After originally thinking that the Fed’s statement was going to be taken as an overall positive for stocks (and therefore negative for the dollar), I think what we have is a situation that’s a bit more complicated than that.

One key to using fundamentals when trading is to know how markets moved in similar situations. My idea that markets would react positively to the Fed’s gradual withdrawal of its emergency measures is based on the fact that stock markets rose as the Fed raised interest rates from 2004 and fell once the Fed started easing in 2007. That theory still holds.

The question here is how to judge what’s actually happened with the Fed’s statement, which may not be all that easy to do. The problem lies with what the Central Bank plans to do with its $1.25T program of purchasing agency MBS (mortgage backed securities issued by Fannie Mae and Freddie Mac).

This program is a crucial aspect of the Fed’s support of the economy. Banks are basically not writing mortgages which can’t be bought by the two government sponsored entities (GSE’s) Fannie Mae and Freddie Mac and pretty much no one other than the Fed is buying the MBS issued by them.

More “Medicine” Needed?

Regarding the planned purchases of agency MBS, in August the Fed said it would buy “up to” that amount, an indication that the maximum amount might not be reached if market conditions favored that. That was taken as a positive because it implied that policymakers might not have to use all of its “medicine” in treating the “patient” (the economy). So far, the Fed has purchased $650.7B worth of the securities, about 54.2% of the planned total.

However, Wednesday’s statement seems to have indicated something different, namely that planned purchases of would be “a total of” $1.25T, the maximum amount.

The problem here is that this apparent change in tactics could be taken as a sign that the Fed actually sees things being worse than originally thought in August, when it indicated the full amount might not need to be purchased. Markets sold off nearly 2% from the peak reached just after the statement was issued and S&P futures were declining another 1% leading up to Thursday’s open.

Another factor adding to the confusion is that while it now looks as if the Fed intends to max-out this program, they also issued their most upbeat assessment of the economy since the collapse of Lehman Bros in September 2008. In August, the FOMC said “that economic activity is leveling out,” but raised that assessment yesterday by saying “that economic activity has picked up,” a clear indication it believes, as Bernanke said last week, that the recession has ended. But if that’s true, why then does the need now exist to buy the full allotment of agency MBS when last month it apparently didn’t?

So, for now it looks as if stocks and commodities are going to decline for a while, and that means the dollar is bound to get stronger. Apparently, our “patient” is not quite ready to be released from the “hospital” at this time.