US Federal Reserve – the markets are all ears

The big day has arrived.

At 7.30pm BST, Ben Bernanke will speak – and the whole world will be all ears, hanging on his every word. It’s almost biblical!

But why does he have so much dominant power over the markets? And why are markets so dependent on what he says and does?

Consider this: The Fed is buying $1.8trn of AAA bonds each year out of an available market of $2trn. This is totally unprecedented.

Then, the world’s major central banks – who regularly collude – now own $20trn in bonds, equal to around 25% of global GDP.

The fact is central banks are now the market! So far they have been the buyers, but will they turn into forced sellers at some point?

What they say and do have always had an impact on markets, but today it is even more so.

I certainly would not want to be in Bernanke’s shoes. The whole weight of the financial world is on his shoulders – and he knows it!

But we all know that this central bank propping up of markets cannot go on forever, and this is why investors/traders have been busy positioning themselves for what they hope is the correct interpretation of his words.

And the longer this game goes on, the harder it will be for the Fed to engineer a ‘soft landing’.

But the pressure is on to begin starting to announce a plan to try to tip-toe out of quantitative easing (QE) – long-term bond yields are already strengthening, contrary to the Fed’s intentions (or hopes).

As a trader, I try to ignore my own views – in this case, I am open – and focused on what the others are doing.

The swinging COT data

On Monday, I showed the latest commitments of traders (COT) data for the e-mini S&P, which showed a massive swing by the hedge funds to reduce their long exposure, while at the same time, the small specs have hugely increased their long positions.

From this and other sentiment data, it is clear that the small traders/investors have been buying equities with abandon.

Remember, this is classic topping behaviour, especially coming after a strong four-year rally.

Now here is the data for the $5 Dow:

Non-commercial Commercial Total Non-reportable positions
long short spreads long short long short long short
($5 X DJIA INDEX) Open interest: 110,852
45,533 5,485 141 47,755 86,549 93,429 92,175 17,423 18,677
Changes from 06/04/13 (Change in open interest: -5,289)
-3,240 120 5 -958 -3,213 -4,193 -3,088 -1,096 -2,201
Percent of open in terest for each category of traders
41.1 4.9 0.1 43.1 78.1 84.3 83.2 15.7 16.8
Number of traders in each category (Total traders: 97)
30 15 4 34 29 66 46

The hedgies have slightly reduced their long exposure, but are still over eight-to-one bullish. This is a very lop-sided market!

This data is telling me that the consensus believes that the Fed will make no substantive changes to the QE programme. What I think doesn’t matter.
But with the long side as overcrowded with specs as it is, there is scant room for error.

Bubble tops are too tricky to call

A while ago, I showed an Elliott wave label scheme on the rally from the November low in the Dow, where the 22 May high at 15,540 was the wave 5 top. When fifth waves top, the next move is down.

But here is an equally attractive alternative labelling:

Dow spread betting chart

The 22 May high is now my wave 3 top, the decline this month is a new wave 4, and we can expect a new high for wave 5 under this labelling.

This actually looks better, as my new wave 3 has a clear five-wave pattern within, whereas the old wave 3 did not have such a clear pattern.

Now, I can draw a new tramline pair, with my upper line having good touch-points.

With markets – and Elliott wave labels – we are dealing with probabilities, not certainties.

The bottom line is this: As a coward, my policy is to sit this one out, as bubble tops are notoriously tricky to judge – and the top may be my new wave 5 which lies above 15,540. We shall see.