Fish or Cut Bait

Fed Chairman Ben Bernanke outlined his plan to remove the massive stimulus the Fed has infused into the U.S. economy. In a prepared statement (his live address was canceled due to the blizzard many of us are experiencing on the east coast). Mr. Bernanke suggested that the Fed could begin raising the discount rate (the rate at which financial institutions can borrow from the Fed window overnight). In 2008, the Fed lowered the discount rate to match the Fed Funds rate to help rescue the financial system. Typically, the discount rate had been 100 basis points above the Fed Funds rate. Typically, banks would not borrow from the Fed window for fear of being labeled a troubled institution. My how things have changed.

Making in more expensive for banks to borrow short-term funds should, in theory, force banks to stop the "government carry trade" in which banks borrow from the Fed and lend to the treasury (by purchasing treasuries) and write more loans. Logic says that if it cost more for banks to borrow they must earn a higher return on the borrowed capital. However, banks do have an alternative. They could simply borrow less and lend less. That is not what the administration would like to see. Mr. President, behold the independence of the Fed!

Such actions would cut into bank profits, but it would probably not leas to failures among large banks. Credit ratings downgrades and wider credit spreads yes, defaults no. This of course would lead to higher borrowing costs and wider credit spreads throughout the markets. I expect modest spread widening to continue.

The equity markets did not like what Mr. Bernanke had to say. For all the bullish bluster emanating from the equity markets participants know that, thus far, the recovery is almost completely stimulus driven and that corporate profits are not yet sustainable at current levels without significant stimulus. The markets mostly recovered late in the day, but that was probably more due to traders leaving early due to the storm and flattening their positions rather than any belated confidence in the economy.

I believe that 2010 will be a long hard slog. Upward, but slow. I don't believe that the foreign debt crisis is over either. Look for export-driven economies to look for ways to devalue their currencies to export their way to success. Beware the PIGS. Germany's proposed rescue of Greece is, at this time, a loan. Loans have to be repaid, unless one is a U.S. homeowner. :o