“Cover all your Treasury shorts!!”
I will never forget that mandate put forth by Tom Kirch, then head of Fixed Income at First Boston, as the stock market was crashing in October 1987. As a young trader, moments like that are not soon forgotten. Why? Mr. Kirch through dint of experience knew that you “don’t fight the Fed.”
With the crash of the stock market, the Fed cut interest rates and flooded the system with liquidity. In the process, the U.S. Treasury market had a massive rally. Kirch knew what was going to happen and saved the firm millions in the process. You can rest assured I immediately broke out some ‘Buy’ tickets and covered my Treasury shorts in a heartbeat.
“Don’t fight the Fed” is a tried and true rule of trading on Wall Street. While the bond market can often get overbought or oversold in the midst of a Fed easing or tightening scenario, ultimately if the Fed wants to move rates in one direction or another, it will make it happen.
Fast forward to the Brave New World of the Uncle Sam Economy 2009. How are market participants supposed to view the Fed currently? Dare I say, as challenging as it may be for market participants, myself included, “don’t fight the Fed” is still very much applicable. How so?
While the Fed has no more ammo in terms of lowering interest rates (Fed Funds of 0-.25%), it clearly has all sorts of other firepower at work to flush the system with liquidity. Additionally, the Fed is working in concert with the U.S. Treasury.
The challenge for all those interested in the markets is assessing the cost-benefit analysis of the Fed’s actions on both a short term and long term basis. There are no historical price models, econometric equations, or market participants who can categorically tell you exactly what will happen and why.
All I know is “don’t fight the Fed,” and right now Mr.”Fed” plans on providing all necesary liquidity to support the economy and markets as much as possible.
The disconnect between the economy and the markets? That is nothing more than the massive hand of the Fed.