Background

There is much speculation and anecdotal information regarding the rally that began March 6 2009, which have suggested the gains are the result of massive manipulation on the part of the Federal Reserve (FR) and the large institutions that dominate Treasury securities dealing, program trading and the derivatives markets.   Traders have reported that traditional indicators and metrics used for market analysis stopped working for periods of time or altogether, and that correlations among markets have been erratic and quick to change.  Record program trading by Goldman Sachs as reported by the NYSE, heightened focus on high frequency trading (HFT), outsized profits by the large and well-connected banks, along with unprecedented intervention by the FR in the markets only fuel the manipulation speculation. 

If we had a big picture model (a Grand Unified Theory, or G.U.T.) that described the intentions, motivations and actions of the influential players, we could attempt to predict future market direction.  A limiting factor is that the rules of the game have changed quickly, and what we believe is important to the major players now may not necessarily have been important twelve or even six months ago.  Accordingly, while we will present as much supportive data as possible, our sample sizes will be small and we will rely on educated conjecture when necessary.  As such, we would expect to be, at worst, self-referentially coherent and, at best, correct in our predictions for the coming weeks and months. 

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The Precise Take – 7 Year Auction buys time for bonds as equities finish record strong month

We were at a crossroads this week contemplating that our primary theory of the markets, the dominant theme of which is the interplay between US Treasuries and equities, was no longer or was never correct.  After yesterday’s 7 Year auction, we are more convinced than ever that this is the case, and that the markets are caught in a tug of war between Bernanke’s Federal Reserve (FR) in Washington attempting to keep down long term interest rates and Dudley’s FR Bank in New York (FRNY) trying to keep equities on a tear for the large member banks.  The administration prefers both as they help keep public opinion from swelling to be too negative and hurting the chances of pursuing its agenda (which is already in danger). 

The entire week’s price action in the ES with all its zigs and zags could have been forecast in two scenarios as early as last Friday, with the correct scenario being known Tuesday afternoon.  It involves the varying dynamics of (1) the paint-the-tape closes induced by permanent open market operations (POMO) by the FRNY, (2) the Treasury-supportive signals broadcast early in the week in the EuroYen forex cross as well as the gold and Treasury futures markets (to this we note that the FRNY contains massive gold holdings as well as foreign currency reserves in exactly two currencies—the Euro and the Yen), (3) declining M2 non-seasonally adjusted which has a strong historical tendency to increase volatility, (4) the record Treasury auctions that needed to show enough demand to prevent a dangerous rise in yields, and (5) the need for equities to close the month on a high note.  It was as to 4 and 5 where we went slightly askew because 5, above, was the priority (equities needed to post as much gain as possible end of month) and, as to 4, we had hypothesized that Treasuries needed to rally at the expense of equities whereas they actually only needed to tread water until the eventual equities takes place. 

As an aside, M2 NSA as reported yesterday continues to shrink, thus increasing the likelihood of continued or increasing volatility.  A reader correctly commented yesterday that the FRNY’s POMO forays are money printing.  However, this increase in the monetary base is not working its way into M2 for whatever reason, and it is M2 that has the most effect on the economy and not M1 or M0 (the monetary base).  Historically, the Fed has had little control over M2, but we suspect that, with its increased powers, the Fed has more control than previously and may be intentionally counteracting the money printing of the NYFR.

To further support the priority of a strong equities close, the FRNY announced yesterday it would conduct POMO for Agency securities (Fannie/Freddie) today, and we commented pre-auction yesterday:

After $3 B yesterday and $6.5 B today, another (probable) $1.5 – $3 B tomorrow [Friday] in Fed funny money sent to banks that can be leveraged 100x or more should give the bears pause, especially into month end (tomorrow).  Our question is, what is the NYFR so worried about?  The contrarian in us would believe it’s to overcome a weak GDP report tomorrow and/or a very strong 7 year auction today.

That the 2 and 5 year auctions did not send the 10 and 30 Year futures down by 3 or 4 big points into Wednesday afternoon was evidence enough that demand was being saved for the 7 Year.  As we updated yesterday post-auction, “Bernanke has probably bought himself two weeks of long term yield control until the August 12 10 year auction is conducted.”  We will by tying all this together in a more comprehensive report over the weekend that includes possible scenarios for the next couple of weeks.  Register free here to receive this and other updates.

The time profile for the day after a POMO day (as was yesterday) that is also a POMO (A) (n=5 since May 09) shows a strong tendency for the ES to head down and bottom in the first hour, with no clear further bias until the close, which shows a strongly bullish bias.

As we write, GDP has clearly disappointed as expected; however, equities are ensured a good close as we find a close below 973 unlikely.  In light of the new comprehensive analysis above, we are removing our 1008 target and suspect…

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New York Fed Announces July 31 Outright Agency Coupon Purchase

After $3 B yesterday and $6.5 B today, another (probable) $1.5 – $3 B tomorrow in Fed funny money sent to banks that can be leveraged 100x or more should give the bears pause, especially into month end (tomorrow).

