Fed Decision & Gov't Shutdown: This Time Its Real (Part 2)

Part 1

This question suggests that either Fed does not think the economy is strong enough right now, which means there is some thing fundamentally wrong. Or they are anticipating a major shock in the near future. This leads us towards the upcoming budget discussion and possible government shut-down starting on October 1, 2013.

I think Federal Reserves' was looking ahead and they saw a real policy of a government shutdown in October, along with another long-drawn battle on debt-limit increase. That is why, they preemptive these political uncertainties by giving another doze of steroids to the market so that the impact of political stalemate does not ripple through the stock market, and consequently does not derail the nascent economic recovery.

As far as the political stalemate is concerned, this time it will be bad! On all previous occasions politicians started working on the debt-ceiling / government shutdown issues at least ~2 months in advance, with media shouting about this possibility ~3 months in advance. For example, in 2011 debt-ceiling was being discussed in the media in April/May time frame, months before the actual stock market decline in August.

But this time, it is different. Today, was the first time I saw something on the news about a potential government shut-down in a financial news outlet. This means that lawmakers are not taking this shut-down seriously with only 2 weeks left to the the shutdown. This will be followed by debt-ceiling debate, which needs to be settled in less than a month. And finally, since Republican lawmakers have been burnt by sequestration earlier this year, it is highly unlikely they will easily cooperate on this issue.

All of the above mentioned scenarios combined, suggest that there a lot of headwinds for the market in the near future. Under these circumstances, we will analyze the IPM model for trade timing  

Fed Decision & Gov't Shutdown: Logic Behind Fed's Decision (Part 1)

So everyone was surprised by what Fed did yesterday. In fact, it is one of the times after a long time that I have seen so many people caught off-guard. Since I was expecting the market to go up after the announcement of the taper, I was not surprised by the rally after the announcement. I was surprised by the announcement to not taper. And to be sure, this surprise was equally shared between financial news media and economists. Since the surprise decision is now out, the question remains about the context of this decision.

In real world economists, Federal Reserve's officials, treasury analysts and central bankers typically make policy decisions based on fundamental analysis of macro-economic indicators. These indicators tell them how to manage their policy to control inflation, foster job growth and spur economic activity. Therefore, it will be very insightful to analyze the implication of federal reserve's recent decision of "not to taper" from a fundamental & socio-economic perspective.

For one, since everyone was expecting a taper decision. "Not Taper" turned out to be a perfect contrarion trade.

On the other hand, from a fundamental perspective the consensus was that Fed will start tapering its bond buying program in September 2013. And the reason behind this assumption was the language used by Fed's officials over the recent meetings was getting Hawkish. In these meeting's Fed's officials had started becoming "Hawkish" about the fiscal policy i.e. they were getting concerned about the potential increase in the inflation rate due to extremely accommodating monetary policy.

Behind the shift in Fed's language towards stricter monetary policy was recent economic data which was hinting towards robust economic growth in the US economy, along with significant gains in the housing market and stock indices. However, this data was available to the general public all over the world, and the data did not get worse over the last month or so.

Therefore, the question is: "What did the Federal Reserves' see differently during the September's FOMC meeting, which forced them to keep the extraordinarily accommodative monetary policy intact?"

This article will continue in next part ...