Uh...Global Coordinated Liquidity Injection ?

The perceived market's disappointment on Tuesday was the refusal by the Fed to make the Discount window more attractive. Now we know why they chose that course of action: Global Coordinated Liquidity Injection.

Uh, ok... but what does all that mumbo jumbo really mean? In order to understand it, let's step back for a moment go way back in economics history...far, far away.... .

Some are calling today's coordinated move by global central banks unprecedented? Is it? Not really! But that doesn't mean it's not extraordinary. In fact, the extraordinary nature of it is.., why we say it's "bullish" but not bullish. These types of things just don't happen when times are good! To understand the present credit market conditions in context, let's go back to... Shhhhh... don't say this too loudly... 1930!

What happened in 1930? The formation of the Bank for International Settlements (BIS). The BIS essentially laid the groundwork for global coordinated liquidity facilitation. After the end of World War I there was a deep distrust among countries, which magnified the global credit contraction conditions. Debt was massive at that time. Global markets seized up.

The BIS was initially a failure. Among the first loans the bank intermediated were packages to Austria and Germany, neither of which helped those countries avoid financial crises. What is important is not that the BIS failed to stop financial crises, but why. The answer is that markets eventually chew through fiscal and monetary intervention in spite of us. So frequently, in fact, almost always, the cure is far worse than the disease. Just something to think about.

Liquidity Unfrozened.

There is a stigma attached to borrowing funds from the Fed through the discount window: the banks have to disclose it and it illustrates severe financial weakness to their shareholders and depositors.

So the Fed is considering a “new auction system”. Essentially, what the Fed is doing is taking the stigma away from the discount window--the Fed will lend directly to banks and the banks don’t have to tell anybody. Theoretically, the Fed could make these quiet loans for indefinite periods, thus giving banks more permanent capital (it’s really credit, but banks call it capital).

I have a feeling the Fed moved less yesterday than expected because foreign investors (foreign central banks) were crying foul. A bigger move would further deteriorate the dollar and thus their investments in the dollar. It would also hurt their exports. They are getting pretty tired of this game and trade pressures are building.

The Fed knows that higher stock prices are important to reflate since 90% of global liquidity is dependent on high asset prices as collateral. Thus they are desperate to finance banks’ collateral values. How to do that? The only way is to lend directly to them.

The plan won’t work. Under the repo/fractional reserve system the debt can be hidden because it is spread out among many banks. The Fed lending $10 billion (and thus their balance sheet rising by $10 billion) will turn into $500 billion as other banks lend that money out and only keep a fraction of it for themselves. This is not working. Under the “new” plan the Fed will lend directly to each bank. If they want to create $500 billion of new credit the Fed’s balance sheet will increase $500 billion.

This will be obvious to foreigners just like a big cut in the discount rate last nite. This is why gold is up this morning in response to this “new” plan which is really just a hidden discount rate cut: if the Fed is willing to pervert its balance sheet to this extent the dollar will fall. And gold (in dollars) will go up.

Decoupling.

Equity markets have decoupled from debt markets, emerging markets have decoupled from developed markets and the U.S. dollar has decoupled from just about everything.

Short-term government securities have acted as a safe haven for money in transit. Interest rate traders have bet that the U.S. yield curve will steepen as the Fed cuts short terms rates and the long end reflect fears of inflation. European interest rate may follows as economies weaken responding to a U.S. slowdown and a stronger euro.

Debt is distinctly out of favor. Debt is also less attractive in an environment of increasing inflation. Fundamental price pressures are coming from higher energy costs, increasing food prices and rising inflation in emerging markets. The price pressures are exacerbated by seemingly deliberate policies from central banks to inflate their way out of the credit crunch.

Investments reliant upon abundant and cheap debt - highly leveraged hedge funds, private equity, infrastructure and property look less attractive.

Equity markets have benefited from lower interest rates, strong corporate balance sheets and profitability.

