Sunday, August 12, 2007

Fed action versus dollar survival: another view.

- Market was heading for another plunge before the Fed provides a floor for the week. Stocks end mixed.
- Fed officially comes to the rescue, doing what it does everyday but on a bigger scale.
- Fed action versus dollar survival: another view.
- Lots of stocks in good position to bounce, but is it just a siren song?

Fed does some carpentry work, helps build a floor in stocks for the week.

Stocks were melting again early Friday morning on more credit worries something we noted in the morning alert that was not necessarily a bad thing as the market needs to get this out of its system, and once way to do that is to get rid of all the sellers such as the hedge funds liquidating positions to prepare for August 15 redemption demands. Futures were a long way down when the Federal Reserve announced it was purchasing $19B of mortgage backed securities. Now there was only $3.9B offered, the usual amount on any given Friday, but the Fed wanted $19B to buy. And it only wanted mortgage backed securities as opposed to Treasuries. It also said it was going to stand at the ready to make sure there was sufficient liquidity for the financial markets to function in an orderly manner.

That stopped the bleeding, or at least it slowed the flow. Stocks started very weak and headed lower, reaching toward the prior August lows, and in the case of DJ30, undercutting it. Still trouble in the financial markets because banks were still not lending back and forth, unable to value each others' portfolios and therefore hesitant to lend. So the Fed came in with another $16B, again wanting mortgage backed, triple A securities. The Fed was buying because it wanted to loosen the market and drop the rate banks were charging each other down to the Fed Funds rate (5.25%) or lower. The banks had to have incentive to loosen up and help out.

Stocks started to recover. Gold, the dollar, stocks, foreign markets, basically everything, was down in the morning and that was troubling. You would expect gold to rise as other assets fell in fear. There was some real nervousness early on and thus the Fed's second step. Stocks rebounded into lunch with the Dow actually turning positive. The sellers returned and sent stocks lower once more. The Fed stepped in a third time with $3B. Finally that seemed to do the trick. In the last hour of trade the rates between banks fell to the Fed Funds rate and the market loosened. Stocks rebounded, closing off their session highs but also well off their lows, indeed turning mixed around the flat line.

Ironically the techs were the weakest of the lot with the large cap techs down 0.6% (NASDAQ -0.45%). After showing the relative strength in the teeth of the selling, the techs were taking a back seat Friday. The small caps, on the back of an energy rebound, led the session with a 1% gain. Financials 'rebounded,' meaning they were not slaughtered again on the session. That helped the SP500 buck up and close flat with DJ30 and even NASDAQ not too far back.

The Fed did its part but the shorts were also active, covering some before the weekend now that this was the Fed's war and its statements about standing at the ready to ensure liquidity for orderly trade. The past few weeks the general consensus was you didn't want to be long heading into the weekend; Friday you didn't want to be short. The Fed could cut 50 BP over the weekend. That is the scuttlebutt we are hearing, though we doubt it will come to pass. The Fed is more likely to try the liquidity injection route again before it resorts to a cut. If it does cut we suspect it would do so during the trading week, likely intraday to allow the market time to adjust. Regardless, investors didn't want to be on the wrong side of the Fed and some weekend announcement of a cut or some bailout action. Thus the stabilization in the afternoon dip and the rise into the close.

Despite the market ups and downs this is pretty fascinating stuff of the likes not seen since 1998. Most of the hedge fund and mutual fund managers today were not around to understand what happened back then. With many relying on those black box program trading methods we discussed Thursday night it is no wonder that when those no longer work as they are not working now that the fund managers don't know what to do. They are losing a lot of money and thus the compulsion to liquidate in order to raise cash to have available for any redemptions. If they do not have the money then they go under (remember 'It's a Wonderful Life' and the need for the Bailey Building and Loan to stay open and liquid? Same thing.). Thus the heavy selling last week that would not likely have been nearly that heavy but for the magnification through the use of those program trading methods.

The technical picture.

