Stocks vulnerable as the Fed sucks up cash

A stealthy withdrawal of liquidity could weigh on equities.

By Anthony Mirhaydari Mar 9, 2010 8:35PM

MirhaydariThe stock rally over the last month comes despite a drying up of liquidity -- a fancy name for extra cash in the financial system. Central bankers around the world plan the emergency programs put in place after the 2008 credit meltdown. Those plans are expected to lift the interest rates that governments, companies, and consumers pay.

 

Investors don't seem concerned. The broad market continues to be led by smaller and riskier stocks, as the Russell 2000 small index has seriously outperformed the large caps in the Dow Jones Industrial Average and S&P 500. Over the last 22 days, the Russell has gained a whopping 14% -- by far its best run since July.

 

But change is coming. The Federal Reserve plans to stop directly buying bonds. Since last March, the Fed has purchased more than $1.7 trillion in mortgage debt, U.S. Treasury debt and government agency debt. It would be naive to believe this withdrawal won't cause interest rates to increase. Intuitional investors like hedge funds won't react favorably to an increase in their cost of capital. That's not all.

 

EFF

 

Compounding the problem is the fact the Fed is stealthily sucking liquidity out of the short-term credit market as well. The Effective Federal Funds rate, which is the interest large banks charge each other for overnight loans, has increased to levels not seen since last September. The Fed monitors this rate closely and adjusts the money supply to account for it.

 

Tom McClellan of the McClellan Market Report has found that this interest rate tends to affect stocks on an 11-day lag. Based on this, we should expect some type of market top on Thursday, though this is far from an exact science. Consider it an informed guess.

 

It's worth nothing that the major market rallies over the last year have been accompanied by declines in the Fed funds rate. When the rate fell through 0.15% in September, interest rates returned to levels that hadn't been seen since 1961 and stocks moved higher into October. And when the S&P 500 hit its high of 1,150 in mid-January, it came days after the Fed pumped a ton of cash into the system and forced the funds rate down to a new historic low of 0.05%.

 

In other words, the increase in the Effective Fed Funds rate marks the beginning of the end for the stock market's unprecedented liquidity support. And with retail investors still skeptical and generally avoiding stocks in favor of bonds it's hard to see prices going higher from here without a retest of the February low in the next couple of weeks and months.

 

You can watch me trade during the day at Wall Street Survivor.

 

Disclosure: The author does not own or control a position in any of the funds or companies mentioned.

 

Anthony Mirhaydari is a researcher for the Trader's Advantage investment newsletter. He can be contacted at anthony.mirhaydari@live.com. Feel free to comment below.

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