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By Costas Bocelli - Creator: Channel Trading Secrets
If you’re trying to figure out where the stock market is headed over the coming months, Federal Reserve Chairman Ben Bernanke gave you a huge clue last week.Forget about the sluggish economic growth. Don’t worry that Europe’s in a recession and Spain needs a bailout. Concerned that China’s still facing a Real Estate bubble? No big deal.
The stock market and risk assets are going higher.
The S&P 500 index and Dow Jones Industrial Average are roughly 6 percent from setting all-time highs. And the Russell 2000 small cap index is practically already there, right on the doorstep of hitting a fresh record high.
Why all the enthusiasm despite the economic malaise?
It’s quite simple. The Fed’s latest monetary policy measures announced last week are a real game changer, and will likely send the broad market indices to test those all-time highs -- vintage Oct 2007.
In a third round of quantitative easing, the Fed is now going to buy $40 billion per month in agency mortgage-backed securities. What makes this different from the previous measures is that the program is now going to be open-ended -- unbound to total purchased or a specified time frame.
Beginning immediately, the Fed will allow the value of their balance sheet assets to rise at a $480 billion annual rate until they see satisfactory results. The balance sheet has been held steady around $2.9 trillion since the completion of the second round of large scale asset purchases (QE2) in the spring of 2011. So it won’t be very long before the Fed’s portfolio tops the $3 trillion mark.
What results are the Fed looking for?
Congress has authorized the Federal Reserve to conduct monetary policy by a dual mandate. The primary objectives of the Fed are to essentially provide price stability and promote maximum employment.
The Fed Chairman has been losing plenty of sleep over the stubbornly slow pace of job creation since coming out of the recession. The unemployment rate has been stuck above 8 percent for over three years, a situation that he recently called a “grave concern”.
So according to the new plan, it looks like the Fed is probably going to be buying a lot of debt for quite some time to get satisfactory results on the maximum employment front.
But what about the other mandate? Price stability is actually the cornerstone of Central Bank policy. In fact, before Congress amended the Federal Reserve Act in 1977, the Fed’s only concern was to promote price stability and keep inflation in check.
The Fed’s benchmark inflation target is 2 percent. Since the credit bubble popped and the great recession followed in 2008, inflationary pressure has mostly been subdued, with households deleveraging and a credit deflationary environment taking hold from the housing market slide. Inflation has ebbed and flowed since, but has spiked around the times the previous rounds of stimulus were injected by the Fed.
On an annual basis, headline inflation is running at 1.7%. When you strip out food and energy, it’s running at 1.9%. The recent drop-off in the level of inflation mainly came from this summer’s drop in energy prices. However, that trend has changed as energy prices have turned sharply higher. Crude oil is over $90 a barrel -- even after a $10 plunge this week -- and gasoline prices are back to previous highs.
The August data showed the largest monthly gain in headline inflation (includes food and energy) since June of 2009, and the next few readings will send it firmly back above the Fed’s target. The September and October data will be great political ammunition for the fight to win the White House come November.
With the Fed now restarting the printing presses and purchasing billions in agency MBS debt, it’s going to keep downward pressure on the US Dollar. And inflationary sensitive commodities such as food, gasoline and gold are only going to rise.
The question is how long will the Fed tolerate this while waiting for the labor market to firm and the unemployment rate to drop to a satisfactory level?
Well, I think we’re going to find out because, in their policy statement, they make another firm commitment:
“...the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens...”
If this doesn’t scream nitrous oxide in a rocket motor, I don’t know what does.
They are basically saying that after economic growth and the labor market show clear signs of improvement, they’re not going to be in any rush to remove the easing measures prematurely.
So they’re going to allow the economy to heat up and run feverishly hot far longer than normal circumstances would otherwise call for.
And to top it off, the committee pushed out their pledge another six months to keep interest rates (fed funds rate) at exceptionally low levels through mid 2015 -- a Zero interest rate policy for nearly three years!
The bottom line is that while there’s plenty wrong with the domestic and global economies, the Fed’s taken aggressive steps to promote a wealth effect environment.
And that leads to higher prices in equities and risk assets.
The stock market should maintain its bull market trend in the intermediate term, and any weakness or pullbacks should continue to be viewed as opportunities to add to bullish positions.
Enjoy the sugar rush while it lasts.
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Costas began his trading career in 1998, at Gateway Partners, an Equity Options Trading Specialist Unit on the Philadelphia Stock Exchange (PHLX). During his successful tenure, and though unprecedentedly volatile trading levels, Costas boldly and adroitly navigated the global "financial meltdown" that saw the downfall of the hedge fund and of Long Term Capital, and the Russian Currency Crisis. Having achieved the coveted Senior Equity Options Market Maker position for his firm, Costas eventually left to join a proprietary trading desk, where he successfully makes markets for large customer and institutional orders. In addition to his more than 7 years of experience as an options market maker, Costas has also trained and educated many junior traders on option theory, risk analysis, and strategy. His passion is helping self-directed investors achieve all of their financial goals through a clear, practical understanding of the power of options and of the many benefits of trading in a proven systematic way. |
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