Fed Feeds the Market: Will It work?

I understand we have had a 3-week rally of proportions not seen since 1938 in the US. On a weekly basis the Dow closed up 6.8%, the S&P 500 6.2% and the NASDAQ 6%. On a monthly basis till now the Dow is up 10.1%, S&P 11% and the NASDAQ 12.2%. The real push came when the Fed announced that it would buy $300 billion in Treasuries from the market over the next 25 weeks or so to help support the economy and spur lending. Also the program to buy housing agency debt and mortgage-backed securities was extended to about $1.45 trillion.

Following this, Treasury prices surged and 10-year yields plunged about half of a percentage point, the biggest drop since the 1987 stock market crash. Also the US dollar plunged. This resulted in commodities, mainly base metals and oil, moving up and as the shorts covered the up move was magnified. The Geithner plan to handle bank toxic assets was also well received, which gave more teeth to the rally.

Some concerns came back when, as a Market Watch report says:

On Wednesday, concerns were sparked after the United Kingdom failed to get enough bids to sell the full amount of 40-year gilts it offered, the first time this has happened in 14 years. Later in the day, a U.S. government auction of $34 billion of 5-year notes drew only tepid interest from foreign investors.

The basic question that arises is will the huge funding required for the various avtars of the bailout plan succeed apart from the question marks on the plans success itself? In fact the reason for the Fed's announcement of the buyback of existing treasuries is in a way to make the Treasury sales successful. While one arm of the government buys, keeping the upward pressure on prices, the other sells. The deficit in 2010 is expected to be of the order of $1.25 trillion.

Says the above mentioned report:

If the Fed is done six months from now, the Treasury market will be looking at the fiscal deficit and a huge amount of supply to come without the Fed being there as a buyer…

So the question now arises, who buys these Treasuries? Foreign buyers have become extremely wary (and many, including Europe and Gulf countries, have their own set of equally grave issues to handle) and the noise being made by the Chinese on a new world currency would be a cause for concern. Will China sell to the Fed and reduce its exposure? It is a certain possibility as it restructures its policy to focus inwards to the local economy and reduce dependence on exports.

This could also mean upward pressure on interest rates, as the report mentioned continues:

Ten-year yields now at 2.65% are likely to end the second quarter, in June, at 2.55%, according to a MarketWatch survey of 15 of the 16 primary government security dealers required to bid at auctions and that trade directly with the New York Federal Reserve. One firm did not reply to several requests for information.

That yield will rise to 2.84% by the end of the year, according to the survey.

Such a rise would mean investors, who in the past year have pumped more of their money into ultrasafe Treasuries and out of stocks and corporate bonds as a series of shocks rocked the U.S. financial system, would pull their money out of this corner of the bond market. Those freed-up assets could be good news for other parts of the financial markets that have lost out in the past year's flight to safety - such as stocks.

Now here is the catch. On the one hand this would mean funding the bailouts is going to be more and more difficult and expensive, while on the other hand liquidity will find its way to other asset classes. While the short term shift in liquidity to stocks and other assets may move these markets, sooner than later the reality of high interest rates and the inability/difficulty of funding the bailouts other than through the Fed's buying of more and more treasuries (printing money or quantitative easing) will become apparent. This we have experienced many times, and it is a sure shot formula for asset prices to finally form a bubble and lo! we are back to square one.

The market players should not get euphoric with current move. Players shifting their liquidity to the market to create such sharp moves would be actually shooting at their own legs. A measured slow consolidation is required, and a sharp move in asset prices will put the medium to long term sustained recovery in jeopardy. This whole process will be time consuming – running into number of years and the market players' own action on a collective basis of how they handle this liquidity is going to determine how long the markets may take to make a long term sustainable move up.

Disclosure: No Positions.