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The FOMC Speaks
The Smart Profits Report: Traders’ Tuesday: Issue #341
Tuesday, August 10, 2006
The FOMC Speaks: Will the Fed Pause? Does It Really Matter?
By D.R. Barton, Jr.
Advisory Panelist, Mt. Vernon Research
For the last 17 straight meetings since June 2004, this imposing 12-member committee had decided to hike the Federal Funds Rate by 0.25%. Regular as clockwork. This hoisted the overnight funds rate to a relatively lofty 5.25%.
But for the first time in over two years, there is genuine uncertainty in the air, as the Federal Open Market Committee (FOMC) prepares to announce its latest decision this afternoon.
And based on the language of recent Federal Reserve speeches, the tilting of the Fed Chairman’s eyebrow, and some tea leaf reading, traders rank the possibility of an 18th straight rate hike at only 16%.
Everyone is expecting the Fed pause. Well, almost everyone (more on that later).
The questions are:
- What’s the big deal?
- Why do the equities markets hang on every vote of the FOMC like it’s the Holy Grail of economic forecasting?
- And should it matter to us normal investors and traders?
Let’s tackle these questions and see if any of it should make us change anything we’re doing…
Like It or Not - FOMC Fund Rate Changes Matter
The equation is simple: When the FOMC changes rates, the markets react. This means that, by definition, rate changes matter to us as traders and investors. However, when the FOMC changes a word in their meeting minutes, the markets also react. I’m sure that even if the FOMC switched from cheese Danish to the apple-filled variety, the markets would react.
All of this begs the question: “Are the rate changes and all the rhetoric surrounding them really that significant to the markets?” Well, one would have to admit that the Federal Reserve does have the money to hire a whole lot of smart folks who do a whole bunch of high-level economic analysis.
And while lots of that analysis is quite good, it’s quite a leap of faith to believe that good analysis leads to good policy decisions. Or that those policy decisions (such as whether or not to raise interest rates) reflect the current economic reality. In the end, the FOMC is a political body operating inside a political system.
So while rate changes matter, I take the Federal Reserve’s broader comments on how the U.S. economy is doing with a grain of salt. Actually, make that a whole shaker.
The Big Question: Will We Get a Pause in Rate Hikes?
Since the “Traders’ Tuesday” editions of the Smart Profits Report obviously comes out on Tuesdays, you may or may not see this article before the FOMC makes its announcement. But you can still have some fun with the analysis either way.
The Chicago Board of Trade (CBOT) trades a Fed Funds futures contract on its exchange. The traders of this contract currently give only a 16% chance that the FOMC will raise rates today. While this is a very good barometer of Fed actions, it’s by no means infallible.
But with the odds firmly tilted in favor of a pause in rate hikes, there are two significant pieces of information that keep this from being a “slam dunk”:
First, the rest of the world is moving strongly toward a tightened monetary posture. In the last three weeks alone, the European Central Bank has raised rates (for the fourth time since last December); the Bank of England issued a surprise 0.25% rate hike (the first of the year), and the Bank of Japan made a widely anticipated but extremely significant hike above interest rate neutrality.
Two of the world’s top investment banks, Deutsche Bank and venerable Goldman Sachs, have been vocal and public about their forecast for another 0.25% increase.
In most trading issues, I generally find it hard to go against Goldman. But in this case, I think the Fed will pause because the short-term market ramifications of a “surprise” hike could be really big.
So What Should You Do With Your Positions?
Despite the importance placed on today’s decision, it will really have little long-term effect. After all, the Fed can’t go on tightening forever. However, here are a few prudent actions you can take:
- For Long-Term Positions: Sit tight. If you have a position you intend to hold for months or years, don’t mess with them based on one FOMC decision. If the Fed does hold rates steady for a few months, that should lead to a more conducive longer-term investing environment.
- For Short-Term Positions: Lighten up or sit on the sidelines. I know plenty of folks who have had their trading accounts pounded because they’ve tried to out-guess the Fed or the market’s reaction. Stick with your normal trading plan, and then take a “wait and see” approach. Most strategies for trading big news events like this are little better than 50/50 propositions - poor odds in most traders’ books.
Important Tip: If the Fed leaves interest rates unchanged, but the language of the announcement send the markets down - watch out. Lots of bulls have been waiting for the Fed to ease, and if that doesn’t give the market a nice lift, price action could get ugly to the downside for a while.
Good Trading,
D.R. Barton
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Today’s Smart Profits Cribsheet
- This morning, I was a special guest analyst on Canadian Business TV (Report on Business Television - ROBTV). You can view my segment on the Fed Funds rate in its entirety on the RobTV website. Just go to www.robtv.com and scroll down to the 10:40 a.m. time slot in the Business Morning with Jim O’Connell program.
- Is today also “D-Day for the Dollar?” Smart Profits Report editor and technical trading expert Jim Stanton pondered this question right here in Smart Profits #328 one month ago. His analysis showed that today could be a pivotal day for the dollar, because while the Fed gets back to “normal,” it could consequently dent the greenback. For the “how?” and “why?” read Jim’s full analysis in D-Day for the U.S. Dollar: As the Fed Gets Back to “Normal,” Why August 8 is Key.
Related Articles:
- Event-Driven Markets: The ONE Case for Using Short-Term Options
- Investor Sentiment & Market Behavior: Seven Tips For A Profitable Downside Bias
- Principal Protection: How to Defend Your Principal From a 50% “Bomb”
The Chart of the Week
We’ve had our eye on this gap in Microsoft (Nasdaq: MSFT) since it formed in May. I’ve read some bullish research reports lately, including one by good friend and big-thinker Porter Stansberry. Technically, buy on a close above $24.50. Until then, that gap resistance is going to contain all the price action. After the break of 24.50, a 10% pop is very probable.
By the way, I would read Porter’s stuff every month even if he didn’t make stock picks, just because he brings such a fresh perspective to his research. This is one of those “how do they do it for so little money?” type subscriptions. You should check it out here.
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