The markets were so oversold by Friday that even a hint of positive news was enough to send stocks higher. The trigger was the revision downward of the nation’s gross domestic product to 1.6% for the second quarter. The initial GDP reading had been 2.4%.
“Why is that good news?” asked a perplexed client from Long Island.
“The revision could have been worse,” I explained..
Federal Reserve Chief Ben Bernanke also helped push stocks higher by throwing the market a few straws of reassurance. He said he would consider another large scale investment in the markets if the economy deteriorated further or if deflation became a problem. At the same time, he said it might not be necessary because he still sees the economy growing next year.
The Fed has three options to further add liquidity to the system. They could buy more government bonds and possibly mortgage backed securities and drive mortgage rates even lower than they are now. A 30 year, fixed rate mortgage is now below 4.5%. In this atmosphere of uncertainty, they could further clarify exactly how long they expect to keep interest rates near zero. To date, they have only said rates would be low for an “extended period.”
Finally, they could cut to zero the interest rates the Fed pays banks to park their reserves at the Fed. Right now they are paying 0.25%. That might seem a nominal sum to most, but when you have billions of dollars sitting there, that ¼ of a percent adds up. This last option, I believe, is the key to getting out of the liquidity trap we find ourselves in.
For the last year and a half the Federal Reserve has been dumping mountains of money into the financial system, hoping that the banks and corporations will in turn lend it to consumers and use it to hire workers, build new plants and buy equipment. Instead, financial institutions have been hoarding the cash and getting paid by the Fed to do so.
Why? Given the uncertainty of the recovery, the high unemployment rate and the risk of even more bad debts coming through the door, the banks believe it is better to keep the cash then risk losing it on future bad loans or, in the case of corporations, on hiring workers that they won’t need in a double dip recession. Fear is the name of that game.
“Play it safe, after all,” they say, “a 0.25% return is better than no return at all.”
This monumental timidity in the face of 9.5% unemployment and a housing market that is tipping precariously back into a downward spiral should be unacceptable to all of us. So how do we get the banks to lend again?
Simple, instead of reducing the rate the Fed is paying to zero, make it minus 1% or 2%. That’s right; in order to park your cash at the Fed instead of lending it out, it’s going to cost you. I believe faced with losing 1-2% on their money or risking it by lending to you and I at 5-6%, fear will turn to greed. This good ole American financial system will begin to work for us again instead of against us.
In the meantime, we are bouncing around the 1,050 level on the S&P 500 Index. I still maintain that 950 is in the cards. It’s simply a matter of time before that occurs. I know this five-month trading range is frustrating to investors but patience will be rewarded, possibly as soon as September. The doom and gloom is building but has not yet built to a crescendo. We may well get another bounce this coming week but once again it will be on low volume and will simply be another bear trap, so don’t be fooled.