Monetary Policy -- FOMC 9/21 Meeting

Short Term Interest Rates
No change. The indicators I use to suggest whether rates should be
increased remain at 50% in favor of a lift. Fed sees too much slack
in the economy to raise rates now.

My super long term interest rate model suggests that the 91 day T-bill
should be priced to yield 3.4% presently. The spread between the
model and the .15% yield on the bill reflects the large slack still
extant in the economy and the Fed's concern that the CPI is weak on a
cyclical basis.

Liquidity
In a convoluted statement that appears logically inconsistent to the
layman, the Fed gave itself more leeway to add liquidity to the system
in the months ahead under the premise that a rising CPI was too weak
for this point in the recovery cycle. The Fed sees this view as
consistent with the idea that deflation pressure could re-emerge and
create difficulties for the credit market (collateral values).

The Fed made it clear that it does not wish to shrink its balance sheet
and the monetary base at this time. That is fine. However, the FOMC
has leeway to expand its balance sheet on a seasonal basis when it
wants to. I would also advise the Fed to plan to expand its balance
sheet at a 6% annual rate until it sees a clear positve turn in private
sector credit demand in order to maintain minimum liquidity growth
as we go forward.

Right now, the Fed is providing sizzle without the steak when it comes
to liquidity.

Stock Market -- Technical

If you have followed the blog over the past month, then you know I
anticipated this most delightful rally. There were promising technical
undepinnings at the end of Aug., but what captured my attention was
so many bulls were conceding a bad Sep. /Oct. interval.

Well, we've had this nice rally. The short term uptrend has been
confirmed, and today the market blew through resistance to the
upside, leaving an apparently clear path for a continuation of the
the rally.

The market is at an interesting point. On my 25 day price oscillator,
we have reached the strongest overbought in about one year's time.
As the chart link below will show, the SP 500 is also getting over-
bought on RSI as well. The routine expectation here is that the
market is due for a pull-back soon. The possible kicker is that should
it get further overbought against the 25 day m/a, it might well be
signaling that a stronger advance is in the offing. I say this also
because my smoothed 40 wk oscillator has turned positive as well.
This latter indicator does whipsaw once in a while and it is not the
best for short term timing, but it has helped me make good money over
the years, both long and short.

SP 500 chart.

Economic Indicators

The weekly leading indicators I follow most closely have turned up
over the past few weeks, but further strength is needed ahead before
one could plausibly conclude the economy may be regaining some
momentum. However, up beats down in this case.

Disappointingly, The Fed has again shrunk the monetary base here
in Sep. There is much speculation that the Fed plans to wait until
after the mid-term election in early Nov. to provide another large
dollop of quantitative easing. This speculation has fueled the gold
price for sure. I do not know whether such speculation has any merit.
I do however think a strong round of seasonal liquidity injections
would serve well.

Weekly coincident data suggest the economy has flattened out through
mid - Sep from the latter part of Jul. The ECRI monthly coincident
also declined slightly for Aug., following 8 straight months of progress.
My own "stripped down" set of coincident indicators fared a bit better
in Aug. on gains in employment, production and real retail sales.
However, the clear takeaway is that the economy started to lose
growth momentum in Aug.,with this development coming about 4
months after the leading indicators experienced a cycle-to-date top.

Viewed yr /yr, my coincident indicators were up 2.7%. Momentum
has been decelerating primarily because of a flattening in retail
sales after a strong bounce from 12/08 through 4/10. Consumers
have not only operated on a cash and carry basis in the aggregate, but
have been building savings as well.

Total civilian employment has flattened out in recent months. The
economy did add 1.3 million jobs from 12/09 through 6/10. That is a
big number, but represents only about a recovery of 16.3% of jobs
lost. That large deficit plus a slowdown on the jobs front in recent
months has proven very costly to the Obama administration.

My primary profits indicator did rise in Aug. for the 14th straight
month. Yr / yr, momentum is decelerating, but this is a widely
expected development. Profits have continued to progress nicely
through Aug.

