After months of speculation and attempting to read between the lines of every Fed meeting since February, the time has finally arrived. We will, once and for all, get the answer to whether the Fed will raise rates in September.
There’s an old adage on Wall Street that there are only 2 things that matter: interest rates and earnings. Everything else is noise unless it impacts rates and earnings. It goes without saying that nothing impacts US yields more than the Fed’s monetary policy. All eyes will be on the Fed tomorrow.
Should the Fed decide to raise interest rates, it will be the first Fed hike since June 29, 2006. In the 110 months that have since past, global central banks have cut interest rates over 700 times, central banks have bought $15 trillion of financial assets, zero, and even negative interest rate policies have been adopted in the US, Europe & Japan. And since the Financial Crisis, both stocks and corporate bonds have soared to all-time highs thanks to financial markets awash in liquidity.
Despite efforts to increase transparency, the Fed has been saying two seemingly conflicting things. On one hand, Yellen has been telling investors not to make a big deal about the initial lift-off. She has indicated that the path to normalization will be gradual and that the final rate will be well below the peak of the past cycle.
On the other hand, the Fed runs the risk of seemingly linking the rate hike decision to short-run high-frequency data or particular market conditions. This linking of the rate decision says that the initial lift-off is, in fact, significant, otherwise why not go ahead and pull the trigger?
As I mentioned a couple of weeks back, a rate hike in September is really all about the Fed’s credibility. Imagine if the Fed puts off the September rate hike because it doesn’t want to disrupt the markets. This will paint the Fed into a corner because the anticipated rate hike will be in December and as people are repositioning into year-end, markets could get very volatile. Will the Fed then punt on a December hike to avoid spooking the markets further? It becomes the boy who cried wolf.
In the final 3 weeks, leading into this week’s Fed meeting, starting with Black Monday’s closing prices, markets have sent a distinct signal as to what they’re expecting. Over that 3 week time frame, long-dated US Treasuries and gold have each lost 4%. The US Dollar has gained 2% and US 10-year yields have gained 19 basis points, or 10%. And from an equity perspective, my US High Growth index has gained 3.7%, while my US Slow Growth Index has declined 2.5%. That is 620 basis points of outperformance by assets that thrive in an accelerating growth, higher US yield environment.
There are also a couple of other factors that lean towards a rate hike this week. First, Inflation-adjusted money supply continued to contract annually for the third month in a row. This is the first decline for base money, in real terms, in three years.
Second, the effective Fed funds rate continues to move higher. While these indicators don’t guarantee a rate hike, when coupled with recent price action in financial markets, seems very much in favor of a September lift off.
Third, slightly more than 80% of economists surveyed by the Wall Street Journal in July and August anticipated a September lift-off.
Fourth, at 5.1%, the unemployment rate is the lowest it has been in decades, and well within a range that the Fed believes is consistent with full employment. Not to mention that most of the broader measures of the labor market have steadily improved.
So, here is a summary of what to expect and how to position yourself no matter what the Fed decides to do on Wednesday.
If the Fed doesn’t hike then it will cause a short-term rally in most risk assets. No rate hike will be a relative positive for emerging markets, commodities and resource related stocks and economies. I say “relative” positive because although an unwind of the higher US yields, higher US Dollar trade will help buoy emerging markets and commodities, the effect will be limited beyond the short term.
As I have discussed on many occasions, the fundamentals underlying most emerging market economies have been deteriorating for years, not months. Likewise, the supply and demand characteristics of key commodities like copper and oil, just do not support substantially higher prices. These fundamentals are not going to change if the Fed decides not to raise rates.
No rate hike will also be a positive for higher-yielding assets like utilities, REITs and MLPs. This makes sense, right? When US yields give up the “2015 rate hike” premium, investors will once again be in search of yield. This search will bid up funds and individual stocks across those three sectors.
If the no rate hike is interpreted as the Fed being concerned about US growth over the next couple of quarters, then you could see a big rally in gold and volatility. You could also see value oriented sectors of the US economy outperforming growth sectors on a relative basis.
On the other hand, if the Fed does go forward with a rate hike this week, then all eyes will be on long-dated US Treasuries. If long-dated Treasuries rally in the wake of a Fed rate hike, it means that the market is indicating that the policy change was a mistake.
If this occurs, then gold, volatility and assets that perform well in slowing growth environments will be the place to get LONG. If however, long-dated Treasuries weaken after the rate hike, then it means that the market agrees with the Fed’s inference that US growth will continue unabated.
If that happens, expect investors to continue allocating towards strong US Dollar, higher US yield and accelerating US growth types of assets. US financials, consumer discretionary and technology should outperform sectors such as consumer staples and utilities.