Last Friday, the US markets’ (bonds, equities and foreign exchange) dynamics was unworthy of a first-world country. When all markets are driven by speculation on what the Secretary of the Treasury or the Chairman of the Fed may or may not say, the great nation dreamed by Jefferson, Hamilton, and Franklin is in peril. Until Wednesday, we had seen a reallocation of resources take place. We saw investors selling Treasuries and buying stocks or vice versa. On Friday, we saw Treasuries and stocks and USD trade in tandem until 2:15pm, when the Treasury released its White Paper on the banks’ stress tests. This is scary. This is systemic risk at its best…During the day, the other important news was the always closer bankruptcy of GM and Chrysler and, last but not least, the accusation by Bank of America’s Lewis that his management team

 

were forced by Paulson and Bernanke to acquire Merrill… The S&P500 finished +1.5% (866.23 pts) and the 30-yr Treasury plunged to 93-13 (by 4pm). In credit, the CDX IG12 tightened 6bp, to 174bp, and the Fed bought another $3.6BN of GSE debt (2-4 yr maturities). Today, we have the Fed’s purchase of Treasury coupons (Sep/13 to Feb/16).

The market is concerned about the Fed’s effectiveness in keeping yields low while at the same time it buys billions of government debt. I look at this from another angle: I think that the market needs details on how the Fed will carry out an “exit strategy”. An “exit strategy” is a plan to take liquidity out of the system, after pumping in billions through a quantitative easing program (for a simplified discussion on quantitative easing, refer the April 23rd letter). Thus, from today, I will propose Thesis No. 3: “Knowledge of an exit plan is a condition for the stocks AND credit markets NOT to fall”. It will be very difficult to see stocks sustaining the rally without a minor hint on how to exit. Why is this so important? As I said before, think of yourself when you keep eating those cakes in Xmas… you feel a lot better when you tell yourself that in January you will start a new diet. Not many analysts have speculated on the details of an exit strategy. Michael Cloherty (Bank of America-Merrill Lynch, Rates Strategy Team) wrote perhaps the most insightful research on the subject so far (Global rate focus report, April 21st, 2009). There is an important assumption in his description: The Fed would start tightening only after two milestones have taken place: 1) The build-up of reserves (driven by the purchase of distressed securities) has peaked and 2) Reserves have been reduced to normal levels ($5 to $10BN). According to Mr. Cloherty, we are STILL $1.282 trillions away from milestone No. 1! This perspective scares me. Why? Because such policy is based on the belief of an inverse relationship between Output gap (i.e. Potential GDP minus Real GDP) and inflation. The wider the difference between a nation’s potential and real GDP, the lower the inflation. Therefore, the Fed would only be worried AFTER reserves have been reduced to normal levels = AFTER billions in loans have been issued. This can only make sense, if the Fed believes that a price level increases AFTER the Output gap decreases (thanks to the loans that were issued, which took reserves down to normal levels). Please, take any history book and find a nation, since the times of the Byzantine Empire, where a nation’s output gap has decreased debasing the currency! On future letters, I will elaborate more on the exit plan, because it will SIGNIFICANTLY influence markets’ action in May. But here’s my two cents: The real exit strategy involves Fiscal policy. Monetary policy alone can only fail. And we have heard NOTHING on the fiscal front so far, except perhaps in Canada, where I think we have more certainty about fiscal than monetary policy!