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Fed Fears Inflation

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Fed Fears Inflation

The Fed expressed concern that inflation pressures have increased in recent weeks and increased pricing power was becoming more evident. The Fed warned that "with appropriate monetary policy action" those risk could be contained. With that statement the yield on the ten-year spiked to levels not seen since last July and the bottom fell out of equities.

Dow Chart - Daily

Nasdaq Chart - Weekly

The stage was set with the morning's PPI report, which showed rapidly rising inflation pressures in the internal components. The headline number was tame at 0.4% for February after a 0.3% gain in January but the picture is clear. Inflation is rising in finished goods and much of the gains can be attributed to the rise in energy prices. Food prices were also spiking with a 0.8% jump overall with 18.7% jump in vegetables. Gasoline prices jumped 5.2%. Core intermediate goods, which are seen as a harbinger of real inflation, have continued to rise and are now up 8.1% over the last 12 months. This report set the stage for the Fed announcement and they followed the game plan almost exactly.

Also suggesting trouble ahead of a different type the Richmond Fed Manufacturing Survey posted a drop of -4 points to zero for March and a continuation of a decline in conditions since last September. Shipments fell from 12 to only 3 and the order backlog dropped to -20 from -4. There is no way to put enough lipstick on this pig to produce a positive picture.

The Fed raised rates by 25 points to 2.75%, which was not a surprise to anyone. What was a surprise was the language about increasing inflation. They said, "pressures on inflation have picked up in recent months and pricing power is more evident." This is the 1-2 punch for investors. With inflation rising and pricing power growing that means the rate of inflation could increase rapidly. The Fed tried to head off concerns with their language a little further in the release but may have succeeded in causing more instability instead. The key words were "with appropriate monetary policy action" risks should remain balanced. This was a strengthening of stance that they were prepared to continue raising rates, possibly sharply, to prevent inflation from getting out of hand. The Fed likes to talk rates higher whenever possible and I believe this was a calculated effort to force the market rates higher and allow them to remain on track. They did toss equity traders one more bone by maintaining the "measured pace" language but traders were not impressed.

The impression the Fed left was that they had a long way to go before easing up on their current measured pace scenario. The Fed funds futures are still suggesting that they will raise 25 points at every meeting until November with rates hitting 3.75% in October. The November and December meetings are still up for grabs with the most likely result of at least one more hike from at least one meeting. If they did remove the measured pace language before then it would only suggest the pace would accelerate into year-end, not slow down. There had been considerable speculation that the Fed could pause its rate hike scenario at the May meeting and that speculation was crushed along with the hopes of equity traders. Once the Fed gets behind the curve it typically accelerates the process and traders worry that the Fed language today could be an indication that the Fed may already be losing the battle by not raising faster in prior meetings.

A key point to consider in this economic puzzle is the price of oil. As long as oil continues to remain over $50 it will help the Fed by keeping a lid on the economy. Pressure from high-energy prices works as an undeclared tax on businesses and consumers and slows growth. Unfortunately it is also inflationary as higher energy impacts almost all products including food. The stronger rate language and the spike in the ten-year yield to 4.6% will strengthen the dollar since those yields will attract more foreign investors. A stronger dollar will lower the price of oil since it takes fewer dollars to purchase the same amount of product. Confused yet? The jump in bond yields knocked oil back from its high for the day at $57.58 to a close at $56. Oil continued to fall in the overnight session to $55.38. With the seasonal Q2 demand slump just ahead this could be the signal for traders to take profits and potentially the beginning of the buying opportunity we have been hoping for.

Oil Chart - Daily

SPX Chart - Daily

You would think with the price of oil dropping, rates up only 25 points and the retention of the measured pace language the equity markets would have celebrated. Unfortunately the fear of sharply rising interest rates as the Fed gears up to tackle inflation aggressively sent equities to new lows. The Nasdaq dropped to 1989 and closed below its 200-day average at 1993 for the first time since October and at a new five month low. The challenge for the Nasdaq is the potential for higher interest rates. Tech stocks typically have high debt levels and rising interest rates normally depress tech profits. Ironically, nearly everyone expected rates to rise to 4.0% by year-end and today should not have been a surprise. The more aggressive language by the Fed shocked some traders out of their slumber and reminded them there is always risk in the market. This is exactly what the Fed wanted to do to the bond market and equities suffered by default. The sudden drop under 2000 erased two days of a hard fought rebound and puts the Nasdaq future in serious danger.

