We found out two critical things last week. First, the Fed did not raise rates. Second, I am not Babe Ruth and unlike him, I was not able to call the shot ahead of time.
We could certainly have a spirited debate as to whether the Fed made the right decision or not. But what’s more important, is to try and understand the way in which the Fed is making its decisions. This will allow us to monitor the markets with the correct perspective and nimbly keep our portfolios positioned out of harm's way and in the path of profitability.
I’ve been anticipating a rate hike for more than 6 months. There were 2 primary reasons I believed a rate hike would occur: guidance from the Fed's leadership and evolving US economic data.
While I recognize that over the last month there has been an increase in both economic and market uncertainty, neither the Fed’s guidance nor the latest US economic data would have indicated the need to punt the rate hike to another time. That said, we now have our decision and we can formulate a game plan for how to trade the next couple of months.
Luckily for me, I do not need to be a great forecaster in order to be a great trader. Despite whiffing on the timing of the Fed’s path towards normalization, last week’s trade ideas tacked on an additional 5.96% to this year’s returns, putting us up just over 24% for the year. Last week’s returns were also the ninth best weekly returns since I began publishing TWR 145 weeks ago. Take that Nostradamus.
The main reasoning behind the Fed’s decision to delay its first rate hike is both the recent developments in China as well as market volatility since the beginning of August. If you’ll remember, in June, the FOMC statement listed “international developments” as one of the factors it uses to assess the US economy.
In last week’s statement, these same international developments seem to have been given equal weight in line with the US labor market and economic activity as catalysts for or against a rate hike.
Despite not pulling the trigger last week, the Fed’s point of view is that a rate hike is in fact warranted if you look solely at the US economic profile - 13 of the 17 Fed officials believe that US economic conditions will allow for a rate hike this year. Of the 4 dissenting votes, 3 believe 2016 is the appropriate timing for a rate hike and 1 wants to wait until 2017.
This seemingly newfound emphasis on international developments is interesting because the fact that China’s economy is slowing is hardly groundbreaking news. The yearly growth rate in manufacturing peaked in 2013, industrial production peaked in 2009, retail sales peaked in 2011 and GDP peaked in 2010.
All four economic measures have been in sustained downtrends ever since. While growth forecasts for China vary greatly, the one thing that is certain is that the days of 7%+ growth are in the past.
That said, it doesn’t appear as though a hard landing is in the cards, at least not yet. If the Fed was concerned about China’s economic impact on the US economy, then why wasn’t it concerned in February when Yellen put the prospect of a 2015 rate hike on the table? Seems to me that the Fed simply wanted an out. Is China’s economy going to rebound by December? Doubtful.
Does this mean the Fed won’t tighten until China’s growth gets back on track? It certainly seems like the Fed has backed itself into a corner and “international developments” are certainly one of the walls of that corner.
The other wall of the corner is the Fed's acknowledgment that recent market volatility played a role in its decision to not raise rates. So, now the Fed is going to be held prisoner by market volatility that was largely caused by the uncertainty surrounding the timing of its first rate hike.
Yellen attempted to downplay the role of market volatility saying “I do not want to overplay the implications of these recent developments, which have not fundamentally altered our outlook…The economy has been performing well, and we expect it to continue to do so.”
If your outlook hasn’t been altered, the US economy is performing well and you expect it to continue to do so, then tell me again why you didn’t raise rates? I don’t think it has anything to do with China or stock market volatility.
I fear the answer is that 0% has become the anchor for interest rates and moving away from that anchor is more difficult than the Fed expected. Monetary policy is built around a primary tool, the adjusting of interest rates, up and down, in order to either encourage expansion or cool an economy at risk of overheating. When interest rates are at 0%, that tool becomes ineffective. Since you can’t cut from 0%, the only measure left to combat an economic downturn is massive asset purchases through quantitative easing.
US DIVERGENCE TRADE
I’ve been writing about the US divergence trade for well over a year now. And despite the delay in its initial rate hike, this divergence trade is still well intact. The divergence trade was never tied to a particular date but rather just the trajectory of US monetary policy as compared to the rest of the world.
While the US may not have begun tightening, it hasn’t been actively easing since December 2013. This is not true of the rest of the world. The easing policies of the ECB and the PBOC over the last couple of years are well documented. But the easing doesn’t stop there. A number of emerging economies have also eased and we could add several more names to that list when the central banks from Mexico, Turkey, South Africa and the Philippines meet this week.
The Fed doesn’t need to raise rates to propel the divergence trade further. As long as there is no QE4, then the monetary policy of the rest of the world is going to act as a significant tailwind for this trade.
There has been no bigger winner in the divergence trade than being LONG the US Dollar. So, what does last week’s announcement mean for the most crowded macro trade?
Well if last week’s price action is any sign of things to come, it would appear as though everyone in the LONG US Dollar trade has nothing to fear. In fact, if we look at recent USD rallies, it would appear though there could be a lot more upside from here.
The Fed’s trade-weighted USD index is the most important measure of the USD. If we look at the average move of the other 2 USD rallies since the end of Bretton Woods, the Fed’s USD index could trade an additional 20% higher from here. Despite weakness on Thursday, the DXY regained all of those losses during Friday’s trading session and closed the week up 12 basis points. That should be confidence inspiring if you're a USD bull.
By not raising rates the Fed has increased fear in the markets that things are worse than expected and they have also prolonged the markets' anxiety over the initial rate hike. What is clear from last week’s Fed meeting is that while the trajectory of US policy may be diverging from the rest of the world, US policy makers are still on the side of speculative assets and will act to support those assets.