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Evan Schnidman
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Evan holds a Ph.D. from Harvard University as well as Bachelors and Masters Degrees from Washington University in St. Louis. He is the founder and CEO of Fed Playbook LLC. Evan’s financial research has been featured in Bloomberg News and his academic research has been published in journals and... More
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  • Strap In For A Crazy Week 0 comments
    Jul 31, 2012 12:26 AM

    Since the original version did not get posted as quickly as I'd hoped I decided to post this on the blog so it could provide some guidance on the coming volatility this week...

    Markets are often particularly volatile the week of an FOMC meeting and this week will be no exception. Add on the meeting that is going to take place between ECB President Mario Draghi and Bundesbank head Jens Weidmann ahead of the ECB meeting later this week, and you are set up for extreme volatility. Muddying the waters further will also be the massive data dump this week including the Case-Schiller index, ADP employment report, ISM manufacturing numbers, initial jobless claims, and the employment situation report. So, what should we expect from the equities markets?

    The data releases are only going to add to the volatility we have seen in the last week as earnings reports have been made public. The data is likely to be mixed with some indicators like employment and manufacturing noting weak growth, and real estate data probably looking a bit better. These contradictory indicators about the strength of the recovery will make it hard for the markets to jump in one direction or the other without some other unifying theme. This is where the central banks come in.

    The Fed is unlikely to announce QE3, but that doesn't mean they will necessarily sit on their hands either. As I have noted in recent articles, the Fed has options. They can initiate a new largely symbolic transparency measure that will satisfy few, but still signal the Fed is striving to provide better information to the public. This will not sit well with markets, but will likely put less downward pressure on equities than doing nothing new and relying only on the June decision to extend Twist.

    The other Fed options are more proactive and include different ways to induce banks to lend more freely and hold smaller cash reserves. One option is based on the Bank of England's "Funding for Lending" program and the second is a simple rate cut paid by the Fed to banks on their reserves. Both of these programs have strengths and weaknesses, but should be seen by markets as broadly stimulative. So, once market actors get past the initial drop from no announcement of QE3, most investors should see these options in a positive light and equities (except financials) should move higher. Unfortunately, we don't know exactly which of these four options the Fed might do and we still have another player moving markets this week.

    The news of the European front is going to be at least as important as the Fed decision this week. While the ultimate driver will be what the ECB decides on Thursday, the early-week meeting between Draghi and Weidmann may be a big signal to the markets as well. Last week Draghi made some bold pronouncements about big steps coming from the ECB to further stabilize Europe, but it is completely unclear how he can back up those words without German support. The trouble is that Germany has previously refused the exact type of ECB bond purchases Draghi seems to be pushing. If Weidmann makes it clear that Germany has not changed their position, European instability will cause the Euro and equity markets to plummet and we may even see further flight into U.S. treasuries. Should Germany reverse their position and sign off on an ECB bond buying program, the value of the Euro will rise and equities markets will rise. Again, we don't know exactly which way this will go, so keeping a close eye on the news is crucial.

    The Most Likely Scenario

    Given the data dump and central bank actions this week, I see a couple of the scenarios outlined above as significantly more likely than others. Any of the prognostication provided here can be superseded by a shock in one (or several) of the pieces of data released this week, but given the information presently at hand, this is how I see the week broadly playing out:

    1. Monday was quiet with some downside to the dollar, just as expected.
    2. Tuesday we will see indications of a cordial but not productive meeting between Draghi and Weidmann (no date has been released for this meeting, so I am speculating on which day it will occur). Markets will read this as diminished chances of substantive ECB action and barring the release of significantly positive data, the Euro and markets will decline.
    3. Wednesday will be dominated by the FOMC news so markets will be biding time until the 2PM hour, unless a shock comes through in any morning data release. The Fed will not announce QE3 thus prompting an initial market drop. However, the Fed will announce a new program to promote lending and free up the capital they have already injected into the market. Once the market understands this, equities will rise but depending on the structure of the new program financial stocks may decline.
    4. Thursday will not be a hangover from the party on Wednesday afternoon, but a hectic mess interpreting the ECB's actions. The ECB (and Draghi) will try to save face by announcing a weak new bond buying program that lacks full German support for buying Spanish debt. This will allow markets to rise slightly on an anemic signal of European action, but the rally will be short-lived and investors will begin looking to the newly released data.
    5. Friday may be the first chance to really digest new central bank programs and an enormous amount of data this week. I suspect we'll see stocks returning to closer to their true values as the macro movers are not going to be pulling the weak up or pushing the strong down.
    Themes: Economy
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