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Follow the Money - The Fed's Open Market Operations
David Yu
After a furry of bills enacted passing along hundreds of billions of dollars to the energy, construction, and transportation sectors - including a $231 million bridge for Representative Don Young (R-AK) to be named after himself - and leaving the tab for our children and grandchildren, the legislature had finally gone home for their August holiday. And, just when we thought we could all feel a little safer, the market seemed to be treading dangerous water again.

There's no better way to follow the market than to follow the money, and there's no better way to follow the money than to follow the Fed's daily Temporary Open Market Operations. Open Market Operations are the most powerful and flexible tool of the Fed's monetary policy, yet it's probably one of the least understood and discussed topics. Basically, the Federal Reserve, which is NOT a branch of the government, buys and sells government securities in the secondary market to add or drain reserves from the banking system.

There are two different approaches in the Open Market Operations - Temporary and Permanent. When the shortage or excess of reserves are expected to persist for a long period, the Fed makes outright purchases or sales of securities that permanently affect the Fed's portfolio and the supply of reserves. This Permanent Open Market Operations only occur a few times each year. Temporary Open Market Operations, on the other hand, occur daily as the Fed implements monetary policy by using short-term repurchase agreement (Repo) to add and reverse repurchase agreement to drain reserves.

One observation that should make anyone question the integrity of this private banking cartel called the Federal Reserve is the fact that there has been NO Reverse Repo, or the "draining" of reserves in the banking system. Although I've only started tracking this little known data since 2004, the duration of this data set should be sufficient to call the Fed's intent to fight the inflation a bluff - to put it mildly.

Chart 1 shows the Fed's weekly temporary repo activities in the past 2 months. I use the weekly total to smooth out the wide fluctuation of the daily figures. The consecutive Repo transactions of $50 billion and $52 billion for the week ended 7/8 and 7/15 were the largest 2-week total I've seen thus far. This infusion of liquidity was much more significant in relation to the low of $29 billion in the beginning of June, just a month ago. It's no accident that the market suddenly took off after the 7/7/2005 bombing in London.


Chart 1

However, the open market operations are also dictated by the law of supply and demand. The supply of money is only as effective as there's demand for money. Recent data indicates that demand may be declining. Chart 2 shows the total value of bids submitted in the Fed's Repo transaction in the past 2 months. It appears to have topped out at the $360 billion mark.

Last week (8/1/ - 8/5/2005), the total value of bids submitted dropped to $180.35 billions, a decrease of $132.82 billions from a week ago. And, what happened was that the Dow average fell 82.88 points, the S&P fell 7.76, and the NASDAQ fell 6.92 for the week.


Chart 2

From the declining value of the total bids submitted, it's likely the lending activities have begun to slow down due to the rising interest rates. With the Disposable Personal Income grew at a measly annual rate of 1.4% (Chart 3), the U.S. Consumption, the engine that keeps our economy and the world economy going, may have gotten exhausted.

The retail sector thus took a hit last week. According to Wall Street Journal, someone sold about 1,500 September 100 call options on the Retail Holdrs Trust (Symbol: RTH) and another sold hundreds of August 165 calls on the Morgan Stanley Retail Index (Symbol: MVR) last week.

As per my Sunday Chartmentary on 7/10/2005, we'd know exactly where the market and our economy are headed if we'd only pay attention to the retail sector, which is directly affected by the consumption. And, the retail sector doesn't look good right now.


Chart 3


David Yu

www.davidyu.com

August 8, 2005


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