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Don’t Fight the Fed

Posted by Larry Doyle on July 30, 2009 12:37 PM |

“Cover all your Treasury shorts!!”

I will never forget that mandate put forth by Tom Kirch, then head of Fixed Income at First Boston, as the stock market was crashing in October 1987. As a young trader, moments like that are not soon forgotten. Why? Mr. Kirch through dint of experience knew that you “don’t fight the Fed.”

With the crash of the stock market, the Fed cut interest rates and flooded the system with liquidity. In the process, the U.S. Treasury market had a massive rally. Kirch knew what was going to happen and saved the firm millions in the process. You can rest assured I immediately broke out some ‘Buy’ tickets and covered my Treasury shorts in a heartbeat.

“Don’t fight the Fed” is a tried and true rule of trading on Wall Street. While the bond market can often get overbought or oversold in the midst of a Fed easing or tightening scenario, ultimately if the Fed wants to move rates in one direction or another, it will make it happen.

Fast forward to the Brave New World of the Uncle Sam Economy 2009. How are market participants supposed to view the Fed currently? Dare I say, as challenging as it may be for market participants, myself included, “don’t fight the Fed” is still very much applicable. How so?

While the Fed has no more ammo in terms of lowering interest rates (Fed Funds of 0-.25%), it clearly has all sorts of other firepower at work to flush the system with liquidity. Additionally, the Fed is working in concert with the U.S. Treasury.

The challenge for all those interested in the markets is assessing the cost-benefit analysis of the Fed’s actions on both a short term and long term basis. There are no historical price models, econometric equations, or market participants who can categorically tell you exactly what will happen and why.

All I know is “don’t fight the Fed,” and right now Mr.”Fed” plans on providing all necesary liquidity to support the economy and markets as much as possible.

The disconnect between the economy and the markets? That is nothing more than the massive hand of the Fed.

Hat tip to kbdabear for the prompt on this topic.

LD

  • Mike

    LD,

    Given the lack of fundamental data to support this years rally in the markets, do you think the Fed is essentially creating a huge bubble in it’s recent efforts of liquidity injection?

    I refuse to believe that this rebound will have any long-term legs…

    If so, would it have been smarter to just let the markets fix themselves? Or would doing nothing have made things even worse?

    I can’t help but think we are only planting the seeds to an even worse financial crisis, and that the past 5 months have only been a concerted effort to temporarily sweep our trash under the rug and pretend it’s not there.

  • Larry Doyle

    Mike,

    I share similar concerns.

    Not that I would promote a total collapse of the system, but as I think through what happened, my instincts tell me that certain large creditors, starting with the Chinese, pressured Washington (Bush and Obama administrations) to backstop the banks and other large financial institutions.

    In the process, I think we have purchased a prolonged Japanese style underperforming economy.






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