SPECIAL COMMENTARY May 4, 2009

Financial Green Shoots Today Induce Policy

Contradictions Tomorrow †
John E. Silvia, Chief Economist
john.silvia@wachovia.com
704-374-7034

“These stages are the fundamental principles of the universal process. Each is again,
within itself, a process of its own formulation.”
-Georg Wilhelm Friedrich Hegel 1
Financial Green Shoots
Public policy seeks to resolve certain economic conflicts but such a resolution sets up
another set of issues. In the post-WWII period this has been made most obvious by
the use of Keynesian stimulus in the 1960s and 1970s which led to stagflation. The
latest installation of this story is the mid-1990s effort to stimulate home ownership,
which fed upon the globalization of capital markets but ultimately collapsed. The
massive monetary/fiscal stimulus today is beginning to work but is setting up its
own set of contradictions in the future.
“Recovery Possible in 2009”
We would certainly agree with Vice Chairman Kohn’s assessment. 2 Our outlook is
for positive economic growth, as measured by real gross domestic product (GDP), by
the second half of this year. Yet, our outlook is that the composition of the recovery
will be quite different than prior economic recoveries in the post-WWII period.
Growth will be led by federal government spending and a modest recovery in
consumer spending but this recovery will be below trend for the second half of this
year as well as all of 2010. We likely will not witness a V-shaped recovery in housing
or consumer durable goods spending as envisioned by some analysts. The
composition of the recovery is heavy on federal spending and monetary stimulus,
and thus should contribute to economic conflicts ahead.

† Presentation for the Richmond Association for Business Economics, April 23, 2009. Exhibits here are as

originally presented and may have been subsequently updated by the source.
The author would like to thank Adam York and Kim Whelan for their contributions.
1 Reason in History, edited by Robert S. Hartman, 1953, Liberal Arts Press, Inc.
2 Hilsenrath, Jon, “Fed’s Kohn Says Recovery Possible in ’09,” Wall Street Journal, April 21, 2009.

This report is available on www.wachovia.com/economics and on Bloomberg at WBEC

 Financial Green Shoots Today Induce Policy Contradictions Tomorrow
May 4, 2009 SPECIAL COMMENTARY

Figure 1 Figure 2
Real GDP Real GDP vs. M2 Money Supply
Bars = Compound Annual Growth Rate Line = Yr/Yr Percent Change CAGR
8.0% 8.0% 25% 8%

20%
6.0% 6.0% 6%
15%
4.0% Forecast 4.0% 4%
10%
2.0% 2.0% 2%
5%
f
0.0% 0.0% 0% 0%

-5%
-2.0% -2.0% -2%
-10%
-4.0% -4.0% -4%
-15%
-6.0% GDPR - CAGR: Q4 @ -6.3% -6.0% Real GDP: Q4 @ -6.3% (Right Axis) -6%
-20%
GDPR - Yr/Yr Percent Change: Q4 @ -0.8% Money Supply Growth: Q1 @ 9.7% (Left Axis)
-8.0% -8.0% -25% -8%
2000 2002 2004 2006 2008 2010 90 92 94 96 98 00 02 04 06 08

Source: Federal Reserve Board, U.S. Department of Commerce and Wachovia

Signals for the Recovery

Long lead indicators, such as money supply (M2) and the yield curve, suggest a
recovery in the next year (Figure 1). Unfortunately, M2—the source of stimulus to
the economy today—sets up its own contraction and need for resolution in the future
(Figure 2). These leading indicators, however, need confirmation from short-run
lead indicators such as jobless claims, factory orders and the ISM index. Jobless
claims remain above 600,000 per week and we would expect a decline in this series
below 550,000 to suggest recovery. Orders are still declining and the ISM index
remains below 40, well below the demarcation line at the 50 level.
Role of Finance in the Recovery
Global capital flows and domestic liquidity are two financial phenomena that set the
context for the last expansion and the credit crunch of 2007-2008. These same factors
are now called upon again to support the pending recovery. Chairman Ben
Bernanke, among others, has cited the global savings glut as a source of the easy
financing in mortgage and other securitized credits that supported the housing &
consumer spending boom as well as its correction. 3 For the past six months central
banks have attempted to restart the same credit engines—but with a bit more
discipline. But will such discipline be enough to ensure effective policy management
in terms of both timing and magnitude?

