Stock Market / Fed's Expanding Role

As I write this, the market has rallied powerfully out of
the 1/08 low test zone. News this morning that the Fed is
expanding its role in liquifying the credit market triggered
a massive short squeeze and follow through by traders eager
to join the rally.

This bounce interrupts a breakaway downtrend and puts in a
short term double bottom. The rally has brought the SP 500
from a deep short term oversold to a modest one. The double
bottom is an encouraging sign in the short run, but since
powerful, brief rallies are a hallmark of a bear market, it
is too early to tell whether more extended positive action is
in order.

Today, the Fed announced expansion of its special term credit
facilities to $400 billion. It has increased these facilities
by $340 billion in less than a week. Banks and primary dealers
can offer less liquid, lower quality debt to the Fed for Treas-
uries after the private stuff has been given an appropriate
haircut. So far, the Fed has "sterilized" these acquisitions
by selling Treasuries in the open market, with the result that
the liquidity pool has improved in quality, but not in size. It
will proceed with this dual process going forward, but the new
larger scope of transactions will give them some "cover" to add
permanent reserves as needed.

Financial corp. commercial paper has contracted by roughly $550
billion since peaking in early August, 2007. Much of this
contraction is mortgage backed paper. This market has struggled
since the sub-prime crisis broke. With only a slight recovery in
outstandings and a recent new spike in quality spreads, the Fed
felt called upon to act. The $400 million in Treasuries offered
as an effective swap equals 24% of outstanding financial corp.
commercial paper. That does provide a more secure lifeline for
illiquid players in the market.

The broad measure of system liquidity I use is flat with August,
2007 levels. Without rapid improvement, the economy will remain
at considerable risk and this may eventually force the Fed to add
more permanent reserves, inflation risk notwithstanding. The new
line of term financing also allows the Fed more time to see if
the high flying commodities markets break.