The Bifurcated Risk-Rally Continues with an Eye on FOMC

2016-06-09 13:43:00

Talking Points:

- Rallies continue to show in a flurry of asset classes with both ‘risk on’ and ‘risk off’ tonalities; giving the appearance that markets are expecting an extremely dovish stance from the Fed at next week’s rate decision.

- The primary mechanism with which the Fed can transmit that dovishness is via the dot plot matrix in their economic projections; but given the fact that they’ve shown a propensity to be hawkish over the past year, are markets expecting ‘too much’ from the bank while the S&P continues to trade near 2016 highs?

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Many equity markets are continuing to exhibit bullish price action, with the S&P 500 setting a fresh 2016 high during yesterday’s trading, and the all-time high is but a quick 17 handles away from yesterday’s top. But this hasn’t necessarily been a completely bullish scenario as other markets are showing signs of stress in the financial system, such as the fact that we’ve also been seeing prices surge in Gold and US Treasuries; which is often indicative of risk aversion as investors look for cover.

But this can also be indicative of another type of market environment, similar to what was seen in 2009-2012 in the wake of the Financial Collapse when the United States was actively pumping QE into the financial system. This was, in essence, US Dollar debasement, so many assets denominated in USD rose simply from this dilutionary impact. Gold prices surged from a low of $682.41 at the depths of the Financial Collapse to a high of $1,920.80 less than three years later (for a total move of 181.5%); and this was largely driven by lower rates, lower inflation expectations and the prospect of loose monetary policy for a long, long time.

On the below chart, we’re looking at a couple of distinctly different phases in markets in the post-Financial Collapse world, as seen in Gold prices with the S&P 500 overlaid (blue line chart). In the Financial Collapse, both Gold and stocks got hit as investors embarked upon extreme risk aversion. But in the wake of the Financial Collapse, as the Troubled Asset Relief Program was triggered in October of 2008, followed by multiple rounds of QE; both Gold and stock prices caught a major bid as shown in the blue section of the chart below.

Created with Marketscope/Trading Station II; prepared by James Stanley

Of course, this period indicated in blue is when the United States was actively pumping QE into the financial system while also keeping rates extremely low. But as markets began to anticipate the inevitable end to Quantitative Easing in the US, Gold sold off while stock prices continued to throttle higher; and this is likely due to the fact that the Fed stayed on ‘emergency-like’ rate policy, which amounts to an especially accommodating environment for companies to operate (thereby increasing valuations, stock prices, etc.).

But more recently markets have seen a shift in the world’s largest national Central Bank. The Federal Reserve has taken on a path of hawkishness over the last year-plus; and this is despite numerous warning signs coming from Asian markets, commodities and now showing up in US labor data. After spending much of 2015 watching markets banter about the sustainability of a single 25 basis point rate hike, the Fed expected to raise rates a full four times in the calendar year of 2016: A stark contrast to the ‘extremely accommodative’ operating environment that they had embarked upon for the seven years prior.

As we discussed coming into the New Year, this combination of risks would likely be too much for markets to bear, in and in short order risk aversion was back as stocks around-the-world got slammed in January and early February. But on February 11th while speaking to Congress, Chair Yellen gave comments that were inferred to be very dovish, saying that the bank would not take the possibility of negative rates off of the table despite being unsure of the legality of such an arrangement. This gave the appearance that the Fed was ready to go dovish whenever it might be needed, and further, the bank wasn’t against exploring ‘new options’ in the effort of shoring up financial markets. The near-immediate impact of these comments was a massive risk rally similar to what markets were seeing in 2009-2012; Gold was surging, Oil was soaring off the lows, Treasuries were driving higher (with yields moving appropriately lower, and of course Gold caught a major bid. On the chart below, we can see how the S&P 500 has responded to perceived hawkish/dovish Fed comments over the past year.

Created with Marketscope/Trading Station II; prepared by James Stanley

It All Goes Back to the Dots

As we’ve been discussing of recent, one of the primary obstacles that the Federal Reserve is contending with is the prospect of issuing forward guidance in a rising rate environment. Forward guidance was rolled out as a stimulus measure to transmit to market participants that rates would stay especially accommodative for a long, long time. And in a low-rate environment, this can be a great idea. But as rates begin to rise, this forward guidance can become a major hindrance because investors will likely be reticent to invest in rate-based instruments if they know that the Fed wants to kick rates higher.

And given the bank’s persistence towards higher rate policy; staying hawkish despite the calamity in Asia last August, or looking for four full rate hikes in 2016 after the world spent much of 2015 debating the sustainability of a single 25 basis point hike, or taking on a hawkish stance in May despite initial evidence already being apparent of slowdown in American labor numbers, it becomes rather obvious that the Fed has a motivation to continue moving rates off of emergency-like policy. And if you’re a fixed-income (bond) investor, this is an issue because if you invest today, while rates are really low, the value of your investments will likely take a hit as the American Central bank continues to hike policy any chance that they get (when markets aren’t showing extreme signs of stress).

With prices of Treasuries, Gold and Stocks all moving higher while USD moves lower, it appears as though markets are loading up for another dovish move by the Federal Reserve. And at this point, with rates still extremely low, near ‘emergency-like’ levels, it’s unlikely we’ll see an actual rate cut. The primary modal through which the Fed can transmit dovishness is via the dot plot matrix. This is what the bank did in March as they reduced that median expectation for rate hikes in 2016 to two from a previous expectation of four. This, on its own, was like a form of stimulus as it removed the pressure of the prospect of higher rates in the years ahead.

The big question is whether the Fed will submit to markets by reducing this expectation even further to one hike this year; or whether they’ll continue to drive for higher rates even in the face of a series of risks.

For those that do want to look at a short equities play, the Nasdaq 100 may be a more attractive venue in American equities. While the S&P is rallying to fresh highs, the Nasdaq 100 is staying lodged at a lower high, with resistance showing on a projected trend-line as well as a Fibonacci retracement of the most recent major move.

Perhaps more interesting, if we are sitting in front of a legitimate market reversal in equities as the Fed continues a hawkish drive to move off of ‘emergency-like’ policy, we’ll likely see the Nasdaq tilting lower ahead of the S&P and the DJIA as tech usually gets hit before more established, blue-chip-like names.