3 Chairman Ben Bernanke, “Four Questions about the Financial Crisis,” Speech at the Morehouse College,

Atlanta, Georgia, April 14, 2009.

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May 4, 2009 SPECIAL COMMENTARY

Figure 3

Foreign Private Purchases of U.S. Securities

12-Month Moving Sum, Billions of Dollars
$600 $600
Treasury: Feb @ $259 Billion
Corporate: Feb @ $39 Billion
$500 $500
Equity: Feb @ $11 Billion
Agency: Feb @ -$58 Billion
$400 $400

$300 $300

$200 $200

$100 $100

$0 $0

-$100 -$100
98 99 00 01 02 03 04 05 06 07 08 09
Source: U.S. Department of the Treasury and Wachovia

As illustrated in Figure 3, foreign purchases of U.S. securities, especially corporate

bonds (which includes many securitized products) and equities, took off after 2005
only to crash over the last year. Since 2007, purchases of agency debt have declined
while foreign investors have increased purchases of Treasury debt as a safe-haven.
The global savings surplus of the 2002-2007 period set up the means of its own
correction as risk became under-priced and yields failed to account for the risk of
economic and credit underperformance. Yet, as we look at Treasuries today we can
also see the case for a repeat of the cycle of too much money chasing Treasuries.
Over-paying for the flight to quality today presents a possible risk that low returns
today fail to account for inflation, currency and supply risks ahead.
At the short-end of the credit curve the actions of the Federal Reserve appear to be
very successful. We can see this in the decline of the TED spread over the past six
months since the failure of Lehman Brothers (Figure 4). In this way, the markets
support Vice Chairman Kohn when he asserts that the Federal Reserve has been
effective in easing financial conditions. 4

4 Governor Donald Kohn, “ Monetary Policy in the Financial Crisis,” Nashville, TN, April 18, 2009.

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May 4, 2009 SPECIAL COMMENTARY

Figure 4 Figure 5
TED Spread Aaa and Baa Corporate Bond Spreads
Basis Points Over 10-Year Treasury, Basis Points
450 450 700 700
TED: Apr @ 95 bps Baa Spread: Mar @ 560 bps
400 400 600 Aaa Spread: Mar @ 268 bps 600

350 350
500 500
300 300
400 400
250 250
300 300
200 200
200 200
150 150
100 100
100 100

50 50 0 0

0 0 -100 -100
2004 2005 2006 2007 2008 2009 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Source: British Bankers’ Association, Federal Reserve Board and Wachovia

In addition, the Fed has been very effective in lowering private market rates such as
the rate on commercial paper and thereby improving the liquidity of money market
funds. However, Vice Chairman Kohn also recognizes the limits of such success. He
asserts that the Fed is “not trying to favor some sectors,” but in our opinion, it would
be effectively impossible not to favor certain asset markets where the Fed is
purchasing securities in contrast to asset markets where the Fed is absent. In this
sense, the Fed is acting as a policeman that stations himself on one corner and
witnesses very little financial crime (narrow credit spreads). Yet, crime (wide
spreads) continues where the policeman is not present at another corner. 5 This is
contrasted, for example, in Figure 5 with the lack of spread improvement in the
corporate bond market.
In recent weeks, we have seen some improvement even in the corporate bond
market. High grade bond issuance (Figure 6) has been solid and high yield issuance
(Figure 7) has started to improve as well. These improvements are part of the green
shoots that suggest credit markets are beginning to be supportive of economic
growth.

Figure 6 Figure 7
Investment Grade Corporate Issuance High Yield Corporate Issuance
Billions USD, 3-Month Moving Average Billions USD, 3-Month Moving Average
$120 $120 $18.0 $18.0

$15.0 $15.0

$90 $90

$12.0 $12.0

$60 $60 $9.0 $9.0

$6.0 $6.0

$30 $30

$3.0 $3.0

$0 $0 $0.0 $0.0
2004 2005 2006 2007 2008 2009 2004 2005 2006 2007 2008 2009

Source: Wachovia Securities and Wachovia

There is also the issue of the exit strategy. How and when does the Fed remove itself
from such targeted lending and what is the impact on the market as the Fed

5 John E. Silvia, “State of the Global Economy: The Intersection of Economy and Credit,” Presentation at

the Credits Markets Symposium, Federal Reserve Bank of Richmond Conference, April 2, 2009.

