The chart in todays article illustrates the concept of a liquidity trap. In a liquidity trap interest rates fall so low that people just hold onto cash rather than seek the small incremental return. When rates are high holding cash does not make as much sense as people will generally invest it to get those higher rates of return. When rates get too low the motivation to hold debt, especially with any percieved possibility of non repayment, people will just hold on to the cash prefering to view very slightly higher rates of return as not worth the risk. So at some point lower interest rates can fail to add any more stimulus.
If you recall the previous article on inflation/delfation and how they can be defined; additional money must be injected into the system to effect inflation, but also important is that faster movement and exchange of that money (called velocity) is also needed.
M x V = P x Y (Monetary base times it’s velocity equals prices times real output is the formula that will always balance – when one side of the equation changes the other side must adjust.)
In other words the old definition of inflation as’more money chasing the same goods’ requires that the money has to be chasing the goods. Money has to be moving around the economy more rapidly. Juxtaposing this to the above comments if every one is just holding on to the additonal cash that is dumped into the economy nothing will happen to stumulate the economy and inflation cannot evolve. Therfore a liquidity trap can occur when interest rates become so low that velocity is not elevated.
John Maudlin writes,” We are embarking on a course through uncharted waters. No one (including the Fed) has any idea what the unintended consequences will be. I remarked a few weeks ago that the Fed is throwing an inflation party and not sure whether anyone will come.”
If these additonal ‘monetary’ efforts fail there are always ‘fiscal’ efforts that can me made to spark more velocity and growth. This would be all the talk about taxes (Bush tax cuts, the reduction in payroll taxes proposals)’ you are now hearing about in the press.
As for the stock market it is still the single best indicator itself of the economy. It has run up about 16% since early September adn has survived the elections, the Feds QE2 program announcement, and earnings sseason. There was alot of call buying at the end of last week which those buyers are thnking bullish. It has sent the Put/Call ratio into overbought territory. Both the Total and Equity Put/Call ratios are extended.
Bespoke Investment Group noted the rally has put the major indexes and sectors into “extreme overbought territory” in the near-term, with the S&P 500 and six sectors at or near two standard deviations above their 50-day moving averages.
“Some sort of correction may be in order at some point from after the events of” last week, “and the ‘feel good’ holiday seasonality period looming a few weeks away,” said Robert Zavell, a derivatives analyst at Jones Trading. “Is it possible we will be up every day from now through New Year’s? I thought not every day, but you never know.”
The S&P 500 faces strong resistance at around 1,228, a key retracement of the benchmark’s slide from its historic high in 2007 to the 12-year low in March 2009. The first attempt at piercing that level in April failed and preceded a decline that took the S&P to its 2010 low in early July.
“It’s the second test of a very important number so what the market does here is pretty critical,” said Richard Ross, global technical strategist at Auerbach Grayson in New York. “The difference from last time is that we had a pretty sizable correction from that April high, so we have a much stronger base now,” he said.
A factor not to dismiss that may fuel a breakout is performance chasing, with investors who may have been left behind during the rally. They may be jump into winning stocks with the ‘hope’ they will continue to gain in an effort to enhance their portfolio’s performance. While this is novice type activity, if it is strong enough the rally can continue or absorb professional selling if it takes place for a while. “You are seeing momentum investing — managers just moving into stocks that have been doing well,” said Tim Ghriskey, chief investment officer of Solaris Asset Management in Bedford Hills, New York.
So we are again left to watching the clues. Will the market base and breakout? Base and break down? Shakeout and return to the base? Pullback and then rally again? These are all possibilities. As price action takes place traders ‘in the moment’ will be able to pick up the clues and place knowledgeable trades with smart risk to reward parameters in their trading plans.
Trade with a plan