The market is bouncing off the lows and the volatility (premiums) is mellowing again. The Fed officials were on the parade last week; hinting, implying, commenting on future monetary policy. Two Fed officials even suggested halting the taper and extending QE. I believe those soothing words have certainly helped calm the market and quieted the panic, for now at least. The countdown to the FOMC meeting has begun, next week this time we will know for sure. For now, while we are rallying from the recent sell-off, don’t expect volatility to end all together.
One factor I have been focusing on is the rise in the U.S. dollar against the western currencies. The Currency War (devaluation) is in full swing. During the start of the crisis and through those initial dark days the western central banks worked together to halt the economic slide.
Then something changed, in 2010-2011 when the economic collapse seemed to have been averted and we could start getting back to normal, the Federal Reserve launched into another round of easing (QE2). That pushed the dollar down against the western currencies. Regardless of reason, which may have been the best of intentions by our Fed in an effort to kick start our economy, the other western central banks took notice. To others it could have been seen a slight and perhaps the first sign that the western central banks were no longer working together. A race to recovery started, by like minded central banks and the game was to devalue their currency.
Japan was not going to sit idle and fired off their own massive QE program of unprecedented scale in 2012, which pushed their debt to GDP ratio over 200%. The Yen plummeted 25% and the U.S. fired back with QE3 which halted the decline in the Yen, but the damage was done. Japan’s currency broadside blasted a hole in the trade deficit.
In late 2012 and through 2013 Europe was still flaying with its own problems. If it wasn’t one of the PIGS (Portugal, Italy, Greece, or Spain) it was Cyprus. Rather than the ECB focusing on the currency war, it was trying to shore up the failing Club Med countries that were going down like dominoes. Backing bonds, bailouts, special lending rights, and managing the chaos was all they had time for. The Euro started to climb against the dollar as both Japan and the U.S. were exchange blows. The Europe climbed above 1.30 and then 1.35 and on the way to 1.40.
Courtesy of wikipedia
2014 was a huge year for the U.S. Federal Reserve. Bernanke had announced and started the clock to wind down QE (taper). The rare changing of the guard, as Janet Yellen took the helm. The first time since the inception, the Fed board of governors had vacant seats, and a single President had the opportunity to appoint all of the governors.
Yet despite these changes at the Fed, the market rallied. Bernanke had set in motion a slow-methodical-boring course for the Fed Ship. All Janet Yellen had to do was stay true to the course and everything should move easy. The Fed had pumped enough into short-term maturities, that even with the wind-down of the QE (taper), they had enough assets maturing to roll their positions to maintain their policy of monetizing government debt (buying bonds). Unfortunately Janet fumbled at her first press conference and implied a date of rate hikes. The market jolted and jerked – she quickly backed off that statement and the market eventually calmed down and continued to rally.
As summer of 2014 approached concerns started materializing again about the economy and the current Fed policy. The 1st quarter GDP was revised negative, the 2nd quarter GDP was gut-wrenching at negative -2.9%. By the end of July the market was heading lower and sharply. The FOMC statements, minutes, and press conferences saw hints of pushing out interest rate hikes from late 2014 to early 2015 and beyond. The talk help calm the market again, rates were not going up and QE was still here (but they were tapering slowly). The market rallied despite the weak economic data, many predicted the next quarter would be better and it was (shockingly so).
As Europe seem to be calming down during the summer, they decided to refocus their attention on the BOJ and Fed currency (devaluation) war. The ECB announced a rate cut and the euro started declining, breaking below 1.35. By September the ECB announced another rate cut and the start of their QE program. The euro fell to 1.30 for the first time since July of 2013 and would head lower.
The dollar index broke above the 81.5 level by late August after the first ECB rate cut and push towards 83 as rumors swirled that the ECB was about to enter the currency war. The announcement of Euro QE by the ECB rocketed the dollar higher.
Courtesy of silexx.com
All eyes turned to the Fed for a response, but none came. The Fed talked dovish, but there was no action – they proceeded with their taper that was scheduled to end by the next FOMC meeting in October. The dollar index climbed higher and reached 86.
The dollar strength has helped the domestic consumer as prices declined. We are a net import nation; food, energy, clothes, electronics. The drop in gas prices have the biggest impact on consumer spending. However a strong dollar increases the trade deficit and will hurt the multinationals.
October brought forth an entire disjointed market and even TV commentators, analysts, and economists seem to be talking out both-sides of their mouth to try to make heads and tales of what was going on. Perhaps they were getting lost in the minutia and failed to see the big picture.
Step back and take a look at what we know and the big picture and then let’s try to put this puzzle back together.
-> FOMC Meeting: We know the Fed has a meeting Oct 28-29th, the last FOMC meeting before the mid-term election. The Fed has set a target of 2% for the CPI and their policies have tried to create inflation and devalued the dollar to boost manufacturing, jobs, and exports. So a strong dollar has the exact opposite result.
-> Mid-terms: Regardless of whom the incumbent is (Republican or Democrat) they will be blamed for the economic woes and any problems. President Obama and the Democrats are on the defensive heading into the mid-terms, they need any economic help or boost they can get. A strong dollar resonates with voters, giving them more buying power and lowering gas prices.
-> Fed Speak: We have had several Fed governors state that ramping up QE and pushing out rate hikes further is a real possibility and will depend on the economic data.
