Here's how markets respond to Fed rate hikes
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“It is easier for the world to accept a simple lie than a complex truth”. Alexis de TocquevilleIf you want the right answers, you need to ask the right questions. THE WRONG QUESTIONS:Will the Fed raise rates this week? Yes. Knowing that will not particularly help anyone. The market has almost fully discounted a rate rise. How much will FOMC raise by? Probably 0.25% The flex is possibly in the scale of either a 0.25% or 0.5% rise. But one thing we do know is that this ‘data dependent’ FOMC is cautious. We would not be surprised then in a unanimous vote for only a 0.25% funds rate increase to 0.50% rather than a more creditable 0.75%.
What will the Statement say? Nothing that will surprise anyone. FOMC is likely to upgrade the outlook to a mere “balanced” from “roughly balanced” and its view of policy stance to only “moderately accommodative” from “accommodative”. They are also like to revise GDP upwards and unemployment downwards with a small increase in inflation. Nothing that will surprise or rock the markets.
What will Janet Yellen say in the press conference? Nothing different to recent speeches from members of the FOMC. They will rely on current data and therefore indicate only a gradual increase only in rates and possibly not even mention Donald Trump’s potentially very expansionist fiscal policies.
Waiting for historic and often unreliable data this year and indeed for the world to be free of mini crises (China, Brexit, EU) will continue to place the US Fed behind the curve, even if it is the right curve. They may have got away with it so far because the movements in their key Inflation and unemployment variables have not been significant in a historical context.
Inflation & Rate chart
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However, once the Fed is behind the inflation curve as it was in the post war boom in the 1950s and the oil ramp in the 1970s, it is much harder to control. Economic variables don’t wait for policy makers to make up their minds. Nor do markets. US 10 year yields, stocks and the dollar are all rallying in anticipation of the expansionist Trump Effect. This is similar to the last Republican President with a majority in both houses in 2000, a triangle we believe that will hold the key to 2017.
2000 US Triangle chart.
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As money moves out of global bond markets, it needs a home and Donald Trump’s potentially inflationary US stocks appear to be a home with a quick return.
Are stocks currently over-valued? Yes. Whether one takes PE or CAPE as a guide, US stocks are higher than historically sustainable levels but not at their record level – although now close the 20.19 highest PE prior to the 1929 Crash. But that doesn’t mean it can’t go appreciably higher on speculative buying and/or inflated earnings before adjusting to sustainable levels.
SPX and PE/CAPE Chart
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THE RIGHT QUESTIONS:
Is the market already well long stocks and too dangerous to buy? Depends on your time frame. Price does not equate to a market’s positioning. A market can often be short at, and in fact cause, new highs. As Perma-Bears finally give up the ghost, the stock market may now be getting long but probably not long enough.
As an investor who seeks value, is it wise to buy and hold until the end of the Trump Presidency? Unless you can find the ‘exceptional’ stock then NO.
As a position trader looking for 5% what should my strategy be until 2017? Buy dips until year end. Celebrate New Year and then use January to recover from your hangover.
As a swing trader looking anything from 1-2% what should my strategy be this week? History provides the answer. Buy dips until year end. Celebrate New Year and then use January to recover from your hangover.
But in both cases, use history as your guide.
The Historical Impact of Fed Rate Hikes on 10 Year Notes
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US 10 year yields have followed a similar path to the previous three tightening cycles even if it has started later. That can partly be attributed to size and duration of the previous downtrend but also to the noticeable difference between the tightening cycle of this Fed and Alan Greenspan’s: the lack of rate hikes under Janet Yellen. There had previously been at least 5 hikes within the first year.
The Historical Impact of Fed Rate Hikes on the Stock Market
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As we mentioned last year, the first rate hike typically causes a fall of approximately 5% even if it is widely anticipated but in all four cases this has proved a buy opportunity for new highs. The second and subsequent rate hikes (as we are expecting this week) have a similar but much smaller effect providing buying opportunities.
Unless the FOMC does something uncharacteristically surprising then we fully expect the S&P to follow the FOMC Fractal in the shorter term. This is, on average what the S&P500 does before and after FOMC meetings.
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The noticeable difference between the uptrends in the 1994-1995 tightening, and those of 1999-2000 and 2004-2005, is volatility. Whereas Greenspan’s period of ‘irrational exuberance’ gave rise to sustained aggressive strength, the last two tightening cycles prompted a struggling uptrend into a top. Interestingly the 1994-1995 bull market can be compared to that under Republican Eisenhower’s aggressive fiscal expansion in 1953 [spending $53Bn on the interstate road network] unlike the restrained Republican George Bush of 1999-2000. Despite early promise we are yet to see Donald Trump’s true colours. But we believe they form a warning flag later rather sooner.
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For the last 3 years, we have argued the need for a 1929 or 1987 style blow out of breath-taking dimensions. People have found this hard to accept. How it has got here has not always been easy. But now it is here, it is time to accept the complex truth.
“It is easier for the world to accept a simple lie than a complex truth”. Alexis de Tocqueville
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