Stock Market and Commodities Traders Front Run the Federal Reserve

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In my view traders and hedge funds have been buying up junk bonds, treasuries, stocks, and gold ahead of expectations that the Fed will announce QE at their next Fed meeting in November.

This is why treasury bonds appear to be trading at crazy levels that make no sense. Why buy a long-term bond with almost zero yield? The hedge funds buying these bonds are doing so in anticipation that the Fed is going to buy treasury bonds.

Bulls are arguing that it doesn’t matter what happens with the economy. If economic data is weak the Fed will print money. If the stock market drops the Fed will print money. Bernanke has in effect created a “Bernanke put” on the stock market similar to the “”Greenspan put” that led to the moral hazard that created the housing bulls and the implosion of Wall Street banks.

James Vale of Beacon Equity writes, “official statements from the Fed serve to lower the ultimate cost of its upcoming massive buying spree by allowing the PIMCO-led herd to feed at the trough first, other less-connected fund managers to feed second, and the public to pick up the remaining feed last in order to reduce the appetite needed from the Fed to reach its objectives regarding interest rates.”

“Whether QE II becomes official at the FOMC meeting on November 3, December 14, or as far out as January 25, PIMCO’s Bill Gross and his rivals have already scaled into assets expected to benefit from the coming tsunami of printed cash by the Fed—and in amounts equivalent to QE I, at least.”

A month ago rumors were that the Fed would do one big one trillion plus QE buying program, but now the Fed has been leaking stories to the Wall Street Journal that they are thinking of buying smaller amounts of bonds multiple times spread out over several meetings. One goal is to bring long-term bond rates down to below 2% in order to help the mortgage refinancing market in 2011.

Bank of America projects that the Fed will push 10-year treasury rates down to 1.75% in the first quarter of 2011.

Traders are positioning themselves in front of QE. The big question is what happens when QE comes?

The market still has heavy resistance at its April highs and is unlikely to be able to create a sustainable rally through those levels without first reaching them, having a big pullback off of them, and then going through them again. That is a process that would take the rest of the year to play out and part of it would be a move to those highs that would simply trap a lot of people who buy into them.

It is just as possible that the market rallies near those highs as we reach the November Congressional elections and a Fed QE announcement and then it peaks on the news and falls all of the way back down to the 1040 level on the S&P 500.

What will be important to watch are investor sentiment readings. If sentiment gets as frothy as it did last January and April in a few months then we’ll have be on guard for another nasty sell-off like we saw in May – in fact it would probably be worse. But until sentiment gets all bulled up like that for now the momentum for the this month should be sideways to up with a likely dip to start the month due to the market’s current overbought condition on a daily chart.

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