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Financial Green Shoots Today Induce Policy Contradictions Tomorrow
May 4, 2009 SPECIAL COMMENTARY

withdraws this liquidity? In this sense we can see again that the actions taken to
solve one problem—the post Lehman liquidity squeeze—have now set up conditions
for another test of the market as policy makers act to reverse the earlier solution.
Such action reversals will also apply to the Fed’s diminution in its purchasing of
Treasury, agency and mortgage-backed securities. As the recovery begins to take
hold, rising interest rates are likely to be the market implications of the unwinding of
these Federal Reserve positions in Treasury, agency and mortgage debt. Rates are
likely to move even higher as the housing recovery begins. Unfortunately, the
timing of these unwinds are not likely to fit the economic cycle nor the political cycle.
For investors, the implications of less than perfect timing and magnitude of policy
changes are greater volatility and higher interest rates than are currently discounted
in the marketplace.
Two Faces of Federal Reserve Policy
Traditionally, monetary policy is characterized by the simple reference to the federal
funds rate. This is often an oversimplification but in today’s environment the reality
is that the funds rate does face the lower bound of a zero policy rate. Facing this zero
bound, the Fed has pursued a different solution to the recession and credit crunch.
Again, today’s solution to the credit crunch will generate new problems when the
recovery appears.
Today, the Fed’s credit policy takes several forms. First, the Fed is lending directly to
banks and primary dealers through the Primary Dealer Credit Facility (PDCF) as
well as the Term Auction Facility (TAF). Such lending is very short-term and we
believe would not present a major problem when it is time to turn off the tap. Our
concerns are more focused on the extent of the decline in spreads in agency and
asset-backed security markets. For agencies, we have seen a decline in spreads over
the last five months to levels reminiscent of early 2007. So far the Fed has bought just
$60 billion or just over ten percent of the total benchmark debt currently available for
purchase. If the Fed does indeed purchase its targeted $200 billion then spreads are
likely to narrow significantly further and indeed will likely attain levels associated
with the credit bubble period of 2005-2006. This suggests we are about to repeat the
same narrow spreads that were criticized for the failure to account for risk. Is the
solution to the credit crunch today bound to recreate the conditions for another
overextension of credit ahead?
For asset-backed securities we have witnessed a rapid decline in spreads, for
example CMBS, as illustrated in Figure 8. Spreads have also declined sharply in
recent weeks for prime auto credits, subprime auto credits and credit cards. Our
expectation is that spreads will continue to narrow given the commitment by the
Federal Reserve. However, is the extent of the improvement too much given the
state of the economy? Have we simply overcompensated for the credit crunch by
again creating conditions that will only lead to another correction? Is there just too
much credit chasing too few credit-worthy deals? Fundamentally, Fed intervention
in these markets creates the possibility that price discovery has been obviated in
favor of economic stimulus and that the over supply of credit by the Fed in selected
markets today is creating distortions that will require a further reaction down the
road?

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May 4, 2009 SPECIAL COMMENTARY

Figure 8 Figure 9
5-Year and 10-Year AAA CMBS Spreads Growth of Securitization Markets
Basis Points Yearly Securitized Issuance, Trillions of Dollars
1600 1600 $2.5 $2.5
5-Year AAA CMBS: Apr @ 1,025 bps CMBS
10-Year AAA CMBS: Apr @ 825 bps CDO
1400 1400
Non-Agency
$2.0 Student Loan $2.0
1200 1200 Home Equity
Credit Card
Auto
1000 1000
$1.5 $1.5

800 800

$1.0 $1.0
600 600

400 400
$0.5 $0.5
200 200

0 0 $0.0 $0.0
2005 2006 2007 2008 2009 90 92 94 96 98 00 02 04 06 08

Source: U.S. Department of Commerce, U.S. Department of the Treasury and Wachovia