Fear of inflation underpins demand for real businesses with strong, preferably recession insulated cash flows. Fossil energy, hard commodities and food producers are key areas of focus. Alternative energy, water resources, essential infrastructure (especially in emerging markets) and environmental services are perceived as attractive.
Support for equity markets has an emerging markets angle. Emerging market growth is expected to be insulated from the turmoil of developed markets. Suppliers to emerging markets ( e.g. commodity producers) are seen to be protected from a US and European downturn.
Outward investment flows from China, India, Russia and the Middle East - the emerging market "bid" - are a key driver of equity market resilience.

A weak U.S. economy and concern that the Fed will continue to ease interest rates further in an attempt to prevent recession and support the banking system weighs heavily on the dollar.

Major dollar investors, especially Asian central banks who have invested a substantial portion of their reserves in U.S. dollar assets (estimated around 60-70%), have started to diversify their currency investments. Moves to replace the dollar with the Euro as the settlement currency for trade in key commodities such as oil, if it eventuates, also removes an underlying pillar of support.

This has supported currencies, especially emerging market currencies or currencies seen to be closely linked to these markets. Appreciating currency values reinforce asset values in these markets triggering positive feedback loops. This helps keep the emerging market asset price bubbles going.

Rebound...

December has been up 75% of the time since 1929 in the S&P 500, with the second highest average monthly return and the smallest average drawdown. And whenever the S&P has lost more than 4% during November, December was higher five out of five times by an average of +5.6%.

Past results is no guarantor of future performance, as the saying goes, but while history rarely repeats, it often rhymes.

The autumn swoon stopped directly on the August lows, precisely ten percent from an all-time high. While this is admittedly a bit

cute for my liking, the technicians in our midst now have a level to lean against.

Keep in mind that the sharpest rallies occur in the context of a bear market and formidable resistance resides above at S&P 1490. The bulls seems to have chewed through that resistance, and the double-bottom ten percent blink-and-you-missed-it correction will be obvious with the benefit of hindsight.

I believe that “Don’t fight the Fed” is one of the most dangerous axioms in finance. Still, the perception that the FOMC is on call and at the ready could buoy markets through year-end, particularly if he they cut Fed Funds by fifty basis points and again adjust the discount rate lower on December 11th.

However, as traders, the path we take is entirely more important than the destination we arrive at. Interesting times indeed, fraught with risk and by extension opportunities. Stay alert and understand that a litany of agendas are littering our financial landscape. You don’t have to agree with them, you simply have to respect them. All the way to the bank.

Cutting rates any good ?

As the markets seem to want to be relieved that global central banks have the “liquidity” problem under control, let us remind ourselves of the magnitude of the problem.

Just how central banks inject “liquidity” into the markets when they need it? Essentially central banks encourage debt creation - for people to borrow money, so that they buy things (consumption) to spur the economy. But due to too much debt, financial engineering has had to create new and better places to stuff more and more debt.

You may have seen the chart above before. It shows the results of that financial engineering. Central banks can only affect the bottom two parts of the chart- ie high powered money and M3. The Federal Reserve is growing as fast as it can in order to indirectly support the much larger problem of scrutinized debt and derivatives.

These two phenomenal pockets of debt are supported by asset prices: when asset prices (which act as collateral) decline, liquidity gets sucked out of the system. So the purpose of pumping new debt into the system is to keep nominal asset prices up to protect collateral values of the real problem of leverage in the system that the Fed cannot directly control. It takes more and more debt to do this because people are having huge problems servicing the debt they already have.

So we have two huge forces fighting each other right now: the central banks desperately attempting to re-flate (create more debt) and the market grudgingly but purposefully attempting to deflate by paying back (which the bureaucrats are trying to help with) or more likely destroying (write-offs) that debt. We have extremely high volatility as these two forces fight it out.

Looking at the chart above, eerr... which do you think will win?

Don't ignore the market.

We find ourselves at an inflection point where just about every piece of news imaginable indicates that our financial markets should be falling lower. The mortgage mess is just starting to heat up while the credit crunch is in full swing. Despite some improved retail numbers the general consensus is that the consumer is strapped, gas prices are high and inflation for everything except what the government counts in their basket of goods is ramping. Yet despite all this the market is actually starting to rise.

