John Hussman: Impact of Fed 'Liquidity Injections' Sorely Exaggerated

by: John Hussman

Excerpt from fund manager John Hussman's weekly essay on the U.S. market (12/3/07):

Last week, the stock market enjoyed a typical clearing rally from an oversold low - “fast, furious, and prone to failure.” This presents a good opportunity for investors to reduce positions that they would not be able to tolerate through a complete market cycle, with the S&P 500 only about 5% below a record high...

My greatest concern at present is that investors are being bombarded with empty hope that the Fed will save them by “injecting liquidity” into the banking system. Time spent examining these false perceptions is not time wasted.

Very simply, the impact of Fed actions is sorely exaggerated. The amount of liquidity that the Fed provides is minuscule in relation to the U.S. banking system, and also in relation to the volume of capital inflows (about $2 billion daily) that the U.S. relies on from foreigners, thanks to our massive fiscal deficits and low savings rate.

What strikes me as particularly absurd is that the analysts who wax rhapsodic about “Fed liquidity” speak in a way that makes it obvious that they have no understanding of how these Fed operations work. Then again, it's precisely because we do understand how they work that we're convinced that they're irrelevant (aside from boosting short-term market psychology and accommodating short-term spikes in the demand for currency)...

...the total amount of liquidity added by the Fed since March is only about $16 billion.

Last week, investors made a great deal about an $8 billion 43-day repo that the Fed initiated. While this was reported as an extraordinary measure to stabilize the financial markets, the fact is that the Fed regularly enters a long-dated repo every year, just before the holidays, in order to accommodate a moderate increase in the demand for currency (in 1999, the amount was massive because of year-2000 fears, and was quickly reabsorbed after the new year). The $8 billion repo the Fed entered last week amounts to roughly $25 per American in extra cash to carry around the malls. To frame this as some sort of extraordinary effort to stabilize the banking system is absurd.

Again, the problem with the U.S. financial system here is not liquidity, but the solvency of mortgage loans and securitized debt. The Fed's actions are not likely to have material impact on this. To believe otherwise is mindless sheep-like superstition. Do investors really want to bet their financial security on the hope for “Fed liquidity” promised by uninformed analysts who don't understand monetary policy because they can't be bothered to look at the data?