Two Great Fed Hedges

I have a contrarian mindset, no matter what my endeavor.

So it comes as no surprise that I have developed an investment process that is built on a number of contrarian-inspired tenets.

There is nothing more contrarian than being aware of and limiting the impact of human biases on my decision making. As vigilant as I am, I still routinely find myself “nodding my head” right along with everyone else when it comes to generally expected outcomes in markets.

I realized a couple of weeks ago that I was once again nodding my head right along with everyone else. Everyone is expecting the Fed to end the longest period in US history of zero percent interest rates this week.

It was then that I asked myself, “But what if they don’t?”

Don’t beat yourself up if you too have been lulled into thinking that a Fed rate hike is a foregone conclusion. We would be crazy not to think they are going to raise rates based on the commentary of various Fed members and especially, Chairman Janet Yellen’s comments herself.

Even last week, Yellen left very little room for doubt. The one statement that stood out above all the rest is when she said that delaying a Fed rate hike too long would carry the risk that the Fed would have to hike further and more quickly.

Let’s be clear, if the Fed raises rates this week, it’s for credibility reasons not because the world economy is healthy enough for a hike. If you read last week’s commentary about the ECB disappointing the markets and the subsequent market reaction, then you already have a sense of what can happen when central banks don’t act the way markets have priced in.

If you think the market’s reaction to that disappointment was extreme, wait until you see what happens if the Fed decides to hold off on a rate hike. In the immortal words of Bachman Turner Overdrive, “You ain’t seen nothin’ yet, B-B-B-Baby, you just ain’t seen n-n-nothin’ yet.”

So how do you prepare yourself to profit if the Fed surprises by not raising rates?

This is one of the most important central banking events in a decade. You need to understand which of your investment holdings have been driven, up or down, by the Fed rate hike scenario. Any trades that are based on the Fed hiking rates should be evaluated and possibly hedged.

As we discussed last week, even if you are in markets with a lot of volume, should the Fed surprise, liquidity could be at a premium and the slippage in those circumstances can be extreme.

Markets will move quick, fast and in a hurry and getting your order(s) filled at a favorable price isn’t going to be easy.

As for the question of how to profit there are 2 characteristics that you want to look for ina possible “Fed Surprise” trade.

The first characteristic to look for is to find a market that has over shot, to the upside or downside, because of only the Fed rate hike or because of the divergence in monetary policy that has been created because the Fed stopped easing and everyone else in the world has doubled down.

The second, and equally important criteria, is to find a market where the positioning has become so lopsided in one direction that if the mood shifts just a little, everyone will stampede for the doors.

There are two markets that jump to mind that fit both of these requirements nicely: oil and gold.

Before we dig into these two trades, a quick word about the US Dollar.

Obviously, the divergence theme has pushed the USD to 12-year highs, so any trade that is inversely correlated to the USD would be a good place to start. However, be careful of confusing correlation with causation. Our first market makes this point perfectly.

A lot of people make the mistake of saying that a weak USD is good for oil and a strong USD isn’t. Because oil is denominated in USD’s, the direction of the USD will have some impact on the price of oil.

But having some impact is a very different thing than being the main catalyst. I can promise you that crude oil isn’t getting back to $60-70 a barrel just because the USD falls. Crude’s price will begin to sustainably rally, if and only if, the glut of supply in the oil market begins to get worked off.

A falling USD can help sustain and accelerate a supply based rally in the oil market, but it can’t push crude up all by itself.

For our purposes here, we are looking for trades that have the possibility of posting good returns in a hurry by taking the other side of a popular trade. Oil fits that bill. Oil’s dissolution over the last 18 months is well recorded. Hell, OIL, lost over 16% in the past two weeks alone!

OIL has been oversold by just about any measure possible for quite some time. Box 1 is checked.

As for positioning, smart money is at a historically bearish point and the dumb money has been increasing short exposure for the entire crash and is now sitting at its most short position over 2 years. Box 2 is checked.

If the Fed doesn’t raise rates, oil will move higher for a short period of time, barring an OPEC announcement that they would be quite content to see oil at $20.

The other trade I think has merit is being long gold. This another trade where I see a lot of inaccurate “correlation” talk. Simply put, gold is a proxy for yields and that’s it. If yields are rallying or are elevated gold has a difficult time.

If yields are falling or are lower, gold’s performance stands out. Any other conversations about gold are historically inaccurate and pure noise.

A Fed stay on a rate hike would push yields further down then they have already fallen over the last month. The 2-year yield is the only member of the US yield complex that has traded higher in the last 6 weeks.

From a performance perspective, gold is trading at a 5-year low, is down 44% from its 2011 highs and is down 11% so far this year. Box 1 is checked.

In last week’s Focus Market commentary for gold I wrote, “After the worst monthly performance since 2013 and the weakest close since February 2010, it appears "smart money" has piled onto the SHORT side. According to the latest CFTC data, hedge funds have never been more SHORT gold.”

If you think hedge fund guys 2 weeks from a potential quarterly performance fee are going to wait to see what happens if the Fed disappoints, think again. These guys will be throwing their short positions out of the window just to get rid of them. Box 2 is checked.

There are infinite ways to put a long oil or gold position on.

I think being a net buyer of options makes a lot of sense for this type of trade because of the liquidity issues I spoke of earlier in the piece.

You know your downside in advance and you don’t have to be worried about how the market moves post-Fed announcement and whether you can get a favorable price or not. Also, keep in mind that these trades could profit even if the Fed raises rates but does so with heavily dovish commentary attached. A Fed rate hike with strongly hawkish commentary is the only way neither of these trade ideas work.