How The Markets Can Keep The Fed On Hold

by: Kevin Flynn, CFA

The markets may have done a good job of shooting themselves in the foot yesterday. The three prime drivers behind the big market rally yesterday - biggest of the year, actually, but as usual, on low volume - were 1) talk that the Fed is getting more stimulus ready (pre-market); 2) talk that the Fed is getting more stimulus ready (this time just before the close; 3) the observation that short interest on the NYSE was at a two-month high, making the maximum pain trade upward.

There were a couple of other idiocies thrown in: the ECB didn't cut rates, leaving the door open to a rate cut in July (that one should be working every month, when you think about it). Wisconsin Governor Walker won his recall election, cheering Wall Street hopes for a Romney victory in November (Obama leads Romney in the state by even percentage points). The euro rose against the dollar, because the ECB didn't cut rates and the Fed said it would (that euro rally may go down in history as the calm before the storm)

We would put the oversold-plus-short-squeeze factor at about half the rally, maybe sixty percent, with the stimulus chatter being the spark needed to set it off. There's just one problem with that angle - a rising stock market is about the last thing that is going to make the Fed want to ease. A few more percent from yesterday's 2%-plus action, and markets will be up around 5% on the year come the next Fed statement two weeks from now. Keep dreaming if you think that's going to encourage stimulus. Rather, it'll encourage the Fed to keep doing nothing more than saying it stands ready to do more.

One strategist pointed out that bad news will be good news going into the Fed meeting. He's got a point, because while most traders dismissed yesterday as just another oversold reflex, some are seeing a parlay. To wit, if the Greeks vote in an anti-bailout party the weekend before the next FOMC meeting, the Fed will step in and ease. If there is any more bad news this month - and retail sales don't look promising - the Fed will step in and ease. If the market goes up and the Fed doesn't step in, it's only because the market rose enough. Ergo, all roads lead to buy today, worry later.

It gets better. Markets also rallied on the ISM non-manufacturing survey being slightly better than expected. However, in both the manufacturing survey last week and the services version yesterday, prices dropped sharply into decline territory. Prices happen to be the most sensitive leading indicator. In fact, without seasonal adjustments, both reports would have shown headline declines. Remember how precipitously they fell last summer? Responder comments were indeed broadly favorable in manufacturing, though not so much in the services version. Still, the overall indicators for both surveys were around the 53 level, and one can prosper for a long time with a steady diet of 53 readings.

What about the jobs report? We dissected it here, and found it better than it looked. We would hope that the Fed staff picked up some of the essentials we did. The biggest threat to the next Fed meeting - or if you like, motivation for more stimulus - besides the Greek election and some potential accompanying drama, is retail sales next Tuesday. The weekly reports weren't encouraging and it looks to us like a decline (ex-auto) could be in store. That's good, you know. Or at least it is this week. So was the Beige Book, which said optimism "was more guarded." Another damning factor that supports more stimulus.

If only we could get May housing data next week (weekly purchase application data from mortgage brokers imply a decline), instead of that stupid April data. With housing and retail down, all we would need is a weakish high-profile jobs story to lock up QE-3.

We wrote last week that any whiff of European action, or American easing, would provoke a violent reaction. It wasn't that hard to figure out. We could still get some more upside volatility, partly because floor traders didn't seem to much believe in yesterday's move, keeping the direction of the pain trade up, maybe all the way through Friday. You should expect more stories about a Spanish rescue to move things along.

But the European recession is deepening, and is going to get worse before any agreement can arrest the downslide. German is talking about more fiscal union, but it wants more control as a pre-condition. Trouble is, by the time all the paperwork got done giving the Bundesbank - er, ECB - veto power over other state budgets, the EU would probably be a relic of history. Unless, of course, a massive crisis intervenes first and forces action. So maybe the real parlay is rotten data this month and a major confrontation in the old continent. Now there's a rally we could sell with conviction.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.