Markets Send Mixed Messages Ahead of Fed Meeting

Stocks and bonds have been ignoring each other lately.

Some say stocks are rallying because investors are front running another Fed QE program while others feel stocks are moving higher because it's simply the path of least resistance, one that fast money accounts are following, presumably in the footsteps of corporate buybacks (corporate debt issuance huge right now!).

Regardless, bonds haven't sold off in size during this risk rally and mortgage rates, while off record lows, are still extremely aggressive. Possible explanations include the idea that investors are front running another Fed QE program. BIG PICTURE fundamentals also remain weak thanks to a broken link in distribution of wealth, deflationary pressures exist in the housing market and job creation is spotty. This has provided a consistent flight to safety bid for risk averse assets. 

The fact that we are pointing toward the same reasons as an explanation for the behavior of two different markets creates a lot of crosswinds and confusion though. Let's slow it down a bit and try and get to the root of the problem..

What are the main issues facing the market at the moment in regard to the FOMC announcement today?

1. How much has economic growth "decelerated"? (as mentioned in the Beige Book)
2. How worried is the Fed about "disinflation"?
   
3. Is the Fed ready to take new measures to promote economic recovery and price stability? Read "new measures" as more asset purchases/quantitative easing.

One thing we have working for us: we know the economy slowed over the summer. The housing market is stagnant and the jobs being created do not match the skill set supplied by workers in the labor force.Plus companies aren't spending on capital investments like they were before the August meeting. From that perspective, we should expect to hear more on "widespread deceleration" of economic growth. This would be supportive of low bond yields in the BIG PICTURE.

But we have to consider the shock that might spread if the Fed supplies no new verbiage on another QE program. Meaning, if the Fed fails to bring up more asset purchases, then knee jerk selling could lead rates higher in the near term.  On the other hand, if stocks have rallied on the premise of another QE program, then they too should sell on a lack of QE announcements, which would send $$$ back into bonds.

I don't believe stocks are rallying on that assumption though. Instead  I am in the camp that stocks are rallying because of a general lack of resistance. The pain trade played out in bonds and now fast money traders have latched onto portfolio managers who are chasing returns on the heels of equity buybacks.  That rally is still built of glass and I would expect further gains to draw out profit taking, which is when the short term bond market selloff would reverse course, likely before 2.85% in 10s. That is unless the Obama Administration concedes on extending the Bush tax cuts.

The first issue affects the second and the third. The more the Fed is worried about economic "deceleration", the more likely they are to act to promote an economic recovery and price stability. The second issue could be partially solved by the third.  If the Fed is really worried about disinflation, which we know they are based on Ben saying he would be OK with a higher level of inflation (currently below target) at Jackson Hole, then there is room for another QE program because printing more money could reignite inflationary fears which in turn could spark real inflation on its own.

Ugh. Confusion is abundant. Making matters worse, remember what we heard from the Board at the last FOMC meeting:

"To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. The Committee will continue to roll over the Federal Reserve's holdings of Treasury securities as they mature."

Plain and Simple: the Fed just announced a mini-QE program in August, which has kept a lid on sell offs in the bond market. Unfortunately this policy action was not intended to be a quantitative easing program. The announcement was taken the wrong way by markets. The Fed believes it needs to keep a certain amount of assets on its own balance sheet, view it has printing money.   This leaves me feeling like the Fed will likely mention widespread deceleration and continue communicate the following:

"The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability."

MY BIAS: no new QE program. Stocks and bonds sell after the 2:15 FOMC announcement. Knee jerk. I just don't see the FOMC doing something shocking ahead of mid-term elections.