Will the Hawk/Dove Conflict Lead to a Channel?

It's too soon to confirm yet, but keep an eye out for a possible reversal

   

Fed Chairman Ben Bernanke spoke to members of the House of Representatives in Congress Wednesday, and his prepared remarks were quite dovish. “Dovish” and “Hawkish” are terms unfamiliar to many traders, and until four years ago, only bond and currency traders used the terms on a regular basis. If the Fed is dovish it means they want an easy monetary policy or lower interest rates. If they are hawkish then higher interest rates and tighter monetary policy is expected in the near term.

Bernanke’s comments indicated a greater emphasis on easy monetary policy than we heard in May or June. He also emphasized a need for fiscal policy that should be aligned with what the Fed is doing, which may also be a little confusing to individual investors. The Fed can engage in monetary policy, which includes interest rates and the money supply itself. The government engages in fiscal policy including spending and bond issues. Monetary and fiscal policy are managed semi-independently, which can result in conflict.

Right now there is a conflict between a dovish Fed and a more hawkish Congress. This conflict is a big concern to the Fed Chairman, and to traders in general, so it wasn’t much of a surprise to see that this was emphasized as one of the most important risks to the economy. Bernanke said “the debate concerning other fiscal policy issues, such as the status of the debt ceiling, will evolve in a way that could hamper the recovery.” Reminding Congress and traders that the debt ceiling will need to be raised again this year is going to ruffle some feathers, and is a clear attempt to preemptively point the finger at Congress if the economy falters later this year.

In 2011, the debt ceiling crisis, and a subsequent downgrade of U.S. credit by S&P, chopped 20% off the major indexes, which is a technical bear market. If traders start getting concerned about a repeat of August 2011, they will discount that into 2013 prices. The market started to get pretty toppy a few months before the 2011 debt ceiling crisis, so a bounce down from resistance on the S&P 500 right now would be a major concern for fourth-quarter performance.

Will the Conflict Lead to a Channel?

7 18 13 spx1 300x225 Will the Hawk/Dove Conflict Lead to a Channel?
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The push and pull between the doves at the Fed and the hawks in Congress is unlikely to change in the near term. It’s too early to say that the market indexes will channel at this point, but those conditions could be confirmed over the next few trading days. In the chart at right, we have compared the S&P 500 as it bumps against resistance again today with the Dow Jones Transportation Index that is at a potential resistance level as well. Transports have tended to lead the large-cap index in the past, so a return to the lower trend line in transports would give us a much greater level of confidence that a channel is emerging.

We are clearly speculating about both upper channel lines at this point, but if those are confirmed, it would happen over the next few trading sessions. Based on the momentum in the market, it could take two to three weeks to reach the lower channel line again. That will be a challenge for traders, but it does not necessarily have to be an unprofitable period.

Channels are tricky because they tend to be tight and investors have to be ready to make bearish trades after the market has been rallying, and also ready to make bullish trades after the market has been declining. That can be stressful for some investors, and is likely to increase overall volatility. Again, it’s a little too early to call it a channel yet, but if one is going to emerge, this is when it would happen.

Bernanke’s statement, questions and answers to the Senate today are unlikely to be any different than they were yesterday, but it will still be something that traders pay close attention to as we head into the weekend.

InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news.  Get in on the next trade and get 1 free month today by clicking here.

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