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 ...

Fed's Taper & Market Reaction

Federal Reserves will make a decision about its monetary taper in this upcoming week. Majority of analysts are expecting a taper. The question one should be asking right now is that how will the markets react to Fed's decision to taper. This is because only market's price reaction to the news pays, and not what the news was. As for the market, it has been rising nicely for the past 2 weeks. In fact, after bottoming on August 30 (the IPM Model bottom date), market has rallied to 1690 in 2 weeks i.e. an increase of ~70 points.

As we approach this critical week, markets are over-bought and some sentiment measures are touching optimistic extremes. This type of market behaviors asks us to be cautious over the next week or so.

If we had a Federal Reserves meeting scheduled with possibility of taper at a time when sentiment was pessimistic and market had been over-sold, it would have been a good time to buy the FOMC meeting's outcome. However, current market structure from an Elliott Wave perspective along with Market Matrix's analysis suggests that we might be in for a sideways to down market over the next few days.

From a global perspective, emerging markets are in a very interesting position. These markets have been in a downtrend since January 2013. Although they have seen a sharp rally over the past few weeks, this rally has brought the emerging market index at a critical resistance level.  If EEM fails to break sharply above recent highs, there is a serious potential that downtrend will resume.

Please note that according to proprietary market classification methodology, emerging markets recently entered a bear market in May 2013, and have been in a bear since then. Now the question remains if they will be able to break into a bull market, or the Bear will re-assert itself. Bear's reassertion would lead to widespread consequences. Next week will give us a better picture of how the emerging markets will react to Federal Reserve's monetary policy decision.

Finally, futures are rallying sharply on the decision of Larry Summers withdrawal as Fed's next chairman. This rally has taken most of U.S. indices to all time highs. It falls nicely in line with September Strategy

The Bond Story - Case for QE3

Over the last few days, I have heard a lot about a possible stock market crash, 10%+ correction, end of QE2, global socioeconomic uncertainty, impending Greek bankruptcy and much much more. As a result, I decided to look at long term Treasury Bonds charts to decipher the market behavior.

Following chart shows the 30 year bond yields since 1980 top. 

Figure 1

Bond yields have been falling since 1980s. Consequently bond prices have been in a long term bull market. However, recently we started hearing a lot about the end of the bond bull, and the beginning of a new multi-year bond bear market with higher yields.

I would agree that one year ago people were very bullish on bonds and rightly so because bonds had been rising for the past 30 years. However, to my amazement people turned bearish very fast. Many experts like Bill Gross of PIMCO not only exited his US treasury bond positions, he even went short. 

Figure 2

In this regard, I came to a totally different conclusion after carefully analyzing the historical bond market data from daily, weekly and monthly perspectives. It seems like that over the past 3 years, the bond market has been carving out a triangle pattern (not complete), as seen on the left. 

Triangles are continuation patterns, and lead to sharp move in the prior direction. In this case, the move out of the triangle pattern would mean that we will soon experience a sharp decline in bond yields and a sharp rise in bond prices.  

Implications of such a move are very severe because bond yields decline would mean the following: 

We are about to see a sharp rise in Bond prices, which happens in situations of extreme fear. Therefore, we might be heading towards a depression, sharp stock market decline and commodity bear market.

However, in order for the triangle pattern to complete the bond yields need to rise once more in an 'e' wave (shown in fig 2). This rise in yields would result in declining bond prices. The following chart paints a very interesting picture this regard.

Figure 3

This chart highlights the impact of QE announcements on the bond prices i.e. Bonds decline after the announcement of QE e.g. QE1 in Dec 2008 and QE2 in August 2010 (If you invert this chart, you will get the yields). Now, lets put together various pieces of the this convoluted puzzle:

1- Next week is the FOMC meeting 

2- Economy is lagging

3- Stock market is declining

4- Unemployment is high

5- Bond prices have been rising for the past several weeks

6- Bonds need final 'e' wave to complete the triangle pattern

Under these circumstances, it would be highly coincidental if the Fed announces QE3 or something similar. This announcement could result in lower bond prices completing the 'e' wave, and allowing the stock market to rise further into October 2011. After that bond prices might be ready to embark on their final rally leg, changing the face of economy as we know it. 

Note: In order for this scenario to play out, bond prices should not decline below the first low made after QE1 announcement. 

This is a hypothetical but an interesting possibility that I wanted to share with my readers. But it should not be treated as the best indicator of the future stock market movement. I will be presenting the latest readings of the Market Matrix & Market Barometer over the next few days, delineating the market behavior from various perspectives.