Bonds and the Fed

We have never had more confidence in the Fed and it's ability to manage the economy. Yet, the Fed has a history of creating excessive credit conditions, and then taking steps to remove these excesses. Tight money tends to cause distress first in the areas that are most overextended. The chart below is from David Rosenberg at Merrill Lynch. His theory is that when the Fed is in a tightening mode, they will continue reigning in credit until something bad happens. Then they will ease to counteract the damage they have just done, and the cycle repeats itself. Some of the most memorable examples from Merrill's chart are, the Tech Wreck, Long Term Capital, S&L Crisis, and Penn Square Bank. Many of these negative events were a result of the excessive credit conditions the Fed created in the first place. When they took steps to get the market to return to normalcy, "bad things happened."

One might ask why this pattern tends to repeat itself? This is largely the result of the Fed trying to manage the economy. Their tool of choice is to control the process of "borrowing short and lending long". In essence, this is how our banking industry works, and it is a great system. When the Fed lowers short-term rates, they make the yield curve steeper. This allows banks to make a larger spread (profitability) and over time increases the amount of liquidity that is available in the credit markets. This increased availability of credit allows borrowers to have the funds that are necessary to make purchases, which in turn stimulates the economy. The reverse is also true when they raise short-term rates which drains liquidity from the system. Isn't it interesting that our system depends upon the borrowers to get it going and to slow it down?

After 9/11 there was a massive reduction in short-term rates which produced large amounts of liquidity and availability of credit. Much of this money went into the housing market. Many of those loans were financed with little or no money down, and many of the borrowers were sub-prime borrowers. It wasn't that long ago that the public and economists were thinking that higher rates wouldn't have that much of an impact on the housing market. Then they were saying that the housing slowdown wouldn't affect the economy and it would continue to grow, and activity would pick up later in the year. Now we are seeing high defaults in sub-prime mortgages by the people who couldn't afford the houses they were buying in the first place. So, will the sub-prime problem spread to the rest of the economy? That is the question being asked now. Shouldn't the question be: Why wouldn't we experience ripples across the credit markets? After all, the Fed has made money tight and we know from experience that they will continue in this mode until something bad happens.