Friday, September 19, 2008

Central Bank Liquidity Tsunami Returns

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Our video related to this posting:

After Lehman declared bankruptcy on the Monday the 15th, Merrill Lynch had to be taken over by Bank America and AIG was nearing its end, the market was looking for a rate cut from the Fed during its Tuesday meeting. The Fed and Treasury had conditioned the market to expect bailouts for financial firms and then failed to deliver when they didn't rescue Lehman and grant AIG its initial loan request of $40 billion. The Fed failed to deliver again when it didn't cut the funds rate. This seeming policy reversal, refusing to support failing financial firms with loan guarantees and the stock market with rate cuts, not surprisingly started a huge market sell off.

The Fed started pumping money into the financial system at the rate of $70 billion a day on Monday and Tuesday. While this was well above normal, it was by no means adequate for the financial crisis that was unfolding. Not only did the Dow go down 45o points and gold go up $90 on Wednesday, but the bond market indicated a panic flight to quality. For a brief time, interest rates on 1-month T-bills became negative. The rates on 3-month T-bills remained barely positive at 0.2%, the lowest level since 1954. The TED spread a measure of financial system stability, or lack thereof, hit the level it reached during the crash of 1987.

The Fed's apparent obliviousness to the magnitude of the situation was truly mind boggling, but not inconsistent with Bernanke's previous missteps - after all he didn't expect the subprime crisis would have any serious impact on the market as of June 2007, if not later. After the market route on Wednesday, along with Morgan Stanley acting as if it was about to go under, the Fed decided to flood the world financial system with liquidity. It supplied a line of credit of as much as $247 billion to the ECB, Bank of England, Bank of Japan, the Swiss National Bank and the Bank of Canada. These banks in turn added their own funds and a gusher of money poured forth from every central bank spigot available. As one observer noted, the central banks were essentially providing unlimited liquidity to world financial markets. Not surprisingly, stock markets reacted positively everywhere with big rallies, with the Dow being up 410 points and the Nasdaq up 100 points on Thursday.

Euphoria from liquidity injections usually lasts only a short time, unless the underlying problems get fixed. In this case, the problems may be even worse than the market realized. The Fed's delayed reaction to the market turmoil and its initial cold shoulder to AIG may not have been voluntary, it may have had no choice. On Wednesday, the Fed asked the U.S. Treasury to raise money on its behalf by selling bonds and by Thursday it had received $160 billion from this operation. The Fed has never made this request from the Treasury before. While the official explanation for doing so was to help with its cash management, this is highly unlikely. More plausible is that the Fed itself has run out of money and is being secretly bailed out. Events that took place Thursday evening lent further credence to this belief.

NEXT: The Free Market Goes Under

Daryl Montgomery
Organizer, New York Investing meetup

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

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