F_O_M_C_ Wednesday

It's not easy or probably very useful to try to predict what the F_E_D / F_O_M_C might or might not due. The 12:15 announcement is one part of the equation, the Bernie presser at 2:15 is the second part of the equation. I watched the September 13th Bernie press conference and even though market's rallied sharply on the somewhat expected QE-3 policy statement (and rallied a bit more on the 14th before stalling), the market did hit an exact top all at the same time, in fact the same minute which where the highs of the day on the 13th precisely when Bernie was asked something about "How the F_E_D might change or tweak policy should QE3 stoke inflation"-at that very moment when Bernie answered, that very minute, the market topped for the day. What happened? The market realized all at once that QE3 (which is or will be printing of money and dilution of the dollar-it's ALWAYS INFLATIONARY) like QE2 and 1 before it, WILL be inflationary and the F_E_D is likely to adjust buying to keep inflation within their mandate.

There's no way that kind of money can be given to Primary Dealers like Goldman Sachs or the now defunct MF-Global and not see inflation. Tomorrow the F_O_M_C is expected to announce Treasury buying in addition to MBS which was already announced on 9/13, it has always been the POMO (Permanent Open Market Operations) that buy treasuries from Primary dealers that see that money flood in to the market, that's why for a while the motto was , "Just buy the dip", the market could not decline while these programs were underway until they came near their end; perhaps that's why QE-2 was left open-ended as QE2 saw the market start to decline in anticipation of the end of the event which was known in advance.

The mechanism of Treasury purchases...

I would assume MBS is somewhat the same, they are bought from the same banks for the most part. However in Treasury purchases in QE, the F_E_D cannot participate directly in Primary Treasury offerings like we saw today on a 3 year note auction (more to come on this). Like the ECB, the F_E_D cannot buy offerings of debt from the treasury so they have their minion do it for them, the Primary Dealers like Goldman, JP Morgan and other Wall Street investment banks. These banks would in some cases only hold the Treasuries for a week or two (no downside risk at all) and then they would be bought in open market operations by the F_E_D (this is the secondary market where the F_E_D can buy) and in almost all cases the PD's took on zero risk and made billions per POMO day (sometimes there were 4 a week) and those risk free billions for simply buying debt from the treasury and flipping it to the F_E_D for a nice profit in a few weeks or months, would be put to work in the market right away, often within an hour of the conclusion of the POMO.

The banks were making billions risk free as the F_E_D bought their Treasury holdings and took that money in a sort of "Carry trade" and invested it in high beta momentum stocks which sent the market soaring higher, they also bought commodities which sent commodities higher and created inflation, in fact the US's primary export to the world was inflation, but the Primary Dealers were making a bundle, many reported earnings for the quarter without a single day of trading losses.

So the PD's do what the F_E_D would like to, but can't and then they sell the T's to the F_E_D for a large profit and buy stocks and make money on them, but also stoking inflation. This is why the question to Bernie on 9/13 at the press conference marked the EXACT top for the day. The market didn't have the assurance that the F_E_D would continue to monetize debt no matter what, that inflation had to be kept down and if it went up as it always does during POMO/QE, then the F_E_D may alter their buying which created uncertainty (actually certainty of inflation, but uncertainty of how much the F_E_D may scale back purchases in response to inflation).

As mentioned earlier, the initial QE1 that was announced in late 2008 really didn't do much for the market as it was only MBS like QE3 so far, in 2009 the F_E_D added Treasuries and that pumped the market, this is what is expected tomorrow, the F_O_M_C policy statement will include a section about billions a month in Treasuries bought up by the F_E_D from PDs.

The problem the market has... The F_E_D has made noises on several occasions that they want to move away from a date for policy (like ZIRP through mid-2015) and instead adjust buying to the incoming economic data. This new metric causes the market a lot of uncertainty because at this point P/E ratios are about 50% richer on average than they were during QE1 or QE2, that means if these Primary Dealers take the money and go all in with stock purchases with their risk free POMO money, they could be blind-sided by an economic report or string of them that sees the F_E_D adjust their buying (say scale it back), which leaves the PD's in a situation in which they may have a big open long position and all of the sudden no idea what the F_E_D will do as far as purchases which could leave them exposed with high P/E stock multiples, large positions and an unexpected change in policy that effects the market, it's kind of like having a huge position and then the music stops and you don't have a chair. This is the new yardstick the F_E_D is putting together and the market doesn't like the uncertainty although from a common sense standpoint it is perfectly reasonable.

The other problem that was present with QE3, unlike 1 and 2 in which stock prices were depressed, QE3 was widely expected while 1 and 2 were more of a surprise so the market had an opportunity to discount QE3 and probably did with the rally from June 4th 2012 to the recent September QE3 top. In effect or reality, the market already discounted QE3 with that rally and it became like a "Buy the rumor, sell the news" event. It seems much in the same way the market expects Treasuries to be added tomorrow to the F_E_D's shopping list which may be part of why we saw a spike today, strange activity last Tuesday, etc.

