John Hussman: Let's Add Up That Liquidity Injection Again

Excerpt from the Hussman Funds' Weekly Market Comment on the U.S. market (12/24/07):

Contrary to the impressions they attempt to create, neither the Fed nor the ECB has "injected" material amounts of "liquidity" into the international banking system in recent months. This is not a call for them to do so - to some extent their hands are tied by inflation pressures, currency risks, and profligate government spending (particularly in the U.S.). The problem is that by creating the illusion that they are doing something material - when the problem in the global financial system is not confidence, or liquidity, but solvency - the Fed and the ECB misdirect the attention of investors, provide false hope, and will ultimately do a great disservice to investors and to their own credibility.

The eagerness of Wall Street analysts to hail the moves by the Fed and ECB as important, without even examining or understanding the data, is a discouraging reminder of how willing many investment professionals are to parrot common misconceptions, rather than thinking for themselves. We should not be so alone in pointing out these issues.

Last week, the Fed executed the first of its highly publicized "term auction" transactions. As I noted in A Little Acid Test for Fed "Liquidity" last week, the Fed had $53 billion in repos outstanding on Friday December 14, fully $39 billion of which were due to expire last week. This ensured that the Fed would initiate new repos of a similar amount. The acid test was whether the term auction repos would represent a) new liquidity, or b) just a different way of rolling over the same money. Last week, we learned the answer to that question is b.

Hussman then listed the Fed's actions over the past week, in terms of auctions and repo trades, in detail, showing how the Fed was not injecting liquidity, as widely reported, but draining liquidity from the system.

Thursday (12/20): And now the acid test. The $9.75 billion 1-day from Wednesday comes due, along with a $10 billion 7-day (from 12/13), a $20 billion 8-day (from 12/12), and a $4 billion 14-day (from 12/6). Total expiring repos: $43.75 billion. Now remember, this is the day that the $20 billion from Monday's auction settles. If the Fed initiates less than $23.75 billion in new repos, the "term auction facility" fails to "inject" any new liquidity at all.

On Thursday 12/20, the Fed initiated just $20 billion in new repos: A $10 billion 14-day, an $8 billion 7-day, and a $2 billion 1-day. So given $43.75 billion in expiring repos, the Fed replaced $20 billion through standard means, and $20 billion through the term auction facility. Overall, the Fed drained $3.75 billion of "liquidity" on the very day its first "term auction" transaction settled.

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At present, the Fed has injected less than $20 billion in total "liquidity" since March, nearly all of which has been withdrawn from the banking system as currency in circulation. Normally, the Fed would have done a "permanent" open market operation by now, to finance this increase in currency demand (which predictably grows by $30-50 billion annually). But by constantly rolling over temporary repos every week or two instead, the Fed can act as if it is "doing more."

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It may make people feel good that the Fed looks like it's doing something, but these actions are being misrepresented to investors as being far more than they actually are. Misinformation simply creates false hope, and directs attention away from real problems. This is a disservice to investors.

Over the years, the misperceptions of investors have tended to be a source of periodic frustration for us (the 1999-2000 tech bubble being a good example), but avoiding those misperceptions has also generally been a great source of long-term returns. I don't have any reason to believe that this instance will be much different.