Knee-Jerk Reactions

Over the last couple of years, knee-jerk reactions to the latest FOMC statement or Fed Chairman testimony have become commonplace.

Last week was no different, as market participants were quick to read the tea leaves of the latest Fed statement and reallocate assets accordingly. It's our job to determine whether these knee-jerk reactions are temporary and should be exploited to align ourselves with the prevailing trends or whether these reactions represent a regime shift for various asset classes.

 

The Statement

The Fed met the widespread market expectations by dropping the word “patient” from its latest statement regarding the data of the first interest rate hike.

This action ended the date-approach to the Fed’s forward guidance and began the data-driven approach. The Fed explicitly stated that a hike at the upcoming April meeting was unlikely. Further, in order to signal that a rate hike isn’t imminent, the Fed acknowledged that US growth had moderated and that it would be appropriate to tighten when “it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term." 

Keep in mind that Yellen is preparing to exit the most aggressive monetary easing in the history of earth. No central bank ever has stayed at 0% interest rates for as long as the Fed has since the Financial Crisis. Ever is a very long time.

At the same time that Yellen is attempting to wean markets off the juice, inflation and wage growth remain too low and are giving Yellen cause to pause.  Despite the market’s uber-dovish interpretation of the statement, it was well balanced between hawkish and dovish points.

Changes to the Fed's assessment of economic activity were generally dovish, with growth at a "solid pace" downgraded to growth having "moderated somewhat." In particular, "export growth weakened." The Fed lowered its forecast for 2015 GDP from the 2.6-3.0% range down to the 2.3-2.7% range.

The fact that Q1 growth is tracking much lower than the Fed expected requires an adjustment to the forecasts for the entire year. This downward revision happened last year as well after it became clear that the economy contracted in Q1 2014.

This is why Yellen hawkishly noted that despite the moderation in economic activity, the Fed still anticipated growth to be above trend. Remember, that despite the contraction in Q1 2014, the Fed continued with its tapering plan.

A slowdown in US growth early in the year doesn’t indicate anything about what the Fed will or won’t due at the end of Q2 or Q3 2015.

 

The Reaction

The market dovishishly reacted to the statement, mainly because of the acknowledgment of slowing US growth combined with the fact that the Fed clearly said the Fed was not prepared to hike rates.

Keep in mind, that a rate hike before the June or September Fed meetings was never on the table. So, I’m not entirely sure why the markets would grab on to that part of the statement with both hands, except out of hope that the Fed changes its mind and re-joins the rest of the world’s easing party.

The reaction to the statement varied across markets. Traders in the Fed funds futures contracts reassigned the probabilities that Fed will tighten at the forthcoming meetings. The likelihood that policy makers will lift their benchmark rate in September fell to 39% from 55% and the chance of an increase in June fell to just an 11% probability.

The two markets most impacted by the statement were of course, the US Dollar and the US yield complex.

There is a lot of confusion about the Fed’s view of the USD. Many participants expected the Yellen to directly discuss the USD’s recent strength in her testimony but she did not. However, in response to reporter’s questions, Yellen said that the strength of the USD was dampening inflation through import prices.

The markets completely ignored the rest of her more hawkish comments about this and they also ignored the fact that Yellen acknowledged that the USD’s appreciation was partly a reflection of the strength of the US economy.

Yellen also acknowledged that the rise in the USD was one of the factors that were slowing exports. The other factor dramatically impacting our exports, which wasn’t discussed at all, is the fact that both the IMF and World Bank had cut their forecasts for world growth.

Flat out the best thing that can happen for US exports is an acceleration in world growth. Because of the crowded nature of the LONG USD trade, the market reacted quickly and violently to the overall dovish interpretation of the Fed and Yellen’s comments.

The USD lost 2% on the day after having spent the prior two days above the the critical psychological level at 100.00. Most of this decline was regained on Thursday, before falling over 1% on Friday to close the week at just above 98.00.

The speculation data from the futures markets are reported on a 2 week lag, so we don’t know if there was a significant shift in positioning last week. My take is that intermediate- to long-term investors used the sell-off on Wednesday to add or initiate LONG USD positions. Despite the 200 basis point loss last week, I’m still maintaining by LONG bias for the USD and UUP.

Last wek’s price action simply shook out weak hands, nothing more. Even if US economic data doesn’t markedly improve with better weather and the improving labor market, the divergence trade, which has the US being the tallest of the pygmies, is still very much intact and will continue to act as a tailwind for the US Dollar.

The other market that was severely impacted last week was the US yield complex and by association the US fixed income markets. US 10-year yields fell 9% last week to close the week back below the 2% line at 1.930%.

Friday’s close is also just below last week’s ABYSS line of 10-year yields at 1.931%. This decline in yields pushed all fixed income markets higher, including Treasuries, investment grade corporate and even the high yield market. As with the USD, which I believe will continue to show strength despite last week’s action, I believe yields will rebound from last week’s decline.

There are two main reasons why I remain a yield bull and bond bear.

First, based on the data we have today, there is no reason for the Fed not to raise rates in either June or September. Second, US economic growth will begin to accelerate in Q2 and Q3, once the weather improves and the robust jobs numbers we’ve seen lately trickle down into improved consumer spending. That said, that doesn’t mean that yields can’t show weakness for the next several weeks. I would view this as an opportunity to reload SHORT bond positions rather that a reason to initiate LONG bond positions.

As I’ve mentioned before, the strongest periods of US economic growth have always been accompanied by a strong US Dollar and rising or elevated US yields. I can’t say for certain that 2015 and 2016 US growth is going to be historically great. But I can say that US growth will be better than the rest of the world on a relative basis and could accelerate higher on an absolute basis.