Exquisitely Poised...............

The NASDAQ Comp. has made several trips up to the 2300 level in
recent months, only to be turned back by selling pressure. Well, it's
there again, with a cliffhanger 9/16 finish at 2303. Chart.

There is confirmation of the NASDAQ advance in the short run, but the
market is approaching a short term overbought. Logic says the market
should absorb more of the overhead resistance without great damage
before advancing to higher ground up and through 2300. But, logic
and stock price movements do not always happily coalesce.

Place your bets!

A Look At China

I downgraded the China stock market early in the year because I
felt a cost / price squeeze could develop on profit margins because
of the sharp acceleration of wage growth. Profits have held up
better than I expected as productivity gains appear to have been
relatively strong. However, the Shanghai Composite slipped into
a substantial correction, anyway, and remains with a bear profile.

Foreign investment, limited already by regulation, has been even
more limited as China took steps to curtail a major real estate boom
and head off an acceleration of inflation. I think the Chinese have
stayed clear of the stock market to pursue the residential and
commercial real estate markets which have been more rewarding.

Since the economy has been growing briskly, and tighter real estate
lending standards are in place, I think it might worth tracking the
stock market more closely again. Political tensions between the
US and China over trade issues and the value of the yuan may also
intensify in the months ahead, so it might be worthwhile to watch
the Shanghai for that reason as well.

Based upon China's long term economic performance and potential,
I still think the Shanghai should trade around the 3250 - 3500
area. It is at a sizable discount now, but has rallied some in recent
months. The link below shows a bearish chart with the market now
struggling to improve on RSI. Failure to regain postive momentum
could signal a retest of the lows seen a bit earlier in the year, but,
let's keep an eye on it.

$SSEC.

Stock Market -- Short Term

The market has been in a trading range for the past four months,
with most of the action confined to 1040 - 1130 on the SP 500.

Stocks have been in rally mode since the end of Aug., and the
market has been pushing higher to get confirmation of a more
durable rally. The SP 500 has been closing in on resistance at the
1130 level, and most traders are eager to see if the current upturn
can successfully challenge and break through resistance to the
upside.

My Weekly Cycle Pressure Gauge -- a decent fundamental
coincident indicator of the market -- has also been in a tight range
since early Jun. after falling sharply from the end of Apr. This
tells me that players remain especially sensitive to key weekly
data such as sensitive materials prices, unemployment insurance
claims, market short rates and monetary conditions. The gauge
has increased by 2.5% during Sep., and has reinforced the stock
market.

The pressure gauge will probably improve a bit more over the
next week or two, but not enough to signal that the economy --
now running flat -- is about to start lifting again.

When it comes to the weekly gauge, periods like this, when the
gauge has minor bouts of volatility but remains essentially
trendless, can be very frustrating and can last for extended
periods, such as occurred for lengthy intervals in 2004, 2005 and
2006.

On the technical side, the challenges right ahead are to see if the
25 day m/a for the SP 500 turns up and whether the market can
break through 1130 resistance. To make the situation more
complicated for traders, the 14 day RSI would get into overbought
territory on a near term run up and through 1130.

SP 500 chart .

US Trade

One success of G-20 in the face of the 2008-09 global economic
meltdown was to obtain agreement from players to keep the trade
windows open. The recovery in US and in global trade has been
outstanding. However, old issues that plagued the trade front over
most of the past decade have resurfaced.

China continues to run an agressive mercantilist policy. Even
when it locates a business outside of China, such as in Iraq or in
Africa, the facilities are primarily staffed by Chinese. Since
employment looks to be a substantial political issue within the US
in the coming years, so it is logical to expect that the issue of
China's large export subsidies will be revived within US political
circles as well as pressure from the US for China to open its
markets further. EU trade also took a heavy beating from China
in 2009. So, I would expect a more contentious period ahead
between the US and China and also within the EU, where
German exports are undermining domestic recoveries in
troubled European states. I can understand tolerance of
mercantilist economic policies when a country is just emerging
as an industrial player, but The US has put up with China's
damaging policies far too long. It will be interesting to see how
much mercantile trade issues heat up in 2011 and whether the
US congress readies itself to be more forceful with China.
Since Geithner has been a patsy on this issue, it may fall to the
senate to do the heavy lifting.

