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Surprising Reaction to Unsurprising Fed Report   April 28th, 2011
Markets paused, but then the trends spiked       


More observations...

The Federal Reserve yesterday said exactly what everyone was expecting it to say. There were no surprises. Yet most of the markets acted at least somewhat surprised.

Fed Chairman Bernanke, in his first post-Fed meeting press conference, did a good job articulating the Fed's position. He did a good job at responding to some pointed questions from reporters and he didn't, in my opinion, have any gaffes.

Market Reaction

Stocks didn't have much initial reaction to the FOMC written report that was released at 12:30ET, gaining only about 30 points over the next hour. They drifted only slightly higher until about 2:30ET, about when Fed Chairman Bernanke started answering questions. They then rallied about 60 points from there. It would appear that stocks were ready for the FOMC report but were cautious about anything Bernanke might say. Stocks staged a moderate rally when it was pretty clear Bernanke wasn't going to say something stupid. The DJIA hit highs not seen since May 2008.

Gold rallied from about $1510 to almost $1530 starting when the FOMC report was released at 12:30. It dropped just slightly before Bernanke started to speak, but then resumed its march upward once he started. Gold reached new all-time record highs.

The dollar took a beating immediately when when the FOMC report was released. Like gold, it went the other direction briefly just before Bernanke's press conference, but then started heading down. The dollar index hit new three-year lows.

The U.S. bond market yawned with virtually no significant change.

It appears that all markets had the same expectations but with differing degrees of confidence. The stock market expected the results but wouldn't commit to the "good news" of another two months of free money until it was clear that Bernanke wouldn't fumble his press conference. Both gold and the dollar seemed to have been more cautious, perhaps with just a little uncertainty as to whether the Fed might end QE2 earlier than June. Once it was clear that it wouldn't, they both continued on their respective trajectories. The bond market didn't seem to care, but with the Federal Reserve as the largest current player in that market that's not entirely surprising.

Diminishing Retutrns

The markets all agreed with each other on what the Fed was going to say, and they all moved in the logical directions once it had been said.

Having said that, the stock markets didn't move up all that much considering this was confirmation of the remaining QE2 juice. This might be confirmation of what Bernanke said at one point during the press conference: More monetary stimulation probably will reach the point of diminishing returns. As such, the news that QE2 would continue until completion didn't really do all that much for the stock market--especially considering it was already expected.

Post-QE2 Market Disruption

Answering a question about the possible reaction on markets when QE2 ends in June, Bernanke stated that he didn't expect major market disruptions. He stated that the plan has been well-communicated so markets should already have priced that in.

I would disagree with that. The markets already knew what the Fed was going to say today with virtual certainty, yet there were some significant moves in the markets after the news was "confirmed."

Given the Fed's reduction in estimates for economic activity, it's more likely today that QE2 will be extended (or QE3 will eventually be rolled out) than it was yesterday. If economic news continues to be discouraging, the possibility of QE3 will only increase.

If markets can do what they did Wednesday upon receiving confirmation of what they already knew, I'm not at all certain they'll be immune to reacting to the confirmed end of QE2.

Oil Supply

One thing that Bernanke said that I consider outright false was his comments that the rising price of oil is responding to the laws of supply and demand. He blamed Middle East conflict for squeezing oil supplies.

However, neither of these statements was true.

As I wrote earlier this week, Saudi Arabia is actually cutting oil production because there was too much supply. Just today this was reiterated:

Oil traded near its lowest price in a week in New York amid speculation that rising U.S. inventories show demand is slowing in the world's biggest crude consumer...

'There is plenty of supply and enough spare capacity,' said Gerrit Zambo, an oil trader at Bayerische Landesbank, by phone from Munich today. An increase in crude stocks 'is of course one of the fundamental weak signs.'

So Bernanke's statement that prices are increasing due to insufficient supply don't hold much water.

Also, while it may be true that fear of a supply problem due to Middle East unrest may be impacting prices somewhat, it's not true that oil supply has been reduced by the conflicts. Not yet, anyway.

In any case, he said the Federal Reserve is expecting oil prices to stabilize or drop soon. We'll see.

Economic Outlook

Bernanke admitted that the Federal Reserve does see a lot of uncertainty in the economic situation. He said that, in his opinion, none of the government spending cuts he's seen would appear to make a significant difference in the near-term economy. And he also said that the Federal Reserve would monitor conditions, both the general health of the economy and inflation, and respond as needed (of course).

The economy isn't in very good shape, though. Yesterday the following news came out:

Wal-Mart: Our shoppers are 'running out of money'

Wal-Mart's core shoppers are running out of money much faster than a year ago due to rising gasoline prices, and the retail giant is worried, CEO Mike Duke said Wednesday...

Wal-Mart shoppers, many of whom live paycheck to paycheck, typically shop in bulk at the beginning of the month when their paychecks come in...

"Purchases are really dropping off by the end of the month even more than last year," Duke said. "This end-of-month [purchases] cycle is growing to be a concern.

That consumers are actually running out of money faster this year than last year is not at all encouraging. It suggests thinks are quite a bit worse than the Federal Reserve's assessment--which itself is less than ideal.

It also looks like the impact of the destruction in Japan may be larger than expected (though why anyone expected the impact to be other than large is somewhat strange):

Japan's economy had a greater hit from last month's disaster than anticipated, with factory output declining the most since at least the end of the U.S. occupation and the central bank slashing its growth forecast.

Factory output fell 15.3 percent from February, the biggest drop since data began in 1953, and household spending slid 8.5 percent from a year earlier, the government said today. The Bank of Japan cut its growth estimate for the year ending March 2012 to 0.6 percent from a January prediction of 1.6 percent.

That kind of deceleration in Japan's economy can't help but to impact the United States, including reducing the amount of money Japan can invest in U.S. debt. It's also interrupting supply chains that could have direct economic impact in the U.S. as domestic plants shut down for lack of parts.

And the first quarter is already looking pretty grim according to initial reports:

The economy grew at a 1.8 percent annual rate in the January-March quarter. That's the weakest showing since last spring when the European debt crisis reduced growth to 1.7 percent. Higher prices for oil and gas have constrained consumer spending.

Separately, the government also reported that more people applied for unemployment benefits for the first time last week. The increase, the second in three weeks, suggests that the job market remains sluggish.

QE3 Still Coming

Given that the first quarter was sluggish to the point of Wal-mart shoppers running out of money, unemployment claims are increasing, the shock from Japan mostly hasn't manifested itself in our economy, and the Fed's estimation of plenty of uncertainty in their forecast, it's probable that our current leaders (Obama and Bernanke) will conclude more stimulus is necessary. Obama must know that there's no chance of another fiscal stimulus getting through Congress, so this would once again fall on the Federal Reserve in the form of QE3.

I remain a contrarian to current market sentiment and to Bernanke's own statements. I believe that not only is it likely that QE3 is inevitable, the evidence in support of this view is actually mounting.

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