This is an interesting chart, it shows the day just prior to the F_O_M_C announcement in which 5 of the last 6 times the market rallied the day before the policy statement, only once did it fail to and that was after QE3 and before the election and the market expected nothing from the F_E_D.

The green arrows are the day before the statement and we can also see the difference between the 10 year Treasury and the SPX, it was wide at QE3, which was days from the top (REMEMBER THE KNEE-JERK EFFECT IS ALMOST ALWAYS WRONG), we also see the "Richness" of equities compared to 10 year T's, which is close to highs for the year, same as the QE3 period. While this suggests the market may in fact do exactly what I expected (A fast and strong move up followed by a fast and strong downside reversal) whether that be today being the move up and tomorrow or after the knee jerk effect we get the downside move; or even we see both tomorrow, up and down the same day; I a always careful to not assume because it happened once or even many times, that it will happen the same way again. If I thought like that we would have sold all shorts on Sept. 13 and bought all longs and we would have been 100% wrong even though that was "Conventional Wisdom".

In any case it is worth noting, especially the high P/E for stocks and the lousy earnings; because of that equities are not as attractive as they were during QE1 and 2 when the P'Es were about a third less than now.

I mentioned today' 3 year Treasury auction which had some strange internals. $32 billion in 3 year T's were auctioned off today, internals of the auction were weak. The Indirect allocation was 21.9% (IB's are typically foreign entities such as Central Banks like China) which is the lowest since 2007. Apparently the demand for US 3 year debt among foreign bidders is pretty low. Here's a link to the Treasury with today's results...

The ugliness in internals of the auction can be summed up right on that page at the bottom...

Note that the Direct Bidders Tendered and Accepted were both higher than the Indirect Bidders, this is the first this has ever happened. A few years ago all of the talk was how Directs were taking up to 10% of an auction which was unheard of then, now they are higher than our typical lenders (indirects) like China or Japan.

Now take a look at what happened the last time the indirect bidder take up was so low vs the SPX...

The red Indirect is close to the 2007 level in which the SPX topped (note the scale in red for IDBs moves from high to low at the right).

So some interesting things going on there as well.

Earlier in the day I posted the Leading indicators... I saw some things that I thought were a bit unusual such as credit and other L.I.s moving with the market rather than diverging, but with a risk on move like this, it does make sense that they'd use these risk assets to make money on the move. I did however notice something I thought might be a model for the day,

"I see some surprising moves among short term leading indicators, however there is one that may be setting the example for the others and how this will play out"

" High Yield Corp. Credit was surprising, but if there's a risk on move, this is where smart money will place large bets, in credit as it is such a large, liquid market, HYG may be showing us how this is going to go down as it is diverging way negatively from the SPX (green) intraday, if this continues, it could lead to a very fast shift in market trend/price"

" HY Credit on an intraday basis also may be providing the model as it was moving in the same direction as the SPX early today, now it is diverging negatively."

I believe the market did exactly what I had been expecting, just consider the IWM range and what I thought would happen, a stop run and a bull trap as the IWM's range was so obvious that it was a natural area to run as Technical Traders would place orders just above the obvious range and that's what happened in the market with the 50-day for all of the averages and specifically for the IWM.

The range I've been expecting to see taken out on the upside, hitting short stops and triggering long orders was too obvious, we have been expecting this move for the last several days. Volume on such a breakout wasn't impressive.

As for the market compared to Risk Assets via ES and CONTEXT, exactly what I thought might happen in Leading Indicators (as mentioned above) did happen and it's obvious in CONTEXT for ES.

SPY Arbitrage to the left shows the SPY rich compared to the model and then come back down to where it belongs. More importantly, ES was way rich to risk assets as I suspected and it also ca,e back down to the CONTEXT model (ES in red/CONTEXT Risk model in green).


Here's a look at a few closing Leading Indicators...

 The Euro was in line intraday early on as expected Monday (a move up short term, but longer term falling apart), by the afternoon it looks like the Fiscal cliff took the SPX lower than the intraday correlation with the Euro, but...

 Longer term, the Euro (which I like as a confirmation/non-confirmation indicator)  is in a negative divergence so the SPX is rich here, dislocated and not very well supported.

More importantly and to the point though... Credit (Credit leads and stocks follow).

 High Yield Corporate was in line early today which threw me a bit, but this is the biggest risk on move in nearly 2 weeks (9 trading days) so it does make some sense that the highly liquid HYG saw some of that action, but did fade as I thought we might see (remember the early clues in the post above).

 High Yield Credit also was initially moving up wit the SPX, it warned earlier than the others as to how the close might play out and saw deterioration before the SPX, just as we see in the CONTEXT model for S&P futures.

Longer term HY Credit still remains in a deeper negative divergence which is a red flag for market bulls.

