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The Global Window of Danger and the Fed's Next Moves

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It's likely that after a relief rally associated with a Fed move -- or anticipation of a Fed move -- the trend will most likely continue downward.

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The concept of a "window of opportunity" is often spoken of. Right now, I think we need to be thinking more in terms of a "window of danger."

In my view, the maximum "window of danger" for global financial markets will transpire between now and October 1. The reason is that the economic data all around the world that will be published in August will be horrible because July was a terrible month. Similarly, the data published in September will be horrible because the turmoil in financial markets likely in August will certainly take a toll on economic momentum all over the world. And of course, there is the issue of seasonality, which may only be psychological. But it is there.

(See also: What's Next for the Stock Market?)

With regards to stress points along this time-line of danger, I would highlight bank-funding markets. Right now, there are ominous signs of stress. For example the 3-month EUR-USD Libor spread has spiked to levels similar to those seen in April of 2010 in the midst of the initial round of sovereign debt crisis in Europe. Stress of this magnitude in funding markets have often (not always) been a precursor to sustained downwards moves in equities – well beyond that which we have seen already.

This sort of funding stress begs for decisive government action in Europe to contain fears of sovereign default. It also raises the specter of more active central bank policies around the world.

We might be hearing news from the Fed in the next few days. The first move, in response to global funding stress, might be to re-open special Fed funding windows. Second, I am intrigued by the possibility of the Fed taking down the reserve deposit rate to 0%. They have hinted that they are actively considering this option. This latter option has the potential to be a significant source of support for markets in the medium term.

The downside of this option is that there will be unpredictable and difficult-to-control effects on the money supply. Furthermore, it may hinder profitability at banks and raise their risk profile – something that goes against the grain of what the Fed would normally be trying to do to help repair the still-fragile US banking system. However, the Fed may reckon that it is a gamble that they will have to take. Ben Bernanke strikes me as a gamblin' sort of man.

Finally, I would not make too much of today's intraday rebound. I think it is almost purely a technical phenomenon. I would expect today's intra-day lows to be tested and then violated in the next few days or weeks.

The strength of the ongoing rebound may be determined by Fed actions or perceptions about potential Fed actions.

Unless the Fed comes up with something that I cannot anticipate, I believe that after a relief rally associated with a Fed move or anticipation of a Fed move, the trend will most likely continue downward. I tend to think that the S&P 500 is ultimately headed toward a test of support in a band between the 1,180 to 1,220 area. Whether this area holds depends upon a stabilization of the sovereign debt situation in Europe, and a recovery in consumer and business confidence in the US.

In anticipation of some short-term follow through on today's intra-day rally, I have sold my entire VXX position for a large gain. This is a vehicle that has a huge tracking error and can only be used for very short time frames.
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No positions in stocks mentioned.
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