Can The Federal Reserve Continue to Fuel the Liquidity Rally?

The change in mood is almost tangible this week as President Obama delivered his State of the Union message, Ben Bernanke doggedly sticks to his QE2 guns until June, the divided Congress talks “austerity,” “Dr. Copper” and his friends, gold (NYSE:GLD) and silver (NYSE:SLV), say the party is coming to a close, Case/Shiller chills, bonds get crushed and riots break out across North Africa.

In a nutshell, things look like this:

1. President Obama and the Congress appear intent on reducing “unsustainable” Federal spending.  (Good luck with that until you all step up to Social Security and Medicare, the 900 pound gorillas in the room)

2. The Fed says they’re sticking to QE2 through June but it’s an increasingly tough sell as a Bloomberg poll reports 35% of respondents say it has had no impact, 33% it will negatively impact inflation and just 27% say it’s actually working. (source: Bloomberg)

3. “Dr. Copper”, (NYSE:JJC) called that for copper’s predictive value as a forecaster of global economic trends, is down approximately -5% since the start of the year, and his cousins, gold and silver, also major beneficiaries of the global liquidity party, are sharply retrenching, now down approximately -6% and -10%, respectively from recent highs, perhaps sensing the change that lies just ahead.

4.  Meanwhile, this week’s Case/Shiller Home Price Index registered an unexpected decline in home prices, -1.59% compared to -.84% previously, indicating a growing potential for a double dip in the all important housing market, while the MBA Mortgage Purchase Index fell a dramatic -12.9% versus +5% previously.  However, on the upside in the housing market, new home sales came in better than expected at 329,000 compared to 280,000 the previous month.

5. Bonds continue to fall, with the long bond (NYSE:TLT) dropping -1.5% today as perhaps the market is beginning to wonder about who is going to buy all of this Treasury debt and at what price when Dr. Bernanke leaves the market.

6.  Meanwhile, North Africa continues to be further consumed by violence as the Tunisian revolt seems to be spreading down the Mediterranean to Egypt.

Overall, things look stack up like this.  Everyone can pretty much agree that the Federal Reserve’s “punch bowl” has largely fueled the liquidity rally of the last many months, and now with the shifting tides in Congress and popular opinion, it will be increasingly difficult for the Federal Reserve to refill the punch bowl yet again after the expiration of QE 2 in June.

However, in spite of this record setting government intervention, unemployment remains stubbornly high, economic growth limps along at painfully low levels and the housing market remains largely comatose.

Quite likely “Dr. Copper” and his friends, along with the brainy bond market, are sensing that the party is coming to a close, and as smart guests who know “when to say when,” are leaving the party early.  Global equity markets are supposed to be forward looking by six months or so, and by my calendar, the end of June and QE2 lie nearly exactly six months from today.

Daily Moves for Major ETFs:

Dow Jones Industrials: (NYSE:DIA)              +0.10%

Russell 2000: (NYSE:IWM)                           +1.59%

NASDAQ 100: (Nasdaq:QQQQ)                     +0.53%

S&P 500 Index: (NYSE:SPY)                        +0.42%

MSCI Emerging Markets:(NYSE:EEM)          +0.89%

MSCI China (NYSE:FXI)                                +0.61%

Gold (NYSE:GLD)                                          +0.81%

7-10 Year Treasuries: (NYSE:IEF)                -0.61%

20+ Year Treasuries: (NYSE:TLT)                 -1.5%

VIX: (NYSE:VXX)                                           -5.4%

U.S.  Dollar (NYSE:UUP)                              -0.18%

Disclosure: No positions in ETFs or stocks discussed in this article.

John Nyaradi is the author of Super Sectors: How To Outsmart the Markets Using Sector Rotation and ETFs.

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