The Fed: All In

December 6, 2010

Thursday night I wrote: “tomorrow’s jobs report may be a disappointment for traders hoping for a third day of large equity gains” due to the fact the monthly birth/death from the BLS would likely show a negative adjustment. My forecast was correct as November payrolls rose only 39,000 with the monthly seasonal adjustment subtracting 8,000 jobs instead of its normal rise. Bonds and the dollar reacted in normal fashion (lower) to the weak report but stocks are using any news as an excuse to move higher on the theory a weak economy will bring more Fed money printing that will end up in the stock market. A stronger report would have found buyers adding to stock positions because of rising profits so either way stocks are pushing higher on any news. The 10 year rose to 3.01% with the inflation component ending the day at another new high (2.24%). The 10-30yr. spread is trading tonight at 133bp as the 10 year has picked up a slight bid after Bernanke’s 60 Minutes interview.  Monday has no economic reports so markets will focus on Washington and the possibility of tax cut extensions and a possible reinstatement of extended unemployment benefits. Friday’s 0.2% rise in the unemployment rate (9.8%) gives politicians needed political cover to support for passing both of the above items before year end.

Bernanke – 60 minutes

The Fed chief was interviewed earlier this week for tonight’s program as he tries to sell his latest version of Fed easing to the general public. As usual I played the on-air and web extra interviews many times to not only hear his words but also his facial expressions when answering questions. He was emphatic is telling the audience the Fed is NOT printing new $$$ as the money supply is “hardly changing.” While technically true (monetary base flat for the past six months) he should have told viewers the intention of the program is for monetary aggregates to grow thus signally an increase in bank lending leading to more business investment, new jobs and finally consumer spending. He said he has 100% confidence in the Fed’s ability to control inflation (no one should ever be 100% confident in anything other than death and taxes) and “the Fed could raise interest rates in 15 minutes.” Even in the wild times of the early 80′s the Fed never raised rates in 15 minute increments but I’m sure he was trying to make a point about Fed inflation fighting tactics. After carefully analyzing his facial expressions for each answer he was most nervous (and twitching) when commenting on his confidence level and the lack of money supply growth. His most prescient comment was that it takes 2.5% annual economic growth to “keep UN-employment stable” which under normal circumstances would send chills up every investor since the economy is unlikely to hit that target this year. But the sheep are running towards the finish line wearing blinkers as year end is only a few weeks away and for many its full speed ahead with maximum risk to stay ahead of the S&P.

Following the money

The Fed’s weekly h.8 report released Friday showed banks increased their cash assets $170.4 billion in the week ended November 24 (before the latest stock rally) while their holdings of Treasury and agency securities rose on $4.3 billion. ($3.5 billion was technical adjustment) Trading assets fell $13.5 billion as banks appear to be darting in and out of the US stock market as fast as the sheep (hedge funds) with a goal of minimal positions at month end. These numbers are often subject to massive revisions and can be very volatile and should be analyzed over a 4 week period to smooth the fluctuations. Using last week’s numbers banks have been using the new money (created by the Fed for Treasury purchases) to add to existing cash positions. If this trend continues the monetary base will stay flat and the Fed will have to create another stimulus plan. For now hedge funds are trying to jump on the equity train to the land of endless profits with little regard to what happens if someone wishes to exit before the final destination. It’s similar to the mortgage business a few years ago when everyone focused on today hoping someone would ring a bell before the storm arrived. If someone did ring a bell few heard it and no one really cared until it was too late….

Interest rates

Technically the Treasury market is a mess with everyone selling to the Fed (they bought $6.81 billion 3-4 year paper on Friday) and moving the $$ to cash or equities. Only 31% of traders were betting on lower rates at Friday’s close and with three auctions this week (3yr.,10 yr. and 30 yr) the shorts are accumulating large positions sure they will cover at auction time with large profits. The repo rate on the 10 year was MINUS 0.05% on Friday while both the 3 yr. and 10 yr. were 0.10% while the general collateral rate was 0.25%. We have the potential for a massive short squeeze (especially with the 30 yr.) if rates rise into the auctions and the repo rates stay near or below zero. I’m sure the Fed is watching closely and wouldn’t mind sending the bears running for cover later this week with large losses and forcing them to cover much lower rates. Just wondering but could the Fed buy at this week’s auction making it difficult if not impossible for the shorts to cover? It’s a bet that could have a sizable reward with limited risk IF the above conditions are met later in the week.

Before entering any investment, everyone should consult with their own investment professional and discuss the risk of possible loss of capital.