Stock Market Fundamentals

There was a marked deterioration of market fundamentals from late
2009 through July, 2010. The apparent negative impact on the
prospects for economic growth and for the stock market happened
very quickly and with a vengeance.

As I have discussed, the Fed shrunk its balance sheet and the monetary
base over the Feb.-Jul. 2010 period. Specifically, the monetary base
was cut by a large 7.3%. I do not think the Fed was being malevolent.
I believe they wanted to get a jump on their "exit strategy" in
anticipation of the development of private sector credit growth and the
eventual tapping of the $1 tril. + in excess reserves in the banking
system. Well, as you know, private sector credit demand, rather than
increasing vigorously, continued to wind down further, and this left
an economy and stock market exposed to a liquidity freeze.

By late April, my weekly cyclical pressure gauge, which includes
liquidity measures, started a tumble, paced by a sharp 13% decline in
my sensitive materials price composite. The reaction in the stock
market was immediate and sharply negative as it moved right along
with the decline of the weekly pressure gauge.

My SP 500 Market Tracker, based on rolling 12 months eps and an
inflation driven regression model for the market p/e, kept right on
rising and today stands at 1300 fair value for the "500." However,
the divergence between the earnings based Tracker and the weekly
pressure gauge was resolved by investors smack in favor of the
weakening pressure gauge on the premise that it was signaling that
earnings would eventually roll over.

The situation has improved somewhat since the end of July. The
monetary base is expanding again and even the broader measure
of credit driven liquidity has experienced some recovery as banks
bid for large deposits. The cycle pressure gauge has leveled off and
actually turned up sharply last week on a nice pop in sensitive
materials prices.

What is interesting here is that when system liquidity is squeezed or
frozen for an extended period , you get a recession and a bear
market in stocks. This liquidity squeeze / freeze lasted only five
months, but it produced significant negative results anyway.

Just how chastened the Fed is is anyone's guess, but it appears that
if the Fed wants to keep the recovery going, it will allow the
monetary base to expand moderately at least until cyclical private
credit demand recovers.

For now, it looks like stock players are going to watch Fed activity
re: liquidity, and weekly economic data like materials prices and
unemployment insurance claims carefully.

At 1105, the stock market is reasonably valued as you do not have
to have above normal earnings and dividend growth over the
longer term to earn decent returns. But we obviously have to see
a timely and favorable resolution of the frozen liquidity situation
to see a positive pay off. The Fed has made a healthy down
payment in recent weeks, and players will be looking for more.

Stock Market -- Short Ride In A Fast Machine

Back on Tues. I opined that a rally in September would fulfill one of
the market's favorite pastimes -- catching the greatest number of
folks flatfooted. Bingo! We get one, but this is a tricky move and has
more "fool ya" potential.

As mentioned on 8/31, a tradeworthy oversold was at hand and
stocks have swung quickly to a mild overbought. But the market
was unable to take out the April - early August downtrend line,
closing about on the line. You can expect some guys will sell out
early on 9/7, with that indiscretion as the basis. Secondly, even if
the market holds up next week, we may have to wait as long as a
week after to get full confirmation of a shorter term uptrend.
Finally, the trajectory of last week's shot upward is too rapid to
continue without a pullback.

My intermediate term momentum indicator -- an oscillator based
off the 40 week m/a -- has been an effective tool for charting
direction over the years. It can be slow to signal change,
but has the merit of whipsawing seldom. The smoothed value is
starting to base after an extended deciline, and means attention
should be paid to whether a long side opportunity might be
nearing. I also note that the 21 day TRIN and the weekly OEX
put / call ratio have been signaling a "sold out" market for
several months (the institutional players have, in sum, been
net call buyers, whereas they are traditionally net put buyers to
hedge out long positions).

