| NEW YORK
NEW YORK Fear that a hobbled banking sector may
set off another Great Depression could force the U.S.
government and Federal Reserve to take the unprecedented step
of buying a broad range of assets, including stocks, according
to one of the most bearish market analysts.
That extreme scenario, which would aim to stave off
deflation and stabilize the economy, is evolving as the base
case for Bernard Connolly, global strategist at Banque AIG in
In the late 1980s and early 1990's Connolly worked for the
European Commission analyzing the European monetary system in
the run up to the introduction of the euro currency.
"Avoiding a depression is, unfortunately, going to have to
involve either a large, quasi-permanent increase in the budget
deficit -- preferably tax cuts -- or restoring overvaluation of
equity prices," Connolly said on Monday.
"If conventional monetary policy is not enough to produce
that result, the government may have to buy equities, financed
by the Fed," Connolly said.
Legal changes would be needed to give the Federal Reserve
and the U.S. government the authority to buy stocks. Currently
the Federal Reserve can buy only debt issued by the Treasury,
as well as U.S. agency debentures and mortgage-backed
While Connolly already sees some parallels with the 1930s,
he expects that a more pro-active central bank and government
will probably help avert a repeat of that scenario today.
The build up of a credit bubble in recent years was similar
to the late 1920s run-up to the Great Depression, he said.
Then, investors were very optimistic about new
technologies, and stocks rose against a backdrop of low
inflation, and a trend toward globalization. There was even an
equivalent of the modern day subprime mortgage debt meltdown in
the form of U.S. loans to Latin American countries which had to
be written off.
"The big difference is the attitude of central banks and
specifically the attitude of the Fed," Connolly said.
Some economists have blamed the U.S. economy's travails in
the 1930s on the Federal Reserve's hesitation to inject
reserves into the banking system.
However, today's Fed has tried to preempt the danger of a
protracted economic slump and has responded swiftly to a credit
crunch in the past year and gathering signs of deterioration in
the economy, Connolly said.
The Fed has stepped up its temporary additions of reserves
to the banking system, and swiftly slashed its benchmark fed
funds target rate to 3.0 percent from 5.25 percent in
September. Analysts expect at least another 0.5 percentage
point cut in next month.
At the same time, "the fed funds rate can't stay
significantly above the 2-year note yield," Connolly said.
On Tuesday, the 2-year Treasury note yield was at 2.00
percent, not far above the lowest level since 2004.
The Fed "almost certainly" has to cut the funds rate to 2.0
percent by the end of this monetary easing cycle, he said. If
conditions in the banking sector worsen, the Fed could cut the
funds rate to 1.0 percent, a low last seen in June 2004.
Global banks have already written down more than $100
billion of bad debts associated with the U.S. subprime mortgage
debt meltdown and housing market decline.
However, Fed rate cuts alone are unlikely to avert a
prolonged period of economic weakness because the danger still
exists that a burdened banking sector will choke off credit to
consumers and households.
"The Fed probably can't fix it all on its own now,"
Connolly said. "There is a chance the Fed gets forced into
unconventional cooperation with government," which could
involve buying a range of assets to reflate their value.
That would be reminiscent of some steps the U.S. government
took in the 1930s when the economy was mired in deflation and
One turning point came when agricultural prices were
restored to their pre-slump levels, Connolly said. Such
measures were among the New Deal programs that President
Franklin D. Roosevelt launched to bolster the economy.
Either way, investors face bleak prospects now without some
kind of further government intervention, he said.
Those steps might offer clues to investors in stocks and
commodities, which Connolly expects the government might be
ultimately force to step in and buy to stabilize markets. He
expects that a depression may be averted, but only by the state
and the Fed reinflating the price of such assets.
Beleaguered housing, non-government fixed-income securities
and even the now overvalued Treasury market have little hope of
generating substantial returns for investors over the next few
years, he said.
"If we don't avoid depression, the only thing worth holding
is cash," he added.
(Reporting by John Parry; Editing by Tom Hals)