Our question is, what is the NYFR so worried about?  The contrarion in us would believe it’s to overcome a weak GDP report tomorrow and/or a very strong 7 year auction today.

If Bernanke manages to keep long term yields down after Geithner’s Lollapallooza in Treasuries while the FRNY keeps the stock market juiced into tomorrow, we will personally pin the Precision Award for Masterful Manipulation on Bernanke, Geithner and Dudley.

11:19 am EDT:  Despite the bearishness being broadcast by the above leading instruments, the ES refuses to die.  Again, the 1:00 pm EDT 5 Yr auction is key today, though the 2:00 pm Beige Book will give insight into the data the Fed is pondering. 

On a typical POMO day such as today, we see a dip into the 1:30 pm hour before a paint-the-tape close.  As we said in this morning’s report, the key for the bears is to keep the ES under 973.00 before the final tape-painting hour (45 min) begins at 3:30 pm.  Above, and the bulls have a chance to break to new highs. 

So far, the day has been a VWAP oscillation day, but that will likely change this afternoon.

10:44 am EDT:  ES is testing yesterday’s lows after a worse than expected Consumer Confidence report.  We’re willing to short between 975 and 977, but if the ES cannot get back above 973.25 soon, we could easily head down to the next support area of 962.75 to 965.25, at which we would fade long with tight stops.  We’re not outright bullish until the ES can again get above 980, which we think is unlikely today.  Watch price action around the 1:00 pm Treasury auctions because a disaster (unlikely) would be enough to turn equities bullish.

Gold materially down from resistance and 30 yr/10 yr holding support today give a bearish tilt to the market’s direction this week and are forecasting successful Treasury auctions.  Also, the EuroYen forex cross, as a barometer of risk, has also materially corrected today in a bearish engulfing candlestick pattern. 

Accordingly, the most likely scenario this week that we envision is a down day today, up day tomorrow into the close because of POMO, retest of highs either by end of tomorrow or early Thursday, then heading down again into Friday close, with the markets attempting to find support and continue the rally sometime next week.  If we can reach new highs by early Thursday, then we could easily see another short covering rally into the 1008 target zone by Friday close; however, this is the less likely scenario.

The Precise Take – Slight weakness into significant Treasury auction day

The short term and TIPS Treasury auctions went well as expected yesterday, with the first test of the real demand for medium term Treasuries today at 1:00 pm with the 52 Week and 2 Year auctions.  We’re still looking for leadership clues with gold trying to break through 61.8% resistance or reverse to the downside off this level, and similarly a break in 10 year notes and 30 year bonds of support or a reversal to the upside, with none of the three moving materially since yesterday.

Tomorrow and Thursday of this week are back to back days in which the Federal Reserve Bank of New York (FRNY) will be conducting permanent open market operations (POMO)*, which will flood large banks with leveragable liquidity at about 11:00 am on each of those days, and which has an end of day tape-painting effect.  See page two for time profile graphs of what can statistically be expected for today, tomorrow and Thursday.  There is a tendency on a Pre POMO day, such as today, to front run the expected liquidity injection into the close (3:30 pm to 4:15 pm).  Tomorrow, we would also expect most gains to be into the close.  And, though there have been only 6 prior back to back POMO days (all since May), the bullish edge appears to disappear on the second POMO day, which would be this Thursday.  Accordingly, swing longs may want to close out positions by tomorrow (Wed) as opposed to waiting for the close on Thursday.

Today is a moderately full news day with the times to watch as 9:00 am, 10:00 am and 1:00 pm.  With premarket action in the ES getting down to daily S1 (day-session-only) and below yesterday’s highest value area point of control, we have a bearish bias.  Longs will need to get above the daily pivot/gap area of 976.25 to 980.00 to regain…

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10:30 am EDT:  As we wrote this morning, statistically, on a PostPOMO / POMOA day (if that’s Greek to you, hit POMO in the tag cloud below for descriptions in other posts), we see the low in the first hour, which is now up.  As we’ve tested overnight lows, price supports a reversal as well.  Below 963.50 (overnight low), we won’t get aggressive short until 957.50 is taken out as day trade and longer term traders will see 957.50 to 960.00 as a good entry area for a variety of reasons.  We’re still willing to fade a rally at the ~972 area if we still have below average volume, but will not stick around short above overnight high of 973.75.  Above, and we’ll look for longs up to daily R1′s at 980.50 to 981.00.

