Last week's gains in equity and commodity prices, and the further fall in the dollar, followed a moderately disappointing US employment report the previous Friday. This reinforced expectations that the Federal Reserve will maintain rates near zero and continue to supply ample liquidity for the foreseeable future. Comments last week by Fed Chairman Bernanke on exit strategy and National Economic Council Director Summers favouring a strong dollar failed to dent this consensus.
The current sensitivity of markets to the Fed's liquidity provision was discussed in an article by Andy Kessler published in the Wall Street Journal in July. The article included a chart showing a correlation this year between the Dow Jones industrial average and a weekly monetary base measure calculated by the St Louis Fed. (The monetary base comprises currency in circulation and banks' reserve balances with the Fed.)
An updated version of the chart is shown below, with the start date moved back to September last year – the monetary base began to surge following Lehman's collapse. The apparent relationship has continued since the summer, with the Dow's new rally highs last week accompanied by the weekly base moving above its May peak.
The theoretical basis of the relationship is questionable and it is unlikely to survive over the medium term. Markets, however, are unusually sensitive to news about the Fed's policy stance currently and many investors seem to be interpreting the weekly monetary base as a real-time indicator of policy-makers' intentions.
The Fed's ongoing securities purchases will tend to expand the base further although the impact could be offset by other factors, such as reduced emergency lending to the banking system or a moderation in the public's demand to hold currency. The weekly numbers may continue to hold exaggerated significance for both bulls and bears.
The strong consensus in favour of the Fed staying "loose for long" rests on a forecast that employment will continue to decline into year-end, resuming growth only in early 2010. The key risk for liquidity-driven markets is an earlier-than-expected return of jobs expansion. Perversely, any "good" labour market news will warrant increased investor caution.
