Zero Beta

Today’s Fed action along with the recent policy instituted by the Fed has caused many people believe that the Fed has been reactionary to the stock markets lately - its actions coinciding with major selloffs in stock markets. The most notable was its 75 bp surprise rate cut on January 22, 2008 - after global markets sold off on Martin Luther King Day. Many people believe that the Fed has been doing this as a way to bail out the markets, and the Fed has received a great deal of criticism for it.

I agree that the Fed is reacting to the markets almost exclusively lately and we have had as many “surprises” in the last 3 months than official Fed meetings. I do not believe the Fed is trying to bail out the markets, because the markets have shown over the past few months that they don’t believe that the Fed can do anything to help this situation. The fact that the market has sold off most short term rallies after Fed moves illustrates this. Nobody knows better than the Fed that what they have done thus far hasn’t helped, so I doubt they are trying to put a bottom in the market. The Fed also does not want to risk credibility unless it gets returns greater credibility in return. In reality, we have no idea what the Fed is exactly up to (and neither may they), but today I came up with an interesting thought.

It seems that the Fed is making its surprise policy announcements, at technical market junctures, possibly hoping that the short term Fed bounce could trigger a technical rally. Below is a chart of the past three surprise Fed announcements (click on it for a better image).

The 12/12/2007 TAF announcement happened the day after the market fell 2.5% through S&P 1480, which was a very big technical battlefield in the prior months. On 1/22/08, when the Fed announced its infamous 75bp rate cut, the market was at deeply oversold levels right around S&P 1310. This was a major technical level back in 2006, that the market blasted through during its rally the end of the 2006. Today’s announcement came under similar circumstances. Of note also, that on Friday, they announced a $100 billion repo injection at these same levels which was sold off.

Now, if you are like me and believe that the Fed isn’t trying to bail out speculators, then what is it trying to do with these surprise announcements?

The Fed could be trying to take the short term bounce that the market makes whenever the Fed announces a surprise liquidity injection in hopes that the market will turn it into a longer term rally, whereby the Fed regains some credibility from the markets simply through association with the event. They know how the markets work and if they could get the market to rally through a technical level, in a very volatile environment, than the market would take it from there.

Essentially they are trying to alleviate the the problem that was introduced with the Greenspan Put, along with Fed Fund Futures - that the Fed’s actions became much more easily priced into the stock market, to a point where the markets expect unreasonable Fed actions. Look at the Fed Funds Futures the last few weeks to see this. They were predicting 100bp rate cuts at a time when inflation is surging. The Fed is then forced either to adopt a policy that is much too inflationary, or disappoint the market ensuring that regardless of the long run impact of their policy, they are seen as “behind the curve”, thus undermining any future policy. It is a very precarious situation and a situation where any action they take causes them to lose credibility. Since credit is all about confidence, if the market in general has no confidence that the Fed is able to expand the money supply and fix a problem, then the Fed won’t be able to do so. The perception of the Fed by the market is the most important factor determining its eventual success.

So, while it may seem like a bit of a silly conspiracy theory to think that the Fed is trying to align its policy with technical market levels, the idea that the very survival of the Fed rests on how the market responds to Fed policy decisions is an important one. A Fed that is currently powerless, will try to grab power at moments that it is most opportune to do so. If the markets rally from here (and I mean a longer term actual rally, not a one day 400 point rally), they will associate the Fed with helping them get there. Would they have rallied if the Fed had not stepped in? Probably. Back January 22nd I was angry that the Fed made that announcement before the markets opened because I wanted to start to fish around in some of the Financials and other stocks. I’m sure I was not alone. The markets will engage in price discovery without the Fed backstopping it and the Fed can not affect the market in the long term unless its monetary policy is a success.

In our present situation, where there is an enormous lack of confidence, and the Fed is running out of arrows in its quiver, the Fed will try to buy confidence when confidence is cheap and buy as much as it can. Confidence is cheapest when markets are just at or below technical levels where there is the greatest probability that a Fed announcement could spark a short term rally that would trigger technical indicators on many trading programs, and force those who are short above a resistance to cover.

Today’s price action, along with the next week or so, should hold the key to what the Fed does at its next meeting and going forward. We blasted through S&P 1310, and should rally up towards 1400 where the next major resistance is. If we rally, expect the Fed to cut more than the market expects at the time, as it tries to further reestablish its credibility and confidence. If we fall back down, however, the Fed will most likely not be able to cut as much as the expectations, and that is where the danger lies.