As readers know, I played the July rally to the hilt, but I did not
think another opportunity would come along very fast, and if
last week's mini-rocket is the prelude to a nice upside move,
well that would be delightful.

Economic Indicators

Leading Indicators
As most all know, the weekly indicator sets I follow declined sharply
from the end of April through mid-July before flattening out. Of note
here were a swift move up in unemployment insurance claims and a
fast move down in sensitive materials prices, both of which have
stabilized for now. The monthly new orders breadth index made a
cycle-to-date peak in May and, although still in positive territory,
has fallen sharply through August. There is a slowdown at hand,
but the indicators do not yet suggest clearly how damaging it will be.

Real Time measures now show the economy has flattened out in
August following a strong July period, when retail sales and
industrial production lead the way. There is no indication yet that
a downturn is underway, but the leading indicators do suggest that
at least transient weakness is ahead.

My long term leading indicators have lost substantial ground
since late 2008 and would suggest a pronounced economic down
turn could occur unless the monetary and financial liquidity
components begin turning up by late in 2010.

The Economic Power Index (yr/yr % changes in the real hourly
wage and civilian employment) has finally turned positive but
remains depressed reflecting a net loss of seven million jobs and
a low real wage rate. The index has not yet progressed enough to
support a decent economic recovery without dependence on
government assistance programs or an upturn in household credit
demand.

The Capital Slack Measure remains well below normal levels
with super low short rates, high unemployment and capacity
utilization more than five full points under "average".

Looking over all the monthly economic series I follow, I would say
that we have recovered only about 40% of the ground lost in the
past, deep recession as low private sector confidence has
engendered a strong sense of caution throughout. And this we
just have to watch. It is fine and dandy to be prudent, but too
much forbearance will produce a dysfunctional economy with
far more on the line than most folks realize.

The foregoing did not make for pleasant reading, but I would be
much more comfortable with the economic situation nonetheless
if financial system liquidity was growing and was not de facto
frozen, as that can be deadly if it proceeds too long.

Stock Market -- Technical

We are set to steer into Sept., so let's take a look. The market is in a
clear short term downtrend. Moreover, the chart shows the SP 500
was not been able to push up through a downtrending 10 day m/a
in August -- not a good sign. The market is moderately oversold, and
it has been able to rally off this degree of oversold going back to
Jul. '09 -- not a bad sign. The "500", based on closing prices (and
factoring in the "flash crash"earlier in the year), is at the top of a
1020 -1050 support zone that goes back to Oct. 2009. The market
is in a reasonable position for a bounce, but should one ensue, it
would need to take out the 10 day m/a on the way up at the
minimum to attract much interest.

My primary longer term measure for the market has been trending
down since early in 2010, reflecting deteriorating price momentum
measured weekly. It turned positive only briefly in the early part
of the year when the market rallied. I am watching it closely now
because a rally in Sept., should one eventuate, would turn this
historically very useful measure positive. That would be a rather
amusing development, because even many of the few advisory
bulls out there have all but conceded Sept. /Oct. to the bears.
Since the market often does what inflicts the most painful
surprise to the the greatest number, a positive turn in the weeks
straight ahead would be a delight and present a nice opportunity.
Wishful thinking, maybe, but not without precedent.

Benchmarking The Fed

Fed chair Bernanke spoke at the central bankers' annual confab in
Jackson Hole, WY yesterday. He promised further accomodative
action by the Fed should the recovery falter and should the US find
itself facing an episode of price deflation. Easiest way for the Fed to
help out is via purchase of additional financial assets. Time to
benchmark where the US is.

