Saturday, September 21, 2013

The Fed decision: Impact & Meaning

The overriding event in the financial markets in the past week was the FOMC announcement on Wednesday afternoon.  The market was expecting the commencement of the so called "tapering" of Fed asset purchases; the beginning of the great liquidity unwinding that everyone knew must come.  And, as with all things in the financial markets, suspense and surprise were part of Wednesday afternoon when Bernanke and company defied expectations and refused to start taking away the punch bowl.  Stocks, treasuries, gold and even commodities loved the sugar rush and all the major indices either made all time highs or new post crash highs.

Emerging markets, battered by the prospect of capital flight as investors pulled liquidity from their economies back to the safer haven of developed country higher yields, were given a very welcome reprieve.

As we entered the end of the week the market settled down and came off their highs only to limp out on Friday as the ongoing budget brinkmanship in Washington and a possible government shutdown took center stage.  In addition, it was a Quadruple Witching expiration Friday when September options expire and quarterly futures expire. On top of that, the S&P 500 was rebalanced and key components of the Dow Jones Industrial average were replaced. Nike (NKE), Visa (V), and Goldman Sachs (GS) replaced Alcoa (AA), HP (HPQ), and Bank of America (BAC).

Here's a daily chart of the S&P 500 as of the close of business on Friday:

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The S&P is still in uncharted territory even with Friday's sell off and there is NOTHING in this chart that would suggest that it is taking anything more than a much needed breather before it continues it's climb higher.

Here's a weekly chart of the iShares MSCI Emerging Markets ETF (EEM) as of Friday's close:

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Unlike the S&P, this weekly chart is sporting a "doji" (black arrow) after a failed attempt to broach a support turned resistance trend line (charcoal dashed line).  The "doji" spells indecision.

Yields dropped after the Fed "non taper" announcement on Wednesday which is exactly what the Fed wanted yields to do.  Here's an update of the Ten Year yield daily chart going back to late September, 2008:

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We're getting some movement on the "reflation trade" but honestly, when we look at the aggregate picture, it's not that impressive.  First, here's the stellar news:

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This is the Baltic Dry Index which is an excellent measure of the money shippers are collecting for moving raw materials around the globe.  It has been absolutely surging and China has been behind this surge.  More on this below.

Here's the encouraging news:

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This is a weekly chart of the Dow Jones US Steel Index ($DJUSST) and we've broken out of a bottoming pattern (green & red dashed lines).  Momentum indicators and the price relative to the S&P is also encouraging.  However, I don't like that long wick on top of this week's candle (blue arrow).

Here's a weekly chart of the Dow Jones World Basic Materials Index ($W1BSC):

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Again, we see almost the same pattern as the Steel index above, courtesy of China.

Now for the flat news.  Industrial commodities are still going nowhere:

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Here's a weekly chart of the Dow Jones UBS Industrial Metals Index ($DJAIN).  It's comprised of the spot prices of copper, aluminum, nickel and zinc.

Finally, here's a weekly update on Gold:

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In spite of the recent rally we've seen in the precious metal, when we look at a broader time frame, we can see that it is also acting in a similar way to the industrial metals.  Regular readers of my commentary know I now view Gold as an important indicator of the resumption of the "reflation trade" for the following reason: with all the fiat money our central bank and Japan has printed any inkling that the reflation trade is gaining momentum will stoke inflationary pressures upon which gold will react.  But so far, no cigar!

Now, to splash some water on the encouraging news above.  The positive moves we've seen in shipping rates, steel and to a lesser extent, raw materials, is the direct result of an uptick in economic activity in China.  But the sources I'm reading believe that the recent rebound in the Chinese economy will be short-lived.  The credit boom in the country is still largely uncontrolled despite government efforts to reign it in and the regime is essentially caught between a "rock and a hard place" because if they do what's truly needed to remove the speculative froth in the system they risk a serious economic slowdown. This speculative credit boom is feeding excess capacity in the real estate market among a population that, generally speaking, is not wealthy enough to purchase that real estate.  

The forced overhaul of the Chinese economy from an export driven to consumer based economy will continue to create distortions in the financial markets for at least the better part of another decade.  We already saw the initial distortion in the first decade of this century when industrial commodity prices went thru the roof only to be thrown aside as a child throws a rag doll when they've become bored with it when the Chinese government attempted to temper the frenzied over development.  The next phase in their transformation will be the ongoing migration of their huge population from the rural to metropolitan areas they have built which should be interesting.

So, what does this have to do with the Fed's decision this week?

