As expected the Fed did NOT raise rates, but the market reaction was unusual and unexpected. There are perhaps bigger problems. I think some of those problems reside in the Margin arena and I believe we will see MORE, not less, accommodative changes from both the Federal Reserve as well as margin rations in the lending institutions.
In trying to describe the market action yesterday and perhaps in over the next week, we need to understand the current positioning and how order flow will move.
Remember, heading into the FOMC meeting the expectations were for a rate hike. We saw unwinding in the bond market, which sent yields higher. Also, we saw some unloading in the equity markets.
A perception shift
I noticed a shift in the perception of U.S. economy after Yellen’s press conference. Are things really that bad globally and will that translate to a weaker U.S. economy? That was the tone of Yellen’s press conference.
Courtesy of wikipedia
We face an economic marketing conundrum. The President and the Fed wave strong U.S. economic data in our faces, convincing us the U.S. economy is strong; GDP improving 2.3%, U3 Unemployment 5.1%, No Inflation – the U.S. economy is roaring back and strong. Look at the stock market!
Their marketing plan has worked and convinced the majority that if the economy is so strong, why hasn’t the Fed raised rates. Some have argued they should have raised rates months ago.
Then the Fed doesn’t raise rates and in the FOMC statement and in the press conference tell us a completely DIFFERENT story.
In the FOMC statement they ADDED a new sentence. This is noticeable and we should pay attention. Please note that since the beginning of the QE/ZIRP program, they have changed words but the core FOMC statement has remained the same. This new sentence is a shift in Message Crafting that I wrote about the other day:
“Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.”
This one NEW sentence can easily be interpreted to meaning, we are not going to raise rates and don’t expect them to be raised regardless how great we tell you the U.S. economy is. To lay on the sarcasm even more, the government economic data is to make you feel good, it’s window dressing. In reality, the Fed’s actions in monetary policy clearly tell you how they really feel about the economy and it is not as great as you think.
Of course academics will argue with me, but my quick retort would be – remove ALL Fed monetary accommodation (including their ongoing bond and MBS buying and let rates float) – THEN tell me how great economic conditions are! The fundamental reality is that the Fed’s monetary policy and DIRECT participation in the financial markets (bond and MBS buying) coupled with allowing leverage to expand, is the primary factor helping to improve government economic data. Remove it and that government economic data we have so much faith in doesn’t look that good.
Courtesy of wikipedia
Sorry for the heavy handed sarcasm, but I think we need to fundamentally understand how deeply rooted the current monetary policies are, even after the supposed end of QE.
The first knee jerk reaction was a race back into the bond market, to lock in the higher rates and also (hopefully) participate on the bond appreciation. The 10-year bond yield had moved up to 2.45% in June and July, when the perception became overwhelming that the Fed was going to raise rates. Then the markets (bonds and equities) got rocked with uncertainty. The equity market got hit, volatility popped, and we saw a panic race back into bonds (a supposed safe haven) that sent yields in the 10-year below 2%. When the dust settled and the market bounced off the lows – the market took a breath and calmed down. Talk returned to how supposedly “strong” the economy is and that the Fed should raise rates. Bonds sold off and we saw yields rise back into the 2.2% range waiting for the FOMC meeting.
There was so much convincing in the media that the Fed WOULD be raising rates (even the “one and done” camp) that bonds further sold off this week, sending yields to 2.3%.
Then the Fed didn’t raise rates and the bond order flow reversed course and rushed back in, sending the yield down from 2.28% to the pre-market levels of 2.15% and I think we could get back below 2.1% quickly.
The market action initially moved as expected. We saw the Dow Jones rocket 200 points higher and it looked like the party was going to continue and money was going to flow into the markets. Then into the closing session we reversed course, contrary to popular belief that zero rates would keep money flowing into equities. That late session selling coincided with Yellen’s press conference sharing the concerns about an economic slow-down.
Much like bonds, order flow rushed into gold as well. Gold had been under pressure since QE ended and the focus shifted to rate hike expectations, which also help boost the dollar. Now the story has changed and with no rate hikes and concern leveled at global growth slow down – which means inflation is on the horizon – there has been a knee jerk move into gold.
The dollar I think is extremely over-valued relative to the Fed’s monetary policy. The reason it has become strong is that there has been a worldwide perception that the U.S. economy is strong and the Fed is getting ready to start their hawkish tightening cycle on rates, which would further boost the dollar strength.
That perception has changed backed up by NO rate hikes and a depressing FOMC statement and press conference. Money supply will continue to increase and low rates are here to stay, it is that reality that is settling in on the dollar and we should see dollar weakness.
Support & Resistance
I would look at 16,400 as short-term support, with 16,200 as a total flush if we close on the lows. Once bond rise (yields fall) and if we get more leverage capacity, the equity markets will again be the place to put capital. It will be the close that will determine the order flow come next week.
This is short term support with 4200 as a broader low support area. This is index can be extremely volatile so expect action. We could get a late session rally – ignore intraday action and watch how we close.
Short-term support and this also is a straddle strike. The market is returning to a highly volatile straddle strike range, meaning that we can move rapidly and violently from 1960 to 2000 or 1920.
Of all the indices that I have confidence in as to where money is flowing, it is the Russell as it measures the broadest flow of capital. The Russell looks relatively STRONG compared to the other indices and actually long-term bullish. Even a drop to 1160 and if we hold there and bounce, then we could be setting up for a strong run higher. Again – watch the close. The Russell is not showing any really big concerns yet.
The market is absorbing the Fed’s FOMC statement, No Rate Hike, and the Yellen Press Conference. It is confused and doesn’t know what to make of it. On one hand the market is convinced the economy is doing well from all the great government data, but the Fed didn’t raise rates and is warning us about concerns.
This is a perception problem and a marketing problem. The reality is nothing has changed, the Fed is still supporting the economy through their monetary policy, more so than we are lead to believe and will not stop until the economy can TRULY stand on its own.
From an ideological view, the Fed is led by Keynesians and for the first time since inception the entire board of governors has been appointed by one President and thus we have all likeminded members. Keynesians (for better or worse) believe in interventionism and have now become part of the market. For them to step back is hard as they want to make sure the economy can stand on its own. The Fed doesn’t believe it can and thus will continue with their monetary program.
I believe there is the possibility of another QE or something similar, if global economies weaken further. We could also see bank leverage increase, to continue to fuel (borrowing) spending that drives the economy.
I don’t see an end to this cycle for some time.
The current market action is based on perception right now and NOT fundamentals. If we hold supports and margin levels continue to expand, we could see a rally into the end of the year, despite fundamentally weaker earnings. Remember share-buy backs and bottom lines can mask problems with top-line revenue.