Friday, May 2, 2008

Increased Risk Of Stagflation

Federal Reserve a.k.a. “Reverse-Rumpulstilskin” Now Accepting AAA ABS
The word is out that the Federal Reserve is now accepting AAA rated asset-backed securities (ABS), including ABS secured by credit cards, auto loans, and student loans. With this action, the Fed is acting like a Reverse-Rumpulstilskin, turning junk (ABS and MBS) into gold (UST). However, their efforts to provide liquidity to the market is setting the U.S. up for an increased risk of stagflation.

The Fed’s hope is to coax the banks back into lending again by making the bank’s assets more liquid. However, like Rumpulstilskin, the Fed will not get what it was hoping for. The banks are concerned about the longevity of the current downturn. The banks also know that the “AAA” ratings on the ABS and MBS bonds that they hold are not truly “AAA” material and they would be very happy to unload them in return for UST.

The banks will continue to exchange junk for UST, build up their reserves, and refuse to lend until the consumer market gets more certain. When that’s is going to happen is anyone’s guess. However, given that the smart monies are still counting on a prolonged slowdown, it is going to be a while until the banks begin lending in earnest. My guess is that the banks will sit tight on general lending until 2Q 2009.

In the interim, the Fed will continue to inject more liquidity into the system by swapping ever increasing amounts of UST for ABS and MBS. As this is happening, it is quite likely that the quality of the ABS and MBS bonds that the Fed is holding will deteriorate, leading to the Fed having to either mark down the value or asking the Treasury for more money.

Traders and speculators will then take advantage of this situation and short the dollar, as they sense that the declining quality of the bonds held by the Fed will lead to the U.S. potentially losing its “AAA” rating (if this happens, it will be down to “AAA-“ at most). As the dollar continues its fall, it will drive up the price of everything valued in dollars, which will lead to even lower consumer spending – a vicious downward spiral toward stagflation.

All the rosy projections for the second half of 2008 as being the period of recovery may come to a shocking end as investors lulled by the promises of the rainbow at the end of a storm come face to face with even a bigger storm. Brace yourselves and make sure that you are prepared for the soaking.

Ed Kim

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