Monday, December 10, 2007

Overbought in an Unfavorable Market Climate

Now, if the belief in “Fed liquidity injections” was not so clearly misguided, I could launch into detailed speculation about how much “stimulus” the Fed might provide, and how long that liquidity will take to “work itself through the pipeline.” But as I detailed last week, the Fed has only “injected” about $16 billion into the banking system since March, all of which has been drawn out of the banking system as currency. Suffice it to say that I see speculation about the Fed's "stimulative" impact as useless because it is based on the demonstrably false premise that the Fed is actually injecting meaningful “liquidity” in the first place. Despite investors' flight to the safety of Treasury securities, commercial lending rates are not responding either (though economic softness is providing downward pressure that moderates the competing upward pressure from rising default risk).

Also, as I've frequently emphasized, monetary policy is not, and cannot be independent of fiscal policy. All the Fed does is to determine whether government liabilities take the form of Treasury bonds sold to the public, or currency and reserves held by the public directly or indirectly through the banking system. Monetary policy determines the mix of government liabilities held by the public (and even then only at the margin). Fiscal policy determines the total quantity of those government liabilities, most which are absorbed these days not by the Fed but by foreigners (in an amount many, many times what the Fed absorbs). If you want to worry about some entity that could have enormous impact on U.S. economic activity, ignore the Fed and focus on the real “maestros:” foreign purchasers of U.S. Treasuries, particularly China and Japan.

In the continuing saga of repo rollovers masquerading as “liquidity injections,” the total amount of Fed repos outstanding declined to $45 billion last week, which may be somewhat thin given the holiday shopping season. Most of this predictably comes due again this week, so the FOMC will initiate at least $33 billion in new repos by Thursday (a $12 billion repo matures on Monday, with $13 billion to roll over on Wednesday, and $8 billion on Thursday) – more if it refinances the rolls on Monday and Wednesday with 1-3 day repos. This fairly stable $45 billion pool of “liquidity” provided by FOMC actions is useful in maintaining the similar quantity of “required reserves” in the U.S. banking system. It is helpful in accommodating the day-to-day demand for currency and reserves (monetary base), but has no material impact on the volume of bank lending, nor the solvency of the $12.7 trillion banking system or the mortgage market in general.

Again, the Federal Open Market Committee (FOMC) has “injected” only about $16 billion of “liquidity” into the U.S. banking system since March – all via short-term repos that are continually rolled over. Meanwhile, foreign investors (particularly China's central bank) have provided about $2 billion in fresh “liquidity” per day, mostly by purchasing U.S. securities (primarily Treasuries).

As I noted last week, “The market has now cleared the oversold condition that it established a week ago. Stocks aren't overbought here, but overbought conditions in unfavorable Market Climates tend to be rare. The steepest bear market losses tend to follow immediately on the heels of such overbought conditions.”

So we remain defensive here, both with regard to the stock market, and with regard to the economy as a whole. Possible enthusiasm about the Fed notwithstanding, an overbought condition in a negative Market Climate is rarely a prescription for strong returns at acceptable risk.