Thoughts on market jitters

Markets are skittish today, struggling through yet another bout of nerves, struggling with yet another wall of worry. Will the Fed change its language at next week's FOMC, laying the foundation for an earlier-than-expected reversal of its quantitative easing? Will massive Treasury bond auctions combined with a tighter Fed push yields higher? Will higher yields threaten the economy?  Will Congress allow the homebuyer's credit to expire, thus removing vital support from this fragile market?

I'm not worried about concerns such as these.

I would dearly love to see the Fed start tightening, since I think it is already overdue. The Fed should be paying attention to all the green shoots out there, and they should be worrying about how weak the dollar is. A tighter Fed would restore confidence to the dollar, and since this recovery is all about the return of confidence, that's exactly what the economy needs. The worst thing would be if the Fed refused to acknowledge the signs of recovery and the weakness of the dollar. The prospect of higher rates coming sooner than the market expects would provide strong support for the dollar. A stronger dollar, coming off such a low base, would make U.S. investments much more attractive to foreigners. Strength is always better than weakness.

Yields today are so low that they could increase an awful lot before they posed a threat to the economy. Plus, a tighter Fed would send a message to the markets that things are indeed improving; it would be the equivalent of the Fed endorsing the notion that the economy is on solid ground. Also, as I've mentioned several times before, higher yields are actually good for households, since U.S. households have more floating rate assets (e.g., money market funds, bank CDs) than floating rate liabilities (e.g., adjustable rate mortgages); higher yields work out to be a net plus for households.

Higher Treasury yields would be bad for Uncle Sam, since they would increase the cost of funding trillion-dollar deficits. But they wouldn't necessarily mean higher borrowing costs for the private sector. Credit spreads are still unusually wide, and they should get narrower as the economy recovers. A tighter Fed and higher Treasury bond yields can co-exist with flat or even lower yields on corporate bonds; in fact, that's what typically happens in a recovery.

If the economy continues to enjoy just a modest recovery (3-4% real GDP growth), then Federal revenues should do better than most are forecasting, thus mitigating the size of the future deficit. Regardless, the deficit is still going to be so gargantuan that it will be extremely difficult for Congress or the administration to push through big-spending plans such as healthcare or cap-and-trade, and that will be a good thing for the economy and for confidence.

As for the homebuyer's tax credit, letting it expire would be a good thing. We don't need such distortions in the marketplace; the housing market is perfectly capable of recovering on its own. Prices have fallen significantly, borrowing costs are quite low, and activity is picking up in many markets around the country; optimism is already returning. Given time, markets adjust and recovery; that process is well under way.

So I am still optimistic, and I can still see light at the end of the tunnel despite all the market's concerns.