Firmly Focused on the Fed

Stay home.  That’s what we all should have done today after yet another lackadaisical equity trading session that saw a miniscule 2.8 billion shares change hands on the S&P 500.  All eyes (what few eyes there appear to be at this point) are on the Fed and its rate decision that is scheduled to be released tomorrow at 1:15 PM CDT.  While no one is expecting any change in the Fed’s targeted interest rate, many are looking for them to provide a change in their press release language that will suggest additional monetary stimulus is on the way.  Chairman Bernanke’s recent Congressional testimony (in which he stated that the economic outlook is ‘unusually uncertain’) certainly supports this view and was likely a signal of a change in the Fed’s pending policy actions.  And with GDP declining to a 2.4% annualized rate of growth in the second quarter, there is certainly sufficient near term data to suggest that things are not improving on the economic front. 

That said, the fact that many are looking upon this action as a positive development is perplexing and reminiscent of the upbeat reaction seen in the Asian markets last week.  In the latter case, Asian investors looked upon a slower than expected PMI reading as a sign that the Chinese economy is slowing sufficiently to induce stimulative actions by the Chinese authorities.  This stimulus would help spur near term growth and, thereby, push share prices higher.  This is much the same mentality underpinning any potential Fed intervention in the coming months.  And while this logic may be true in the short run, the fact remains that these policies (in both the U.S. and China) will have been enacted to support economies that are failing to sustain positive economic growth (higher growth rates in the case of China).  This lack of organic growth calls into question the longer term economic prospects for the U.S., especially since the federal government is nearing the limits of its ability to support economic activity.  To be sure, this should be a concern for all equity investors in the coming years.  So if the Fed does decide that additional monetary stimulus is warranted, don’t be surprised if the equity markets surge on the news.  I would be inclined to use this subsequent rally as an opportunity to pare down equity positions in preparation for the more challenging environment that lies ahead.

As I mentioned on Friday, I’m expecting a significant move in gold this week and suggested that Tuesday would be the day on which this likely would occur.  With so many eyes focused on the Fed, it wouldn’t be surprising to see a pickup in volatility among all the major markets once the FOMC data is released.  The question is how will gold react?  I think today’s trading action provides some real insight on where things are likely to go.  After trading higher early on in today’s session and testing resistance around the $1,210 level, gold finished down $3.90/oz. at $1,201.30.  This failure to maintain the close above $1,204 level suggests, to me, that the bias is still to the downside in this market.  An announcement of additional monetary stimulus by the Fed would, in theory, be supportive of gold prices as there would likely be a great deal of downside pressure applied to the U.S. Dollar.  However, the past couple of months have shown that gold can trade in a completely disconnected manner from the dollar.  My read is that this is disconnection is likely to continue as investors will probably use a stimulative Fed decision as a reason to sell safe harbor assets (gold, Treasuries) for more risky assets (equities, energy).  This ‘risk on/risk off’ trade has been a hallmark of the markets since March 2009 and I find it hard to believe that this binary trade is close to fizzling out.

Crude oil rebounded today and finished up nearly 1% on the session.  However, this marked an ‘inside day’ (The day’s range is within the previous trading day’s range.  It is usually a sign of indecision.) as energy traders also await word from the Federal Reserve.  Despite this, today’s action was supportive of last week’s break above the $80 level, which must be maintained in order for crude to continue its move towards $87/barrel.  As I mentioned in my gold analysis, I believe that any stimulative actions from the Fed will likely benefit the crude pits as investors flock to more risk-based assets.  Additionally, rhetoric out of the Philippines regarding the United States’ role in the South China Sea continues to highlight the geopolitical concerns that currently abound.  Rightly or not, crude oil tends to be the biggest beneficiary of these tensions, which is one reason why I’ve added some exposure to my personal portfolio as well as suggested it for all of you as well.

Tomorrow should be an interesting day.  I’m looking for a largely directionless trade throughout the morning, with just a little bit of volatility resulting from the lackluster volumes.  With the release of the Fed’s statement, though, things should pick up rather sharply.  Given the widening expectation for additional monetary stimulus, any verbiage that fails to support additional intervention will likely cause a sharp equity selloff.  I don’t believe this will be the case, but this risk is there none the less.  Market participation will likely remain low, so look for whatever move the market makes to be swift and then to stagnate near the day’s highs/lows.  Also be sure to keep an eye on the Treasury market.  Additional stimulus would likely be looked upon as increasing the prospects for inflation, which could send bond prices reeling.  However, if prices remain resilient in the face of such action, this would say a lot about the overarching concerns investors harbor for the economy.  I certainly won’t be looking upon the Fed’s action with the market’s rose colored glasses, but I’ll be happy to make some money during the near term jubilation.    Until tomorrow…..