Most traders will clearly be scratching their head over this dislocation while others skip the scratching and move straight to pounding, choosing to fight the market and its ascent. While it is always fun to debate and form one's own opinion regarding the macro outlook, the simple fact is that the market is acting well in the extreme short term and while it doesn't mean we're out of the woods we must stand up and take notice or at least give it the respect it deserves.

Every market that goes higher starts from some point and while there is great danger in being overly anticipatory, it is he who identifies the move first that will typically reap the most rewards. It is during this early time when the crowd has not yet embraced the move, rather they are fighting the trend and standing stubbornly aside. Ironically, as the ascent continues, these individuals become more and more optimistic and the crowd mentality slowly shifts. Ultimately the pendulum shifts in completely the opposite direction and ironically is about the time when positive news flow starts to creep in and actually supports higher stock prices. Of course, we all know that it is also around this time when you have to start becoming more and more cautious and slowly creep out of the optimistic mentality, moving towards the exit.

The problem most traders face, however, is not just how to identify an early move but how to play it. In my opinion, it is during these early stages that time frames become incredibly important. Most would believe that during the early possibility of a turn, the short term time frame dominates as hyperactive speculators jump in and out in a matter of minutes not risking any more than they have to and capturing as much gain as possible. This activity breeds volatility, which is why short-term market moves acts so erratic at key junctions such as the where we are now. In one sense that opinion is correct but I believe this early playground is wide open and actually may present more opportunity for those with a longer time frame.

Despite this volatile short-term activity, it is also around this time when the new winners start to make themselves known and present perfect opportunities for the longer term trader who can start to slowly wade back in with a much longer leash and a smaller investment size. They are typically stocks that are just starting to show improved relative strength despite after having weathered the recent storm relatively well. They are typically also those that are the most fundamentally sounds as traders seek to move back into their favorites that they sold only weeks before during periods of high emotion and fear.

The individual seeking a longer time frame can easily start to move slowly back into these areas with a long leash, giving themselves the most opportunity for reward while keeping their risk in-line by holding a less than normal position size. Should the market not be turning and falter again, stops will be taken, but if the market does move steadily higher, the longer term trader will be well on his way to building back solid inventory in order to fully participate with the next move.

At this very moment the market has been showing signs of resiliency and is improving. The technical conditions remain extremely precarious but there are also subtle signs of improvement and early speculators are starting to step back in and scoop up inventory. It may simply be another push towards the new longer term trend line resistance, or it may be a move back towards new highs. There isn't a soul out there who knows for sure but if you find yourself already having formed an opinion on what will happen, whether you believe it or not, you are actually predicting the future.

At this juncture especially, we must remain flexible, open-minded, and with both ears listen to the charts.

Dances with energy.

Yesterday I saw a bunch of Bloomberg headlines regarding a new U.S. National Intelligence Estimate (NIE). I parsed through them quickly and made little of it; until, that is, I read an eye-opening piece last night. The bottom line is that the Dec. 3 NIE concluded that Iran halted its nuclear weapon program in 2003, and that since 2005 the U.S. has been overestimating Iran’s plans to develop nuclear weapons.

And with that, the oft discussed “geopolitical premium” presumed to be built into energy prices was pretty much eviscerated. What does it mean for energy stocks? What does it mean for the broader market? Based on recent (and not so recent) history, lower energy prices are not correlated with broad gains in equities, regardless of what the broad media feed us on a daily basis. You can search the archives for many statistical takes on this point, but merely eye-balling this 4-yr chart of crude and the S&P500 (SPX) it is rather obvious that the two have been dancing together quite nicely.

Does it mean then that equity markets will fall together with energy prices? All things being equal, I suspect that lower energy prices would indeed be a drag on equities; but things won’t be equal. The only thing keeping the Fed from mainlining the system with every dollar it can print is the risk of inflation. The mere thought that inflation might be restrained by lower energy prices should be excuse for Bennie to continue his compulsive monetary promiscuity. It matters not that, in my humble opinion, these actions will only prolong and exacerbate the current credit mess; if the Fed keeps printing, nominal asset prices will likely continue their delusional exuberance.