Weighing the Week Ahead: Fixation on the Fed

The "Week Ahead" series is a relatively new concept for me.  I have only been doing it for a few weeks.  It is "thinking out loud" since it is work I always did anyway.  I am open to suggestions.

There are many good services that do a complete list of every event for the upcoming week, so that is not my mission.  Instead, I try to single out what will be most important and help investors think about it.  My theme for the week is what will be the big story for print media and financial television.  It is what I am looking for, and maybe you should as well.

So far, my weekly guess about what will be important has been pretty accurate.  This week I foresee another bout of Fed Fixation.  It is a light week for the economic calendar and I do not expect much on the political front.  On Tuesday afternoon we will see the minutes from the March Fed meeting.  The Fed has made some major improvements in transparency over the years.  When I started in the business, you had to infer the result of the Open Market Committee's decision by watching the New York Fed's open market operations at "Fed time," the regular hour for Fed intervention in the marketplace.  It took some experience to interpret what they were doing -- system repos, matched sales, etc -- and compare it to the Fed funds rate at the time.

The new approach is so much more sensible, both to communicate policy intentions and also to share information about discussion and dissent.

The Bearish Case

To summarize briefly, here are the various bearish positions:

• The Fed should not even exist, so whatever they do harms the country;
• The Fed should have allowed  various banks to fail, mortgage lending to cease, and normal commercial lending to end;
• The Fed has stoked inflation and nothing that they do now can solve the problem;
• The Fed actions have been totally inadequate to deal with incipient deflation, so we face multiple years of economic malaise, crashing housing prices, and high unemployment;
• The Fed is "in a box" where any decision will exacerbate some problem.

A Calmer Look

The Fed has stepped in to fill the post-Lehman void in lending.  The expansion in the monetary base was large in the Lehman aftermath, but it has not continued.  The Fed also augmented a near-zero interest rate policy with an array of special lending facilities and direct purchases of securities.  Despite these actions, credit in the general economy remains tight.

The Fed communications have consistently indicated an emphasis on stabilizing and strengthening the economy with little concern about inflation.  There are now the first signs that some members of the FOMC want to prepare to reverse these policies.

"Prepare" is the operative word.  I expect the process of returning to a neutral policy stance to take about two years.  There will be many small, incremental moves along the way to neutral.  This gradual withdrawal of accommodation is not bearish.  It is a sign of strength.

Look for many commentators to fill pages and air time with speculation about the Fed's exit strategy next week --- and for the next eighteen months or so!

Last Week's Action

Here is my take on the key data from last week.  I make no effort to be comprehensive, nor am I taking a viewpoint.  I will highlight what I found significant, trying to be objective.

The Good

There was some good news.

• State tax revenues are starting to come around.

• The ISM manufacturing report beat expectations and is consistent with an annualized GDP growth of 5%.  James Hamilton summarized the week's data with "It looks good to me."

• ECRI Index Uptick.  The ECRI leading indicators made a ten-week high indicating a "resilient" recovery.

The Mixed

For a change, the economic news was not so bad.

• The March Employment Report.  The first month of significant net job gains is good news and it generated a positive response in holiday futures trading.  The payroll job gain was better than most expected if one considers the revisions to prior months and the size of the census hiring, only 48K so far.  The household survey has a larger margin of error (400K versus 100K), but it has now registered a net gain of a million jobs in three months.  This might be overstated, but it is probably not zero.

This is only a start.  The unemployment rate of 9.7% did not move, and will not until net job gains are higher.  An improving economy will also attract people back into the labor force.  The unemployment rate is a popular focal point, but not the earliest indicator of improvement.

Mark Thoma cites the same facts, but is discouraged about the prospects for improvement.  For the really bearish takes, you can see a roundup of comments from the usual suspects here.

Our Trading Forecast

Our own indicators are now bullish, and that was our vote in the weekly Ticker Sense Blogger Sentiment Poll. Here is what we see:

• 87% (87% last week) of our ETF's have positive ratings.  This is very strong.
• The median strength is +31 (up from +24 last week).
• 69%  (down slightly from 80%) of the sectors are in the "penalty box," showing a continued high level of uncertainty.
• Our Index Package now has a solid, positive rating, consistent with a gain in the market over the next three weeks.

Investment Implications

With a quiet economic calendar and a lull in earnings, it is time to be flexible.  I continue to pick up health stocks and economically sensitive names on dips.