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State of the Fed


...liquidity has two fronts

Normally the Fed accumulates treasuries in the beginning of the year, seasonal flows and such. But even accounting for this, the Fed's balance sheet shows once again that they are being very accommodative by buying lots of treasuries from dealers (REPOS and coupon passes) despite higher short term rates.

As the Fed continues to raise short term rates to placate our foreign "investors" (other central banks printing money just as fast), they are not ready to wean the U.S. consumer from the teat of liquidity despite their claims of a "very strong economy."

But liquidity has two fronts. The supply is still there as the Fed keeps the candy store open, but the demand is falling rapidly (Why aren't companies using all that cash to invest in capital expenditures?) as the consumer has a stomach ache and banks don't want to get sick. As rates rise and floating rates get fixed, more discretionary "cash" is going to debt service.

We saw credit spreads widen by 20 basis points in Europe earlier this week and markets shrugged it off as a blip. We think this is additional evidence that investors, at least the smart ones, are beginning to "respect" risk a little more.

And this is the key to when the game of musical chairs stops. When either investors decide to reduce their risk or foreign central banks decide to diversify out of dollars (this is really the same thing), the liquidity game will be up: all that excess liquidity will go out of risky assets like stocks and into less risky ones like paying back debt (the reduction of debt is equivalent to investing in a riskless asset). That is deflationary.

This is the last thing Mr. Bernanke wants to see. If Boom Boom childishly decides that he is all powerful and the markets can't beat him and he "drops dollars from helicopters," he will accomplish nothing more than reversing the roles of deflation and hyper-inflation: the former will precede the latter and you better be long gold.

The state of affairs is unchanged, but the state is getting old.
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