Last Call for Liquidity

For much of this year a powerfully rising stock market seemed immune to deteriorating economic fundamentals. The most plausible reason was the Fed pumping billions in liquidity into the economy through their quantitative easing program known as QE3. But last week’s markets highlighted some flaws in that logic.

It was the Fed’s plan that the liquidity provided by buying $85 billion in Treasuries and mortgages per month would stimulate both consumer spending and corporate investment and that this year’s rally in stocks was proof that it was working. However, the ferocious across-the-board asset selling that followed Ben Bernanke’s announcement that the Fed would soon begin ‘tapering’ liquidity suggested that the market was supported more by the fuel of liquidity than fundamental spending and investing.

Justin Wolfers wrote in a Bloomberg op-ed piece Thursday titled Why Markets Aren’t Getting the Fed’s Message that after “drawing on a dozen careful academic studies of quantitative easing, Goldman Sachs Group Inc. economist Jan Hatzius has estimated that it takes about $1 trillion in bond purchases to move long-term interest rates by a 0.4 percentage point. In other words, the market’s recent reaction is roughly what would have occurred if the Fed had revealed a plan to cut back on quantitative easing by $1 trillion.”

But the Fed did nothing remotely close. Bernanke said the central bank expects to start tapering its $85 billion a month in bond purchases toward the end of this year, with an eye toward stopping purchases by the middle of next year; assuming the unemployment rate has fallen to about 7 %.

Wolfers points out that no part of Bernanke’s comments indicated a change in his commitment to keeping its short-term interest-rate target at or near zero until unemployment falls to 6.5%. It was a clear case of emotions trumping logic; the perception grew among traders and investors that the Fed would start raising short-term interest rates sooner than was previously thought. Prices in futures markets currently indicate a high probability that the Fed’s target rate will rise to 0.25% by May 2014. Before last week, that rate would not be reached until much later in 2014.

The stock market has rebounded strongly each of the last three days on both better-than-and worse-than-expected economic data – most notably a steep downward revision in gross domestic product from 2.4% to 1.8%. Remember, a weaker economy means the Fed is likely to leave the liquidity spigot open longer.

In the struggling economy housing continues to be the lead story. The Case-Shiller Index which measures home price movements in 20-cities was up 1.7% in April and 1.9% in March boosted by the lack of supply and a recent urgency among buyers as prices and mortgage rates rise.

New home sales came in at a stronger-than-expected annual rate of 476,000 in May, up from 454,000 in April. Pending home sales reinforced the trend as that index jumped 6.7% for a year on an annual gain of 12.1%. The index level of 112.3 is the highest since the real estate boom days of 2006, according to Econoday.

While the Chicago Fed National Activity Index points to contraction in May, the regional Feds which reported this week all showed improvements. Texas factory activity increased sharply in June. Both the Kansas City and the Richmond Feds reported strength in May as well.

The Durable Goods report showed that manufacturing may be regaining some of its momentum after slowing during the first part of the year. New factory orders for durables in May jumped 3.6%, following a matching 3.6% jump the month before. The transportation component lead the way with a 10.2% spike following an 8.3% increase in April.

Consumer confidence came in this month at a recovery high of 81.4 in June, and up nearly 7 points according to Econoday. Confidence translated into economic improvement as spending in May rebounded by 0.3% following a 0.3% drop the month before. Supporting the spending boost was an increase in personal income of 0.5%.

When all is said and done, the Federal Reserve with the best data and some of the smartest economists on the planet believe the economy has sufficiently improved to begin slowing the liquidity pump, known as QE3. In their view the economy, or more specifically, the banking system has sufficiently healed to begin weaning it from the money drip.

It may also be that the central bankers now view the once desirable flotation-like, life-sustaining qualities of QE3 as highly flammable mixture threatening to ignite uncontrollable inflation at the first hint of a significant bursts of economic fire.

Either way, Fed members have decided it’s time to back off the pump and end the program within a year. It is highly unlikely that they will sell bonds at the end of the program, rather opting to hold them to maturity. Also, it is unlikely they will raise interest rates any time soon having stated their target for unemployment is a distant 6.5%.

So the Fed has revealed their game plan. QE3 is on the way out in about a year (barring a significant downturn in the economy). Interest rates will remain in the 0% to 0.25% range for perhaps another two years. US Treasuries, the whipping boy of far too many ‘experts’ will likely soon return to their normal trading patterns as the artificial pressures exerted on them by the Fed diminish. And if the central bankers are right, stocks and the corporations they represent, will grow once again – but this time based on the fundamentals of a healthy growing economy, not the fumes of inflated dollars.