Zeev's Turnips Patch-No Politics (ZEEV)

[Joe Stocks]

Public Heel- You were asking how the Fed moves the market. Here is a good essay on how they do it.

The Fed's Open Market Operations- Daily Tides in the Financial Sea
By Jonathan Levinson

From the New York Fed's website:

"Seeing the Federal Reserve Bank of New York, visitors' first
impressions are of the building's formidable architecture. Stored
inside the vaults of this imposing structure is hundreds of
billions of dollars of gold and securities. But what is most
significant about the Bank is its broad policy responsibilities
and the effects of its operations on the nation's economy."

It would be more accurate to say "on the world's economy," as the
Fed is arguably the single most influential presence in the
financial world. There is a debate as to who owns and controls
the Fed, whether it is the US Congress or the world's largest
banks. For traders, particularly small or non-institutional
traders such as ourselves, it's an irrelevant issue, as the Fed
acts as a primary force in the financial markets. The Federal
Reserve's primary role for us small traders is as the controller
of liquidity in financial markets across most timeframes. Prior
to Chairman Greenspan's tenure, the Fed's focus was domestic
monetary conditions, but it has since become a commonplace that
the Federal Reserve concerns itself with global financial
liquidity and stability, acting in all markets just as the US
asserts its will in the world political arena.

In order to understand the importance of the Fed, one must
consider the impact of liquidity on financial markets. My
favorite analogy is of the markets as a liquidity meter- they
rise or fall depending on the availability or scarcity of money.
The Fed seeks to achieve financial stability by controlling the
availability of money in different markets. Like sailor holding
a course by making continuous corrections at the helm, the Fed is
continuously using subtle and not-so-subtle mechanisms to manage
liquidity as it sees fit. We have all seen the short-term impact
of interest rate hikes and cuts, which I would characterize as an
example of not-so-subtle liquidity management. By raising rates,
the Fed increases the cost of money to banks, thus restricting
liquidity and, theoretically, deflating financial markets. More
subtle, however, is its ongoing Open Market Operations (OMO),
which are done on a daily basis. During the past months, I have
been following the Fed's OMOs, and have found this to be an
indispensable tool in predicting short term market bias. The
Fed's Open Market Operations will be the focus of this
discussion.

Before looking under the hood of the Fed's OMO procedures, an
example from our favorite book, Reminiscences of a Stock Operator
by the legendary Jesse Livermore, published under the pen name
Edwin Lefèvre in 1923. Livermore tells the story of the crash of
October 1907 during which lenders had run out of cash.

Reports from the money crowd early indicated that borrowers would
have to pay whatever the lenders saw fit to ask. There wouldn't
be enough to go around. That day the money crowd was much larger
than usual. When delivery time came that afternoon there must
have been a hundred brokers around the Money Post, each hoping to
borrow the money that his firm urgently needed. Without money
they must sell what stocks they were carrying on margin - sell at
any price they could get in a market where buyers were as scarce
as money - and just then there was not a dollar in sight.

Livermore was, of course, short the entire market.

The president of the Stock Exchange, Mr. R. H. Thomas, so I heard
later in the day, knowing that every house in the Street was
headed for disaster, went out in search of succor. He called on
James Stillman, president of the National City Bank, the richest
bank in the United States. Its boast was that it never loaned
money at a higher rate than 6 per cent. Stillman heard what the
president of the New York Stock Exchange had to say. Then he
said, "Mr. Thomas, we'll have to go and see Mr. Morgan about
this."

The two men, hoping to stave off the most disastrous panic in our
financial history, went together to the office of J. P. Morgan &
Co. and saw Mr. Morgan. Mr. Thomas laid the case before him. The
moment he got through speaking Mr. Morgan said, "Go back to the
Exchange and tell them that there will be money forthem."

"Where?"

"At the banks!"

So strong was the faith of all men in Mr. Morgan in those
critical times that Thomas didn't wait for further details but
rushed back to the floor of the Exchange to announce the reprieve
to his death-sentenced fellow members. Then, before half past two
in the afternoon, J. P. Morgan sent John T. Atterbury, of Van
Emburgh & Atterbury, who was known to have close relations with
J. P. Morgan & Co., into the money crowd. My friend said that the
old broker walked quickly to the Money Post. He raised his hand
like an exhorter at a revival meeting. The crowd, that at first
had been calmed down somewhat by President Thomas' announcement,
was beginning to fear that the relief plans had miscarried and
the worst was still to come. But when they looked at Mr.
Atterbury's face and saw him raise his hand they promptly
petrified themselves. In the dead silence that followed, Mr.
Atterbury said, "I am authorized to lend ten million dollars.
Take it easy ! There will be enough for everybody!" Then he
began. Instead of giving to each borrower the name of the lender
he simply jotted down the name of the borrower and the amount of
the loan and told the borrower, "You will be told where your
money is." He meant the name of the bank from which the borrower
would get the money later. I heard a day or two later that Mr.
Morgan simply sent word to the frightened bankers of New York
that they must provide the money the Stock Exchange needed.

"But we haven't got any. We're loaned up to the hilt," the banks
protested.

"You've got your reserves," snapped J. P.

