Fed Has Economic, Political Cover To Launch Bullish QE3

Includes: FXE, SPY, UUP
by: Chris Ciovacco

According to the 1977 amendment to the Federal Reserve Act, the Fed has a dual mandate to keep inflation in check and produce "maximum employment." The Fed now has three months of weak job creation numbers in hand. Last month, the economy created 80,000 jobs. The two prior months saw tepid gains of 77,000 and 68,000 jobs. To bring down the unemployment rate, the economy needs to create at least 250,000 jobs per month. Obviously, the reports from the last three months are nowhere near 250,000, giving the Fed more cover to announce a third round of quantitative easing (QE3).

In recent months, the Fed has been reluctant to move, fearing QE3 would be seen as being politically motivated to assist in the Obama re-election bid. Given the weak employment data over the last three months, the argument can now be made that continued inaction by the Fed could be seen as being politically motivated to assist Mitt Romney's run for the White House. You can bet the "why is the Fed not acting" rhetoric is going to pick up in the coming days and weeks. The odds are also favorable Wall Street will begin to anticipate QE3, which may put a floor under asset prices once the initial wave of post-employment report selling runs its course.

Another source of pressure on the Fed will come from other central banks around the globe. The European Central Bank (ECB) lowered interest rates this week. The Bank of England announced additional bond purchases. China lowered interest rates. The Fed will be expected to fall in line and "do their part."

Rather than view the markets with any particular political bias, our job is to evaluate and manage risk. Part of risk management involves evaluating possible future outcomes relative to central banks. After another round of lousy job creation stats, we believe the pressure will increase significantly on the Fed to take action.

There are no scheduled speeches by Fed governors in the coming week. We will be watching the pages of the Wall Street Journal (WSJ) for possible "Fed-feeler" articles. The Fed often uses the WSJ to gauge the market's reaction to possible policy changes. We are not predicting an impending announcement of QE3, but there is no question the heat has been turned up on the Fed's pressure cooker.

The currency markets may be foreshadowing an announcement of QE3. Since QE involves printing additional U.S. dollars, Fed action would be bearish for the dollar and bullish for the euro. On Friday, we noted bullish divergences in the euro (FXE), which align with the expectation of future U.S. dollar weakness. As shown on the weekly chart of the U.S. dollar below, buyers are having second thoughts about holding greenbacks before the Fed's July meeting. The dollar has a negative divergence with a widely-used technical indicator. A negative or bearish divergence occurs when price makes a higher high and an indicator makes a lower high. The divergence can be seen by comparing the slopes of lines A and B in the chart below.

Divergences can appear on charts early in a topping process, meaning even if the dollar eventually falls, it may experience more gains in the short-term. The divergences above are "pay attention" signals rather than sell signals. The dollar ETF (UUP) closed Friday at 22.95. A push toward 23.43 is reasonable and may act as resistance. A bearish divergence in the dollar increases the odds of another leg higher in stocks.

On Thursday evening, we noted that below 1,375 on the S&P 500 (SPY), the short-term risk-reward profile told us to be patient since a better entry point may come somewhere between 1,363 and 1,330. We also noted Thursday's close was weak with indicators making lower highs, which showed waning bullish interest in the very short-term. The chart below is as of noon Friday. It shows Fibonacci retracements levels based on the June low and recent high. Retracement levels are used by traders to help determine where buyers may become interested (a.k.a. support). The lower blue trendline shows a clearly established uptrend off the June low. We will treat the current pullback as a buying opportunity as long as the retracement levels shown below hold. We would prefer to see the S&P 500 hold near 1,330, but a move to 1,308 would not be atypical for a healthy uptrend.

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