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Where Will Extra Fed Liquidity Go This Time?

  • Written by Syndicated Publisher No Comments Comments
    September 16, 2012

    The Fed’s decision Thursday was to buy $40 billion of mortgage-backed securities (MBS) per month, while leaving the previous QE2 and ‘operation twist’ bond-buying programs in place. Since the effects on the economy of the combined $45 billion a month being spent on QE2 and operation twist are not having the desired impact on the economy, the Fed is hopeful that an additional $40 billion will do the trick.

    In effect the Fed will be buying the MBS from current holders, banks, hedge funds, investors, whoever, and hope they will move the money into areas preferred by the Fed to give the economy a boost.

    The extra liquidity will obviously go somewhere. The Fed says it hopes it will affect the housing industry and so increase construction spending and employment. The goal makes sense since the housing industry and auto industry are traditionally the two main driving forces of the economy.

    Fed Chairman Bernanke said he wouldn’t mind if some of it goes into the stock market since if people see the value of their 401K’s and IRA’s and investment portfolios going up, they may feel better about the future and spend more, which would also help the economy. 

    Given the multi-trillion$ size of the housing industry and stock market, if the entire $40 billion a month all went into them (and none into commodities or gold on the inflation concerns the extra liquidity produces) it still would be only a drop in the bucket.   

    So wherever it goes its role is to encourage the public and investors to add much more in the form of their own money in order for it to have an effect.

    The stock market’s initial reaction reflected the widespread conviction of investors that QE3 will produce a big rally in stocks.

    And it may. That thinking has history on its side, at least based on the last two examples of QE2 and operation twist.

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    But there is a big difference in the timing of the Fed’s action this time that’s worth noting.

    In his press conference Fed Chairman Bernanke admitted what everyone was already aware of, that the Fed has been targeting the stock market as much as the economy with its actions and promises of actions of the last few years.

    And previous stimulus efforts did not take place until the housing industry was nose-diving again, and the stock market was down sharply and needed rescue to prevent it from entering bear market territory, which would have had a negative effect for sure on consumer confidence and the economy. (Actually it was already in a bear market at the time of QE1).

    But this time the Fed is taking its latest aggressive action at a time when the housing industry is potentially recovering on its own, and when the stock market is robustly positive, has already spiked up 13% since its June low in anticipation of the action, and with the S&P 500 already at levels most bullish analysts had as targets for the full year.

    My own forecast at the beginning of the year was for a sell-off beginning in April or May, a summer rally, and then another sell-off, but then a favorable season rally that would have the S&P 500 up for the year by year-end. But here we are with the market already at my year-end target since we haven’t seen the second sell-off to a low in October or November that I was expecting.

    I have to wonder, since the Fed had already achieved its goal of halting the summer correction that had taken place to the June low by simply promising action “if needed”, why it has chosen to provide the action now.

    Is the Fed trying to create another stock market bubble with this timing, or is it hoping that with the market potentially overbought this time, that it will have more success in having the extra stimulus actually affect the economy by flowing into housing rather than paper assets?

    Two back-to-back Thursday surprises!

    Last Thursday it was the ECB’s announcement of an aggressive open-ended bond-buying program aimed at saving the euro, and putting an end to concerns that Greece or Spain or Italy might be frozen out of credit markets, default on their debt, and be forced to leave the euro-zone.

    The announcement itself worked so well that before the plan can even be implemented the announcement itself seems to have done the job. Borrowing costs (bond yields) for the troubled countries have fallen significantly as investors have poured into Spanish and Italian bonds, driving prices up and yields down, convinced the eurozone debt crisis is solved, at least for awhile.

    Stock markets weren’t as convinced as bond markets, with no follow through from the big one day spike-up rally.

    And this Thursday it was the surprise of the aggressiveness of the Fed’s FOMC decision.

    So far, the initial reaction was similar, a big spike-up on Thursday, limited follow-through yesterday.

    It does have the market quite overbought and extended short-term above 50-day moving averages.

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    And at a time, with next week being this quarter’s triple-witching expirations week, when according to the Stock Traders Almanac: “September has opened strongly in 12 of the last 16 years but closed weak”. And “September Triple-Witching Expirations week can be dangerous, and the week after is pitiful.”

    To read my weekend newspaper column click hereEnough With The Fed’s Transparency Already! September 14, 2012

    Subscribers to Street Smart Report: There is a hotline from Thursday evening, and an in-depth U.S. Markets Report from Wednesday evening in your secure area of the Street Smart Report website. The next issue of the newsletter will be out in three trading days, next Wednesday.

    Images: Flickr (licence attribution)

    About The Author

    Sy Harding publishes the financial website www.StreetSmartReport.com and a free daily Internet blog at www.SyHardingblog.com. In 1999 he authored Riding The Bear – How To Prosper In the Coming Bear Market. His latest book is Beat the Market the Easy Way! – Proven Seasonal Strategies Double Market’s Performance!
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