12:04 pm EDT:  Below is the table from this morning’s report updated to include the funding announcement of the US Treasury released today at 11:00 am.  We don’t recall the 52 wk auction scheduled to be announced this morning and it appears to have been slipped in at the last minute.  The bottom line is a record $199 B will be auctioned next week, a $34 B increase over the corresponding week in the previous month (even without the 52 wk auction, the increase is $7 B).  Including the 10 Yr and 30 Yr, which were already auctioned this month, there is $229 B in new debt being issued this month. 

Not surprisingly, long term yields are soaring and bonds are sinking to the lows established before Bernanke’s congressional testimony on Tuesday.  With a soaring stock market (inflationary), record debt issuance, and a Fed that refuses to monetize debt (evidenced by shrinking M2–updated weekly report today at 4:30 pm), we are on a collision course with a very volatile end of summer into fall.  We pay respect to the breakout today and would not discourage experienced traders that can monitor positions on a daily basis and enact good risk management, but the threat to long term passive investors is immense. 

Eventually Bernanke will either further shrink money supply to keep yields under control (with the good possibility of inducing another market crash), or yields will be allowed to explode and we will enter the beginning of a hyperinflationary cycle that will take some time (perhaps a year or more) to become dangerous, but ultimately ends with a bond market singularity that results in the reptriation of all US debt and practical end to the US Dollar.  Bernanke is aware the latter is much more onerous that the former, which is why we are skeptical of suggesting any long term investment in equities by any but experienced traders.

In the ES, we hit our 970.50 major upside target and are closely approaching the daily R3′s at 974.75 to 976.50.  Given the strength so far, we would not be surprised to see them eventually exceeded and could even hit monthly R2 at 986.25 on the permanent open market opearations (POMO) close ($3 B in funny money [before leverage] dumped into the markets this morning).  Also, the Treasury just announced that tomorrow it will make Agency POMO purchases, suggesting another strong close tomorrow.  Accordingly, even if the market is extremely overextended on the close today (likely) and a short is initiated, it should be closed in the first hour tomorrow rather than held to close.

10:20 am EDT:  The ES tested supply in our bullish area just above yesterday’s settlement of 853.50 and now needs to get above this area to test contract highs at 957.50.  Otherwise, we will probably test overnight and day session lows in the 942.75 to 944.75 area, which we would fade long with a tight stop, but not hang around long below.  Fading short above the current day high of 954.50 is very risky.  Then again, so is a long between 853.50 and 857.50.  The shorts need the high to be in and the longs have the advantage of being able to test lows and rally again in the afternoon.  Only below 940.75 does it look like the high is in for the day.

10:30 am is the petrol report with crude so far backing off its high of yesterday.  Higher crude = improving industrial capacity utilization = higher equity prices.  The inverse is true as well.

For Post POMO day profile followers, the down correction came a bit early pre-market, so we’re not as encouraged for the typical pattern to hold and would not hang around with shorts should we see new highs.

The Precise Take – Continued gains, but hanging at resistance

Yesterday’s 16.75 point intraday correction in the ES was the largest since July 8’s 18.25 point correction, which set the interim low of 865.25 that was tested three days later and began the latest up swing.  Though the rally from the early afternoon into the close yesterday was impressive, it was entirely consistent with the profile of one of the days in which the Federal Reserve Bank of New York conducts permanent open market operations (POMO), flooding large banks with cash, which can be leveraged, and is highly correlated to a very strong end-of-day close*.  The profile for Post POMO days (today) typically sees a strong decline in the first hour of trading (already begun today premarket), a brief afternoon reprieve into the 1:30 pm closing hour and continued marginal declines into the close.

Additionally, yesterday’s day-session-only generated a hanging man candlestick pattern with a small body on top with a long shadow beneath it, which we have not seen in some time.  Placing the additional condition of having the open or close of the hanging man be greater than the greater of the open or close of the previous bar, we have only seen this pattern a few times in the last few years.  The last such one was on July 18 08, which was after a prolonged down move and did see higher prices in the subsequent months.  Prior to that, however, there was one on May 16 08, which saw a spike high above the 200 day MA the following day, only to be hammered lower over the next two months.  Before that, another on Dec 26 07 was the high for the next month and also coincided with a peek above the 200 day MA.  Prior to that, there were two close together, one on Mar 26 07 that saw a 5 day decline, and another on April 4 07 that saw a precipitous two month rally.  Accordingly, if the ES cannot close materially higher today (or tomorrow at the latest), this is a very bearish pattern short and medium term.

Bernanke speaks again at 10:00 am; however, we think his points were made yesterday where he talked bonds up and yields down to save a retest of recent extremes.  As we wrote in an intraday update yesterday, he does appear more concerned with keeping down long term yields than propping up the stock market.  With oil on the rise again, eyes will also be on the 10:30 am petroleum status report.

As we write, the ES has entered our bearish zone and already broken down to the daily S1’s, where it has found temporary support.  We are bearish again from…

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