Opinion: the risk of a mini-correction

2010-01-16

There is a relatively high risk of a mini-correction by March - April, around the time that the Fed will start exiting its liquidity and stimulus programs that support the economy.  The economy has been stabilizing, but this has come at a large cost to the government in terms of buying securities in the open market in order to support low interest rates and providing massive liquidity to make sure that if there is indeed any demand for loans that it be met.  Nevertheless, the economy is still losing jobs, capacity utilization remains at very low levels, and business line utilization is at record lows, while foreclosure and credit card loss reports are showing a mountain of problems coming up.  The plan is to buy time and smooth out problems by spreading them over months or years, instead of dealing with them head on right now.  Buying time can certainly help banks, as they will have the opportunity to slowly earn their way out of their problems.  However, the government may not be able to keep up its support for much longer, and sooner or later it will have to wean out the economy from its heavy hand.

There is a high likelihood that the government will do something "stupid" before bailing out the economy once again.  Politically, the government has to show a strong hand and to regulate banks heavily in order to convince the public that the same debacle is not going to happen again, as well as to gain the public's support for further budget deficits and other programs that will be required.  The government knows that if it leaves the financial system alone, there is high probability of collapse and then the government will not be able to save the financial system again, because investors will have lost all confidence.  On the other hand, the government has to pretend that it is in control and that the taxpayers will not be paying forever.

The solution is to exit the more obvious and direct plans, and to provide the same support through alternate routes.  An example was the backstopping of Fannie and Freddie's balance sheets (announced this past December), which now have a blank check to expand as much as they want to, effectively taking the government's place in the mortgage market.  Initially, the government had to take matters directly on its own hands in order to jumpstart the mortgage market, since there were no new originations.  Now that activity has picked up, it can pass on the torch to the mortgage GSEs and provide guarantees on their debt to grow.  This stimulus to the mortgage market is probably not going to show on the Treasury's balance sheet, since it comes in the form of guarantees.  So, the mortgage market will be taken care of and it will look like the public is getting off the hook.  But what will happen to the Treasury market, which the government has also been supporting and will exit in March.  The gap in demand will probably get filled by banks, which have excess liquidity and may have to take haircuts on their financing if they invest in anything but Treasuries, as per new regulatory proposals.

The bottom line is that the situation is extremely complex and officials are probably smarter than they get credit for.  When you think they are doing something stupid, they probably have an elaborate plan to fix things while making sure all stakeholders are pacified in the end.  It doesn't work always great, but they are better than you might think.  What does it mean for the markets?  They are likely to correct in the short term due to political headline risk, i.e., while the government convinces the public that the "villains will pay", but they should recover once investors realize that the government has not really forsaken the markets.

Given the balanced risk-reward in the S&P right now (up 15% - down 15%, according to Marc Faber and other investors and economists), it may be better to stay in cash and wait it out until the end of 1Q perhaps, when the government has announced that it will stop supporting the market.

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