We continue to believe much of the weakness can be explained by temporary factors, including the disaster in Japan, severe winter and early spring weather, and a spike in oil prices that has since reversed. It is the waning of these pressures that we believe will usher in a better second half of the year.
The Federal Reserve apparently agrees with this assessment as during their most recent meeting they came to the same conclusion and held steady on their policy. QE2 has now ended without much fanfare as Treasury yields remain historically low despite the lack of Fed support going forward. The asset purchases have not stopped, however, as the Fed will continue to reinvest money received from securities maturing in order to maintain the size of its balance sheet. Stopping this process would be a likely first step in the long road to a more normal policy. The Fed gave no indication of a fresh round of asset purchases, despite downgrading its economic assessment slightly, and signaled that the bar for such a move remains quite high.
We continue to believe the Fed should be considering moving toward more normal monetary policy. While the aforementioned factors are keeping money on the sidelines, the near-free ride banks are getting gives them little incentive to move out the risk spectrum on their loan portfolios. With the ability to borrow from the Fed at near-0%, and invest the proceeds in Treasuries, they earn a risk free 2.5-3.5%; and as seen below, that has enticed many banks to do just that.
Banks are holding Treasuries instead of making loans
Source: FactSet, Federal Reserve. As of June 27, 2011.
A rise in rates may provide the incentive needed to get money flowing through the economy, while also potentially strengthening the dollar, which could further pressure commodity prices down, helping US consumers while also attracting more foreign capital.
Greece: what still needs to happen
While near-term moves to avert a default in Greece have whipsawed global markets, we believe a default is not likely in the cards at this time. Meanwhile, exposure in the United States to a default of any one peripheral country is not definitively quantifiable but is likely small, reaffirmed by Fed Chair Bernanke in his press conference following the June Fed meeting.
The near-term liquidity strain, with Greece needing cash immediately to keep its government working and make interest and principal payments on its debt, was likely solved when Parliament passed the austerity package demanded by the ECB and IMF. However, longer term, there is a need for Greece to address its two main problems: too much debt (insolvency) and an inability to grow.
The current Greek "bailout" program is too reliant on austerity, which alone cannot work. As austerity increases in each successive change to bailout terms and funding, the recession deepens. The result can be a never-ending spiral of cutting spending and raising taxes because the pie never grows enough to support current spending policies, increasing the likelihood of default.
Even if Greece meets its austerity goals, grows inline with what are likely optimistic growth forecasts and privatizes government-owned companies and sells assets, debt as a percentage of GDP is forecasted to rise to 160%. This is unsustainable because the interest burden continues to rise and eats up an increasingly larger portion of the budget. This is no bailout. As such, Greece needs to restructure its debt, allowing it to wipe the slate clean and provide a strengthened position from which to grow.
Additionally, Greece needs to increase tax receipts by addressing growth and tax collection. Greece needs additional labor reforms to allow companies to more easily fire employees and adjust when times are tough. This would allow companies to be more efficient and productive, increasing profitability, and attract new businesses that are now starting in more business friendly eurozone countries. Greece's economy remains largely in state-run hands; typically less efficient and less productive than privately operated companies. Additionally, measures should be put in to foster new industries.
