The Fed’s Hallelujah Rally

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If the major video game makers had gotten around to putting together some kind of game called “Economy,” where the player acts as the Federal Reserve, the gameplayer’s efforts to add liquidity during crises would probably include a chorus of “Hallelujah” and computer-generated dancing in the streets.
This euphoria would ultimately dissipate in the wake of dragons eating the townspeople or something. That hasn’t happened (there hasn’t been a dragon in these parts for a thousand years), but previous actions taken by the Fed have produced short-term equity rallies that were eventually cannibalized by sellers reacting to more gloom and doom.
Today’s action from the Federal Reserve has drawn praise for its targeted approach. Instead of a sharp interest-rate cut, the Fed is adding liquidity to the fixed-income markets through auctions. “The market was getting so gummed up that it was becoming difficult to use in any sort of normal circumstances what would be very high collateral,” says Bill Stone, chief investment strategist at PNC Wealth Management.

But the market has seen this movie before, and so far, it hasn’t done the trick. Will this work? “If you define the problem as a purely irrational move in the credit markets, then you might think this is a panacea,” note analysts at Bianco Research. However, they say, if housing prices — the underlying factor in this mess — continue to fall, this move may be yet another one that is steamrolled by the markets.




The first four moves were as such:

• August 17: The Federal Reserve cuts the discount rate, narrowing its difference from the federal-funds rate to a half-percentage point, from a full percentage point. The news led to a 400-point rally in the Dow industrials over four trading sessions. The Dow remained buoyant until the middle of October, when it started to sink .

• December 12: Prior to the market’s open, the Fed announces the creation of the Term Auction Facility. The market had declined by 300 points the day before, when the Fed cut rates by a mere 0.25 percentage point.

• The one-day rally on this news amounts to just 40 points, and the industrials never manage to gain any ground through the rest of the year.

• January 23: As global economic worries engulf foreign markets, prior to the market open. The Fed surprises the market with a cut of 0.75 percentage point. That day, the Dow gains 300 points, beginning a fresh rally that lasts for another two weeks before fizzling out.

• March 7: The Fed announces an increase in the TAF auction, along with a new 28-day repo, just before the jobs figure is released. In a bit of reverse psychology, the Dow falls by more than 100 points as investors wonder, “What does the Fed know?”