Submitted by Mark J. Grant, author of Out of the Box,
There is no plan, no scheme that the Fed can concoct for exiting their support for the U.S. economy that will not negatively affect both the bond and equity markets and have a positive effect on the Dollar. The markets have relied upon the manna from Heaven to rise and virtually nothing else. The American economy cannot justify either the absolute levels of yield or the compression that has taken place or the lofty levels of our stock markets. All of this has had a single driver which is the Fed.
There does come a point in time, however, when a 4 trillion dollar balance sheet and the flip side of the coin, the decline in the wealth of the investor, the consumer, starts to impact the market as paltry returns eventually lead to declines in capital for goods and services. The Fed has spent four years providing gifts for those that borrow and for the banks while penalizing those who save and invest. What one group gained the other lost.
Now the Fed faces the dilemma of its own making; how to gradually exit their current strategy without setting the financial markets on their rear ends. This is a situation that I have contemplated for some time and I have been asked about it by some of the most senior people in our industry. So this morning I will share with you and the Fed some of my thoughts.
First would be to exit your support of the various agencies first. They are now doing fine. Profits will be down but not out and a gradual withdrawal is called for as an initial step in the process. The definition of “gradual” will be the key but I think this is the logical first step.
For the Treasury markets a different plan can be utilized in the first instance. Use the same amount of money that you are using now but buy the bonds directly from the Treasury and not in the open markets. This will have the effect of lowering the borrowing amounts for America, having smaller auctions, and so the demand will not need to be so sizeable to sustain them. Then as the Dollar strengthens and as both European and Asian investors move out of their troubled economies and into Treasuries for safety there will be increased demand from overseas.
Yields will probably still rise and the compression in fixed income will reverse but not as dramatically as feared by some. A tremendous amount of corporate and mortgage financing has taken place during the last four years so that the amount of new issuance will also decline which will also help in this process. It can also be announced that some portion of the Fed’s balance sheet will be allowed to just run off which will also decrease the pressures on the markets. The Fed bombed its way into the markets but the way out must be slow and carefully considered.
The Fed should also concentrate on its primary objective which is the financial well being of America. Another area where the Fed should cut back on in the first instance is supplying capital to the European banks. The ECB and the EU will have to pick up the slack and stand on their own feet without so much dependence on the Fed. In my opinion the Fed has been overly generous to foreign institutions and this should stop. The ECB needs to learn to take care of its own mess and not rely upon the Fed to help them.
The Fed’s tapering off of their European support will also be a positive for Treasuries and American credits as spreads will begin to widen between the two groups. America will be seen, once again, as the safer haven causing some European money to flow into the American markets. External demand will have been increased by employing this part of my strategy.
“Tapering off over time” should be the mantra. Baby steps should be the pace. The continuing strife in Europe will also help the United States as investors are forced to deal with more problems in Cyprus, Greece, Portugal, Spain, Italy and Slovenia. The difficulties in Europe will be positives for America as a result of relative safety and value.
This is the course I would set and honest words backed up by policies that match those words will go a long way to preventing serious market erosion. The beginning will not be easy but the path can be contained if it is maneuvered properly. Market corrections will take place but giant upheavals can be avoided by a studious and honest approach. The Fed can also learn a lesson from Mr. Draghi and make forceful pronouncements that “it will do whatever is necessary” to maintain orderly conditions and then demonstrate this tactic if needed.