MISH: Does Stability Breed Instability?

Mike Shedlock who has been terrific on the subprime and credit crisis has a great post with some good charts (including the one above) showing the disconnect between longer term treasury yields and mortgage yields. He asks the question "does stability breed instability?" I would answer not necessarily but stability with the Greenspan put does breed instability. Assuming the Fed is going to insure stability encourages excessive leverage and excessive leverage guarantees instability.

Levered players tend to favor "liquid markets" because the relative ease with which they can slip into and out of those markets makes the leverage seem safer because one can always get out. Every so often, and this is one of those times, the market reminds these people that liquidity is not a fixed constant but another variable. Liquidity is inversely correlated to crisis. To illustrate the point I remember being in the bond pits during the 1987 market crash. One day the bid ask spread in the bond price was one thirtysecond of a point wide ($31.25 between bid and offer on $100,000 of bonds) with thousands of contracts bid for and offered. The very next day the bid ask spread for the same contract was one full point wide ($1000.00) with one hundred contracts bid or offered if one was lucky. That occurred in one of the most liquid markets in the world. Liquidity happens when traffic is heavy in both directions when everyone heads the same way, not so much.

The unwinding of leverage in the credit markets has completely erased the normal liquidity in the credit markets by sidelining so many of the participants. Cutting the Fed Funds rate in this environment is like handing out two for one coupons for circumcision. There just aren't that many takers.

Bargains exist in credit securities right now but not many bargain hunters. The Fed and Treasury need to engineer a quick dollar intervention to shake out the short dollar speculators and send a message to potential overseas buyers of long term credit market instruments that the US government is not going run a continuing policy of benign neglect of the dollar. A few of them might just begin to look for bargains. The Fed cannot quickly cure the housing situation and it does not need to. Mr. Bernanke needs to concentrate on finding a way to put a bid in the credit markets.