Peter Tchir On Risk Positioning Heading Into The FOMC Conference, And Outcomes Heading Out

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From Peter Tchir of TF Market Advisors

Fed-up With The Fed

So here we are, finally at the big day.  We get the first press conference from the most important man in America.  Before you gag on the claim that he is the most important person, can you name one other person who has so much power coupled with the ability to act virtually unilaterally?  It's not so much what he can do, print money, change rates, print money, change reserve requirements, print money, that makes him so powerful, it's that basically anything that he wants to do becomes policy. 

Ahead of the Fed there are two interesting moves in the market that bear watching.  Treasuries rallied strongly into the close yesterday, but have given back a lot of the late day gains already.  The other more interesting phenomena is what is happening to Greek, Irish, and Portuguese spreads.  The bonds are blowing out, as much as 80 bps for Greek 10 year debt, but the CDS is actually tighter.  This divergence may be a result of the bonds starting to trade at recovery levels, so investors don't want the hedges, or an indication of yet another expected bailout, but it is worth watching as the divergence is quite large.

So, now to the Fed. 

Re-investing Proceeds

I remain convinced that the Fed will continue to re-invest proceeds from pre-payments and redemptions.  If they don't do this the market will be caught off guard as no one expects them to contract their balance sheet.  I continue to believe they will signal their intention to use the money to purchase bonds further out the curve as they try to re-link their purchases
to the mortgage market rather than the Russell 2000.  So the re-investment policy is unlikely to provide any upside, maybe a touch of curve flattening, and any indication that they will not re-invest will surprise the market to the downside.

QE3 and Extended Period

I now believe that they will NOT implement QE3.  The data has been too strong to easily justify QE3.  They also need to argue that QE2 has been successful.  That argument is greatly diminished if they say that QE2 was a great success, but not so great that we immediately need QE3.  To temper any disappointment, the Fed will make sure they are prepared to step in any time we need, and at any sign weakness, they will be able to rush in QE3.  This should mollify the news of no QE3, but I expect the market will react slightly negatively to this because although most people say they don't expect QE3, it feels like they are positioned as though there is a chance. The more cynical people in the market may even choose to believe the Fed was pressured by the government and PIMCO into dropping QE3.  This would put further pressure on the market if the belief that QE3 won't be easy to implement becomes more widespread.

There is a slim chance, that the Fed will hint at tightening.  At the very least I expect they will remove the extended period language from their accommodative policy line.  This would definitely catch the market unprepared and would see a sell off if near term rate hikes are implied.

So any statement regarding QE3 and future interest rate policy is likely to be negative for the market, though again I see most scenarios leading to a flattening of the curve.

The Economic Outlook

I expect little surprise from this.  The Fed will say signs of strength, firmer footing, sustained, but throw in a couple caveats that some data has been less robust of late and jobs continue to be more difficult to create than hoped for.  Some of the outlook will be based on information not available to the public, but most of the data is already out there.  Their outlook will be structured to make themselves look good.  They will mention how much better things are so that they can claim success with QE2.  The small negatives will be included so that they can seem compassionate about jobs (some consultant told them it would be a good idea to pretend to be sympathetic to the jobless) and to create wiggle room so they can continue to experiment with alternative methods and to keep more QE on the table. Hard to see how they say much in their outlook that is surprising.  If anything, maybe they will paint a more rosy picture than people are expecting.  Any rally on that should be faded, as people realize it is more spin than reality.

The Conference

Now we get to the interesting part of the day.  I see three distinct outcomes from this session.

Do I look fat in this dress?  (60% likelihood)

In this scenario, the Chairman fields mostly softball questions. Questioners will ask seemingly difficult questions, but where there is really only one answer.  The questions will let the Chairman talk about all that is going well - stock market.  He can defend what is not going well - signs of inflation are merely temporary and jobs are turning the corner.  He can re-assure the public that he has the tools in his power to ensure we never have another crisis.  He can say that he is on guard for signs of weakness and prepared to react.  So long as he comes across as dovish and willing to focus on supporting stocks at any sign of weakness, then  the market will react positively.  In theory, this is nothing new, but just as saying 'you don't look fat in that dress' always creates some good will, this line of relatively dull questions followed by trite answers will lead to rally in stocks.

Should I send the wine back?  (30% likelihood)

Have you ever ordered a reasonably expensive bottle of wine that doesn't taste quite right?  Not so bad that its clearly vinegar, just bad enough that you aren't sure if its corked, but not good enough that you really regret having spent the money on it?  Well, most of us will stick with the bottle, feel bad about the purchase, tell the waiter its okay, and regret the decision, but not really do anything about it.  Well, in this scenario, the reporters delve into performance of the dollar and signs of inflation post the start of QE2.  It gets a little contentious.  We are forced to digest the argument that oil inflation is deflationary, we don't really get good answers, but the tone remains civil and in the end the market does nothing.  The experience will plant some seeds of doubt in the Fed for many who fully backed it and its policies, but this will play out over the longer term and have no immediate impact. 

The man behind the curtain?  (10% likelihood)

Just like in the Wizard of OZ when the curtain comes down and the myth is debunked, in this scenario the market becomes extremely concerned with the man pulling the levers.  Occasionally during his congressional testimony, the Chairman has become surly, condescending, and almost antagonistic.  He gets away with it, in part, because the questions he is forced to answer are often bordering on asinine.  If reporters hound him on dollar weakness, inflation, and jobs, will he become surly?  Will he be belligerent?  I think the reporters will need to press hard to get this reaction, and are unlikely to be given the opportunity, but if he does get pushed on these very real issues, there is a chance we see a 'you can't handle the truth' moment.  If he can get pushed to that edge where it becomes clear that in reality he too is scared about inflation or is manipulating the dollar we would see a crisis of confidence and a sell off across stocks and treasuries.  Unlikely to get there, not because it's the truth, but because the format of the conference won't let any hot button issue get pushed hard enough.

So coming into the conference, I like a flattener and small short in equities, but will be watching step by step for cues to grow the stock short in particular.