Monday, April 18, 2011

Did the Fed Add to the Fall in Stocks?

Today, Standard and Poor's lowered its outlook on long term U.S. Treasury debt from "stable" to "negative". What happened? U.S. Treasuries went up in value.


Market forces would have dictated that Treasuries should have fallen. In fact, they did drop immediately after the announcement. But then they rose, even while stocks fell. If anything, one would have expected stocks to do comparatively well. Investors might logically ditch Treasuries and buy stocks.

So what happened? One serious possibility is that the Fed was buying in the Treasury market big time today, as part of its quantitative easing program and perhaps as part of its open market operations as well. The last thing the Fed wants to see is a rise in interest rates. If a downdraft hits the Treasury market, the Fed would move quickly to counteract it.

All that's understandable, given the Fed's statutory mandate to maximize employment. But it's possible that the fast traders on Wall Street--which would be most of the market today-- saw an arbitrage opportunity. If you know the Fed will be a heavy buyer of Treasuries, then you'd think about ditching stocks to raise cash, buying Treasuries quickly when they first drop, and reselling them at a profit to the Fed as it revs up its buying. The smart traders on the Street like to take advantage of large buyers and sellers, who often provide such arbitrage opportunities. The really cynical smart money would, indeed, short sell stocks to profit from the expected downdraft. That, if it occurred, would have added to the downward spiral of stocks.

The Fed also doesn't want stocks to drop. That might cool the consumption of the well-to-do and hamper the economic recovery. But the Fed is a lumbering cow in a market full of wolves, and today's weird market action indicates the wolf packs were probably voracious.

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