Even raging market bulls can have a concern, whether it is about the economy or the market itself. I have flagged my concerns about the Fed's exit strategy over the past 6 months. Tremendous liquidity has been poured into the economy and it must be removed shortly.
Back in March, Chairman Bernanke provided phenomenal insight during his 60 Minutes interview. He stated that his biggest fear was that Congress would not have the political will to "do what is necessary." Six months later, that fear becomes the realization that the Chairman will never get to implement his ideal exit plan to remove the excess liquidity from the system.
His optimal strategy, which I agree with, would be to continue to pay interest on bank reserves held at the Fed, providing an incentive for banks to soak-up the liquidity by paying an attractive interest rate. The problem is that if banks keep their cash at the Fed, while it will soak up the excess liquidity, it will restrict lending to Main Street. Congress will not go for that. However, in a balance sheet recession, banks will not be lending that much anyway. So, while it plays well at the polls for Congress to roadblock the plan, it has no feasible justification.
It now seems that Chairman Bernanke is on to "Plan B," which is never the best plan. Here is where I get a little queasy. The conversation about Reverse Repo Agreements is beginning. In essence, the Fed would approach the primary dealers that remain in the market and get them to purchase the $1 trillion worth of assets the Fed has acquired over the past 9 months, acting as a buyer of last resort. By the way, those assets have witnessed a historic increase in value well beyond $2 trillion, approaching as high as $2.5 trillion.
The conundrum: one, the primary dealer world is dramatically smaller one year after the Lehman debacle; two, why would the remaining primary dealers "pay up" to take those assets off the Fed's balance sheet? Why take the market risk? They are smart enough to understand there is a better, lower risk way.
All in all, an interesting situation that is fueled by politics, not intelligent monetary policy. The solution becomes a trade, most likely by the Fed's selling price being lowered well below its current market value. Makes you want to own some currencies, doesn't it? - Just not the one with George Washington on it.