Did the Fed ‘Slush Fund’ Cause the Biggest Rally in 5 Years?

Today was the stock market’s biggest up day in five years. The Dow jumped 416 points or 3.6%, and other benchmarks were equally impressive. The salient question now is whether the gains will continue.

The rally today was sparked by an announcement from the Federal Reserve that it is creating a “Term Securities Lending Facility.” We will spare you the technical details. The bottom line is that the Fed has created and made available to banks a $200 billion slush fund. Banks will be able to get troubled mortgage loans off their books and replace them with rock-solid Treasury bills. There are limits, of course. It’s not exactly a bailout for the banking system. It is, however, a very large helping hand.

This is the latest in a series of actions by the Fed since the mortgage market first ran into problems about this time last year. The pattern has been the same almost every time: the Fed announces action, the markets rally for a few days or weeks, and then more bad news emerges and the benchmarks take another dive. From there the cycle repeats. Is there any reason to think this time will be different? Not really. The new Facility will temporarily re-liquefy the credit markets, allowing large investors to exit some of their low-quality investments. It will not necessarily inspire them to make any new investments. The pain is still too fresh on everyone’s mind.

Until lenders regain enough confidence to resume expanding their balance sheets, I don’t anticipate a lasting recovery. The only cure will be time. In the meanwhile, the U.S. is still at substantial risk for both inflation and recession. Smart investors are looking for ways to hedge those risks.