The power of the Fed……..

After reviewing yesterday’s action, I’m beginning to feel that I was absolutely dead wrong about the reasons for the market rally the previous day. No it had nothing to do with the China rumours of a more relaxed monetary & fiscal policy stance but everything to do with what the future actions of the Fed might be. Here is the evidence. From the market open, NYSE & NASDAQ breadth trended sideways right on the zero line, A/D lines were a similar story and cumulative ticks were in slightly positive territory (+10,000). Volume was also coming in well below yesterday’s levels as the market was in a holding pattern. After Bernanke began to speak at 2pm E.T. volume surged in both the SPY and on the ES to the 30 day median level and market internal indicators began to weaken significantly. The A/D lines went from flat to -1000 on both exchanges, the breadth went from 50/50 to 80% down volume versus 20% up volume and cumulative ticks went from +10,000 to finish at -10,000. To me it seems quite clear that the Fed is still the 600 pound gorilla sitting in the room when it comes to talking about who has got the muscle to move this market (remember the rally off the March 09 lows came just days after the Fed announced the first quantitative easing program). I suppose the market was expecting Ben to drop more dollars from his helicopter in the form of another quantitative easing program or something similar but it never happened as Ben stuck to the same story that the Fed is ready and willing to act when it’s time to do so. This type of uncertainty just ain’t going to cut it as the markets hate uncertainty! I suppose the current economic conditions are just not bad enough for any Fed policy action (the Fed is still forecasting 3.5% growth in 2011). We probably have to see much more weakness from the data and the SPX to drop about 300 points from here to invoke any kind of policy response from the Fed.

So there you have it. We have a pretty much a directionless market at the moment, what we do know is that earnings season hasn’t been that stellar to date, economic data points are now weakening and we won’t see any help from the Fed for now. If I was a bull I’d be wondering what catalyst going forward is going to continue to support this market. To me it is clear that economic news will continue to drive the market as investors look for any kind of information to determine what fair value for this market is. The worrying thing for the bulls is that the trend of economic data of late seems to indicate deteriorating conditions. If it doesn’t improve rapidly, the uncertainty of it all is going to make investors dump equities into something more certain like that of fixed income assets. We are already seeing U.S treasury (UST’s) bonds rally close to the highs of the last couple of years so perhaps that is a telling sign. From a game theory perspective UST’s still remain a dominant strategy compared to equities. If the economy weakens, the safe haven and fixed income aspect of it becomes all the more attractive, whilst if the economy weakens to a point that the Fed steps in and we get another round of QE then that extra demand will support prices. Obviously we should see some type of rally in equities at this point just like March 09 as investors will once again be looking for inflation hedges ie buying hard assets – no doubt that was a reason why commodities and materials rose so strongly the day before on anticipation of another QE type program (I note the AUD and other commodities are all off today). Really the only fear in being long bonds at this point is the spectre of hyper inflation but that fear is simply not justified at this point as CPI is well within 2%. To be honest if you were long bonds one would have ample time to see a rapid rise in inflation coming anyway and have plenty of time to exit positions as the first sign of coming inflation is tied intimately to the employment picture (capacity utilization). So far that hasn’t improved. It’s not like we are going to have 9.5% unemployment one month and then have 8.5% employment the next. Or that CPI is going to be 2% this month and the next it is 4%.

From a trading standpoint, and in line with my prognosis above I might investigate the idea of an iron cockroach (or unbalanced iron condor) on the ZB for next month with the trade skewed for more upside (danger side). More on that later.