The best is yet to come

In case you were deceived by the title into believing I’m about to offer my perspicacious insights on the future of the stock market, let me say you will be disappointed. In fact, I am about to disappoint you even more…

I will be temporarily cutting down on my weekly blogging activity, which I have (miraculously) managed to keep up for a year now, in order to embark on something, let’s say, bigger. I can see you’re about to be heartbroken so let me reiterate… this is not a “goodbye”, rather a less frequent “au revoir.”

So now, let me do give my penny’s worth of weekly insight, which comes after hearing numerous “voices” wondering whether it may be a good time to add on risk—“all these bargains out there,” “volatility is on its way down,” and “credit markets moving in the right direction, still not enough, but in the right direction.”

Perhaps. Indeed that’s exactly what you see if you look at a number of price-based indicators that market-pros are tracking these days. For example, the so-called “LIBOR-OIS spread”, that is the difference between the rates at which banks lend to each other and the Fed’s rates (as captured by the so-called “overnight indexed swap” rates) has been narrowing dramatically. Interest rates on commercial paper (used to finance companies’ day-to-day business) have been falling. So has the cost of insuring the debt of companies (CDS spreads), financials or other.

All suggesting perhaps that the painful dislocations we endured (and will always remember!) during September and October are thawing.

Or are they? I’m not convinced. You see, it would be marvelous if commercial paper rates were falling because the dawn is about to break, confidence is returning and banks are lending again. It would be splendid if LIBOR-OIS spreads had narrowed because interbank lending is truly rebooting. But I, not sure that’s the case.

My favorite indicators these days come from the Fed... The Fed’s balance sheet to be specific (and for the more cosmopolitan among you, you can also look at the balance sheets of the European Central Bank and the Bank of England). What we see is a pretty spectacular expansion of Fed lending—doubling since mid-September from less than a trillion dollars to two trillion last week. One trillion in a month!

What does this mean? First, that the Fed has effectively taken over financial intermediation. To put it in plain English, the Fed is right now the only functioning bank in this country—taking “deposits” by all the other banks, who cannot/will not lend, and lending it on to those banks who need it. So the decline in LIBOR-OIS spreads is to a large degree the result of the Fed’s (and the Treasury’s) backstop in the interbank market.

Ditto for lending to companies in the commercial paper market. For those relieved to see the issuance of commercial paper going up, let me point that this has been matched one-to-one by the Fed’s buying of that paper. In other words, the Fed has been the (only?) marginal buyer/lender.

Bottom line, financial markets are on a fibrillating mode, the Fed is the defibrillator, and as long as we don’t have a power cut of some sort, the game can keep going for a while, in the hope that the dawn will eventually break.

At least that’s what Ben is surely hoping, although I sense a whiff of despair and confusion in his quarters, with all that re-thinking of the AIG bailout, which has personally baffled me (hello? I though it was the Treasury that was in the bailout business, the Fed into the liquidity/ monetary policy business, and the Bear Stearns a “one-off.”)

ANYWAY. All this to end with a Frank Sinatra quote that encapsulates my mood of the day..

“The best is yet to come and won’t that be fine
You think you’ve seen the sun but you ain’t seen it shine”