Technically it was not a great day on its face as the indices straggled in with some modest gains trading on both sides of flat. A bit deeper there were some positives as NASDAQ tested at its 200 day SMA again on the low and bounced once more. SP500 visited its prior lows as well and rebounded to close at its 200 day SMA. Not bad action at all. DJ30 was a bit different, falling below its prior lows on this selling, but it also rebounded to hold above those lows. There was also continued leadership Many solid stocks tested and rebounded holding their own this week in a weak market. Many quality stocks that sold formed short double bottoms this week. Others continued their nice action with either short tests or plain old fashioned base building. If the market can muster a rebound there are some very good stocks in position to move higher.

That said it is hard to buy that this is 'the' bottom in this selling. There is typically more of a downside move, but typically the Fed does not get involved. It does tend to be the 800 pound gorilla in the room; kind of a game changer. With the Fed providing the floor, perhaps an 8.2% SP500 drop, 8.5% on NASDAQ, and 6.8% on DJ30 is enough. As noted, there are certainly many quality stocks in position to move higher if they get some breathing room, and the Fed's purpose in stepping in is to unfreeze the liquidity lockup. That may be all they need to make the break higher. There are still the hedge funds liquidating their positions and that pressure can reassert itself this week. There are still other bombshells that could drop in the credit markets. Again, however, the Fed stands ready to enter if necessary. We will watch, see how these good stocks perform, and act accordingly. We have misgivings about a bottom right here, but what your gut tells you and what the market does are often divergent.


Save the economy? Save the dollar? Both?

The Fed, similar to Hamlet, is conflicted. To cut, or not to cut, that is the question. Whether it is nobler in the eyes of the financial markets to suffer the slings and arrows of lowering rates to prevent a crash, thus rescuing the economy from potential recession, yet most certainly crashing the dollar by so doing.

A bit dramatic, but the Fed has to make some very tough choices, and the road it took Friday has put the Fed on the path of a rate cut in the event this liquidity gambit does not work. If it does not do what is necessary to unfreeze the credit market the economy could freeze up as well with no money available. If it cuts it could cripple the already weak dollar.

The reason the dollar would fall is that there would be even less reason to hold the dollar. A foreign holder gets less of a return for holding dollars or as is the usual case, US treasuries, because the return falls as rates are cut. The Bush administration, despite the declarations of various Treasury Secretaries, has pursued a weak dollar policy in an effort to increase US exports and US business overseas. It has always said it pursued a strong dollar policy, but no one has believed it. Just as Bush I, Bush II talks a strong dollar but winks and nods at the same time. Thus the dollar has had no real support even as the Fed hiked rates. An already weakened dollar would be severely impaired if the Fed started to cut rates once more.

That is why you simply don't tamper with the dollar or the economy, trying to affect some end. There is ALWAYS something that you cannot control that upsets the best plans. Greenspan learned this (or should have) when he tampered with hiking rates to slow the economy and thus narrow the gap with other countries. That failed as he sent the economy into recession and worse. Now that we could use a stronger dollar in order to better effectuate a means out of this credit crunch, we risk severely undercutting its remaining strength and sending inflation through the rough as we import it due to the weaker dollar making oil and other imports jump. That would severely cripple the economy.

That also, however, leads to an alternate theory as to the effect of rate cutting on the dollar. It states the a currency's worth is set by the economic growth differentials of the various countries. In other words, countries with stronger growth enjoy a stronger currency vis- -vis other currencies. Why would China's currency rise if it was not held lower? Growth. Why is the euro strengthening versus the dollar? Growth. Not greater than the US, but rising rapidly. Eastern Europe? Lots of growth. The US is still suffering from the last Greenspan recession, the one that gave away our technological lead and thus our chance at strong growth even as our population aged. That combined with the Bush administration's weaker dollar policy has kept the dollar low.

Now if the Fed does nothing and the economy seizes up, then this theory suggests the dollar will fall even further. If, however, the Fed acts and is able to prevent a recession by cutting rates, ultimately the dollar will benefit because the economy will strengthen. Short term it could get hammered on the news of a cut, but as the economy rebounds it would regain strength. Some will point to the current weak dollar even as the economy grew at 3+% in Q2, but again you have the Bush dollar bashing policy in addition to the relative strength of other economies' growth rates versus our own. If the Fed lets the economy slip into recession that would only exacerbate the current weakness.

By: Jon Johnson, Editor

Jon Johnson is the Editor of The Daily at

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