You are about to enter the market’s version of the Twilight Zone. Before passing through the portal, kindly leave every sense of reason and reality behind, since you will not be needing them for quite some time. Just hold on for the ride, as the stimulus-induced warping you see will make your head spin.
Surprising about 99% of traders, analysts, and rational human beings, the Federal Reserve decided yesterday to keep all easy-money policies in place and unchanged.
While the expectation was for a small reduction to the Fed’s monthly bond purchasing program, “the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases,” so read the FOMC’s press release.
“Accordingly, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month.”
The continuation of stimulus weighed on the dollar, with the U.S. Dollar Index (DXY) plunging 1.25% to close Wednesday at 80.18. And when the dollar falls, everything else rises.
The 10-year Treasury gained 13 basis points, its yield ending the day below 2.70% for the first time in 5 weeks. The S&P 500 skyrocketed more than 20 points, setting a new all-time closing high of 1,725.52 for a 1.22% gain on the day.
Even the beleaguered precious metals broke free of their rout, with gold soaring $57 to end the day 4.4% higher at $1,365 and silver fairing even better with a 7% gain up to $23.08.
But where in La-La Land are we now? If people thought the markets have been distorted through five years of stimulus already, they should prepare themselves for some more stretching and bending because the Fed is not finished yet.
What the Fed Sees
Anyone with a rational mind is likely more than a little perturbed at the Fed for getting us thinking about the bond buying program’s tapering and elimination way back at the beginning of May, when Fed Chairman Bernanke first hinted at the “possibility.”
Of course, markets are not shy about trading a “possibility” with just as much enthusiasm as a “reality.” However, the FOMC and Bernanke himself did tell us repeatedly that any changes to policy would be dependent on incoming economic data.
So something must have appeared in the data that made the Fed nervous about tapering just yet. What did it see? The press release mentions three main spooks:
“Some indicators of labor market conditions have shown further improvement in recent months, but the unemployment rate remains elevated.”
“The housing sector has been strengthening, but mortgage rates have risen further and fiscal policy is restraining economic growth… The tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market.”
“Inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.”
In a nutshell, the Fed doesn’t like the slow job growth, nor the rise in bond yields and mortgage rates that it has been seeing lately. So it is keeping the stimulus gas pedal down. With inflation benign and under control, the engine is nowhere near overheating, giving the Fed plenty of leeway to run at full speed.
But there is more than just anti-growth conditions creeping into the marketplace that is worrying the Fed. It also seems to be growing increasingly frustrated with government policies and politicking.
The FOMC repeated its previous annoyance that “fiscal policy is restraining economic growth” – likely referring to the sequester, those across the board indiscriminate budget cuts totalling $85.4 billion in 2013, rising to $109.3 billion per year for 2014 through to 2021.
Yet this time around, the FOMC added a second frustration with the government: “the extent of federal fiscal retrenchment.” This likely refers to the failure of the two federal parties to resolve the credit limit issue earlier this year, with another contentious battle in coming weeks already beginning to brew.
The Federal Reserve sees a potential crisis there. Given the government’s inability to solve key fiscal problems, the FOMC seems to be taking it upon itself to counter the government’s harm to the economy. If the FOMC is right, we may see some turmoil in the economy and the markets over the next few weeks in a government-induced credit limit crisis.
As Bernanke expressed at the press conference, “A government shutdown, and perhaps even more so a failure to raise the debt limit, could have very serious consequences for the financial markets and for the economy, and the Federal Reserve’s policy is to do whatever we can to keep the economy on course.”
If such retrenchment does indeed develop into a crisis, don’t be surprised to see the Federal Reserve actually increasing stimulus.
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For How Much Longer?
But how much more stimulus will the economy need? With each passing month, more and more economists are lending their voices to the choir preaching that the more they inject the markets with stimulus, the dizzier they get and the harder they will fall when the drug is finally cut off. How much longer will this go on?
“As long as the unemployment rate remains above 6 ½ percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored,” the release answers.
The latest unemployment rate for September sits at 7.3%, with the latest inflation reading for August at 1.5%.
Already knowing the question is on everyone’s mind, the Committee adds, “In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.”
Once again we are reminded that “asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent” upon incoming data.
So the message out of the FOMC yesterday was simple… ‘Don’t fight the Fed. Be patient and wait for us to say when.’
There is just one problem with that… where the expectation of stimulus tapering had been priced into equities in May and August and priced into bonds since May, the coming tapering – whenever it comes – is no longer priced in.
Equities have broken into record territory, and gold is nearly $300 higher than its July low. Even the 10-Year Treasury has given back nearly a quarter of the tapering it had priced in over the past four months.
Far be it from me to spoil such a great feasting as only the Federal Reserve can cater. By all means – indulge, enjoy. Just remember… it’s not free. The bill is coming at the end. All the Fed did yesterday was add another course to the dinner and another round of drinks. And all that does is make the bill that much larger when we finally get it.
So the call to remain defensive still stands. We want to be in the market, of course, as the yellow light is now back to green. S&P at 1,800 is very doable – even 2,000 if we make it through the December holiday season before a taper.
But keep any margined leverage to a minimum. In overbought conditions which will only become more overbought, large caps suffer less than small caps when they finally fall.
Note that when the markets first priced in tapering in May and June, the S&P dropped to 1,575. This is an important number that could be easily revisited when tapering is finally announced – whenever that is. Same deal with gold, which fell to $1,180 when tapering was priced into it.
But if gold can climb another $70 to take out its August high of $1,435, it could continue higher to its pre-taper-panic price of $1,500. And if it takes that out, it could finish the year at its pre-Cyprus gold-sell-off-panic price of $1,600.
The next FOMC meeting is scheduled for October 29th to 30th. But tapering will likely not be announced then either, since the meeting is not followed by a press conference, which the Fed will likely prefer to have when announcing important changes to policy. That puts the next likely opportunity to introduce bond purchasing reductions at the mid-December meeting, which comes with a press conference.
Thus, any rallies here in gold, equities, and bonds will likely come to a stop at the beginning of December, just a couple of weeks before the Fed’s mid-December meeting.
Until then, take profit a little at a time when you can, and buy on the dips. The bias is to the upside.
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