Thursday, March 6, 2008

Fed to Banks: It’s Your Fault

It’s hard to know what it will take for the central bankers of the world to come to the realization that liquidity conditions in the financial economy are in a very precarious position. One central banker, the ECB, seems hamstrung (or is it hidebound?) due to their single mission mandate of maintaining low inflation. Yet, it is the world's primary central banker, the US Federal Reserve, which does have the dual mandate of inflation fighting AND economic growth, that many look to for direction and support.

Since it is the US economy that is the real economy worry to investors, the Fed’s decision making should be understood as best as possible. In this regard, a careful reading of the recent numerous speeches made and congressional testimony given by Fed Governors appears to lead to the following conclusion:

The Fed is walking a fine and dangerous line between being supportive of the liquidity needs of the core of the banking system, the extent to which the US economy will slow, the risks of inflation due to the global growth story, and the moral hazard of bailing out bad banking and financial markets behavior. It does seem rather clear that its policy is to provide as much liquidity as needed to ensure that the core of the system does not collapse while at the same time allowing the market discipline to inflict a (hopefully) manageable level of pain on those who made the bad bets. It is this second part of the game plan that some investors misinterpret. For example,

There appears to be no way to interpret Fed Governor Krozner’s views as expressed this past Monday* other than to conclude that the banks got themselves into this mess and will need to find a way to get themselves out of it. As for solutions, Mr. Krozner notes that international banking regulators are "collaborating to understand the causes of the recent market turbulence and to identify steps to mitigate future problems". (Whew, glad to know that they are hard at work studying the situation.) Then there is his reference to "encouraging banks to maintain more robust liquidity buffers and develop contingency funding plans". Always good to hear words of encouragement.

Investment Strategy Implications

The market discipline philosophy apparently still lives at the Fed. For equity investors, however, the dangerous part of the Fed’s game plan resides in Soros' reflexivity - where the financial economy spreads to the real economy turning a moderate economic decline into a serious recession.

How this drama will play out? Frankly, no one knows as we are in unchartered waters. As for equities, as noted on Tuesday, according to my Expected Return Valuation Model**, stocks currently reflect the deep recession scenario. Should it appear that a deep recession can be avoided, stocks will have the economic justification for a spring rally (listen to the Stovall interview).

*”Liquidity-Risk Management in the Business of Banking”
**subscription required

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