Confusion In Fed Fantasy Land


Triangle Breakout Failure?

The stock market’s initial reaction to the FOMC announcement was interesting, to say the least. After receiving the umpteenth excuse as to why rates can still not be raised, coupled with a promise that they eventually will be, the market initially rallied on Thursday. And why wouldn’t it? More free money is good for stocks, right?



The Eccles Building, home of the FOMC – Meetings

Photo credit: AgnosticPreachersKid



The rally only lasted for one hour though. In the final hour of trading, the market sold off and closed in negative territory. On Friday, the sell-off intensified somewhat. By Friday’s close, the SPX had lost more than 60 points from its Thursday intra-day high, a sizable chunk over such a brief time period. Below is a chart showing the triangle from which it initially broke out to the upside (ahead of the announcement) and a Fibonacci grid – resistance was encountered right between the traditional 50% and 61.8% retracement levels.


SPX fibo gridS&P 500 Index, daily: the breakout from the triangle seems to have failed – click to enlarge.


As we are writing these words on Monday, the index is rallying again from the apex of the triangle to which it had returned as of Friday. So one cannot be certain yet that the breakout attempt will really turn out to be a failure – a clear break below the apex would however strongly indicate that a retest of the August lows was likely in the cards (at a minimum).


A Case of Cognitive Dissonance

Anyway, we have tried to come up with an explanation to the market’s sudden reassessment of the FOMC announcement. What is driving market psychology at the moment? One obvious point is technical: When major indexes return to the vicinity of a previously broken support level, some selling pressure will tend to emerge from traders/investors who were caught by surprise when the break below support originally occurred.

In terms of the content of the FOMC announcement, we may have evidence of a sort of communication breakdown (i.e., the official propaganda line is no longer accepted without question). On the one hand, the excuse given for delaying the rate hike was utterly laughable. Something happened in China? The Fed isn’t the PBoC. There was “market volatility”? Are the Fed’s rate decisions now influenced by every 10% correction in the stock market that happens to come along? If that is the case, there will never need to be a rate hike again.

On the other hand, the delay also makes the constant refrain about how copacetic everything is in the US economy ring ever more hollow. The reality is that important leading economic indicators (such as ISM data, Fed district surveys of manufacturers, industrial production, inventory to sales ratios, gross output data, capex ex-defense, etc.) are for the most part beginning to look worryingly weak and have regularly come in well below expectations in recent months.

So when the Fed stresses in its statement and its members intone in subsequent press conferences and/or public speeches how great everything is and that therefore, the rate hike must merely be regarded as postponed for a little while, it creates an impression of cognitive dissonance. We must stress here that we have no idea what the Fed “should” be doing – we really don’t care, as no-one can possibly know (least of all the “committee” of monetary bureaucrats). As we always point out, this could only be known if it were actually possible for central planning to improve on market outcomes, and that is simply not the case.

Still, the following questions have likely occurred to market participants: 1. is the Fed once again not hiking because it actually knows the economy is in trouble and is just not prepared to admit to this fact publicly? 2. is the Fed actually unaware of how weak the leading indicators look and therefore prone to hike rates right into a slowdown because it is focusing on unimportant data? The possible answers to either of these questions cannot make one feel very comfortable about buying into one of the most overvalued markets of all time – a market that is entirely dependent on continued monetary inflation (regardless of whether it is perpetrated by the central bank directly or the commercial banking system) and needs the economy at least to “muddle through” – lest all the debt corporations have amassed for financial engineering purposes come crashing down.

As to “irrelevant data”, no economic forecaster can possibly care about labor market data, except perhaps as a contrary indicator (for instance, as Lee Adler keeps reminding us, “blow-off-like” drops in initial unemployment claims to record low levels historically have a habit of occurring shortly before recessions begin). There is obviously little mileage in watching a lagging indicator in order to get clues about the future. And yet, given its absurd “dual mandate”, the Fed is widely held to have a special focus on these data – which it actually confirms in its statements.


Unemployment claimsWhen initial unemployment claims reach extreme lows or highs, they tend to become a contrary indicator – click to enlarge.


The other focus is the Fed’s equally bizarre effort to debase the purchasing power of the dollar in terms of consumer goods by 2% per year. No theoretical or empirical justification for this policy exists. However, what is (or at least should be) known about this policy, is that it was the main driver of several of the biggest economic catastrophes of the past century, including the Great Depression.

It is easy to explain why: whenever large productivity increases are putting pressure on the prices of final goods, “stable money” (i.e., debasement by 2% p.a. in this case) can only be achieved by massively expanding the supply of money and credit. The result are bubbles in financial assets, price distortions throughout the economy and consequently capital malinvestment on a grand scale. This feels good for a while, as it is associated with boom conditions – but every boom is really a capital consumption orgy. Most of the accounting gains this produces will turn out to be ephemeral and will be wiped out in the inevitable bust. The often long duration or great extent of a boom is not helpful in this respect: as a rule, the bigger the boom, the bigger the bust will be.



Forecasting stock market moves in the near term is always a bit akin to flipping a coin, but we have a feeling that one should (at least) expect the August lows to be tested at some point. The bullish camp does have one thing in its favor, and that is the fact that short term sentiment has turned quite bearish considering we have only seen a routine-sized correction so far (we have discussed the indicators as they pertain to different time frames previously – the longer term ones all remain in “red alert” territory).

On the other hand, one should keep in mind that the very same short term sentiment indicators haven’t keep the market from rising when they were hitting bullish extremes previously – which we believe is probably a sign that retail participation in the market has declined sharply (the less retail participation, the more likely it is that short term bullish or bearish sentiment data are not necessarily contrary indicators). What is undeniable is that market internals – a measure of overall risk appetite – continue to look very weak.

The Federal Reserve meanwhile (and the same holds to varying degrees for other central banks) is in danger of losing whatever “credibility” it has left in light of the bewildering discrepancy between reality (the shared continuum we all inhabit) and its statements and the growing impression that an ever bigger gap is opening up between its actions (or rather non-actions) and its promises and economic assessments.

We always point out that they are clueless – not out of malice, but primarily because they are clueless. It cannot be otherwise and has nothing to do with the persons on the committee, their personal commitment, education, or intelligence. In stark contrast to the “stable money” doctrine pursued by central banks, this is something that can be proved theoretically and shown empirically.

From a financial market psychology standpoint it is however very important that central bankers don’t appear clueless. A majority of market participants needs to be able to suspend disbelief to an sufficient extent, i.e., they must be able to share in the collective hallucination that central bankers actually do know what they are doing. When it is no longer possible to maintain this facade, many things are likely to be suddenly questioned – and among these is the question whether it makes sense to remain exposed to yet another gargantuan asset bubble.


Charts by: StockCharts