What to look for (while HFT churn the Markets)

By Macro Story;

As we enter what should be a very volatile week below are a few random thoughts to consider as you decide what to do if anything with your current investment strategy.

Redemptions

The big unknown is how spooked retail investors have become the past few weeks. ZeroHedge reported (found here) a $23 billion outflow from domestic equity mutual funds for the week ending August 10 which is a truly massive move. With record low cash levels at funds the only way to meet redemption requests is to sell stocks.

Watch for late day selloffs as a sign of such selling pressure. Funds will look for intraday strength to meet such redemption requests. If they are unable to find such opportunities intraday they will be forced to sell into the close causing late day weakness.

A combination of forced selling via margin calls and redemption requests is a self feeding cycle where selling causing more selling resulting in markets staying oversold far longer than charts say they should.

Commodities

Copper looks poised to test the $3 level based on recent COT data (see here).  A 25% drop may seem rather impossible but look at oil (WTI) where price fell 24.8% from $100.62 on 7/26 to 75.71 on 8/9.

Credit Markets

Bond yields continue to break down with the 10 year closing Friday at a multi year low and below that of the 2008 financial crisis. It’s not limited to treasuries either. High yield and investment grade debt are signaling economic weakness and risk aversion as are interest rate swaps.

Fed Policy Changes

Bernanke’s speech at Jackson Hole on Friday is the big event of the week but I think many have it wrong. The Fed has made it very clear that QE will only emerge when the threat of deflation emerges as well. In the summer of 2010 not only was the economy and market rolling over but so were inflation expectations as measured by treasury TIPS. Across the entire yield curve inflation expectations were well below the 2% Fed target.

Today inflation, not deflation is the threat (see here). From TIPS to CPI to PPI there is currently no risk of deflation. Additionally there are now three dissenters on the FOMC and politicians using Fed policy as a rallying cry to win the White House in 2012. It would be difficult for Bernanke to announce QE3 just weeks after QE2 ended.

The economy is really a game of confidence and if the Fed panics on Friday and comes out with QE3 which would have to be even larger than QE2 they may in fact spook any remaining confidence left. What the Fed has right now is a weakening economy not recession as they publicly claim, historically low treasury yields which was the purpose of QE in the first place and an equity market that is only down 10.7% for 2011. Not exactly the armageddon needed to begin another controversial balance sheet expansion.

Probably most threatening to the Fed is that of the rise in precious metals. This controversial “barbarous relic” is becoming a real threat to the USD as a stand alone reserve currency and the Fed’s ability to print at will. Some call this move in gold and silver a parabolic, overly exuberant and irrational market but realize there are central banks and sovereign wealth funds doing the heavy lifting. The simple fact that precious metals have outperformed the US dollar in the face of economic and geopolitical risk is not lost on the Fed.

The rise in gold and silver is a growing threat to future monetary policy tools available to the Fed.

Bottom line

Bottom line is no one knows what happens next. We’ve all heard the saying markets can stay irrational longer than investors can stay solvent and there is a lot of truth to that. On Friday I highlighted (see here) the September 2008 chart pattern specifically the days after Lehman failed.  Just a few days later markets put in a subsequent high, then sold off for a few days. Just when they looked poised for a technical bounce the bottom fell out and in seven trading days 300 SPX points disappeared.