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Equity markets spent the day consolidating the gains of the past two days. All major equity indices reached new highs above yesterday’s highs, but could not hold that level. Treasury bonds got a slight bid after yesterday’s decimation. The dollar continued its downward slide with oil ramping up in sympathy. Risk appetite continued to be high with the small cap Russell2000 putting up the best performance.

Pending Home Sales Surprise: How Many Will Close?

The market got a shot as the pending home sales released by NAR beat expectations.

According to the WSJ:

The National Association of Realtors said pending sales of existing homes in April rose 6.7% -- the biggest monthly jump in eight years. The data built on a flurry of other recent reports suggesting that the housing market and the broader economy are stabilizing.

The good news about the economy keeps on rolling in providing fuel to the rally. However this particular headline might turn out to be the most misleading.

Two must-read articles discuss the consequences of higher mortgage rates and their impact on the retail mortgage market the day after. Over the past few weeks, mortgage rates have spiked up. Though many prospective buyers would have locked their rates, a lot of others may not have been able to.

The jump in mortgage refinance applications over the past two months has created a jam in the mortgage processing pipeline. As a result, many mortgage originators were unable to process the applications, especially refinance applications, in time for them to make the rate lock (which they do by hedging their interest rate risk). So if this spike in mortgage rates does not recede, at least some of the current contracts may not close, due to the lack of mortgage credit at the right rate.

Market Sentiment Driven by Fear: The Fear of Being Left Out

Right now the market sentiment is being driven by fear: the fear of being left out. This is a strange phenomenon, since typically the fear is of buying too high, only to see the market fall. This is one of the pitfalls of bear market rallies since even though portfolio managers are not convinced about the underlying fundamentals of the economy they are forced to participate since they are paid to be in the market.

The rally is being driven by optimism about future recovery and is fueled by excess liquidity which has been pumped into the system by central banks throughout the world. Though there is no doubt that things will get better, the market is perhaps over-estimating the extent of the recovery in the face of severe macro-economic challenges. However, bull markets have to climb a wall of worry, so unless proven wrong, the markets will continue to rally. However once it is proven wrong, the correction can be vicious.

The Anti-Dollar Trade

The anti-dollar trade continues to be strong with even the beleaguered Euro continuing to charge ahead taking out the 1.43 level yestertday. Oil continued to trade strong with the July contract trading as above $69 before pulling back.

Though there is a lot of talk about inflation due to the Fed’s monetary policy, there has been very little attention paid to the dynamics of how the Fed’s current policy will lead to inflation. There is a large supply of spare factory capacity and unemployed Americans to keep prices on the input side low. Though short term interest rates may remain low, longer term interest rates are likely to continue to be creep higher over time, as the bond market adjusts to the huge overhead of new treasury supply. Higher interest rates will put a cap on economic growth which could have driven inflation.

The Fed’s printing press is pumping money into the economy but so far that money has not translated to higher velocity of money. Most of the excess liquidity has gone to strengthen the balance sheets of banks allowing them to off-load assets to the Fed, cut their leverage, and raise their capital ratios. The new money being printed by the Fed is essentially filing in the gap created by the loss of wealth due to fall in asset prices.

This can change soon if the economy shows signs of a stronger recovery leading to loser lending standards. However, as of now, small businesses continue to be short of credit, and with tougher lending criterion becoming the norm, a return to the go-go days of the past is improbable.

Fed’s Silence does not Imply No Plan

Though the Fed has not yet outlined how it will reduce the amount of dollars in circulation that does not mean it does not have a plan. Till this crisis unfolded, no one thought that Bear Sterns would be bailed out using the Fed’s balance sheet, or the Treasury debt will be monetized using the Fed’s printing press.

The Fed is unable to outline its strategies at this point since those actions are likely going to drain liquidity from the market. From the economic sentiment point of view, any perception of tightening liquidity can become a big damper. They cannot afford to take that risk right now when the economic recovery is in a nascent state. However, once they see the economy finding a firm footing, and asset prices recovering, they will be more willing to lay out the plan.

The Fed has already stated that when it comes to hard to value assets, they plan to hold them to maturity, essentially taking out the liquidity as the loans are paid back, or taking losses if the default. Other assets with short to intermediate term maturities too can be dealt with in the same manner. This gradual removal of liquidity is unlikely to create a shock. The challenge of course will be securities with a longer term but those are not a dominant portion of their balance sheet.

The often cited comparisons with the Weimar Republic are very much out of context. The ability to measure economic activity has increased by orders of magnitude over the past century. Not only is the data more accurate, it is also available real-time, cutting the reaction time of the Fed. The Fed is acutely aware of the risks, and will be monitoring them aggressively; there is no reason to suspect that they are asleep at the wheel.

With savings rate creeping higher and asset prices down substantially, the talk of hyperinflation, in my opinion, is pre-mature. It is driven more by trading houses moving away from the equities into the rally in inflation sensitive instruments like commodities. This anti-dollar rally is not based on measured economic data.

From a trading perspective I do not see any point in fighting the group-think in the markets, except with quick counter-trend plays. However, I see a much higher risk in jumping in on the inflation band-wagon since it happens to be the flavor of the month. One look at oil prices last year should fix those thoughts.

Market Outlook

Yesterday, the SPX tested the 948-949 multiple times but was repelled. Though some may consider this market action as bearish, the fact that this is happening after a strong push over the past two days, means that the bullish sentiment is still very strong.

Others are referring to the relative underperformance of the Banking index (NYSEARCA:KBE) over the past few days. I presume that the market is reacting rationally to the pending new equity issuance from banks. However, banks have been leading this rally, so I will not be surprised if the weakness in that sector results in the market pulling-back to test the 200Day SMA from the upside. We are also approaching the release of market-moving economic data later this week, and traders are likely to book profits.

If the test is successful, which I expect it to be it will likely pull in a large amount of cash parked on the sideline. I plan to do some buying when the market retests the 200 day SMA. However, I will be hedging the positions with either puts or bearish ETFs till a clean break of the current level (the yearly high) occurs.

Source: Equities Consolidate While the Dollar Falls