Fed Stars Align

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The market has made a healthy bounce from the recent sell-off, but I suspect we will have a little reprieve at this point. We need to catch a breath from this roller-coaster ride and we have move back up into previous support ranges so we could be facing some resistance at these levels. The FOMC meeting is just around the corner and we should expect the media to start cycling it to the front page and making headlines by Tuesday – as it will set the tone for the market and even impact the mid-term elections.

Fed Stars Align

Courtesy of wikipedia

The last couple of previews I have discussed the strong dollar and the impact to both the economy and how it is actually giving the Fed not only concerns about the GDP and economic growth, but could be the justification for ramping up accommodative measures. However, the strong dollar is just anecdotal evidence for the Fed to change monetary policy, remember they need to refer to their measuring stick for inflation, the CPI.

Deflation concerns?
As expected the strong dollar is creating DEFLATIONARY pressures measured by the CPI, which is not really DEFLATION, but DISinflation (the reduction of inflation).

Courtesy of wikipedia

The predominant short-term impact is to gas prices, which is realized in a short life-cycle. Inflation and deflation impact on commodities has different life-cycles depending on the shelf-life, for lack of a better word. Food and gas from ground-production-consumption is a fairly short life-cycle compared to iron ore or other hard commodities, which not only has long shelf-life, but the down-chain production and fabrication takes longer and then there is the finished goods inventory periods as well.

The Fed and economist frequently refer to measuring the CORE CPI; this reflects the CPI minus the impact of food and energy. While certainly being disingenuous to consumers that MUST pay for food and energy, there is a valid reason for analyzing the CORE reading, if one wants to measure the longer life-cycle production chain impact. You could say that inflation/deflationary pressures have slow and fast moving averages, one includes the short life-cycle products (food and energy) and the other is the long life-cycle products.

While I have issues as to whether we should even use the CPI to measure inflation, as it is really a measure of the cost of living and actually IMPACTED by inflation, the fact remains it is a model and it is the one (unfortunately) that is being used for measuring and the Fed has suggested targets set to the model.

Fed Target 2 – 2.5%!

The Fed currently has a target rate of 2% and perhaps 2.5% (Yellen and Evans). The recent Fed minutes from the last meetings reflected the concern about the dollar strength, a result of the BOJ and ECB accommodative policies as the Fed is tapering. They correctly assessed the strong dollar will bring deflationary pressures, slow GDP growth, certainly hamper export growth, and that also translates to weaker job creation (manufacturing) as U.S. goods become more expensive.

Remember the Fed has a dual mandate, one part being reaching and maintaining “full employment”. The massive accommodative and weak dollar policy was to promote exports, which they believe would translate to an increase in manufacturing jobs. An additional concern about the strong dollar is the impact of earnings revenue, as earnings are reported in U.S. dollars and a strong dollar means weaker top-line revenue from the multinationals. As I pointed out yesterday, Coca-Cola already lowered their guidance sighting this issue.

Yet for the concerns raised in the Fed minutes, they still needed to see if it would materialize in their measuring stick, the CPI.

This morning the CPI showed that the top-line CPI rose slightly .1% after contracting .2% in August. The CPI is now running at 1.7% over the last 12 months, below the Fed target. The Core is also running at a similar level, ticking up just .1% as well. August and September has seen energy prices drop 5.1%; however food has slightly gained .5% over the same period.

Dollar Index

The dollar index rally has slightly stalled a little and is sitting in the 85-86 range since late September, which will certainly cool deflationary pressures slightly. Part of this pause in the dollar rally is the world waiting for the FOMC meeting and any possible changes to Fed policy, which will either rocket this index higher or send it down lower. I do NOT expect the dollar index to stay in this consolation area and hidden volatility is mounting.

Courtesy of silexx.com

While the CPI went fairly unnoticed by the media this morning, it is a very important indicator for the upcoming FOMC meeting that will give the Fed the justification to take action if they choose to. Remember their target is in the 2-2.5% range and we have seen a contraction over the last couple of months down to 1.7%, that’s disinflation (or deflationary pressure) and the exact opposite of what the Fed policies are trying to achieve.

No doubt the strong dollar will certainly impact exports and that will trickle down to top-line revenue and being showing up in earnings in the next quarters. The good news is the strong dollar will give consumers some solid buying power heading into the holidays, if the dollar remains strong.

Fed stars align

Courtesy of wikipedia

The Fed stars align; they need the strong dollar and weaker CPI to justify more accommodative policies and to keep interest rates at zero for longer periods of time. While the Fed likes to move in baby steps, they will be dovish baby steps. I fully expect a clear statement about keeping rates at zero for a longer period of time to help boost inflation. They may even mention concerns about DEFLATION in the statement, which would certainly imply that QE3+, QE4, or more accommodation may be coming soon. I am not sure if they will actual take action this meeting, but with the weaker CPI at 1.7% and their joint concern about “slack in the labor market” and “structural unemployment problems”, there is possibilities they may NOT end QE3 just yet and let it play out just a little longer.

In sum, it will be a very dovish statement that will imply more accommodation and confirm that rates will remain at zero for a long time.

Market action:

Dovish: Zero Rates for longer and more accommodation (announced or implied) = equity market rallies, gold rallies, dollar weakens, implied volatility declines, bonds rally, bond yields decline.

Hawkish: Zero Rates will end in 2015 and end the QE and wind down accommodation = equity market declines, gold declines, dollar rallies, implied volatility increases, bonds declines, bond yields rally.

Support & Resistance

INDU 16,600 – 16,800
We could put in a support at 16,600 into the FOMC meeting and see some jerk moves in the 16,600 – 16,800 level. I expect to see some consolidation in here because the market is not as confident in the dovish Fed as I am.

NDX 3950 – 4000
This high volatile index will most likely stay in this range into the FOMC statement. Waiting for confirmation of dovish action.

SPX 1940-1960
Much like the other indices, this index will most likely calm down and stay in this range as we wait for the FOMC meeting. The VIX should decline into the 13-16 range coming into the meeting next week.

RUT 1120
If we see the broader based index move above 1120 this week, we could see the other indices move high into their upper ranges as well. Continue to watch the Russell index as a “tell” for the market.

Fed are Doves!

I don’t think there is a Hawkish bone in the governors or Fed Chair’s body, the only two Hawks are the two voting Presidents (Plosser and Fisher), who have both announced their retirement. They will certainly dissent any dovish policy or comments.

The only question I see, because I fully expect a dovish fed, is how well will the statement be crafted and how clear will this message be? The more firm, clear, and concise this message the stronger the market response and rally will be. If it remains vague and uncertain, the market could see more volatility.

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