Overreacting to the Fed?

By Ben Turney

Fighting the tide is one of the contrarian’s toughest dilemmas.  Successfully identifying high and low watermarks can yield the greatest rewards, but putting yourself on the wrong side of the trend is usually a punishing experience. 

In the last week I have had to face up to the fact that the tide is against me and this market wants to move higher.  Even though this defies logical sense, there is no point fighting it.  The recent technical strength of the Dow has been pretty clear, albeit on seasonally low volume.  Probably there is an argument for going long.

The strength of the rebound (reflected in its pace and sharpness of its gradient) suggests the bulls are back in charge and we are within touching distance of breaking all time highs again.  If these are broken there is no obvious technical level of resistance, so who knows how far the market could advance.

However I can’t shake the view that the market has misinterpreted what the FOMC and Ben Bernanke have had to say.

This latest burst of euphoria seems to be based on the misguided view that the planned tapering of the Fed’s QE programme is somehow off.  Market participants and many commentators have seized on the statement that “accommodative monetary policy” will continue until at least 2015.  What they appear to have failed to grasp is that this statement (repeated by Bernanke in his speech last night) almost certainly refers to the sustained use of the Zero Interest Rate Policy, not the indefinite purchasing of bonds.

The difference is surely crucial.

It is time consuming, but I have taken to reading the full policy statements issued by the Federal Open Markets Committee.  They can be found here.  The reason for going directly to the source is that much of the reporting about what the FOMC discusses is unreliable at best.  Taking the time to read through the minutes and it looks pretty clear that the planned tapering is still on.  Better than that it looks like the FOMC has given clear guidance how they are going to manage the process.  Below are two quotes I’ve highlighted, which could have a significant bearing on this market later in the month.

“They (the FOMC Committee) agreed that many of the details of the eventual normalization process would likely differ from those specified two years ago, that the appropriate details would depend in part on economic and financial developments between now and the time when it becomes appropriate to begin normalizing monetary policy, and that the Committee would need to provide additional information about its intentions as that time approaches.”

In other words, we can expect to be given a clear update of what the FOMC is planning to do, before it actually acts.

With respect to the unemployment and inflation, the two primary variables the FOMC has specified it will use to guide its next policy move, it had this to say;

“Overall conditions in the labor market improved further in recent months, although the unemployment rate remained elevated. Inflation continued to run below the Committee’s longer-run objective, but longer-term inflation expectations remained stable.”

The interpretation of this looks simple enough.  The FOMC currently believes the conditions are right to begin the process of normalising monetary policy.  There are of course the usual caveats that deterioration in the economy, a rise in inflation or increased financial market instability could change their plans but for the time being it seems only right that the indicators confirm the Fed will start withdrawing its bond purchase programme, possibly as soon as September.

Although I can’t see an obvious level of technical resistance, beyond the current all time high in the Dow, my plan is now to watch how this market develops ahead of the FOMC’s next meeting on July 31^st.  I suspect a great opportunity is going to present itself, as the reality of QE withdrawal begins to dawn on this wildly optimistic market.