Business sales --retail,wholesale and mfg. -- were up over 9% yr/yr
through June. Monthly demand data including retail sales and
industrial production were up nicely in July to cap off a solid month.
As discussed earlier this week, there has been no positive inventory
cycle swing to speak of and construction remains in the dumper.
Given the large fiscal and monetary stimulus available over 2009 -
2010 ytd, the recovery should have been stronger, but it was solid
enough. Caution by households, business and the banks over the past
year have put a damper on the power of the economy, no doubt
about that.

Weekly economic data so far in August suggest the economy is now
leveling off, as signaled earlier in the year by the leading indicators.
Moreover, monetary liquidity is dissipating and broad credit driven
liquidity is relatively flat. Continuation of the deterioration of the
liquidity environment would point toward development of another
recession in 2011 if the liquidity freeze proceeds through the end of
this year.

Bernanke expressed considerable reluctance to add more liquidity to
the system without further deterioration of the economy. Logically,
this means the economy will be more dependent on rising credit
demand and the willingness of bankers to service it as we go forward.
If such does not materialize, then the economy should eventually
deteriorate and the Fed's hand will be forced. The risk here is that
private sector confidence may decline enough in a newly deterior-
ating economic environment, that further monetary easing may be of
only marginal positive significance.

It could take until the end of 2010 for this drama to play out. since I
have never seen a situation quite like this one before, I am 100% in
cash for the time being, with a short of the long Treasury all that is
on my radar as a possibility for now.
-----------------------------------------------------------------------
Since the Fed more than doubled the size of its balance sheet as well
the monetary base over the past 18 months, the central bank needs
some leeway to see how the fruits of its labors develop. As well, it is
clear that some of the governors of the Board appear very reluctant
to add further liquidity as there is considerable and reasonable concern
about how to manage the excess reserves if the economy proves
stronger than now anticipated. I doubt Bernanke sees this concern as
a cause for inaction, but he has some fire breathers to contend with.

Speaking of politics, the Obama administration seems to be wimping
out on the issue of a decelerating economy. Perhaps sly old Larry
Summers has some positive numbers up his sleeve, but if not, then
time may be of the essence to stand up and say the Gov't needs to
do more. Better to have fought and lost than not to fight and lose
anyway.

US Economy -- Interesting Observation

Weekly data make it clear the economy has started to flatten out
since late July. I think this development was more or less widely
expected, but I am not sure all appreciate what a curious time it is
in that there has been no inventory cycle to speak of during the
recovery over the past year. Available data do not suggest that
flattish demand would trigger substantial involuntary inventory
accumulation relative to sales which would in turn set up a
classic inventory liquidation recession.

Economic & Strategy Review

Economic
Right now, I have long term US growth potential at a modest 2.8%
per annum. With a lower than historical growth profile, there was not
that much reason to expect a gangbusters recovery. However, in view
of the large stimulus and monetary easing programs, the recovery has
been a disappointment to date. Three of the four leading economic
indicator sets I follow have over-amped both the recession and the
recovery to date. They have been spot on with regard to profits, the
bounce of industrial production and the dramatic recovery of US and
global trade. But, they missed on the broader economy.

the recovery has been slow because the major sectors: households,
business and the banks have all been especially cautious. If there is
a single linchpin to a modest recovery path, it has been business,
which has been exceedingly slow to hire and which has kept inventory
investment very low -- up about 1% yr / yr vs a better than 9% gain
in sales.

Total US construction outlays for the US remain depressed. I have
not done much work in this area because I have been figuring that
there would be no recovery of consequence here until the middle of
2011.

Strategy
After a fabulous July, which nearly made my whole year, I went to a
100% cash position in early August (8/6 post). I do not have a good
enough read on the environment ahead to put chips on the table now.
I regard July as purely a case of "better lucky than smart", but I'll
take it.

Looking forward, I think it would be wise for me to look at ways to
tamp down the leading economic indicators I use. One example would
be sensitive materials prices which have been sharply affected by the
emergence of China as a major industrial power and the broad and
growing financialization of the commodities markets. Another
example would be to look more closely at the leading indicators in
comparison to the coincident indicators (That shows the over-amping
of the leaders clearly).

