Frontrunning the Fed (again)

By Ben Turney 

Last month’s meeting of the Federal Open Markets Committee (FOMC) provided an excellent opportunity to go short US stocks. Comments in the FOMC’s policy statement concerning the withdrawal of the bond purchasing programme prompted panic. For many this was a shock, but really the only surprise in the market’s reaction should have been the surprise itself. The Fed has been making hawkish noises for quite a few months now. The economic data set they use have been slowly improving, albeit at a fairly anaemic rate, and “official” inflation remains comfortably in check (as for real world inflation – that’s a different story!).  All in all, the right conditions appear to be in place for the commencement of “policy normalisation”.

The question now is will the FOMC follow through next Wednesday and announce its plans to start tapering QE, possibly as soon as September?

Judging by the trade in July, the market doesn’t seem to believe it will. Since the initial sell off the benchmark US indices have recovered quickly and in fact made new all time nominal highs.  Although the latest action hasn’t exactly been confident, there is enough bullish sentiment to keep the bears at bay.  In this respect the charts are fairly easy to read.

After closing at a new high on July 10^th, the Dow has been stuck in a fairly tight range.  Attempts to break out to the upside have met resistance, while recent selling appears to have encouraged buyers back into the market.  There is a definite feeling of hesitancy out there, which could well provide a substantial trading opportunity.

If you had asked me a month ago what sort of chart I would have liked to have seen going into this week, the one above is pretty much exactly what I would have hoped for.  The market is roughly at its peak and looks tired. This affords me the chance to take on a fairly highly leveraged short, with tightly managed stops. In other words I can back my analysis quite cheaply. 

My view remains that in the coming months the biggest moves in markets will be generated by the relative adjustments in QE programmes among the world’s largest economies. Japan appears fully committed to its expansive programme for the rest of the year, but the jury is out on whether or not Europe and/or Britain will decide if further monetary easing is necessary (as an aside I think both will in fact decide to go for more QE, but more of this in future posts). As for America, I believe the taper is most definitely on and I am not convinced the market has digested the implications of this yet. I note my fellow blogger, Richard Jennings of Titan investment partners shares my view on the short side too (see here – http://www.spreadbetmagazine.com/blog/we-begin-the-building-of-our-short-position-update.html), and one which is a minority one at present, hence my also finding comfort in this

Much has been made of the fact that the Fed looks likely to maintain the Zero Interest Rate Policy (ZIRP) through to summer 2015.  While the continuation of ZIRP will probably dampen any resurgence in the US Dollar and might even keep bond yields from boiling over, it is far from clear if this will be so supportive for US stocks. After all, ZIRP has now been with us since December 2008.  When stocks have corrected in the last 5 years, on its own ZIRP hasn’t provided much of a backstop. What has been far more influential has been the absence or appearance of direct bond purchasing by the Fed.

I see no reason why this pattern shouldn’t repeat itself again this time. If the FOMC announces its plan to start withdrawing its $85bn a month of bond purchases, then it seems reasonable to expect this to have a detrimental impact on the outlook for stocks, at least in the short to medium term.

However, as much as I like my plan for the week, there is one unfortunate caveat.  Last month there was very little to no speculation that the Fed might cause a sell-off. This month I have caught a few pieces, such as this one on Reuters, anticipating just such a move. This really is a shame, as specific guidance from the mainstream media can usually be guaranteed to be wrong. 

Nevertheless I am sticking with my interpretation of the charts and the outlook. I opened my first short after the close on Friday evening.  My plan is to watch the market’s mood on Monday and Tuesday and seek to add to this, by the time of the release of the FOMC policy statement on Wednesday.

EDIT – Also bear in mind that the influential nonfarm payrolls report is due out on Friday, so this really could be a crucial week.  We might even see a reappearance of the “good is bad” reaction to positive news.  Hey ho what crazy times we live in!