US FEDERAL RESERVE Is Financial Markets Sensitive!

``By definition, the center is the provider of capital , the periphery the recipient. An abrupt change in the willingness of the center to provide capital to the periphery can cause great disruption in the recipient countries. The nature of the disruption depends on the form in which capital was provided. If it was in the form of debt instruments or bank credits , it can cause bankruptcies and a banking crisis..."-George Soros

When the seminal bouts of financial stress began unveiling late July, we took the stand that monetary authorities were likely TO INTERVENE with corresponding policy measures (see July 23 to 27 edition Under the Threat of Recession, The FED Will Likely Cut Rates!).

Some monetary figures and experts overconfidently claimed that the FED will NOT intervene because the housing recession had been assumed to have little effect on the economy and the financial markets.

On the other hand, we suggested that the performances of the financial markets are likely to be the key barometers monitored by the US monetary authorities, despite their vehement denials (they are purportedly not to influence asset markets). And to us, it seemed that this sector mattered more than economic figures, since…

1.) Financial assets comprise the CORE source of funding to the consumption patterns for the US households which make up about 75% of the US GDP.

2.) The global financial markets have DWARFED the global real economy (exchanges of goods, widgets and services) and lastly…

3.) The activities in the US markets have been TRACKED CLOSELY by global markets, which similarly could influence the general global economic momentum.

Under such construct, our projections were weighted on the performances of the US financial markets, in contrast to most experts. Here we asserted that a significant decline in the US markets will compel the FED to trigger its Rescue Package, (see July 30 to August 3 edition, A 10-15% Drop In the US Markets Will Probably Activate The Bernanke Put).

Recently in view of the upheavals in the market largely influenced by the spreading of credit drought, global central banks INITIATED such operations by injecting more than $300 billion of money “created from thin air’ to the increasingly distressed financial sector, where the US FEDERAL RESERVE even accepted mortgage backed securities as collateral in exchange for loans.

We even suggested last week that the FED will use its remaining tools under duress which proved to be prescient…``The FED has two more tools left at its disposal the discount rates and the Federal Funds rate and would be used soon.”

Thursday August 16^th appears to have been the crux of the FED’s decision to trigger the NEXT DOSE of the Bernanke Put…

Figure 4: New York Times: A Day of Wild Market Swings and Global Anxiety

According to the New York Times article by Jeremy W. Peters and Louis Uchitelle (emphasis mine), ``At one point during the trading session, major stock indexes were down more than 10 percent from their peak last month — the threshold for the market’s fall to be considered a “correction.” But by the close, the overall market had escaped that territory, powered by a rush of buy orders in the last hour, leaving Wall Street not far from where it ended the day on Wednesday.”

So essentially what happened was the Dow Jones Industrial benchmark crossed over our projected frontier. The intraday trend of the Dow Jones Industrial in Figure 4 from the New York Times, shows of how the main index TRANSGRESSED the 10% threshold…down a little over 340 points during the mid-session!

But in the final hour, the key benchmark got a reprieve from a barrage of late hour buying orders (from the PPT/President’s Working Group perhaps?) to close down by only 15 points! With central banks apparently pumping up the financial system, it isn’t a remote probability to have the US government propping up such key indices.

Nevertheless, the mixed close on Wall Street did not DETER Japan’s market to a swan dive last Friday down by as much as 5.42% at the close, as shown in Figure 5!

Figure 5: stockchart.com: Nikkei’s Swan Dive

Other key Asian markets fell but was able to reverse much of their losses likewise during the final hour. Hong Kong’s Hang Seng Index seen in the topmost pane, the Dow Singapore benchmark (upper pane below center window) and our own PSE following Japan’s collapse in a free fall.

In the meantime, European markets were trading in the red likewise early last Friday, while US futures were initially in deep losses. Then the unexpected happened, FED announced its discount rates cuts before the opening and saw its markets flew as the bells rang!

Again, the Fed’s timing of the discount rate cuts (before the opening) as well as last hour activities in the US markets on Thursday COMPOUNDS OUR SUSPICION of government’s stealth but revealing efforts to levitate the financial markets.

Nonetheless, in support of the recent monetary actions, we note of a volte-face on its priorities.

Early last August 7^th the FOMC declared that the predominant risk had been inflation, although they noted that the risk to the economy has grown (highlight mine)…``Although the downside risks to growth have increased somewhat, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected.”

On Friday August 17^th the FOMC stated that deteriorating market conditions has shifted their risk concerns from inflation to economic growth (highlight mine)…``Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.

I recall William Poole President of St. Louis Fed, who recently declared that it would take only a “financial calamity” to impel the FED to act. The following day, the FED admits of a shift in gears in support of the markets. This implies burgeoning risks for BOTH the US economy and the financial markets.

In the light of such admission, how does one become bullish when the monetary authorities themselves are apparently reacting to the escalating risks through the recent anodyne treatments in the hope that such would restore the balance?

In the first place, wasn’t it their encouragement through their expansionary policies to enter into inflationary excesses which has caused this problem? It’s like feeding more drugs to addicts.

Yes, some features of the latest policy actions could buy some time for the FED, Asha Bangalore of Northern Trust notes of the important variables accompanying the latest rate cuts (highlight mine),

``Why did the Fed change the discount rate and not the federal funds rate? Discount rates are established by each Reserve Bank's board of directors, subject to the review and determination of the Board of Governors of the Federal Reserve System. Today’s change in the discount rate was an official request from the Federal Reserve Banks of New York and San Francisco. There is no special significance to the fact that it was requested by only two banks. In addition to lowering the discount rate, the Fed modified the term of the loan. The Reserve Banks’ usual practice is to make funds available overnight through the primary credit program. Today’s announcement noted that financing is available for long as 30 days and it is renewable by the borrower. The Fed also increased the range of assets that will be acceptable as collateral under this arrangement compared with that of open market operations. These provisions indicate that the Fed strongly believes that addressing the problem of liquidity is the top most priority. The Fed has chosen this route given the difficulty in estimating what banks’ demand for excess reserves are on a regular basis…the Fed has erred on the side of supplying too many reserves rather than too few, with the daily effective federal funds rate trading below the FOMC’s target of 5-1/4% in the past several days. In sum, this innovative procedure under exceptional circumstances has given the Fed flexibility and bought time to evaluate the situation.”

Essentially what we see from the FED are two factors, first a telegraph that they are open to provide a BID on risk assets to support the markets, and second, if the present nostrums don’t do its expected job, they’d throw the kitchen sink to the markets to prevent economy from going under regardless of risks of “moral hazard”.

Once again it appears that based on political incentives, monetary authorities are responding by effecting treatment based solutions than preventive ones. As such, they are unlikely cures for today’s imbalances.