U.S. Policy Moves and Credit Markets

Michael J. Materasso
Co-Chair, Fixed Income Policy Committee,
Franklin Templeton Income Group

From the bailout of Fannie Mae and Freddie Mac this past September through late November, U.S. government policy responses to the financial crisis were ad hoc. Policymakers faced problems on multiple fronts, and it was impossible to deal with these in a consistent way.

Today, we have a new administration. The Federal Reserve (Fed) has enacted a policy of quantitative easing and it has added new facilities, such as the expansion of its balance sheet to purchase mortgage securities. Including programs launched by the Treasury Department, we now have TARP (Troubled Assets Relief Program), TALF (Term Asset-Backed Securities Loan Facility) and PPIP (Public-Private Investment Program). Collectively, this response has achieved credibility in creating liquidity, lowering borrowing costs and improving confidence in our markets. Now we have to hope that these fiscal and monetary stimulus packages will heal the broken parts of our economy.

The massive purchases of U.S. Treasuries and mortgage-backed securities by the Fed does create a potential overhang in the market-especially if the Fed needs to sell these securities to help the Treasury fund a growing budget deficit. There were similar concerns about Japan after the Bank of Japan (BoJ) bought up government bonds in the 1980s. The BoJ did, in fact, end up selling its treasury holdings at a time of falling interest rates, so the impact was marginal. But the Fed's intervention in U.S. markets has been much more extensive. Nonetheless, we believe problems (if any) will probably not emerge for at least three years.

In the credit markets, the average spread on U.S. high-yield bonds stood at almost 1,200 basis points (bps) over Treasuries of comparable maturity at the end of May, versus a long-term average spread of 550 bps. This means there is room for spreads to tighten further. High-grade credit spreads stood at 400 bps at May-end, still higher than the 240-250 bps spread that we have seen during previous recessions.

All in all, we believe the U.S. economy should start to recover in late 2009 or early 2010, but growth will probably be below potential for some time. Financial institutions are deleveraging and consolidating, resulting in continued job losses. Consumer spending should be subdued due to job insecurity, limited avenues of borrowing and the rebuilding of savings for education and retirement. The silver lining to below-potential growth is that the Fed will have a little more leeway when it comes to reining in recent stimulus.

As the U.S. emerges from recession, a major question will be what criteria the Fed uses to decide when and how to apply the brakes. Of course, there are worries that inflation might quickly get out of control if the current loose monetary policies remain in place for long, although many of the Fed's programs are meant to be unwound as the markets come back. The Fed's balance sheet has shrunk in some areas where it has ceased activity, such as commercial paper issuance, reflecting the fact that the market no longer needs the Fed's assistance.

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