What if the Fed doesn’t throw a party and everyone comes? (market view)

I don’t write very often about market views, especially short-term ones. There’s excess supply of that already in the system, and my comparative advantage should be melding policy, economics and behavior to try explain things that I think are misunderstood. At least this is what I try and stick to. 

But I am a trader, and I follow markets very closely, even when I am running low risk. And I have been getting a lot of inquiries about my views at this juncture.  So, here they are. 

Prospectively, I think guys are salivating to short risk in run up to/aftermath of the Fed tomorrow. I think a selloff is likely and will be short lived. The short-term indicators are quite overbought, but the intermediate-term indicators are very oversold, still. (Helene Meisler over at RealMoney.com lays these indicators out very well; in fact, she’s the only reason I’ve kept my subscription.)

A selloff that sucks the shorts back in followed by a return to rally is my base case. I don’t think the rally lasts too long, but breaks of 1410 in S&P, 1.31 in the euro, 1.03 in AUD, 13.40 in MXN, as indicative levels, seem doable—even if for the way I trade I care much more about the dynamics and sentiment than the levels themselves.

Part of the reason I have this view is because everyone is asking “What if the Fed throws a party and nobody comes?” Increasingly, people have recognized QE is largely psychological and the psychological response is diminishing. Even the Fed has. So a lot of bearish traders would like to see the Fed do something and then have the market selloff anyway. This would be ‘the dream sequence’. It would validate the bearish market view, vindicate the “it’s all artificial” theory of monetary policy, AND cast the Fed in an unfavorable light. Hat trick.

But the bigger pain trade right now seems to me the opposite. It’s the question in the market that no one is asking: “What if the Fed DOESN’T throw a party and everyone comes anyway?” This would imply the Fed announces no balance sheet expansion, the market sells off at first, then, once the bears feel like they’re back in control, a rally.

Reinforcing this whipsaw is my fundamental view that the Fed will disappoint. Expectations seem unrealistic. As traders we often act as if our anxiety level should be the principal criterion in the Fed’s reaction function. That, and, of course, the most recent move in the S&P. And our anxiety level has been high.

We have a strong tendency to project onto others our own thinking and preferences. But the Fed doesn’t think the way we do. I think we in the markets are projecting a bit too much here. So, I expect Son of Twist, with commitment to lower rates forever, or something along those lines.

There is very little short-term paper left on the Fed’s balance sheet to sell for a continuance of the current Twist, so I’m guessing they might buy further out and sell a little further out to continue the program. A twist on Twist. Just to be doing something. And because it can’t hurt. It doesn’t matter that I think it is pointless.

There are three main reasons I don’t think there will be any balance sheet expansion at this point—though the Fed will almost certainly discuss options for expansion should they need it further down the road: 

1)  The bar to expanding the balance sheet is high given domestic politics, international politics, and the Fed’s recollection of the sharp market reaction to QE2. I think they are still chastened, despite their intellectual recognition of its diminishing psychological effect; 

2)  Inflation and inflation expectations are running higher than in August 2010, when they were low and falling off a cliff. And they have a clear trend since last year; 

  

3)  They need the optionality now. “Taking out insurance” is pre-emptive. The US economy is healing, albeit slowly. So insurance is less necessary. The bigger risk is that of an exogenous shock from Europe or from a fiscal cliff (or hostage-taking in the run up to a fiscal cliff). The timing of these events is uncertain. Thus, the optionality of holding off with warheads that have been losing throw-weight anyway seems the superior risk-adjusted strategy. Again, I think these policies at this point are not very useful. But they can still short circuit negative sentiment in extremis when it gets to the point where that sentiment starts to feed on itself.

A little longer-term, I think the EZ did buy more time with Spain than the market is recognizing, and there is plenty of scope for further announcements in the coming days/weeks that could hurt those short risk.

To get a good entry point for my fundamentally bearish worldview, I would like to see the bearish tone subside and the bulls to get some chirping chips, to use another poker expression. I would like to see analysts on TV again saying “buy any dip” with the kind of confidence we saw in March/early April. We are not there yet. Until then, my strategic bias is to keep my bat on my shoulder. Often the most profitable trade is the one where you sit on your hands.

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