Surprise Discount Rate Announcment

Yesterday, after the markets closed, the Fed announced that it was raising the discount rate by 25 bp. Here is a story about this. The initial reaction after hours was as expected -- the announcement took everyone by surprise. Before this morning's market open, futures pointed to a down day, although the amount kept shrinking. What all of this points to is uncertainty and indecision as market participants digested all of this and formulated their views of the likely consequences.

Which types of candlestick bars depict this? Forget a candle with a long real body and little in terms of shadows (i.e., tails). Look over the candlesticks I covered the other day in class. One would expect either a doji or a spinning top. What actually occurred for the S&P 500 was a spinning top. Here is a chart of the current data (click to enlarge) as of the Friday close.

The RSI is not yet overbought, so potentially there is room for further upward price movement. Note that the RSI is approximately 60, which is the value that some use to indicate resistance for a time of weak price movement. The most striking thing in this chart is the fact that the $SPX closed above its 50-day MA for the first time since January of this  year. If the market were worried about the impact of the Fed raising the discount rate, would the S&P have closed above its 50-day MA today? No, it would not have. So, today's price action, in spite of signaling indecision in terms of a spinning top, does allow for the possibility that it the S&P will remain above its 50-day MA at least for the very near term. The real question is whether former resistance, in terms of the 50-day MA, will now become support.

How can we arrive at a way to answer this question? Using economic theory, we model stock prices. According to economic theory:

                    Stock Price = f(interest rates, expected profits)

Interest rates pertain to asset substitution possibilities in the short-term (review the stock and bond info in the Supply and Demand notes) and product demand in the medium term. Were yesterday's surprise discount rate announcement taken to indicate that Fed tightening was about to begin, not only would the market have failed to clear the 50-day MA today, there would likely have been a noticeable upper shadow (tail) as well. Also, there was a CPI data report today that signaled benign inflation, which signals that interest rates should not rise much.  So, the primary factor to focus on is profit expectations. For extra credit, due at the beginning of class on Tuesday, plot the relative strength of the S&P 500 (a measure of stocks) compared to TLT, a measure of longer-term bond prices using as a chart type a solid line with weekly data. In a short word document, include the chart with annotations from StockCharts.com (not hand written) and a very short discussion of what the relative strength of stocks vs bonds is showing us about expectations for future economic activity (and therefore profits). Feel free to consult John Murphy's text about this.

When you get a chance, you should read two excellent columns on technical analysis by Michael Kahn in Barron's Online. I strongly suggest that you save these and others throughout this semester (and beyond). The first of these, written in early February, talks about the market correction. Follow his reading of candlestick charts and overall analysis. The second, from this past week, analyzes the question of whether the market will be fighting back and trend up.

Fed Aggressively Cuts Rates

The Fed lowered interest rates today but farther than many (included myself) had expected. Recall, I had anticipated the combination of a 25 basis point fed funds rate cut and a 50 basis point discount rate cut. Along with this, I expected a statement that indicated further rate cuts would be forthcoming as needed.

Recall there are currently two problems facing us -- a slowing economy, which the fed funds rate impacts, and a liquidity/credit crunch crisis that the discount rate addresses. And, there is the question of how much the US economy will slow in upcoming months. Nobody knows this for sure (no matter what they pretend). And, the two "dangerous ingredients," the slowing economy and credit crisis might possibly combine and become very "explosive," meaning cause a more severe slowdown and/or recession. Apparently, it is this potentially explosive combination that the Fed reacted to. And, given the lags in monetary policy changes (6-9 months), the Fed HAD TO BE PROACTIVE. Remember, Ben Bernanke has not been the Fed Chair for very long, so he still has to establish his "Fed Cred," or credibility. And, all the press play for former Chair Greenspan's book probably influenced the magnitude of the move somewhat (this Fed can't allow itself to possibly be "behind the curve" of this slowdown.

The result TODAY: the stock market got what it hoped for, so there was a major increase, +335 points for the Dow Jones, a full +70 points for the NASDAQ, and +43 points for the S&P 500. Shorter duration interest rates fell, a very healthy sign (we will discuss this in the next week it has to do with the yield curve) for future growth prospects. And, the exchange rate picture was mixed: the US dollar rose against the Japanese Yen, but fell against both the Euro and British Pound.

The chart shows Cyclicals ($CYC) for the past three months (click to enlarge). Note how, over this period, the 50-day moving average was originally support (until late July), then became resistance. Today, after the Fed's rate change, there was a very large increase. Note how tall today's bar is and that the close was at the day's high. More importantly, today's close broke above the 50-day moving average. Also, look at the RSI(9) above the cyclicals. It has recently moved into the bullish range, above 50. Finally, the price relative, comparing cyclicals to the stock market (in terms of the S&P 500) has turned up recently. Part of today's large increase was the result of "short covering," where persons had sold shares of various stocks betting that their prices would decline. When the news came out, they hurried to buy back the stocks (covering their shorts). This added demand was an important contributor to today's large run up in prices.

What about tomorrow? Now that the markets got what they wanted, there will no doubt be further deliberation and possibly second guessing of the Fed's decision. Was the large rate cut a sign that the Fed thinks things are actually worse then they have led us to believe up until now? Will today's breakout be sustained, or will something else come to the forefront, making today a "one day wonder," or in technical terms, a failed breakout. Keep following cyclicals through the rest of this week into next week.