You already know that I believe the Fed's heavy handed intervention in the financial markets acts to distort the price discovery mechanism (of interest rates, of stocks, of risk, etc.). And that distortion creates moral hazards as long as market participants believe that intervention will continue. Well, to this end, the action yesterday in the stock and bond markets is instructive.
The treasury auction, by all accounts, went poorly yesterday: a 1.78Xs bid to cover ratio indicates low demand (November was 1.9Xs and September was 2.2Xs). As well, foreign central banks took 24% of this auction, vs 38% in November and 30% no average. Heck, it was only $12 billion in size, vs. November's $17 billion, so one would think that the demand - for a smaller supply - would have been greater. All in, it was a difficult day for bonds yesterday - not horrendous - but certainly not great. Until 2pm ET.
That's when the October FOMC minutes were released and contained in that text was a more definitive idea of what "considerable time" means to the Fed:
"Looking ahead, members generally anticipated that an economic performance in line with their expectations would not entirely eliminate currently large margins of unemployed labor and other resources until perhaps the latter part of 2005 or even later. Accordingly and given the presumed persistence of strong worldwide competition, significant inflationary pressures were not seen as likely."
"In their review of the outlook for inflation, members emphasized that the prospects for persisting slack in labor and other resources in combination with substantial further increases in productivity were likely to hold inflation to very low levels over the next year or two." [Underlines mine]
It took about 2 minutes for those words to be read and the buy orders to be written and then executed in both the bond pits and the stock exchanges. Both markets took off to the upside.
And that always makes me a little suspicious. So let's look at the whole picture for a minute. The Fed has been on an historic reflation course in terms of both length of time and magnitude of rate cuts. The administration, too, has been reflating in its own way: through $1 trillion in tax cuts, capex depreciation credits, the largest defense appropriation ever, and thereby, increasingly large budget deficits. And let's not forget that this is happening globally: Japanese interest rates are effectively 0% and Europe's are 2%, while they too are running budget deficits - 7% deficits in Japan and 3% in Europe (so much for that EU Growth and Stability Pact).
You are probably already aware of the fact that MZM growth is, and has been increasingly, negative for the last several reporting periods. Explaining away that negative growth in the money stock by suggesting that all those funds are going into the stock market is curious, and lacking entirely in evidence: trading volumes have been paltry. If that kind of money were making its way into stocks, you'd know it for sure in price and volume trends. Check out WMT's volume histogram for the last few weeks; that's volume coming out of that particular Dow stock. Commercial and Industrial (C&I) loans too have been contracting: down 3.4% q/q and down 10.3% y/y. C&I loans are used for all manner of business reasons, notable among them inventory building. The government statistics show a rebound in inventory building but the C&I data belies that observation. One of these data series is going fall into line with the other.
So despite the most aggressive global reflationary efforts ever recorded on both a monetary and fiscal basis, we have the money stock contracting, demand for business loans contracting and the Fed saying that it could be until "the latter part of 2005 or even later" before these reflationary policies could start to address the overcapacity still in the US economy.
Benjamin Franklin is credited with saying that "the definition of insanity is doing the same thing over and over and expecting different results", and if this particular course of action by the Fed doesn't fit that expression, I'm not sure of one that does. If they just keep reflating, someday it will work. Despite the fact that it hasn't.
Worse still, bond and stock market participants, despite knowing all of the facts I have outlined above, continue to take their cue from the Fed. If the Fed says they will keep on reflating, take the Dow to 10,000 and buy the 10s and 30s. If you were looking for a real life example of moral hazard, now you have one.
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