I am also going to have to do a better job of sorting out folks' sense
of caution from other data. As an example, I should have taken keener
cognizance of the puny level of inventory investment earlier.

Since I have been an investments professional for over 40 years, I
hope that my current travails serve to inspire you to remember that
if the game was that easy, well, we'd all be rich.

The Five Year Treasury -- Gadzooks!

The 5 yr. Treas. is now trading at a paltry 1.33%. Most folks would
do better to pay off debt, have a yard sale and a garage sale and put
the unsold stuff up for sale on E-bay. Or, you could set up as a Lego
pieces broker / dealer. Chart.

Long Treasury -- Substantial Overbought

The long guy is heavily overbought against its 40 wk m/a and on
RSI, not to mention a 12 week MACD that is sailing up into
overbought territory. As the chart below will show, there is even a
price gap to be filled. The long Treas. is not quite yet a perfect short
because the trader advisory services are not yet at extremes of
bullishness.

There is heavy and faster moving money chasing this market. It is
running ahead of fundamentals and there is positioning long here in
anticipation of what some players see as a September / October
debacle in the stock market as stock traders bail out on a perceived
failing economic recovery.

The Treasury price is now momentum driven and will require a
strong flow of negative economic news to sustain it. It is foolish to
try to call a top in this kind of surge, but it is wise to remember that
a positive turn in economic data flow could well net you 20 price
points to the downside.

Long Treasury Chart.

Stock Market -- Wicked Game Short Term

Fundamentals
As discussed back in mid-June, the market has been tracking along
with my weekly cyclical pressure gauge (6/15 post) in a dogged
fashion. Even the July / early August rally reflected upticks in the
gauge on a significant bounce in sensitive materials prices. the
gauge has dropped sharply over the past two weeks on rising
unemployment insurance claims and a settling down of basic
materials spot prices and is now back where it was in early July.

This kind of tracking represents a wicked game because of the
variability of weekly data and the speed with which the trend can
change. Reminds one of squirrels racing around a tree: The oil
guys chase after the stock traders and vice versa. In yesterday's
post, I discussed how quickly trend can change in the bond
market as well, since the bond guys watch most elements of the
weekly cycle pressure data, too.

The intensity of the focus on short term economic data directly
reflects interest in whether the economy is set to experience a short
slowdown or whether something more serious and darker may be
in store.

Technical
There is a confirmed shorter term downtrend underway, but what
concerns me most at this juncture is that the market has weakened
enough in August to call into question the legitimacy of the rally that
started in early July and which I thought might well have marked a
clear bottom following the deep correction over May / June. I am
not suggesting further, more serious weakness. My point is rather
that a rally from here would suggest both mediocrity and volatility
and not the sort of brisk march up that would inspire much trader
confidence. SP 500 chart.

Long Treasury Bond

Since late 2008, the long Treasury yield has had two anchors: The
Fed's ZIRP policy for short rates and low or non-existent inflation.
The Fed maintains that it intends to keep short term rates either
at zero or nominal levels for an extended period of time, and the
CPI, although having risen from its cyclical low since the economy
started to recover, remains below the all time peak level set in
mid-2008.

The 30 yr Treasury yield did rise sharply from exceptionally
depressed levels at the end of 2008 with the uptrend continuing
right on into April, 2010. The market responded to the development
of economic recovery and sharp rises in all the cyclical pressure
gauges, with the yield running up to 4.8%.

The yield has fallen sharply since then as the leading economic
indicators have weakened and the cycle pressure gauges have eased.
Moreover, the market is now anticipating further weakness in the
economy and a likely continuing deceleration of inflation pressure.
In fact, bond market players may now be expecting that the CPI
could again go negative yr/yr on a further slowdown of the
economy.

The Treasury is overbought on technical and fundamental grounds
but the rally action is not irrational as the market is discounting
further economic weakness and is growing more confident that the
economy is near to leveling off or worse.