Here's how some important market averages closed the day, these are fairly long charts with big leading negative moves that came together quickly in a day or two.

 DIA 15 min deteriorated earlier as we expected the market to move lower, but last Tuesday afternoon we saw something change and toward the short term bullish side, today we saw that play out with the breakouts and taking back of the 50-day average which will trap bulls who buy on price moving above that average. This 15 min chart was very negative today alone in to new highs on the move-it looks a LOT like a good head fake area is being set up.


 The IWM formed that obvious range and broke above it today which also attracts buyers and forces weak shorts to cover, like I said about the strange move on Tuesday afternoon, "Wall Street never does something without a clear reason" and breaking out, hitting all of those stops, triggering all of those orders gave them PLENTY of demand to sell in to and 3C 10 min. shows a leading negative divergence in the IWM hit a new low today.

 QQQ 15 min also hit a new leading negative low today on a close to breakout move, each of the averages has a very short term positive divergence, it is so small and only on 1 or 2 charts that if it works, I don't think it can go far or support much, but maybe make the QQQ breakout a little more convincing for shorts to cover and bulls to buy.

 SPY 15 min chart moved a lot today on a negative leading divergence to a new low as price hit a new high on the move, this looks a LOT like a head fake move. Also note where the positive divergence came in to the market late Tuesday the 4th and Wednesday the 5th, this was the fuel for today's move, the day before the F_O_M_C was likely the trigger day they planned in advance as we see 5 of 6 of the last F_O_M_C meetings saw a rally the day before the announcement (Wednesday).

The TICK chart wasn't extremely impressive on the upside, but it held very well on the lower range and showed some interesting movement that was positive in to the close, this is along the lines of the very small short term positive divergences I mentioned. This could take several of the averages like the Q's and give them that convincing move they need to force an emotional reaction, which of course could very well set up the fast reversal to the downside with the trigger being F_O_M_C related, whether a knee jerk move that reverses intraday or within a day or two (the Sept 13th QE3 announcement was up the 13th, part of the 14th and went lateral, the initial move was wrong on the knee jerk reaction I always warn about when it comes to anything F_E_D related.)

As for futures, the EUR/USD 5 min chart saw a positive divergence which works with the move today, it needed that support, but it is deteriorating, suggesting it won't hold much longer and likely takes the market with it.

EUR/USD 5 min

While the Euro Futures themselves have some 1 min volatility in them, the larger trend on the 5 min continues to be deterioration which confirms the chart above and is a market negative.

EURO futures 5 min.

Market Futures look like this...

 Remember the TICK chart's positive action toward the close? Here we see an ES 1 min positive divergence in to the closing hours and since then a leading negative divergence, but with the market average showing at least 1 small intraday positive, I think a gap up could be a possibility or some sort of upward volatility, maybe on the F_O_M_C release at 12:15.


 Here's the ES chart showing that positive 1 min divergence in to the afternoon lows, it's strong and it fits right with the TICK chart.

NASDAQ 1 min futures stayed pretty negative through the close.

As for VWAP, there appears to have been a churning event, it's when strong hands sell to weak hands, almost the mirror opposite of capitulation, but it would suggest as a particular resistance level or technical trigger was crossed, there was enough retail demand to carry out this churning event, these are almost always a negative signal of smart money leaving dumb money holding the bag.

 ES and the high with large volume at the top of VWAP, right where smart money would want to sell.

NASDAQ futures show the same. Traders always think large volume with price making a new high is bullish, most of the time it is a bearish churning event, it's literally dumb money being left holding the bag.

All in all we'll have to watch trade very carefully tomorrow, maybe we get a leak as we have in the past, but I see plenty of charts that have set up exactly the way we have expected them to, the F_E_D is a wild card, PLEASE DON'T GET EMOTIONAL ON THE INITIAL KNEE JERK REACTION, I'M TELLING YOU 90% OF THE TIME THEY ARE WRONG, BUT THEY ARE EMOTIONAL NIGHTMARES!

The thing we are looking for is continued deterioration, a slightly higher head fake move and ultimately a reversal to the downside which should be powerful and fast. We want to add shorts and fill out short positions as we get signals that confirm a head fake move and the knee jerk reaction might be a good chance to do that.

Finally, while I do not expect it and haven't seen enough to put together even a basic case for this, we want to listen to the message of the market and make sure the market sentiment doesn't shift on us, which I think is only likely if the F_E_D really deploys a Bazooka far greater than what the market expected or forgets about their new yard stick-economic based policy/asset purchasing program they are trying to develop. Either two of those would surprise the market positively, we want to watch for anything like that.

All in all, even though I hate trying to predict or forecast in to F_O_M_C policy days, I still fell really good about what I'm seeing, how it has developed and how we have been about as close as I think you can get with our calls since things got weird last Tuesday.

I need some sleep, See you in a few hours.