Markets Wednesday will sort through the implications of the Fed's move towards further easing... and its increasingly negative impact on the dollar.
In its statement Tuesday, the FOMC signaled that it was ready to take necessary stepsto help the recovery and that inflation was getting too low. For some, it was a clear signal that the Fed will announce "quantitative easing" (QE) to drive rates lower in the next couple of months.
There was an immediate, hard sell off in the dollar, though the greenback was already moving lower ahead of the Fed's 2:15 p.m. announcement. Gold jumped, to another record high, and it was trading at $1,289 per ounce late in the day. Buyers flocked to the bond market, driving yields on the two-year to a record low and causing a steep drop in the yield on the 10-year note.
Stocks reacted as if confused, first moving higher before closing near the unchanged mark. The Dow rose 7 to 10,761, and the S&P 500 fell 2 points to 1139.
"It (the stock market) tried to rally a bit, but I think the implications of the reasons why they need QE2 is just that the economy is not there, and in the long haul that's what's going to drive equities," said Peter McCorry, a trader with Keefe Bruyette. Traders are watching to see if the the S&P 500 can hold important gains made Monday when it broke through a major resistance level at 1130.
Standard Chartered senior foreign exchange strategist Michael Moran says it's the stock market that may ultimately tell the story. He expects the dollar to continue to weaken on the idea of "QE," which he believes the Fed will carry out.
"I think there is still a tug of war between QE bulls and QE bears. I think that is going to be a sort of ideological struggle for the next couple of months..The markets can look at this from a glass half empty, half full perspective.
"The U.S. equity market will give us an idea of what the broader risk sentiment is going to look like. From an FX stand point, it's purely "risk on." You have all these currencies doing well. The dollar is weak and it's very positive for emerging markets. That might be deceptive. It might be just a weaker dollar story. It's a convoluted picture right now. There's a lot of mixed signals..With the dollar and Treasury market, they're probably giving us clear signals as to the impact of QE."
Traders speculated the weakening dollar could prompt the Bank of Japan to step in again to support the yen. But Moran said he does not expect further intervention until the yen hits a level of 83. Yen/dollar was about 85 in New York trading.
Some Fed watchers have said the QE program could amount to a trillion dollars or more worth of Treasury purchases by the Fed. The idea would be that the Fed, which has already moved its target Fed funds rate to zero, would be able to pressure lending rates further through the Treasury purchases.
Jeff Kleintop, chief market strategist for LPL Financial, said he expects the announcement to trigger a mixed reaction for stocks. "The thing that surprised me was they basically told us unless inflation gets a little higher, the Fed's not doing their job," he said.
"I would expect to see precious metals go up. Commodities go up. TIPS go up. Anything tied to inflation is the place to be, and the dollar is going to head lower. Essentially, what the Fed's going to do is put a lot more dollars out there. The quantitative easing doesn't deal with the price of money , it deals with the quantity," he said.
"It will be interesting to see what happens tomorrow -- whether you get the expected move in the market .. Industrials, materials head higher, tied to the inflation theme," he said. "Gold is saying two things. One is inflation and the other is weaker dollar." The Fed's next meeting is Nov. 3.
Kleintop said he has been expecting the stock market to come under pressure and it may now. "So if tomorrow, we get more of a disappointment or money moving out of equities and into commodities and more direct inflation plays, we could see (the stock market) moving back down in the trading range..We do believe the market is ready for a pull back here, and we find more attractive options in the commodity business," he said.
Brian Edmonds, head of rates trading at Cantor, Fitzgerald, said some traders had expected even more from the Fed Tuesday. "When the market creeped up, it felt like people were expecting full blown QE..initially trading was negative. then the market exploded to the upside. Clearly there's people putting money to work on the news today," he said.
He said although the bond market is getting ahead of itself, it could hold up into next week's auction of 2-year, 5-year and 7-year notes. "The one constant in this market is volatility," said Edmonds.
What Else to Watch
Traders will be watching to see who replaces top White House economic adviser Larry Summers, who plans to leave his post at the end of the year. Summers, a former Treasury secretary, will return to Harvard. Summers is the latest of the Obama economics team to step down, after former budget director Peter Orszag and Christina Romer, who was head of the council of Economic Advisors. Treasury Secretary Tim Geithner is staying in his job, according to a senior Administration official.
Some company news after Tuesday's bell could have an impact Wednesday. Microsoft raised its dividend by 25 percent to $0.16 per share. Adobe Systems stock sank after its fourth quarter forecast disappointed investors, and PMC-Sierra stock fell after it lowered its revenue outlook.
The July FHFA home price index is released at 10 .m. Wednesday's earnings reports include CarMax, General Mills, Bed Bath and Beyond and RedHat.
SEC Chairman Mary Schapiro speaks to traders at the Securities Traders Association conference at 2 p.m. The Senate Banking Committee holds a hearing on oversight of the SEC.
Geithner testifies before the House Financial Services Committee on the international financial system and financial regulatory reform.
Goldman Sachs holds its Communacopia conference. Representatives from Time Warner Cable, Comcast, News Corp, CBS and Scripps are among the speakers.
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