Fed set to remove 'patient' and hike in June

Outlook:

Market News parses the Bank of America/Merrill Lynch monthly fund managers survey for juicy and insightful tidbits. This time one of the nuggets is that 2% see the dollar as overvalued, for the first overvaluation label since 2009.

Ah, but overvalued is a judgment call based on who-knows-what. Purchasing power parity? Relative rates of return and if so, over what holding period? Such a judgment is not worth anything at all, and besides, overvalued is not the same thing as “having overshot.” The “overshooting problem” in FX is a function of expectations racing ahead of real data. The direction may still be correct, it’s just that the extent of the move is excessive. And as we wrote yesterday, we may easily demonstrate using any num-ber of indicators that the dollar is overbought but that doesn’t mean it can or will or should fall. Curren-cies can get overbought or oversold and stay that way for disturbingly long periods of time.

The technical picture ahead of the Fed is the epitome of indecision. Big players have already pared posi-tions as much as they need to, and that gave us a rally in the euro (or a mini-rout in the dollar) of a mere 200 points (actually 199, from the low at 1.0452 on Sunday to the high of 1.0651 on Tuesday). This is pure positioning ahead of an Event and no amount of experience in chart reading can tell you what comes next—you need the Event for that.

If you want to stick to the mainstream Big Picture forecast—euro to parity—you have two chief tactical approaches. First, project the highest high the euro is likely to go if the Fed chickens out. We hate to admit it, but Fib numbers might be useful here. A 50% retracement makes some sense, if you can figure out where to begin. Or you can pick a channel high, or a resistance line. We get 1.1061 at resistance for today on the daily chart. You can use a weekly chart for perspective. It’s interesting that the parabolic reversal on the weekly chart is close to resistance on the daily chart—1.1021.

The other tactic is the “prove-it” technique. This is the level at which you are sure the primary down-trend is resuming. The last lowest low is an obvious choice, if probably a bit limiting in profit potential (since the market has already moved a lot in anticipation of the Event). Or sell just under a support line (we get support at 1.0550 on the 360-minute chart). This gains you an extra 100 points over waiting for the last low (1.0452). Or eyeball a number and wait for inspiration to hit.

Another option is to fade the trend (buy euros) because if the Fed does chicken out, a lot of traders will be caught flat-footed and have to rush in to buy, enlarging the spike. Even if you believe in the primary downtrend, trading counter-trend is acceptable when you acknowledge that a genuine pullback hardly ever lasts only a single day. The Fed chickening out would be a Big Deal and almost certainly have ef-fects lasting a long longer.

Bottom line, it has stopped being about the news itself and is wholly about positioning. This is more akin to game-playing than to rational analysis. Never mind that the Fed hike is inevitable at some time in the not too-distant future. We trade in the present, and if the market is not thinking “inevitable,” that’s not the right way to trade. Indicators have become all but useless. For every indicator saying buy, you can find three saying sell and the opposite in a different timeframe.

Unfortunately, some critics say this makes it gambling. Well, not if you appreciate the human behavior behind price moves. Prices don’t move because of some cosmic machinery—every move has behind it a set of people thinking certain thoughts. If a majority of traders think the WSJ Fed-watcher Hilsenrath has the inside scoop, and he says hawkish with an undertone of lowish for longer, that’s how they will trade.

We continue to think the Fed will deliver the goods today—it will remove the word “patient” and that means, according to Yellen herself, a waiting period of at least two meetings before an actual hike, or June. The top reasons for the Fed to stick to the script is credibility and normalization. The Fed gets itself tied up in knots over “communications” that are never really “transparent,” so that grown men and women obsess over small words, missing words and vague words. The members know the markets are frustrated and we can hope for a correction in the direction of some actual clarity.

Normalization is far more important. For the Fed funds rate to be zero to 0.25% is not normal. A central bank goes to the “zero bound” in an emergency. The emergency is now over, judging from employment numbers, even if you’d have to stretch data to the breaking point to see real inflation on the horizon. Ac-tually, you can foresee inflation—after the drop in oil prices gets baked into the statistics. Last summer, oil was over $100. The year-over-year drop will start falling out of the inflation numbers by about De-cember. The Fed needs to stay ahead of this curve.

To signal normalization is the top job of today’s statement. The revised forecasts and the members’ fore-casts dots are important, too, and will be examined under a microscope, but the main event is the State-ment and the key word to watch for is normalization.

As for the too-strong dollar and divergence with other central banks in easing mode, this is not the Fed’s business or focus. We imagine Yellen has some phone calls with Carney and Draghi, but the Fed mandate pertains to the US economy, not theirs. And as for a stock market crisis, too bad. The Fed de-clines to define and try to manage a bubble and presumably feels the same way about a bear market. US equity indices point to another negative day on Wall Street—the equity equivalent of the taper tantrum. The FT reports that yesterday IMF chief Lagarde warned that a US rate hike could trigger instability in emerging markets. Again, too bad. That’s their problem, not the Fed’s.

And the front page of the FT features a story about Bridgwater’s Dalio, who worries that conditions to-day are like 1937, “eight years after the 1929 stock market crisis and at the end of four years of money printing that had led to surge in equity valuations. Premature tightening by the Fed led to a one-third slump in the Dow Jones Industrial Average in 1937 and the sell-off continued into the following year.” Bernanke’s book on the Great Depression covers this material very well. We feel sure Yellen has read it. The Fed said in January it is “watching” international developments. That doesn’t mean it intends to do anything about them. Vice-Chairman Fischer admits the Fed is not just any old central bank but its best contribution is “keep our own house in order.” Avoiding surprises is one way the Fed can help emerging markets (or anyone else). Thus, normalization is the key concept of the day. We get the statement at 2 pm and the press conference a half hour later. Anyone with a position at that hour is a cowboy.