Did the Fed Flinch?

The S&P500 slid 2.2% last week on not so heavy volume.  The VIX (or fear index) jumped 7% extending its slow motion move upward over the last six weeks.

What made the slide more puzzling was the lack of any awfully bad data.  It was weak, as usual, but weak data over the past several months had not prevented equities from rising.  The leading indicators index was slightly weaker than expected, but it did move up nevertheless.  Initial jobless claims, at 530,000, were slightly lower than predicted.  Existing and new home sales were both lower than expected and slightly lower than in the prior month.  Durable goods orders fell; they were expected to rise.  Consumer sentiment was stronger than consensus estimates.

Technically, the S&P500 weakened on a daily chart, but it still maintained its uptrend on a weekly basis.  On the monthly long-term charts, the downtrend is still in tact, although price levels are now just about to bump into this down trend line.

So if the economic data wasn’t the core reason for the drop in the S&P, then what was?

Apparently, the Fed’s comments–not the official committee statement, but an Op-Ed piece by Fed Governor Kevin Warsh–gave the markets something to worry about.

If the Fed’s $1.5 trillion quantitative easing program has helped fuel the rise in the capital markets, then any signs that the Fed might withdraw this program, faster and more forcefully than expected, could bring the party to an abrupt end.

And it seems like Mr. Warsh hinted that the Fed might pull the punchbowl faster and more violently than the markets had anticipated.   In his words, “policy likely will need to begin normalization before it is obvious that it is necessary, possibly with greater force than is customary”. 

Ouch–for the capital markets!

But this could be a sign that the Fed is starting to worry that the world’s holders of dollar securities might reject the Fed’s massive dollar printing program, a program that monetizes debt issued by the Treasury and housing agencies.

As discussed in prior posts, such a rejection could lead to a dollar and funding crisis, which in turn could lead to total systemic collapse of the U.S. financial-economic-political complex. 

Barron’s this week featured a piece on the growing likelihood of a Japanese debt default.  What was once unthinkable is now being presented as uncomfortably probable.  And this in a nation 1) whose huge sovereign debt borrowing is almost exclusively financed by its own citizens, and 2) that exports more than it imports, thereby extracting wealth from the international economy.

The U.S. on the other hand, borrows about half its debt from foreign nations, on a short term basis.  And the U.S. consistently imports more than it exports, thereby taking on even more debt from the international economy to finance this balance of trade deficit.

If the sun is setting on Japan, is America approaching the edge of another cliff without even realizing it? 

Let’s hope the Fed continues to flinch.

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