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  1. Home
  2. / Investing

Fundamentals? It Has All Been About Central Bank Liquidity!

All eyes will be on the Fed this Wednesday to see if this 'weakness' will or can cause them to reverse their policy.
By MALEEHA BENGALI
May 03, 2022 | 01:00 PM EDT
Stocks quotes in this article: HYG, LQD, ARKW

It is incredible that when stock markets rallied 30%+ and stocks moved up in multiples of 100%, investors were very happy taking it all in without doubting what central banks were doing and why. The sheer force of fiscal and monetary action may have been warranted to avoid a systemic collapse of the entire financial system, but it is questionable why the Fed continued to buy Treasury assets via QE and expand its balance sheet for nearly a year following the recovery as well.

Just because inflation did not rear its ugly head in the past decade, they justified their actions to print whatever amount they needed to solve whatever crisis that was at hand. This aggregate boost mixed with supply chains problems caused havoc to raw material and goods prices across the world. Inflation may not be secular at 10% yoy, but it is certainly far from 2% goal on a long term basis. Low and behold today, as the markets are down 5%-10%, the same investors are throwing tantrums like a two year old demanding their dad give them more candy after they have eaten a whole jar of it.

We know how the Fed always comes to the rescue of the market, especially when there is a crisis that causes a collapse in asset prices, like the repo crisis we saw back in September 2019 that caused the Fed to immediately print money on back of a "plumbing" problem as money markets froze.

The problem is that this modern monetary theory (MMT) that has been in place since the GFC in 2008 is now coming to a point where it is causing problems more frequently. Each time the balance sheet needs to grow even more as it cannot handle the targeted increase. Every time the Fed tries to raise interest rates, something breaks. Of course, at first rates of 4% were harsh, then 2%, today we are doubting even 0.5%! The system is too inundated with debt, it is simply too big to fail.

The Fed knows and they can only jaw bone their way into talking rates higher and markets lower to get inflation down, because they know that if they actually followed the Philips curve analysis or targeted the Fed Funds rate vs. the CPI, they would need to raise interest rates closer to 3%-4% at the very least. One can only dare to think what that would do to the entire financial system.

We were facing the same dilemma back in 2019 before Covid hit. Covid just delayed the Fed reset as the whole world shut down unexpectedly. Two years on, most assets like (HYG) and (LQD) that the Fed bought are now lower than before Covid levels, with some major indexes lower too after reaching exuberant levels in 2020. What good was that $5 trillion plus in stimulus as we are now left with an economy that has trillions in debt and inflation causing a serious problem to the US consumer that is seeing rising cost of living and lower wage growth.

One can argue that the past decade of Fed induced stimulus and liquidity has been one of the biggest reasons why the S&P 500 or the long duration assets like technology have done so well, as these long duration assets benefit from lower rates. Today the opposite is true and this is why funds like (ARKW) and other non-profitable over leveraged tech stocks are collapsing as we are now seeing much higher bond yields and rates. What was the real fair value? Only time will tell.

All eyes will be on the Fed this Wednesday to see if this "weakness" will or can cause them to reverse their policy. The market is sure betting on it as they are convinced the Fed will not fail them even this time. We have reached big support levels on the S&P 500 with US 10 year bond yields close to 3%, but this time it is different, they have stubborn inflation which was a problem even before the Russian/Ukraine war. Most traders seek solace from the Fed put, but perhaps this time around, as we come out of decade of MMT experimental decade, the Fed put strike is a lot lower than most can even imagine.

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At the time of publication, Maleeha Bengali had no position in the securities mentioned.

TAGS: Currencies | Economic Data | Federal Reserve | Indexes | Interest Rates | Investing | Markets | Rates and Bonds | Stocks | Trading

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