“Never in the history of the world has there been a situation so bad that the government can’t make it worse.” – Unknown

Commercial paper spreads have come down dramatically.  Libor rates are (hmm - almost) back to normal.  Even high yield spreads are narrowing.  It certainly appears as if the credit crisis is well and truly over or, at the very least, the light which most of us think we can see at the end of the tunnel is no longer that of an oncoming freight train.

The current bull market began in earnest in the second week of March, but what really got everyone going was the surprisingly good first quarter U.S. bank earnings that were reported during the first half of April.  Most commentators interpreted the numbers as the clearest piece of evidence yet that we are firmly on the road to recovery.

Of course, U.S. banks made good money in Q1.  The environment created for them is the equivalent of the U.S. government reducing the cost of goods to zero for its embattled car manufacturers and then going on a buying spree – courtesy of the U.S. tax payer – of a couple of million cars that nobody really needs.  Even Detroit could make money given those conditions!

The problem for the rest of us is that the banks are not sharing the candy they have been handed.  Much of the liquidity created by the central banks remains trapped in the financial sector (as shown in Chart 1).  Quite simply, the multiplier is not doing its job, as many banks prefer to hoard cash rather than increase lending.

This is both good and bad news.  It is good news because it implies that we probably do not have to worry too much about the inflationary effect of the aggressive monetary easing currently taking place.  It is bad news because it means that the economy is not going to kick back to life as quickly as everyone would like – and expect.

This is an excerpt from May 2009 issue of Trader's Journal.