The Dow dropped -94 for the day, -135 after the Fed announcement and appears on track to retest critical support at 10400. The 200-day average is currently 10375 and rising. This will make the 10400 retest even more critical and one that needs to hold if there is any chance of a rebound before the summer doldrums appear. We have not seen any material warnings for Q1 and the earnings picture has not yet changed for Q2. Unfortunately there is a growing feeling that the Q3/Q4 picture is getting progressively cloudier. With bond yields now over 4.5% there could be growing reluctance to take a chance in equities until the road appears less rocky. A safe return of 4.5% in bonds is always tempting in unsure times.

We are rapidly approaching a fork in the road. Bullish sentiment is slowly eroding despite a potentially strong earnings cycle. Oil prices could be on the verge of cracking as the Q2 demand slump appears. In theory this should produce a rebound in equities but sentiment is weakening. There are just too many factors weighing on traders to allow me an optimistic outlook. However, strong rebounds tend to appear when least expected. If we did get a real drop in oil, say back under $50, I think we could see some buying interest appear. Funds have billions invested in oil today and once that foundation cracks the exit should be very sharp and quick. That money will have to go somewhere and I believe equities will benefit. We are also only seven days away from month/quarter end and an ideal opportunity to use oil profits to paint the tape. OR, funds may want to keep their oil stocks until quarter end to show how smart they were to invest your money there. Earnings will begin in earnest two weeks later and we will have a little more than two weeks of heavy earnings before the next Fed meeting on May-3rd. This would be the potential turning point for me. That would be six weeks from today and plenty of time for the oil/equity rotation to occur. As we approach the Fed meeting I suspect the desire to remain in equities over the summer doldrums will weaken and the markets will roll over. If inflation continues to accelerate the Fed could change its language and threaten stronger moves and it would be lights out for equities. This is just my opinion but I fear the dog days of summer will be ugly.

Oracle announced earnings after the close and said earnings dropped -15% due to the problems with the PeopleSoft acquisition. Earlier today Oracle won the battle over Retek for 11.25 per share. After being on an acquisition binge the CFO reiterated several times this afternoon that no further acquisitions were planned. Despite the drop in earnings, revenue increased 18%. Shares of Oracle fell slightly in after hours and I detected no post earnings excitement. This is a stock I typically ignore. Only Larry Ellison can make money here and at $13 it is at the high end of its range.

Homebuilders Lennar and KB Homes both reported earnings better than the street expected and both rallied sharply into the Fed announcement. LEN bounced off $55 support to trade at $58 before the Fed but crashed back to earth to close at $55.50. KBH spiked from $116 to $121 before the Fed but dropped back to $118 at the close. Both homebuilders only had good things to say about demand but their good news could have weighed heavily on the Fed's decision. The Fed has been concerned about a potential housing bubble and with both builders working with huge backlogs it could have appeared to the Fed that things were really going to heat up as the spring buying season hits. Higher rates will eventually halt the housing boom but we are still a long way from any danger level for this year. Next year may be a different story. I would look to exit any builders once the summer season passes.

Another crisis this morning was a panic attack surrounding GM. The morning papers carried a story that GE had revoked $2 billion in financing from GM. GM bonds immediately crashed as investors ran for the exits. If GE was dumping GM then traders wanted out as well. Before the day was over the real story appeared and it was far less material than initially presented. GE decided last year that it did not want to be in the financing business for automakers. GE financed "supplier" deliveries for GE, F and DCX. Suppliers do not want to wait many months to get paid for the components automakers use to build cars. GE told the automakers last year they were going to exit the business. When the news broke this morning it shocked the market and could have set the stage for the post Fed drop. The story remains the same despite the change in what was originally reported. GE saw the writing on the wall for automakers and decided to exit while it could. This should be a signal for everyone still long automakers that there are rocky times ahead. When oil resumes its upward climb, the sales of gas-guzzlers will continue to plummet.

The bottom line for me today is the facts. The Dow has dropped -510 points in 12-days and closed at a two month low. The Nasdaq dropped -111 points over the same period and closed at a new five month low. The SPX broke 1180 to close at 1172 and appears hell bent on retesting support at 1160. These are NOT bullish events. Yes, the indexes are oversold. Yes, there could be a rebound ahead fueled by a drop in oil prices, positive pre-earnings guidance and end of quarter window dressing. I believe it would only be a trading bounce and one that traders should be cautious in buying. This is a market that is flashing warning signals on all fronts but I don't think we are going straight down. I believe any end of quarter bounce will play on bullish hopes by retail traders ahead of earnings and give funds one last pop before they pull the plug in May. With Friday a market holiday things could get crazy over the next two days. It is typically a bullish period but I would not bet on it. Definitely, enter passively and exit aggressively.


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