Placebo QE3: Did The Fed Change the Market Tone?

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 |  Includes: DIA, FXF, GLD, QQQ, SPY, TLT, UDN
by: Mercenary Trader

by Jack Sparrow

On Tuesday’s Fed announcement at 2:15 EST, markets cratered. S&P futures dropped 30 handles in less than 30 minutes, carving out new lows on the day.

Then, major reversal of the reversal. Explosive move higher to overcome Monday’s losses.

The initial market response was vintage Bill Paxton from Aliens. “No QE3? Game over man!

Then the change of heart. “Wait a minute. This isn’t so bad…” Hey Mikey! I think he likes it!

To recap the gist:

The Federal Reserve pledged for the first time to keep its benchmark interest rate at a record low at least through mid-2013 to revive a recovery that’s “considerably slower” than anticipated.

The Federal Open Market Committee is “prepared to employ” additional tools to bolster an economy hobbled by weak hiring and anemic household spending, it said in a statement today in Washington.

Three members of the committee dissented, preferring to maintain a previous pledge to keep rates low for an “extended period” without a specific timeframe.

- Bloomberg, Fed to keep rates at record lows through 2013

No melt-your-eyeballs stimulus announcement, but that would have smelled like desperate measures anyway.

Instead, on electing to roar higher into the close, Mr. Market seemed to hear something like this:

Relax pal — don’t you know your old Uncle Ben will take care of you? Corporate profits are still okay… inflation has evaporated along with the commodity rout (notice the price of oil)… we’ve still got the extraordinary measures option “prepared to employ,” i.e. QE3 right here in our back pocket… and we’re going to keep ZIRP rolling for another two years, brother! Two years! We’re gonna push all those grandmas out on the curve. No more safe assets, nowhere to hide… nowhere for yield except stocks…

In effect, a psychological sea change interpretation could run like this:

  • In promising zero rates for two years, the Fed underscored the economy looks horrible — but the market knew that anyway, so no biggie.
  • While not promising QE3, the “prepared to employ” language had a sort of echo-effect psychology boost. Call it “Placebo QE3.”
  • The historic three dissenters may have even boosted the impact. (Dissent implies action to be upset about.)

Other factors to keep in mind are weak hands, max pain, and signs of safe haven blowoff.

Weak Hands: The bulk of long side investors who practice some discipline of stop loss usage or positional risk control were taken out in this vicious down move (barring precious metals holdings). In fact, many long side investors who don’t utilize risk management got taken out anyway by margin calls and panic. When you wash out the weak hands, it’s the strong hands who are left. Anyone who wasn’t a seller by Monday’s close may be hard to dislodge.

Max Pain: There is an old adage that the market seeks to inflict the maximum amount of pain possible. So what would hurt the most now? A further decline justifying all those who sold out and stepped to the sidelines? Or a wicked retrace to, say, 200 day EMA levels (1272 for the S&P) that leaves everyone, bulls and bears alike, scrambling and confused?

Signs of Safe Haven Blowoff: Prior to the Fed announcement, the Swiss franc saw its biggest intraday move since 1971. USDCHF (the $USD / Swiss Franc forex pair) looks like a runaway train. Meanwhile, gold is threatening to go parabolic. And long bonds (as shown below, click to enlarge, via weekly TLT chart) saw a potentially significant intraday reversal on Tuesday after touching 12-month highs.

Click to enlarge

So what next? Much of it comes down to the kind of world we get.

In a low-inflation world where all kinds of bad mojo is happening — debt ceiling showdowns, deflationary threats, existential crisis in Europe and the like — you probably want to be in the safe stuff, like bonds, Swiss francs, and gold.

But in a low-inflation world where the struggling classes continue to be ignored, corporate profits roll on, the powers that be keep their crap together (barely), and the world mostly muddles through with zero rates as far as the eye can see, you may still want to own… stocks.

Just sayin’ is all.

Disclosure: As active traders, authors may have positions long or short in any securities mentioned. Full disclaimer can be found here.