The trick, if you are invested in or are long the bond market on a
trade, is to realize that the market can turn on a dime if data
pointing to a fresh bounce in the economy are reported. Not only
that, but yields can run up very quickly if players perceive a
change in economic momentum to the positive. You need to pay
even closer attention now, because the Treasury market has
started to run ahead of the fundamentals, however muted they
presently are.

There has been much talk again recently about whether the
Treasury market is a bubble market. I do not find such discussions
to be useful. To be a bear on Treasuries translates into expecting
economic growth that will bring increased inflation and eventual
higher short term interest rates that will trigger substantially
higher bond yields. For that we need to see signs that the
economy is set to experience a re-acceleration of growth.

30 yr Treasury yield chart.

Stock Market & Financial Liquidity

I downgraded this type of work over 2001 - 02, when massive
excess liquidity gave a false buy signal for stocks. But the work
can still be effective, so I keep up on it and use it as a secondary
indicator.

Measured yr/yr, the $ value of industrial production reached
its strongest % change numbers in recent months since the mid-
1990s. Compared against my broad measure of credit driven
financial liquidity, it surged, leading to a large increase in money
velocity and a consequent sharp drop of liquidity. That sort of
development is usually a negative for stocks as the real economy
draws available liquidity away from the stock market. We did see
a roughly comparable situation to the present in 1994 -1995
when strong production growth far exceeded broad financial
liquidity growth. Interestingly, the liquidity situation improved
substantially over 1995 as the momentum of production growth
eased and financial liquidity growth accelerated. This development
helped much to underwrite a strong stock market from late 1994
through mid-1998.

To see a similar development over the next 12 months, we might
look for the yr/yr growth of the $value of production to moderate to
a more sustainable but positive level and also see a marked
acceleration of private sector credit and funding growth. This
re-balancing would signify that recovery is on a more sensible
path and it would sharply reduce the liquidity deficit headwind the
stock market is now encountering. So far, however, we have yet
to see the private sector "loosen up" to conduct commerce with
more credit usage.

The foregoing might strike some readers as mere fancy footwork,
but that would be to miss an important point: Over time, the stock
market does compete with the real economy for liquidity.

Financial Liquidity & Banking System

Narrow and broad measures of money and credit driven liquidity
remain inadequate to fund continuing economic recovery if the
tighter liquidity situation persists through 2010. That is my
current "guesstimate". We are not experiencing a conventional
cyclical liquidity squeeze with fast rising short term interest rates
and overheated credit demand. Rather, we have a liquidity "freeze"
as the Fed presumably waits to see whether higher economic
demand will trigger a resumption of private sector credit demand
growth and an upturn of lending to qualified borrowers. the Fed is
jawboning the banks to lend to businesses with rising order books
and solid cash flows. If lenders and borrowers remain unresponsive
to super low interest rates, the next monetary step would be to
resume quantitative easing to support a shallow "cash and carry"
economy.

Now, monetary and the broader measure of credit driven liquidity
have both been expanding in recent weeks. Even the monetary base
has inched up. Moreover, the downtrends in private sector credit
demand -- business and households -- has eased very substantially.
All to the good, but not enough to signal sustainable positive change.

Banks have restored liquidity and are witnessing a decent recovery
of capital. They are also issuing a little more commercial paper and
are offering more large or jumbo time deposits (mostly reserve free).
The system is still carrying a massive loan loss reserve although it
has started to drift down. But, a number of banks have to be
positioned to lend moderately to high quality borrowers, including
households.

At this stage, the tighter liquidity position of the system is probably
forcing a number of investors to make asset allocation decisions with
more limited reserves and to be tempted to follow relative strength
among asset classes even more closely. Retail money market funds
are at their lowest levels since 2006, and institutional funds have
been heavily drawn down to the tune of 25%. The latter marks a
large reversal for a business with strong underlying growth.