The Fed decision: Impact and Meaning

Bernanke and company have been castigated for the perceived "head fake" they gave the markets this week.  Indeed, many signals from many of the Fed governors over the past two months signaled the very high probability of a minimal QE unwinding in September.  However, the Fed always stated that their decision regarding when and by how much to taper would be data dependent.  Quite a few institutions and hedge funds were forced to cover their shorts on Wednesday afternoon and you could feel the pain behind the criticism that came out after the decision.

I don't want to minimize the issue of the Fed lacking credibility as a result of the perceived mixed signals. Kansas City Fed governor Esther George, the lone dissenter to the Fed's decision on Wednesday, was outspoken in a speech given on Friday concerning this subject.  However, when it's all said and done, it would be difficult for a central bank that has the clout the Fed has to lose the kind of credibility that market players are concerned about.

I think the real message that market players need to take away from the Fed's decision is that their plan to fore go the tapering at this time was a tacit admission that their policies are failing to get the desired results; that being an economy that can stand on its own without monetary intervention.

The immediate fear the FOMC had was the incredible run up in interest rates in the last almost four months that are having a measured negative effect on the private and commercial real estate markets.  These markets have been the "poster child" of the Fed induced recovery and have progressively led the economy out of the mess it found itself in 2009.

The Fed got its wish on Wednesday as rates dropped immediately following the announcement and interestingly right at the juncture of Fibonacci resistance and major resistance (black dashed line) on the weekly Ten Year yield chart:

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I love those Fibonacci lines!  They're almost mystical!  :-)

As an aside, there is an argument out there that postulates that higher rates will actually stimulate the economy because major money lenders will take advantage of the steepening yield curve and ease lending requirements in order to generate more business.  That position is articulated at Soberlook, an excellent commentary that I heartily recommend to my readers.  However, my opinion is that the present deflationary psychology of the masses would militate against such a thesis.  Where have we seen in the past five years the kind of animal spirits needed to spur economic growth in a rising rate environment?  It could be argued that it hasn't been tried.  I would argue that we started to try in May and the housing market took a hit!

No, I think the Fed is correct in their assessment that they need to keep rates low in order to maintain any momentum their policies have gained in this economy.  

The other problem the Fed is starting to acknowledge (without calling it a problem) is the low rate on inflation that we are battling.  Here's a chart courtesy of :

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chart courtesy of

I've harped on this problem for months and despite all the rosy opinions emanating out of the Fed that this disinflationary trend (and that's what it is) is transitory, it finally has haunted Fed officials enough where it impacted Wednesday's decision.  For purposes of the chart above, the Fed considers the Core PCE (red line) as more important than the Core CPI (Consumer Price index).  The chart clearly shows that we're presently at a level that was exceeded to the downside only two other times since 2000.  Both of those times we were in recession.

Let me bring this all in for a landing.  Simply, the concerns I've articulated here & here I believe are still very much with us.  Europe is essentially on its back and cannot get out of its own way.  China's recent positive economic data seems to have given hope in financial markets with the commensurate tepid rise in certain commodity indexes.  And our central bank has stepped away from truly testing whether this economy can stand on its own.  

In such an environment, I fear the Fed is pushing on a string and yes, I frankly fear a liquidity trap.  Now, short term rates have already been pushed to 0% but the fact that any perceived movement away from asset backed purchases causes a severe back up across the yield curve puts the Fed in a quandary; do they bite the bullet and risk slower economic growth or recession?  The low inflation rate terrifies them.  Or do they keep pushing on that string?

I believe the indicators to either verifying or disproving my "liquidity trap" scenario (and I truly hope it will be disproved) will be the price of gold which will measure the traction any inflationary pressures are gaining in the global economy and the iShares Dow Jones US Homebuilding ETF (ITB) which is closely tracking the Ten Year yield posted above.  Here's a daily chart of ITB:

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From a weekly perspective, we can see ITB has had quite a run thanks to Fed induced liquidity and monetary policy:

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This week the ETF sported a "doji" signaling indecision.

We'll need to see ITB move higher as the Ten Year yield moves higher.  That will be the indication that this economy can stand on its own without central bank intervention.

In the short term, get ready for some volatility going into October as the next chapter of the "fiscal follies" unfolds.  If we can get past that relatively unscathed, the stage is set for a ferocious rally going into year end.  I'm more concerned about the market going into 2014.

 In the very short term, Angela Merkel will win another term as Chancellor of Germany as Germans go to the polls on Sunday, 9/22.  However, the composition of the Bundestag and her coalition is tentative and depending on whether she has to reach out to opposition parties in order to create a ruling coalition may affect global markets on Monday.  But this will not effect current stability in Europe.

Have a great week!