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September 16, 2008

Tenuous at Best

If you're wondering why the Fed didn't cut rates today, you've come to the right place. I'll tell you exactly why they didn't cut: the Fed Funds rate doesn't matter. In a normally fluctuating credit environment, a change in the FF target rate can impact credit on the margin. However, when the crisis is huge, a small change in the target rate would have no impact on the margin. Case in point: the Fed Funds rate was trading at 6.33% last night despite the Fed's 2% target and a huge liquidity injection. If the FOMC had voted to reduce the target rate today, it would have done nothing but undermine confidence in the dollar and exacerbate rather than mitigate the crisis because it would have weakened the motivation for foreign banks to finance us.

Turning to the action, we saw a huge rally develop out of the intial negative reaction to the Fed's announcement. The mantra that the first reaction is the wrong reaction after a Fed meeting held true. From the post-announcement low to the close, the S&P 500 rallied 38 points, or about 3%, and left us with a juicy looking bullish candle.

index chart

index chart

No matter what your bias at this juncture, you have to respect today's reversal. The fact that we saw such huge upside after news that would normally send the market reeling means that near-term bearish expectations are tenuous at best. Although I had expected to put back on part of the short position I closed last night (see comments below yesterday's post), I chose deference. In fact, the evening headlines have brought us news that the Treasury will take AIG into receivorship, and the spoos are popping another 1% after hours.

Now, I'm not saying the bear market is over... only that until the market proves otherwise, one has to respect the signals from the charts. The thing that bugs me the most concerns the fact that, with the exception of the VIX, none of the oscillators came anywhere near the panic levels seen at other, recent bottoms. I'm wondering if today's reversal will turn out to be the biggest head fake of the year. If so, we should see weakness immediately. I'm not going to bet on it, though. The best course of action is to wait for a clearer picture.

If one is to interpret strength or weakness relative to normal reaction to the news, then we must also expect some near-term strength in commodities. Although silver, oil, and a few other items were down big today, they were actually marginally stronger after the Fed announcement. However, I'm going to leave the long trades to Tim and Gary for the moment. I just don't like the chart setups, and I continue to believe the surprises will be to the downside for a while. If we do see commodities rally, I will take the opportunity to sell OTM calls and just bank the time.


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