To see the extent of the correction and the degree of disequilibrium that could be
present in securitization markets we turn to Figure 9. Here we can see the rapid run-
up in securitization between 2003 and 2006 and then the dramatic correction after
that. But, if $2 trillion is too much and $300 billion too small, where is the
equilibrium? Moreover, should the markets or policymakers decide?
Fiscal Policy: Stimulus and Resource Allocation?
Although increased infrastructure spending should stimulate the economy, at least in
theory, the longer run problem is fiscal discipline. Is there an exit strategy for
reducing federal spending down the road? Failure to pursue a reasonable program
of reducing Treasury finance may well have negative implications for the dollar and
interest rates. 6 At the microeconomic level of resource allocation, potential tax
increases to pay for such spending would carry significant negative microeconomic
incentives that could partially offset the macro boost from higher government
spending. Not only could higher taxes on dividends, capital gains and higher
income individuals provide a disincentive to work, they could provide incentives for
investment and production to move abroad.

Figure 10 Figure 11
Federal Government Spending Ex. Interest Payments Federal Budget Surplus or Deficit
Year-over-Year Percent Change, 12-Month Moving Average As a Percent of GDP, 12-Month Moving Average
30% 30% 4.0% 4.0%
Spending Ex. Interest Payments: Mar @ 27.1% Surplus or Deficit as a Percent of GDP: Dec @ -5.9%

25% 25%
2.0% 2.0%

20% 20%

0.0% 0.0%
15% 15%

10% 10%
-2.0% -2.0%

5% 5%

-4.0% -4.0%
0% 0%

-5% -5% -6.0% -6.0%

1970 1975 1980 1985 1990 1995 2000 2005 70 75 80 85 90 95 00 05

Source: U.S. Department of Commerce, U.S. Department of the Treasury and Wachovia

In addition, a more interventionist government in terms of regulation and direct

government allocation of real economic resources would alter private risk/reward
calculations. If these allocations did not reflect the careful economic calculation of

6 “Mr. Wen’s Debt Bomb,” Wall Street Journal, March 18, 2009.

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May 4, 2009 SPECIAL COMMENTARY

costs and benefits, such political interventions would lead to economic outcomes that
are inconsistent with those achieved in a purely private calculation of returns. For
example, tougher regulation of financial firms, which will increase the cost of capital
for borrowers, suggests that the price and availability of credit will be limited relative
to previous expansions.
In sum, the microeconomic implications of proposed policy initiatives could be more
significant in their impact on the economy and investors than the broad aggregate
macroeconomic “stimulus” programs that are frequently the focus of conventional
analysis. The incentives implied in policy proposals under discussion raise both the
short-run costs and risks associated with implied economic adjustments. Such
implications are negative to growth and investment returns, and, in turn, suggest
greater fiscal deficits than currently projected.
Exit Strategy: Perfect Timing and Magnitude—Too Much to Ask?
Over the last year the Fed’s balance sheet has risen dramatically from $800 billion to
over $2 trillion today while the money supply, M2, has grown 14 percent over the
last six months. Meanwhile, fiscal deficits are estimated at nearly $2 trillion over the
next two years. Such policies are not likely to be sustainable over time without
significant changes in inflation, interest rates, the value of the dollar and the pace and
character of economic growth.
As economic “green shoots” appear more frequently and a consensus develops that
recovery is coming, will policymakers make a graceful exit from the stimulus stage?
Or, will they stay too long, and thereby generate policy contradictions from too much
stimulus when stimulus is no longer needed. The challenge of the timing and perfect
execution of an exit strategy from extremely easy monetary and fiscal policy should
be clear. The execution of a solution is less so.

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Wachovia Economics Group

Diane Schumaker-Krieg Global Head of Research (704) 715-8437 diane.schumaker@wachovia.com

& Economics (212) 214-5070
John E. Silvia, Ph.D. Chief Economist (704) 374-7034 john.silvia@wachovia.com
Mark Vitner Senior Economist (704) 383-5635 mark.vitner@wachovia.com
Jay Bryson, Ph.D. Global Economist (704) 383-3518 jay.bryson@wachovia.com
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