That the week ended with a quadruple witching, in which investors settle up expiring options and futures contracts, is apt.
If one thing is clear from recent market gyrations, it is that hedge funds using derivatives play an outsized role in driving stock prices. Every move in the market seems to be exacerbated by the panicked reactions of trading desks -- be they to cautious commentary in a conference call, a modulation in the voice of a
official, or an obscure line in a government economic indicator.
A defining quality of hedge fund traders is worry. And, because of the velocity and volume of their assets, their worry often becomes your worry -- at least in the short term. This week, several strong data points convinced fast money that the threat of a massive economic slowdown had eased. In its place returned fears that the Fed must keep raising rates into perpetuity. Luckily for bulls, the paranoia lifted long enough on Wednesday and Thursday for the indices to stage their best two-day performance in more than a year.
In the end, despite flying all over the place on each piece of news, the stock market's major indices ended narrowly mixed on the week. The
Dow Jones Industrial Average
added 1.12% over the five sessions, while the
lost about 1 point on the week and the
Friday saw scattered weakness, mainly in tech, as the huge rally of Wednesday and Thursday cooled off.
, which was one of Thursday's biggest gainers, fell sharply Friday, as did
. On the other hand,
ended Friday up 0.14% despite continued fallout over Bill Gates' decision to step down from running the day to day operations of the business.
rallied 3.64% on the heels of a positive analyst report.
Traders followed Tuesday's third 90% down-volume day in a month by pushing the buy button Wednesday and Thursday. Analysts and traders have likened the amount of herd activity in this market to the impact of stop-loss measures, such as portfolio insurance, on the 1987 stock market crash, and to highly correlated markets and indices that led to the collapse of the hedge fund Long Term Capital Management in 1998.
"This is all about hedge funds," says Phil Roth, chief technical analyst at Miller Tabak. "Which doesn't mean it can't be exploitable. ... But there isn't a lot of investment buying going on.
Traditional investors are sort of in awe of this."
Still, everything is not speculative froth. Several factors this week worked to bolster the U.S. markets on a fundamental level, including Japan's central bank scandal, Bernanke's confident speech Thursday, and a spate of stronger-than-expected reports of consumer sentiment and manufacturing growth.
Just as the stage was perfectly set for Japan to end its 0% interest rate policy in July, a scandal sent the nation's plans off the rails this week. Amid sharp declines in the Japanese stock market, Bank of Japan Governor Toshihiko Fukui confessed to insider-trading charges but declined to resign from his post.
The news overshadowed the BoJ meeting, which ended Tuesday and yielded little in terms of rhetoric. The scandal combined with the poorly performing stock market to virtually put to bed expectations for a Japanese rate hike. An end to the 0% rate policy would have exacerbated the impact of its ending quantitative monetary easing in April, which many point to as the trigger for global market volatility.
The dollar was the lucky winner here. As the week began, the dollar was stronger vs. the euro, but it gave up its gains there only to strengthen against the yen instead. The euro bought $1.2643 last week, and it ended Friday at $1.2636. But the dollar strengthened vs. the yen throughout the week to reach 115.10 yen at the end of Friday, up 1% from last week's 113.94 level.
Fed Chairman Bernanke may have boosted his and the Fed's credibility this week when he spoke about inflation Thursday. It seems his mission to temper inflation fears may indeed be working. The stock market did not react badly to a higher-than-expected core consumer price index, for one. And the University of Michigan consumer sentiment survey also showed that inflation expectations have mellowed. Survey respondents' expectations for inflation one year from now fell to 3.4% from 4% in May. As for 10 years from now, expectations for inflation fell to 3% from 3.2%. While inflation expectations may have tempered, the likelihood of the Fed raising its fed funds rate to 5.5% have increased to 78% by the August FOMC meeting. June is already 100% in the bag.
But investors should be cautious about becoming complacent about inflation, as forces are at work to complicate the Fed's agenda. China's move Friday to hike its bank reserve requirements in an effort to curb easy credit standards in China could dampen the Fed's hopes for pausing its tightening policy later this year. Raising the reserve requirement effectively tightened China's economy, which drove the value of the Chinese yuan vs. the dollar to its highest level ever -- 7.991. China's tightening leads many to believe a significant revaluation of the yuan is on the near horizon -- as soon as July, says Ashraf Laidi, chief currency analyst at MG Financial.
"If so, this could lead to some generalized weakening of the dollar in relation to other Asian currencies," says Paul Kasriel. While this may help correct global imbalances, a sharply weaker dollar could make it harder for the Fed to pause, he says. A weak dollar exacerbates inflation pressures.
The bond market has remained inverted through the week, though yields have climbed, reflecting expectations for higher interest rates. The 10-year Treasury note ended the week yielding 5.12%, up from 4.97% last Friday. The two-year note ended yielding 5.15%, up from 4.99% last Friday.
As the conversation turns to earnings season in the next couple of weeks, the market is likely to enjoy a tailwind of expectations for another solid quarter of corporate profits. Companies are still flush with cash, and cost of capital remains low, as corporate credit spreads have not widened dramatically. But as Bank of America economists Mickey Levy and Peter Kretzmer wrote Friday afternoon, it is important to remember that "Still solid economy + higher inflation = more tightening." If economic data starts to reveal more of the much-feared slowdown, inflation fears are likely to roar again as rate hikes in the second half of the year loom larger.
In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click
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