July 10, 2014

Painted into a Corner – The FED and Congress

portugaldebtPortugal is once again producing seismic tremors as the Eurozone starts a liquidation sale and the ECB is put on alert.  But hey that’s all the way over there – right?  That’s a European problem right?  I mean I don’t have any exposure to Portugal do I?  Come on Sparky, nothing to worry about.  The alarm may be sounding but no signs of panic yet.  The buyers did jump in at the opening and brought prices back to higher in the NDX trying to grab all those bargains that a GS analyst announced pre market on Thursday.

FederalreserveWithin the current cheap money environment the belief in the possibility of deflation would sit somewhere around ‘no way’ or impossible.  The FED’s policy clearly doesn’t suggest that and it would remain true so long as the ‘money spigot’ does not get turned off.  When there is an abundance of money available prices go up hence the natural ease at which the central banks of the world can control inflation.  The problem comes when policy runs to an extreme and not on a short-term basis but on a long-term basis.  An extreme that will take some time and create a credit squeeze and price deflation. Deflation would be much more difficult for the FED to control.  Consider that deflation increases the value of government debt as interest rates begin to rise and thus makes it more difficult to repay.  Deflation has a tendency to build upon itself, which makes the job of the FED to control it akin to battling a wildfire with a garden hose.

demorepublicanAdd to the picture the current Republican bill afoot in Congress that would limit how the FED makes monetary policy.  The essence of the bill would be to require the FOMC to detail a strategy or rule for how it would adjust interest rates.  Without the continued ability for the FED to print money basically at will to fight off actual or perceived inflation, it would force a shut down of the printing press. If this occurs the probability for deflation would jump quickly.   There have been strong arguments towards lowering the debt ceiling or at least discontinue its current parabolic rise.

While deflation maybe a worst case scenario, it has been out there for sometime and may now be demanding attention once again.  Sovereign debt problems are nothing new, they have been occurring with regularity for centuries.  The problem lies within the size of the debt and the parabolic growth it has experienced over the last 30 years.   It should not come as a surprise then that there are large players looking for the FED to start taking some risk off by reducing their positions.  The problem is to do so without creating a scene.  That I’m afraid is just not possible.

From Bloomberg Businessweek on July 8, 2014

While it has little chance of passing in a Senate controlled by Democrats, the bill signals Republican interest in a more constrained and transparent Fed as it closes one of the most expansive periods in its 100-year history. Policy makers have kept the benchmark interest rate near zero for five years and used bond purchases to hold down long-term borrowing costs, expanding their balance sheet to a record $4.38 trillion in the process.

showmethemoneyThe actions this week in Congress drives home the reality that there is a legitimate risk that the FED could reach the political limits of money printing with the Treasury being denied additional funding to keep the home fires burning.  I suspect the FED and the government will continue to succeed in creating inflation and continue to hold rates artificially low.  How long the markets will continue to buy into it may be the more important question to look at now that quantitative easing has been given an end date.

The markets gapped lower on Thursday as a result of European selling as the Portugal problem was revealed.  Again, the failure of follow through selling brought the decline to a halt and the buyers running in to scoop Thursday’s bargins.  While, the fundamental reasons behind the decline haven’t changed the technical and algorithmic reasons did.  Without the presence of larger sellers or buyers for that matter, the bulk of trade is left to professional traders.  Once the initial shorts covered and ran for the sidelines the balance of trade surrounded fair value and premium – or the index arbitrage and volatility traders.  This did provide several excellent opportunities in the broader indexes and I suspect it will continue as earnings season continues to unfold.  The bulls may begin to get nervous as the street begins to digest possible warnings from the likes of Wells Fargo, Citigroup, Bank of America, JP Morgan, and Goldman Sachs where year over year EPS declines and the larger banking sector could see a 3% decline.

earningsAs I wrote yesterday expect capital rotation as the larger players move money across sectors in an ongoing search for yield.  Word has it that the telecom sector will see the largest increase – check out VZ for some insight into what may be yet to come for this sector.  Earnings are just getting started and with an overhanging pall of bearishness look for an increase in volatility swings.

Steer the course and don’t compare yourself to everyone else.  You are not they and they are not you.  Remember to trust and believe what makes you unique at this moment in time and in this situation and allow others to choose for themselves.  Don’t be swallowed up by the chaos and false emotions swirling around.  Remember it’s just a number.

Trading the number remains key to being able to reduce and separate the “noise” from opportunity.  This takes knowing and executing a well-defined strategy and allows you to see opportunities amongst the “chaos” and by trusting the mechanics of your strategy, be able to take advantage of them.

Opportunity continues to knock on our doors.  While it doesn’t come without risk, risk can be defined and more manageable. Volatility and broad moves are exactly what a day trader desires and being able to respond without questioning is a luxury many are unaware of.