"But we're already below the legal limit," they howled.

"Use them! That's what reserves are for!" And the banks obeyed
and invaded the reserves to the extent of about twenty million
dollars. It saved the stock market. The bank panic didn't come
until the following week. He was a man, J. P. Morgan was. They
don't come much bigger.

Livermore's story is one, which we've seen repeated several times
this year, except that the entire has become automated through
the Federal Reserve System. Sometimes these operations rescue
the market, but they are now used as more subtle preemptive
measures as well.

Back to the Fed's Open Market Operations.

The staff of the New York Fed's Trading Desk continuously
monitors global financial conditions and the state of banking
reserves each day. After extensive deliberation beginning early
each morning and a conference call with all of the regional feds,
it determines whether or not it will add to, drain from, or leave
unchanged the level of banking reserves. This is carried out on
a daily basis. A plan of action is established for the day, and
the Fed executes it by moving huge amounts of money through its
network of 22 primary dealers, which are banks and securities
brokerages that deal in US government securities. To give you an
idea of the money flows being executed, these 22 dealers averaged
$375B per day in trading volume of US government securities in
March, 2002, according to the New York Fed website.

The most frequent transactions are called "repurchase agreements"
or repos (RP) for short, which are described as short term
transactions whereby the Fed purchases securities from the
dealers, who agree to repurchase them from the Fed by a specified
date at the specified price. When the repos mature, the added
reserves are automatically drained. The Fed pays for the
securities and takes delivery thereof simultaneously. When they
mature, often the next day as we've seen in the Market Monitor
(known as "overnight repos"), the securities are returned and the
funds reimbursed by the dealers to the Fed.

The reverse of a repo is called a matched sale-purchase
transactions (MSP's), whereby securities are sold to the dealers
for cash, and then repurchased from the dealers upon maturity.

Both Repos (RP's) and matched sale-purchase transactions (MSP's)
are temporary open market operations. Sometimes the Fed will
sell securities to or purchase securities from the dealers
outright, which affects the dealers' reserves on a permanent
basis.

If you're all still awake, or haven't yet dashed off to apply for
jobs with the Fed, here's the kicker. The effect of these OMO's
on the 22 dealers' reserves has a direct influence on the level
of liquidity in the markets, just as we saw in Livermore's 1907
example. When the dealers have excess reserves, they are free to
play with those funds until such time as the funds must be
returned. This liquidity finds its way into the markets,
purchasing securities. On days when reserves are drained, the
liquidity finds its way out of the market. During the past
months, there has been a tendency to see market strength on days
when large repos of 5-10B have been announced. When these repos
expire, if they are not replaced with new repos, we often see
market weakness. This year, because we are in the grip of a bear
market, the tendency has been to see repos. I have only seen one
instance of an MSP this year, although I've only been following
the Fed for the past few months.

The trouble for traders is in knowing which markets will be
affected by each Open Market Operation, and within each market,
which securities. Repo money can go into equities or fixed income
securities, currencies, or whatever else the dealers wish on that
day. I have read arguments to the effect that companies such as
MSFT are prime targets for Fed money because they are listed on
multiple indices, and so buying or selling in MSFT gives the
Fed's dealers the greatest bang for their buck. Remember that
the Fed's goal is to encourage the stability of financial
markets. When these markets are in jeopardy, smart traders watch
for the Fed's morning announcement and consider which markets
need it most. When the SPX broke 775 this month, an overnight
repo of $4.5B was announced, which is at the upper end of
modestly sized for repos this year, and equities bounced off
their lows, which then triggered a selloff in the extremely toppy
bond market, more money flowed into equities, and the rest we
know well. During the summer, I watched large orders that would
show up like a battalion at critical support levels on QQQ –
30,000 to 50,000 share bids that would line up 5 deep all at
once, and the subsequent matches would protect the support level
that had been in jeopardy. So what? We'd also see more such
bids that would line up just below key resistance levels after an
extended runup and the orders would power the index above them.
I'd always thought that the goal of traders seeking a profit is
to buy low and sell high, though perhaps buying high to sell a
little higher works as well. In any event, none of us would
think of using our own money to put on bullish positions just
below key resistance levels after significant runups. This is
the action of participants manipulating the markets using OPM
(other people's money) in the interest of protecting those
markets from what are deemed to be critical breakdowns.

Tracking the Fed's Open Market Operations gives the trader a
window on how much money will be available to the markets that
day relative to past days. Experience will permit you to assess
the impact of different sums- is a $1B drain substantial? Might
the markets tank or just drift? Generally, all that one can know
is how the Fed's daily activity will bias the markets, and so it
is far from a magic indicator. Many traders I know and respect
will not put on bearish positions on a day in which the Fed has
announced a repo for more than a few billion dollars. Follow us
in the Market Monitor each day and start to get a feel for the
impact of the Fed's Open Market Operations. Like most other
indicators, it will eventually help to fill in your overall
market picture in its own particular way.

I have been posting the Fed's daily Open Market Operations in the
Market Monitor and will continue to do so. To follow along
yourself, bookmark the following link:

http://app.ny.frb.org/dmm/mkt.cfm