The Fed's Chessboard

 |  Includes: DIA, QQQ, SPY
by: Kevin Flynn, CFA


The state of the economy.

The state of what the Fed thinks about the economy.

How it matters to the markets.

Alcoa (NYSE:AA) kicks off the first-quarter earnings season next Tuesday, though it doesn't really get underway until the week after next, JP Morgan's (NYSE:JPM) end-of-week release notwithstanding. The stock market, though, hasn't really been about earnings and won't be this quarter either, despite what perma-bull equity fund managers may avow on television. The bar has already been set to below 0% for growth, so one may expect the usual game of "two-thirds of companies are beating estimates, Joe!"

The first quarter rally is sacred and should come off on schedule, but the odds are against it getting underway next week. The market is creeping into oversold territory and will probably get there on Friday's jobs report. I've no idea what the latter will report, but I do know that the market is almost certain to rally regardless. It might also get juiced if the European Central Bank (ECB) makes a move on Thursday, though I suspect that it will wait at least until May before unfurling anything new.

A big jobs number would validate the transient-winter hypothesis, a low number validates the taper-the-taper hypothesis, and everything in between ought to be good for about 40 basis points on the S&P 500. If it hits the ADP initial estimate of 195,000, I expect we'll hear about what a great number it is and how it's a harbinger of 250K in April and 300K in May. Some were calling this week for a number in that range on Friday.

Anything less than a perfect jobs number - and I'm not sure what that is, nor do I think the market is, not yet anyway - will then probably turn into a week of net selling, or "backing and filling" as traders like to call it. Then we'll get our first-quarter rally, but the real background is the chess match between the Fed and the markets, with both of them studying the incoming economic data as a kind of guide to winning moves. Neither of them really know what those are yet.

I was amused to see stories late Monday night about Asian stocks rising on supposedly upbeat economic news in the U.S. Both the March Chicago PMI and construction data for February were weaker than expected, though the former was fine and the latter in line with recent trends (definitely off to a good start the first two months, but the 12-month running total isn't doing much). What really mattered was Fed chief Janet Yellen's speech, in which she reiterated the Fed's " overall commitment to maintain extraordinary support for the recovery for some time to come." What the stock market heard was, "We've still got your back." Or as uber-bull Jack Bouroudjian put it, the "most dovish speech ever" by a Fed chair (Jack isn't known for ever understating a bull case).

The Fed has several pieces on the board in a game it isn't really familiar with. Late in the fourth quarter, it found itself armed with a 4.1% estimate of third quarter growth, a 200K print for the November jobs report, a big drop in the unemployment rate from 7.3% to 7.0%, and a set of bonny projections from its staff about growth the next two years: 3.0% real GDP in 2014, and 3.2% the year after.

Never mind that the FOMC staff has been consistently over-optimistic in its projections for years, or that the economy hasn't reached 3% real GDP since 2005. Like its corporate brethren, the staff issues optimistic projections at the beginning of the year and then revises them downward in the second half. The latest data set looked good, putting the spotlight on another piece on the Fed's board - a balance sheet approaching $4 trillion threatening to link up with a possibly accelerating economy. Thus the birth of the taper was finally announced at the December meeting.

As we all know, the winter of 2013-2014 has been a difficult one in much of the country. The assertions of 3.7% second-half growth fell by the wayside as the data came in and dropped the fourth-quarter growth rate to below 3% (currently 2.6%) and lowered first-quarter estimates below 2%. By the middle of the quarter just ended, economists were talking about an inventory payback instead of escape velocity, and two disappointing jobs reports in a row had given the central bank some pause: Yellen herself admitted to an excess of year-end bank optimism at her first press conference in March.

It is a fuzzy situation. Data in regions not afflicted by the weather hasn't been especially strong either - but some of that could be a spillover effect. I had the sense in late December that some Fed governors had grown increasingly concerned about asset price inflation and all of their hard work being undone a year later by some silly overextended stock market again. Though you will never witness a Fed governor be so stupidly foolish as to say either that something is in a bubble or that the bank can identify them, they are allowed to drop discreet hints that they think about it.

One dull quarter later, though, and things have changed. Not only did Chair Yellen's Monday speech draw a line in the sand around the Fed's employment mandate, it was clear that she was also reminding all that the Fed will wait to see where the ball is lying before choosing its club. In its own words, it will be data dependent (if you've never played golf before - the bank isn't sure what to expect either). That was given further affirmation Wednesday by Richard Lockhart's comments that the bank still wants to stop growing its balance sheet (what if the economy really does expand?) but might put off raising rates for another half-year or so (because it doesn't look much like it now).

Many are convinced that the economy will, must, cannot avoid taking off in the second half (it used to be the second quarter, but you know how these things go). Even Mohammed El-Erian, coiner of the very term "new normal," has been on the 3%-plus side. On the other hand, the data isn't really reflecting it. I probably do more raw data analysis than any of the Fed governors, because I don't have to manage huge organizations and run around giving speeches and fine-tuning policy perceptions. The things I crunch keep turning out the same message - nothing is really changing. Some sectors go up as others go down, and not every quarter is the same speed when it comes to buying and selling, but the big picture just doesn't seem to change - yet neither does the market's excitement over meaningless estimate "beats," or one-month squiggles in the data.

Personal income was up 0.3% in February (seasonally adjusted). Nice, but - the February year-on-year rate went from 3.0% in February 2013 to 3.07% in February 2014. The ISM manufacturing number was positive again, but manufacturing wages and salaries fell for the third month in a row in March. I'm sure they'll bounce back up again, but it's not as if the sector has been on fire. Construction data shows a nice pickup for the first two months of this year versus last, but twelve-month data point a picture much like the one in business capital spending - the growth rate has been slowing for over a year and some feel that the market still has an overhang.

This data matters more to the Fed than it does to the markets. Stocks are still besotted with the concept of stimulus, whether it's the Chinese, European, or US market. In our own country, few investing professionals - or even the Fed itself - seem to believe that quantitative easing is having any impact on anything but asset prices, not anymore. What matters is "TINA," or There Isn't Any Alternative, and the attitude that even if you don't believe it, the trading programs do.

Yet the Fed needs to know if the economy is really getting stronger before it can maintain its attempt to finesse the hand off from the bank pumping out money to the economy doing the job. Both of them pumping at once has always been a disaster in the past. But if the economy is still stuck somewhere in new-normal land, it's vulnerable to disruption, and if it's vulnerable to disruption, the best weapon the Fed has left is to drop hints about "tapering the taper," or even - a mighty step indeed - hitting the pause button.

Some have been scornful of late that the bank simply doesn't know what it's doing - and that's true to an extent. It's not as if the governors have no plans, but the bank has never before had a balance sheet like the one it has now. It has no experience in this end game, no classic matches to study.

Officially the bank maintains its required minimum level of optimism, but it can't seem to let go of point-to-point anxiety either, a bit of attempted fine-tuning that I have never known to work without coming to grief in the end. I don't know what the governors think when one of them sees a trader like Bouroudjian enthuse simultaneously over how great earnings are and how dovish the Fed has to stay anyway, but they must wonder at times how long such magic can go on. I know I do.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have a short position in the Russell 2000