Stimulus Withdrawal: Ain't It A Bitch!

A: When I talk about unintended consequences from policy actions taken to stem a severe episode of global debt deflation, I really am talking about what happens to markets when the brakes are slammed on and liquidity measures reversed. This can come in a variety of forms: higher rates, higher taxes, regulatory reform, tightening of accounting rules, the draining of liquidity by the fed via open market operations or restrictions on banks to curb lending. This is the world that lies ahead of us. But in today's world, the talk of the day continues to be the search for yield through an expanding dollar carry trade. Keeping our eyes open to the future, you can't help but notice what happens when this future reality hits home to a market half way around the world: China.

China led the markets with their stimulus and seem to be leading the markets with their tough talk to prevent another speculative asset bubble from forming. Already there are arguments regarding China's growth and whether or not it is manufactured and cooked. Between the doubling of highways, roads, ginormous empty skyscrapers via this 4-minute China property tour and the government sparked buildout of the empty city of Ordos (must watch that youtube news report; hat tip Mish's "China Faces Crash Scenario"), I wonder how long the party can last? Stimulus included $200Bln on a countrywide railway project and an additional $220Bln for public transportation..All the while Chinese banks lent $1.3 Trillion in new loans in the first 11 months of 2009 - talk about aggressive lending! Have we heard this story before??? Yet through all this, Yahoo Finance states..."By most measures, Chinese banks are among the world's healthiest at the moment. Not only are they flush with cash, but their bad loans, known as non-performing loans, stand at just 1.6 percent". Let's see how long that lasts for and how long bad loans can be hidden off balance sheet in complex vehicles and sold to trust companies.

If today is any indication of what might lie ahead for us when stimulus is withdrawn and liquidity measures reversed, we should take notice of what's happening in China.

The New York Times reports that "China to Slow Lending Amid Bubble Worries":

The Chinese authorities signaled Wednesday that bank lending would slow significantly this year and reportedly instructed some banks to curb loans — the latest in a series of moves designed to forestall inflation and stave off bubbles in the stock and property markets.

“This year we will continue to control the pace and demand of the credit supply,” Mr. Liu said at a conference in Hong Kong, The Associated Press reported. He added that regulators were paying special attention to loans for local government projects and real estate. All banks, he added, had been ordered to “heighten their vigilance against an impossible, embedded credit risk.”

Still, economists said that the Chinese policy makers’ signal was neither surprising nor dramatic and that it showed Beijing “tapping on the brakes,” rather than engineering a major policy reversal.

Ok, so what would happen if our markets corrected 3% in a day? That would take the Dow Jones down about 325 points; something that people would notice! In the grand scheme of things, a 3% correction after a 62% surge from the lows is nothing. But when a 3% correction turns into a 15%-20% adjustment, all of a sudden eyes open up and confidence may rattle.

The purpose of talking about this is to understand how we have come so far, so fast after the world seemed to be on the brink of collapse only 10 months ago. Its quite amazing when you think about the shift we experienced from complete Armageddon to total reflation isn't it?

But when I see some buyers out there get nervous because lending rates rose from a record low of 4.75% in late November to 5.125% today, I get a bit concerned that we are nowhere near prepared for what may lie ahead. What happens when lending rates rise to 6%? Do mortgage refinancings and housing sales take a cliff dive? What happens to IRR (interest rate risk) for those holding loans fixed at lower rates? The FDIC already issued an Interest Rate Risk Advisory to banks just about two weeks ago - hmmm, now why would they do that?

The reason I call it unintended consequences is because it is an unavoidable side effect of having the 'juice' taken away from us! No one intends for it to happen that way but at the same time, a Zero Interest Rate Policy (ZIRP) and $800bln stimulus packages, and homeowner tax giveaways, and buying of agency debt and MBS by the fed and tweaked accounting rules are all temporary forces that will ultimately be reversed. We do know that much. The new world ahead will be one of implementation of an exit strategy and that includes taking the painful steps to drain liquidity, curb bank lending of hoarded excess reserves, raising rates, and removing all the programs designed to stimulate investments and consumer purchases. And of course we need to ultimately pay for all that we borrowed to stimulate our way out of this mess. Stimulus withdraw is a bitch and certainly not as fun for markets as stimulus announcements and expansions. I just worry that once again we have all become addicted to stimulus, free tax credits, very low rates, massive liquidity facilities and accounting changes to cover up bad loans and losses. At some point we will be on our own and have to fend for ourselves, without counting on big brother to bail us out or lower our rates. The question is when?