and whenever they are called to assist in its implementation. The Fed is accutely aware of the potential of 'pushing on a string,' as it has been called, where its actions can have the opposite effect of the one intended.
Make no mistake, interest rates are ultimately set by the intrinsic relationship between confidence as that confidence plays through the forces of supply and demand.
Europe faces a major test of confidence very soon. The magnitude of the numbers and risks associated with things going badly can quickly spiral out of control and manifest in rate spikes, first in specific credits, and then systemically as the magnitudes are assessed.
The U.S. faces the potential of a similar circumstance in its credit markets at any time. Chief among the possibilities is the municipal bond market. Its underpinnings in credit terms are highly vulnerable. Structurally, it is dominated by individual investors either directly, or by their participation through tax-exempt Mutual Funds. History has shown the muni market to be highly suseptible to shocks, whether in the Fall of 2008, or in the aftermath of the infamous "60 Minute" Meredith Whitney appearance in December 2010.
In the end, all the best laid plans of monetary authorities may crumble in the face of hysteria, justified or not. An unwinding would be abrupt and vicious. This leaves us vulnerable to a threat well beyond that of the challenges to growth brought about by rate spikes.
The threat of a conflagration in the form of catastrophic melt down is a clear and very present danger.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
