The purpose of this commentary is to illustrate that the credit markets continue to heal, providing further evidence that the Fed’s policy actions are having their intended effect.

The credit markets continue to exhibit healing as conditions, while not yet fully restored to pre-crisis levels, are normalizing. For example:

1. From 1990–2007, the TED spread (which is used to indicate banks’ willingness to lend to each other) averaged 0.50 percent. It spiked to 4.63 percent last fall when Lehman Brothers collapsed, but has now returned to 0.46 percent, near historical averages.
2. Yields of AAA general obligation municipal bonds, as a percent of Treasury yields, spiked to more than 100 percent last fall and winter. (The range is normally around 80–90 percent.) For the 10-year maturity, it has averaged 110 percent over the past year with a high of 186 percent, but has now fallen back to a current level of 80 percent of U.S. Treasuries.
3. The corporate bond spread for a 10-year maturity has also narrowed dramatically, as the spread between BBB+ industrial corporate bonds fell from 3.91 percent on December 31, 2008 to 1.93 percent on June 2, 2009.
4. Money continues to flow into municipal bond mutual funds at a record-setting rate. Muni funds have been cash-flow positive every week this year and have attracted more than $25 billion since January 1. Muni fund assets total $391 billion, up 14.4 percent for the year. They are now just $3 billion shy of the record $397 billion in assets recorded back in September.
5. And most importantly, the banks have been able to raise huge amounts of private capital (both debt and equity) without any federal guarantee, which is why many are now clamoring to pay back TARP funds.

On another note, we think it important to note that fears of inflation due to a rapid increase in the money supply are overstated. It is true the Fed’s actions have led to a more than doubling of the monetary base since last fall. However, the money supply had been growing at only around 10 percent, and even that rate of growth has slowed recently. If the Fed had not acted to increase reserves, the money supply would have fallen sharply and the economic crisis would almost certainly have deepened.

We do not mean to minimize the risks of inflation. As the economy recovers and people begin spending again, the Fed must remove the reserves it had injected or else the money supply will soar and inflation will follow. The risk of this occurring is one reason we continue to recommend that investors consider including a significant allocation to TIPS in their portfolio and should generally avoid longer-term nominal bonds.

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