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Farrell: Market Too Hopeful About QE Party

It might be due to census workers peeling off the payroll list and filing for unemployment insurance (we won't know for sure for a week or two and, if so, would pass quickly), but the initial unemployment claims hit 500,000 Thursday.

Some optimists also mentioned out loud Thursday that there has been a larger-than-usual mustering-out of military service people, which would be a one-time thing, but the number is the number and I hate trying to explain it away. 500K is a level that has often been associated with recession. The four-week moving average also moved up to 482,500.

The Philadelphia Fed's monthly survey surprised us all with a reading of -7.7 when the consensus had been for a measurement of +7.0. A zero reading is no growth. This Philly Fed number is the lowest since August 2009. The details were as grim as the headline. New orders, shipments and employment sub indices all fell.

The Empire State reading earlier this week wasn't negative, but it wasn't anything to write home about.

Along with the mediocre Empire State reading, the indication is the National Institute of Supply Management (ISM) could well drop into contraction territory below 50. It would take a reading in the low 40s before recession talk would be appropriate, but as a Chinese philosopher (Lao-tzu) said, "A journey of 1000 miles begins with a single step." (Or something like that).

Financial types love to appear smart. Maybe everyone does, but financial types come up with names for things that aren't intuitive, at least to me, so you have to be in-the-know and therefore smart. Quantitative Easing — QE — is defined in Wikipedia as, "A monetary policy used by central banks to increase the supply of money by increasing the excess reserves of the banking system."

I know what it is and I am now lost!

But, to continue, "A central bank does this by first crediting its own account with money it has created ex nihilo (out of nothing)."

Now I got it!

"It then purchases financial assets including government bonds, mortgage-backed bonds, yadda, yadda, yadda." These purchases give the seller (banks) the excess reserves they can hopefully loan out to stimulate the economy.

Fed's 'Magic Checkbook'

In English, the Fed uses a magic checkbook that has unlimited funds to buy stuff from the banks. They give the banks cash which ideally they use to make new loans. The economy gets stimulated and the politicians get reelected, and all is right with the world. The problem is the cash isn't getting loaned out. The banks have redeposited more than a trillion dollars with the Fed where they earn 0.25 of 1 percent in interest. There is now a whole collection of ideas that cumulatively is being referred to as QE, even though the official designation is defined above.

The Fed has already said they will roll over the cash they receive from maturing bonds they bought in QE part 1. Remember, the Fed bought one and a quarter trillion of mortgage bonds and some other stuff to try to prod the home market. As these bonds mature, the Fed will buy yet more bonds so that cash will stay in the system ready to be lent.

Another idea is the Fed should stop paying the 0.25 percent interest on reserves deposited with them to "force" the banks to make loans, since they would no longer be making any money at all on their reserves. It's probably not a bad idea, but you have to have the other side of the trade, i.e., loan demand, to be successful.

We have written often as to why businesses are cautious about borrowing. Plus they have — at least the big companies do — ample cash balances and access to the capital markets, so they don't need to borrow from the banks.

The Fed could extend the "extended period" commitment to keep rates low, but I think most people know it already means a long time. And, of course, the Fed could launch a massive QE II program and buy a trillion or more of government bonds.

That would force low rates even lower, but whether it ignites loan demand is a question. The dollar would suffer, but some would argue that is a good thing temporarily as exports would be advantaged. My feeling is QE could be effective in unfreezing markets by introducing a large and willing buyer, but less effective when you are dealing with a market that has no confidence and is hesitant because the rules of the game are not clear. It could be like you gave a party and no one came!

Methinks the market is too casually assuming a QE party would be popular and well-attended. I think it could be a disaster and lead to a further crisis of confidence. But if unemployment were to move back above 10 percent (not a prediction, just a "what if"), the Fed may feel forced to act. That's the reason for the hyper-focus on weekly unemployment claims.

As I am writing this mid-afternoon on Thursday, the market is absolutely in the tank. At this moment the S&P is off 20 points to 1073. We ought to have some resistance around here. I am leaving for some appointments, so you'll know before I do what the outcome is. I am still of the hope that the 1040 level on the S&P will prove to be the bottom of the trading range.

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