The Overnight Report: Figuring Out The Fed

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By Greg Peel

Weakness in the Australian financial sector was a driving force behind the local bourse’s 2% fall yesterday. The sector fell 3%, which included some big falls yet again from the big banks and more fearful selling in the likes of Macquarie Bank ((MQG)). The catalyst for yesterday’s weakness was supposedly a report that a financial subsidiary of private equity LBO specialist Kohlberg Kravis Roberts had, for the second time, failed to make payment on billions of dollars of commercial paper. While this may be yet another domino in the global credit crisis it should also be noted that Australian banking analysts have this week belatedly turned bearish on the sector. Asia began to weaken yesterday afternoon, and Australia followed suit.

Nor was Europe immune last night, falling on average 1.5%, but Europe has its own demons to deal with as well.

The significance for the Australian market is a technical one, as yesterday the ASX 200 index closed at 5496 – below important support at 5500. If you believe in tea leaves, a breach of 5500 is meant to take us straight to 5300.

The stage was thus set for a weak opening on Wall Street, and that transpired with the Dow down 110 points early. But adding to weakness was the pre-bell release of the January CPI numbers. Economists expected an increase of 0.3% on the headline and 0.2% on the core (ex food & energy), but got 0.4% and 0.3% respectively. This took the year-on-year headline to 4.3% and the core to 2.5%. Whereas the RBA is comfortable with a 2-3% range for underlying inflation, the Fed prefers to see its core measure in the 1-2% range.

Rising inflation is a bad enough sign for markets, but in the US it further throws up the possibility the Fed will have to halt its aggressive, economy-saving rate cuts. What is a poor Fed to do? The hardest scenario to fight is stagflation, and that is the ugly word being bandied around at present.

But yesterday also saw the release of the Fed minutes for the January 30 meeting that cut rates by 50bps. The first point of interest was that on January 9, when global stock markets had begun their new year collapse, the committee held a conference call and decided “substantial additional policy easing in the near term might well be necessary”. And so it was on January 22 the Fed made its famous emergency cut of 75bps.

It then followed up with the 50bps cut on January 30, and will not officially meet again until March. But if the Fed’s intentions for March may now be less clear, there was little doubting its opinion in January:

“Still, with no signs of stabilization in the housing sector and with financial conditions not yet stabilized, the FOMC agreed that the downside risks to growth would remain even after this action.”

Which leads traders to believe there must be at least one rate cut left in there yet. The Fed revised its economic forecasts, now deciding US GDP growth in 2008 would be in the range of 1.3-2.0%, down from 1.8-2.5% in the previous meeting. The unemployment rate expectation rose from 4.9% to 5.3%, and the core inflation rate expectation rose from 1.8-2.1% to 2.1-2.4% – the latter being now fully outside the usual comfort zone.

Which throws up that spectre of inflation. The Fed found the December CPI numbers “disappointing”, and we’re yet to hear their opinion about last night’s January figures. So the Fed is now sitting between the proverbial rock and hard place. However, a clue was provided in the January minutes. The committee “noted that, when prospects for growth have improved, a reversal of a portion of the recent easing actions, possibly even a rapid reversal, might be appropriate”.

In other words, the Fed is prepared to pull down hard on the bungy rope long enough and far enough to prevent the US economy sliding into serious recession, but as soon as the signs begin to turn they will let go of the rope. Inflation will just have to wait for now, but the Fed will definitely act – in time.

So how should all of this be interpreted by the market? The answer is pretty well, as the Dow managed to close almost on its highs at +90 points. What was most noticeable about last night’s session was that for the first time in a long time, the day’s upward shifts were accompanied by strong volume. Is this because we now have the pieces of the puzzle falling into place? Can we see more clearly into the future and decide that we know what the worst of it is now, and we can look ahead to the recovery?

The Dow’s rise of 90 points equated to 0.7%, while the S&P gained 0.8% and the Nasdaq 0.9%. Techs were spurred along by a solid result from Hewlett Packard.

The rally came despite the fact oil held its ground above the one hundred mark, rising US73c to US$100.74/bbl. However, last night was the expiry of the March contract, which means come tomorrow we’ll be trading the April contract. Despite March’s gain last night April closed unchanged at US$99.70/bbl. Technicians are holding their breath at the moment, as it could prove that oil forms an infamous “triple top” at US$100, having now been there three times. At this point technicians are convinced there’s a better than even chance it could go either way.

Oil’s rally came despite a mild rally in the US dollar, which was largely driven on the revelation of the minutes. Any more cutting may be the last of it. But it was the inflation numbers, oil, and general inflationary concerns that sent gold soaring again – up US$18.20 to US$945.60/oz – despite the dollar’s rally. The Aussie, in the meantime, slipped slightly to US$0.9177.

Base metal markets were confused. As a result they closed mixed and uninspired with the only stand-out being another 3% rally in lead.

The SPI Overnight closed up 69 points which, in theory, suggests we should pull back from the brink of the 5500 chasm today. But then it all depends what may transpire in the rest of the session, with another solid and diverse round of profit reports due.

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