Under Pressure

Today, the equity markets started out bad and then went down hill. The day started with poorer-than-expected economic data. Jobless claims climbed as displaced workers filed claims following the holidays. The Philly Fed report indicated that economic activity slipped. Housing starts for December were down 4% versus November.

As if there needed to be more downward pressure on stocks, China announced that it was ordering its banks to scale back lending to slow down its economy and to thwart a growing housing bubble. China is a command economy and its leadership commanded that banks reduce lending. Slower Chinese growths sent metals and raw materials stocks lower.

The icing on the cake came from President Obama. The president announced plans for banks to withdraw from proprietary trading and hedge fund related activities. These businesses are sources of significant income for banks. The result was falling financial stock prices.

However, today was a good day for bonds. China's actions should result increased purchases of U.S. treasuries and prices responded accordingly. The President's announcement,although bad for bank stocks due to reduced earnings potential, was good for bank bonds as more conservative business activities should reduce default risk.

Forcing banks to withdraw form market making activities (proprietary trading) could have a far reaching impact in investors. Without market makers there is no bond markets or OTC equity market. Without market makers there is no new issue underwriting as a proprietary desk is necessary to support new deals.

What about investors who use money managers? They are not immune either. Money managers do not make markets. They do not trade for their own accounts. The relay on the liquidity provided by markets makers (proprietary trading desks) to buy and sell bonds. This is why the claim that investing with money managers results in better executions. They are at the mercy of the very same market makers managed money supporters claimed could be avoided or bettered.

Banks may have ways around this. They could separate their investment banking businesses into separate,but wholly owned subsidiaries. This would permit an investment bank to fail while the FDIC insured bank parent would be unaffected. This kind of arrangement exists among many utilities, Ford and Ford Motor Credit and Bank of America and Merrill Lynch. I get the feeling that the President doesn't under stand the financial system. However, his adviser, Paul Volcker does. Mr. Volcker knows that market makers are needed for capital markets to function. I think we will see financial firms broken up into pieces, banks and investment banks.

Today's economic events underscore another reality. There has been a market recovery thanks to banks and raw material producers, but not an economic recovery. Until job growth returns. Productivity gains by firms during the past year promises to keep job growth below trend. This should bode well for bonds with the exception of TIPs. I plan on writing a TIPs primer this weekend.

Have fun!