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The Master of the Fed Domain


We all know that there are massive imbalances percolating under the seemingly calm financial surface.

"The wind in the willows played tea for two. The sky was yellow and the sun was blue."
-- Robert Hunter

Do you remember the "Seinfeld" episode when George tried to do the opposite of everything he knew in an attempt to change his luck?

Good was bad. Day was night. Tuna was salmon, swimming against the stream.

In that bizarro existence, everything seemed to fit into his own perceived reality.

And it worked, at least until "Friends" came on.

In the real world, we're not afforded the luxury of royalties or repeat performances. Every action has a consequence and every yin has a yang.

Six weeks ago, when the Dow Jones Industrial Average was trading at 13,400, the FOMC proclaimed that "the predominant policy concern remains the risk that inflation would fail to moderate as expected."

Life was good, at least as measured by asset prices, and the notion of a tightening bias was akin to a modern day Newman.

It was annoying, but it was harmless.

As the FOMC prepared to meet yesterday (and with the DJIA trading around that very same level), talk on the Street centered on the potential for a rate cut. Indeed, as Kevin Depew noted in yesterday's "5 Things," the headline on Bloomberg said it all.

"A stock market slump, further declines in U.S. house prices and surging corporate borrowing costs will "shock" the economy and prompt the U.S. Federal Reserve to cut its key interest rate, according to Merrill Lynch (MER)."

Six weeks, flat prices and a polar opposite mindset on the Street?

A "slump," with the mainstay averages higher across the board?

Are we all playing Trivial Pursuit with the Bubble Boys at the Federal Reserve?

With a credit crunch upon us, Bear Stearns (BSC) on the front page and the housing market slipping into the abyss, psychology - and index levels - had seemingly come full circle.

During this strange stretch, we've heard a bevy of Fed officials opine that all is well in our financial fabric. And yesterday, to prove their point, they left the tighten bias in place to prove it.

As a card carrying capital market participant and the owner of a small business, I certainly hope they're right. But as we edge through our finance based, debt-dependent economy, prudence dictates taking a look at the risk behind that reward.

Let's say you were running the U.S. Central Bank and foreigners held monstrous amounts of dollar denominated assets. They're upset because the basis of those holdings -- the reserve currency of the world -- has lost 30% of its value since 2002.

Let's further assume that, on the back of the tech bubble, the U.S. consumer was encouraged to borrow (in order to consume) with hopes that a legitimate economic expansion would take root.

You, as the FOMC, would now be faced with a difficult decision. Do you raise rates, to appease the global holders of your debt, or do you lower rates in an attempt to spark further demand and quell fears?

And if you had to raise rates -- if your hand was being forced by those who owned dollar denominated inventory -- how would you posture your actions?

Odds are, you would keep the collective focus centered on the risks of inflation and spend a fair amount of time trying to convince your constituency that the devil you know is better than the devil you don't.

There's no grand conspiracy here. There is inflation -- in things we need, such as energy, healthcare and education -- but there is also deflation, in commoditized products such as laptops, cell phones and plasma televisions.

But that's not really the point. We all know that there are massive imbalances percolating under the seemingly calm financial surface. The question, from a capital preservation and profitability standpoint, is when and how they will manifest.

The answer is simple. They will "matter" when the price action dictates they do. And that will only occur when the chasm bridges between perception and reality.

For instance, when M&A, which has been the driver of the bovine sentiment, grinds to a halt. As it has in August, which was the slowest monthly deal activity in four years.

I've long offered that we will toggle between "asset class inflation" and "dollar devaluation" and equity gains must be accompanied by slippage in the greenback (-33% in the last five years).

But while dollar devaluation has been stealth in the eyes of most Americans, you can be sure that it hasn't gone unnoticed abroad. That's precisely why we've seen growing seeds of nationalization and increased acrimony in foreign affairs.

I don't envy those in the Federal Reserve as they're in a pretty pickle. As long as the screens are green, however, they'll have wiggle room to navigate this cruise ship through the canal.

Which is precisely why they continue to jawbone and offer assurances. The risk to this market is psychology. And if the Fed's Street credibility is called into question, the wheels will quickly wobble on the wagon.

The key, from a near-term perspective, remains the action in the financials. Those are the trees with "the other side of globalization" being the forest. American society has been lulled into an immediate gratification mindset that spends now and pays later. Big picture concerns have migrated to the back burner.

While we (at Minyanville) didn't expect the Fed to shift their stance yesterday, the muted vernacular in their statement was notable. Yes, they gave a conscious nod to "credit conditions becoming tighter for some households and businesses" but it was almost an obligatory disclaimer before commenting on the expanding economy, solid growth and robust global landscape.

So there you have it -- the answer we really wanted to know was whether the Fed was going appease China and other foreign holders of dollar-denominated instruments or address the stateside credit mess.

Thy ballot has been cast. And perhaps, now, we know why.

We wouldn't be shocked if the powers that be are operating under the surface (Fannie Mae up almost 20% in the last two sessions?) so perhaps they can afford to assume a calmer public persona. But I'm not buying it--literally or figuratively--as something smells to this scrunched up nose.

That, of course, doesn't mean we can't rally -- in fact, the Goldman Sachs (GS), Fannie Mae (FNM), Freddie Mac (FRE) and Lehman (LEH) action after the announcement suggested that we would.

But I stuck to the sidelines, conscious that the first move after a Fed meeting (in this case lower) is typically false, awaiting a possible entry point at S&P 1490 (resistance) to take a short-side swipe.

Until deals start getting done, with or without last night's buff Cisco (CSCO) guidance, the benefit of the doubt remains with the bears.

Pick your spots and stay disciplined. For now more than ever, the ability not to trade remains as valuable as trading ability.

Good luck.
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