The full force of the Fed

PORTFOLIO POINT: The Fed’s cheaper funding has given the market a lift, but questions remain about how much longer the rally can last.

It has been one hell of a week. My initial reaction on the Fed’s intervention: it must have been very bad for it to have to step in. Rumours of an imminent collapse of a large European bank would not surprise me.

However, the fact that S&P downgraded 37 banks including Goldman Sachs, JP Morgan and Bank of America then – hey presto – the very next day the Fed provides cheaper funding to all and sundry, has a whiff off desperate financial lobbying.

Be that as it may, they have done what they have done and the questions remain: how long will it last and how much further will risk assets rally? From a technical standpoint, the S&P 500 chart below shows we have several downward sloping trendlines and the 200-day moving average, which will provide strong resistance from 1250 up to 1270.

This might be a watershed moment but right now here are some other points to consider.

• We have rallied the best part of 10% in three days; German Chancellor Angela Merkel is still pushing back on the idea of an expanded role for the ECB and favouring, Bloomberg reports, tighter economic ties in Europe as the only way forward.
• On December 9 there is a European summit; leading into this there will be volatility, hope and headlines aplenty. If this European summit is true to form it will disappoint the market.

The Elliot Wave crew pointed out yesterday that bailing out the financial system by the central banks is not new news. In fact, it was done in 2007 by the big five central banks and again on October 14, 2008. The market dropped 54% from the 2007 bailout and 34% from the October 14 bailout to its 2009 low.

Stratfor also made some interesting points in a note titled IMF Unable to Save Italy. In relation to Italy’s debt, it said: “It’s unserviceable and Italy faces billions in maturing debt that must be refinanced on a monthly, and sometimes even a weekly, basis '” 300 billion euros in refinancing needs in the first half of 2012 alone.” On the IMF it says: “It simply doesn’t have the resources to bail out Italy.

“The IMF’s entire financial reserves are slightly under $US400 billion (about 300 billion euros). Any credible remediation program for Italy would need to be in the range of 800 billion euros, and that’s before taking into account the costs of recapitalising Italy’s banks.

“Expanding the IMF’s reserves is possible, but it first requires buy-in of every major country (and several not so major countries) in the world. To this point that’s always required multiple years of ratification processes.”

Recent action by the central banks is a positive; it has bought time. European leaders will have more talk fests and perhaps they can solve their problems. I have my doubts.

More importantly the cost of funds has come down as demonstrated by my Offshore Funding Index below. It has dropped 21% from 193 down to 152. Although this is a step in the right direction, as long as it is trading at 150 or higher, money markets are still in a stressed state.

Another positive is that the CRB Index has recently put in a higher low and is threatening to break up through its downward sloping trendline. Right now the trend is still down, but at least there are some signs of life.

A third positive is that BHP held the all-important $35 level once again and has survived, triggering a weekly head and shoulders pattern, which would be very bearish. See chart below.

If you are in the bullish camp and believe recent actions by the world’s central banks will avoid a banking crisis and hence a global recession, then buying risk assets like BHP will be a good bet. Just use the recent lows in risk assets as your stop, because a break below 33.75 on BHP, 1150 on the S&P500 and 96.68 on the Australian dollar would be very bearish.

If you are in the other camp or are trading this market, I think fading this rally is a good bet for a pull back. Once again markets have swung from bearish to bullish, have a lot of hope built into them and we are at the upper end of the range once again.

Tom Lovell is an analyst and independent investor.