Tony Daltorio's  Instablog

In over two decades in the investment business, I never cease to be amazed by how psychology affects peoples' investing. Human beings have the nasty habit, as far as investing goes, of extrapolating the recent past into the infinte future.

Look at the current deflation expectations. Deflation expectations have become so embedded in investors' minds that they now see a deflationary pricing environment lasting for decades! This even exceeds the length of time for the deflation caused by the Great Depression.

These so-called investors believe that central banks and governments have so fine tuned their policies that inflation will not re-emerge or that if does the central banks will be able to smoothly reverse policy and quash it. Investors are expecting these "perfect" policies from the same dimwits who drove the economy into the ditch in the first place. Human psychology is amazing!

Wall Street giants such as Goldman Sachs and JP Morgan seem to be anxious to throw off the government shackles of the TARP program. On the face of it, this seems to be good news. After all, isn't it better that the banks face the discipline of the marketplace rather than corporatist government aid?

However, the short-run effect of such a move could prolong the current recession. The US banking system is still woefully undercapitalized for the size of its balance sheets. The battered capital ratios must be boosted so that lending to the wider economy begins growing again. If banks instead shrink their capital base in order to exit TARP, this will delay the credit expansion that any recovery is reliant upon.

The TARP legislation provides that banks can only leave the prgram with the government's permission. It is not enough to just pay the money owed back to the government. The US government should take advantage of what is written in the legislation.

Currently there are many investors who wonder how central banks will eventually exit from their quantitative easing policies. One of the main functions of quantitative easing currently is, of course, to help governments fund their ever-increasing debt burdens.

What concerns investors is what will happen when economies recover (and they will eventually). In order to reverse quantitative easing, central banks will need to shrink their balance sheets by reselling bonds. Most likely at a time of economic recovery, commerical banks will follow suit. Yields will leap higher in the ensuing bond glut and so too will interest rates.

In order to compensate for higher government borrowing costs, governments will need to slash spending. This is what Japan did in 2006. Economies will then face a double tightening - from higher interest rates and from lower government spending. That raises the likelihood of a double-dip recession.