-> Fed Minutes: The Fed has voiced their concern about the strong dollar and impacts to earnings, trade deficit, and the GDP growth.
Putting this all together it would seem that an entire bench of President appointed governors and Chair would be aligned with a similar ideology and plan. The Fed certainly doesn’t want to disrupt or cause damage to the election process for the party that got them appointed. Remember, “Dance with the one that brung ya!” However, even if we strip away the mid-term election optics, there remains the issue of deflation from the strong dollar, a widening trade deficit, and the implied impact it has on job creation. The Fed now has REAL justification for more accommodation.
Yet for all the real world observations and what seems a reasonable and logical conclusion, the majority of the media and analyst that follow the Fed game and the FOMC – expect the Fed will end QE in the next meeting and that rates are going up in early 2015. While I agree that we should end QE and start raising rates and I even support a REAL strong dollar, just because that is what I think should be done doesn’t mean that is what is going to happen. Staying objective is hard, but we can’t ignore the reality on the ground and inject our own bias.
The markets even disconnected from reality. It seemed the equity markets started believing the media hype that the Fed would end QE and rates would be going higher, much like they feared at the end of QE1 and QE2. Selling pressure started turning into panic. Meanwhile the bond market started rallying and pushed rates down further, reflecting the exact opposite of a concern about a rate hike. If the market was really concern that the Fed would be hawkish, end accommodation completely, and start the rate hike talk we would see 3% or higher on the 10-year.
The Fed’s minutes reference concern about the strong dollar and the impact on the big multi-nation corporations. Stories are already surfacing that K-Street is buzzing with corporate lobbyist that want something down about this strong dollar. It was only a matter of time before we started hearing warnings about the strong dollar in the earnings cycle.
Courtesy of wikipedia
This morning Coca-Cola’s earnings were not that bad, but what is sending the stock down sharping is the warning about “currency headwinds”. They are lowering revenue targets based on a strong dollar. Sure there are sales issue with “sugary drinks” and that is certainly a valid story, but a strong dollar is just (in their mind) an unexpected and unnecessary blow to their revenue. No doubt they are lobbying heavily for the Fed to weaken the dollar again and they will not be the only one.
Remember over 50% of the revenue in the S&P 500 comes from over-seas and if the dollar continues to rally and remain strong, it will have a direct impact on their bottom line. These companies see Japan and Europe in a devaluation currency way, pushing their currencies lower against the dollar as our Fed sit’s by and lets the dollar rally.
What is Fed Policy?
The Fed is now stacked with Keynesian economists. The resurgence of Keynesian economic theory took hold during the crisis and the Fed’s policy has taken a Keynesian stance of interventionist action based on this theory. They want to create some inflation, have targeted 2-2.5% CPI. They want to boost exports, which they believe will create MORE manufacturing jobs. They want to close the trade gap, which drains the GDP. They want to boost asset prices, including houses and help get spending going by keeping rates low.
As they started winding down the QE, they expected that it would not have dramatic impacts on the dollar and it shouldn’t – as they kept their rates at zero. Unfortunately the aggressive accommodative action of Japan and Europe has curtailed the Fed’s efforts. But is the timing really that unfortunate? Perhaps the dollar rally and the timing have helped the domestic consumer for a short-while before the mid-terms, giving them a boost and some optimism. Perhaps the dollar rally has also given the Fed some ammo and justification to redouble their accommodative efforts and extend QE, launch QE4, or some new accommodative program. Perhaps this currency war of devaluation is more of a coordinated effort among like-minded Keynesian central bankers working in harmony and scheduling rate cuts and QE launches to benefit one another. Who really knows and any thoughts on the how or why is nothing more than conjecture and speculation on my part.
The reality is that we do KNOW the results of such actions, the impact to asset prices, interest rates, bond prices, exports, imports. Staying objective and ignoring speculation, the reasonable and logical conclusion is the Fed is going to remain dovish, keep rates at zero for a long-time, and will most likely launch some type of further accommodation (QE3, QE4, or something else). They will most likely announce or hint at such measures at this next FOMC meeting to weaken the dollar rally.
Support & Resistance
We are up above that 16,400 support level from August. I think we could see resistance up at the 16,800 level if we get there before the FOMC meeting. Continue to expect more volatility.
The tech heavy and highly volatile index is making a gapping rally back towards 3950. If it gets above there expect a 3950-4000 resistance trading range.
The S&P 500, like the other indices is making up for the recent free-fall. I would look at 1900-1940 as a volatile range for now. Expect to see some resistance up in the 1940 and above area. The VIX has come off and will continue to fall as long as this rally is in place. However, don’t expect the volatility to be over just yet.
The Russell has again led the way to indicating a bottom and the other indices are racing from behind to catch-up. I would to see some resistance up in the 1125 area with support around 1075. We still have some time before the FOMC meeting.
There are rumors that the ECB may even buy corporate bonds to help boost economic activity in the Euro Zone. That is about as close to private interventionism as you can get, perhaps they are following the BOJ’s lead who actually bought their equity markets. Is the Fed going to dip into the markets, buy corporate bonds or even S&P futures? For now it is a low probability, but if they did it would be another massive step towards the blurry line between government and the private markets. Talk about government trickle down – wow!
Is the Fed freight train coming to the stock market, like it did the bond market?
For now the strong dollar is not what the Fed wants in the long-run, but I can’t help but notice it does help boost voter’s optimism in the short-run.