Sometimes watching the shenanigans of the financial markets gets down right comical. The last couple of weeks of Fed coverage has had me chuckling on several occasions.
I’m not sure who has more of an ego, Donald Trump or members of the Fed committee. At this point, it's a dead heat who likes the sound of their own voice more.
And the reaction by markets to every word uttered is equally laughable. One day Richmond Fed Chair Jeffrey Lacker comes out says “There is a strong case to raise rates in June.” The market responds by selling gold and Treasuries.
Two days later, San Francisco Fed Chair John Williams says “I don’t know what we’ll do in June.” Investors respond by buying gold and Treasuries.
People don’t seem to remember that Lacker has said that there was a strong case for a rate hike before EVERY Fed meeting this year and Williams has mastered the art of talking and saying nothing of value.
Luckily, you don’t need to worry about tracking every member of the Fed that wants 15 minutes of fame because the truth is whether the Fed hikes in June or not, IT DOES NOT MATTER. There is an investing playbook that will work whether they raise rates or not.
What If They Do
Everyone and there mother seems think that the most likely outcome is that the second rate hike comes in June. I’d be remiss if I didn’t point out that just 2 weeks ago markets were only pricing a 20% chance of a June hike and now it’s up to 72%.
There is no doubt that the Fed has been tilting hawkish in recent weeks but what I can’t for the life of me figure out is why.
For those that are new to the game, rate hikes are generally reserved for when the economy is cruising along at a nice clip and is in danger of overheating and needs a bit of cooling. I don’t know what data the Fed is looking at but the US economy is currently cruising more like a Pinto than a Lambo.
Last week’s updated manufacturing and service PMI data shows that Q2 GDP growth is probably going to flat line from Q1. To make matters worse, the numbers being put up in the manufacturing sector right now are the lowest since the Crisis and output fell for the first time since the middle of the Crisis.
Read that last sentence again. And please don’t tell me that manufacturing in the US doesn’t matter because it’s a service economy.
Unlike the Fed’s decision in June, manufacturing in the US does matter when it comes to sustainable US growth. On a similar note, the industrial production report for April showed the 8th consecutive month of negative growth. Why is this important? Because in 96 years, industrial production as never fallen for this long without the US being in a recession. 96 years is a long time. Is the Fed flat out ignoring this data?
I’ve heard a lot of gurus, experts and bloggers spouting off that the Fed is paying attention to the labor market and inflation as a guidepost for rate hikes.
It is true that the Fed’s measure of inflation has picked up nicely in recent months.. And yes, the labor market data looked great last year and has plodded along at an acceptable pace this year.
But is the fact that inflation is finally starting to move towards the Fed’s 2% threshold and there are too many jobs being created sound like a good rationale for a rate hike to you?
This labor market rationale is horribly flawed for 2 reasons.
First, the quantity of jobs being created is decent but the quality is crap. Yes, we are creating bartending jobs by the droves but unfortunately the types of jobs that actually move the GDP growth meter are sparingly hard to come by.
Second, the one measure of the labor market that the Fed really pays attention to is still flashing warning signs. The Labor Market Conditions Index (LMCI) is one measure of the US labor market that the Fed pays particular attention to. Why?
Because Janet Yellen herself helped to create the index when she worked for Helicopter Ben. The April update showed that the LMCI posted its 4th consecutive negative reading, which is the longest stretch of negative readings since when the last US recession, otherwise known as the Financial Crisis.
Do you see a pattern forming here? This would be a fun drinking game. Re-read this commentary and drink every time I say “recession” or “Crisis.”
The Fed raising rates in June is like throwing up that cinder block wall in car commercials with the test dummies. The car folds up like an accordion and glass flies everywhere. Mark my words, if the Fed raises rates in June, they will cause a US recession.
Don’t be scared by the “R” word, be encouraged. It's not quite as fun as the “L Word” but the profit potential is definitely there.
A quick look at the 3 US recessions since 1990 gives us a playbook for profitably navigating this scenario. The S&P 500 has declined in 2 of the last 3 recessions and its average gain during all 3 recessions was actually a -13% loss. On the flip side, the Three Horseman of the Apocalypse: gold, US Treasuries and the US Dollar, have posted gains in all 3 recessions, averaging 10%, 3% and 2% respectively.
Hmmm, does this playbook look familiar? It should. I’ve carried a SHORT bias on SPY for the last 21 weeks and so far, I’ve been dead wrong as the S&P has climbed 10%.
However, I’ve carried a LONG bias on gold for the same amount of time during which gold has gained 9.5%.
I’ve been LONG US Treasuries since December 21 and they have gained 6.6%.
As for the US Dollar, I carried a LONG bias for the Greenback for 79 consecutive weeks before abandoning that in mid-March. The USD gained 11.9% during the time of my LONG bias and has declined 0.64% since I went to a NEUTRAL rating. Quick note, last week’s price action in the US Dollar was a confirming signal and I’m back to a LONG bias in our Focus Markets Commentary section of this week’s report.
Now that you know how to trade if you find yourself on the side of the majority, let’s take Mark Twain’s advice and take time to pause and reflect.
What If They Don’t
If the Fed were to shock markets and not hike in June then we should run the exact same playbook. That’s why it doesn’t matter what they do. The play book is exactly the same either way.
The S&P has elevated once again and is within spitting distance of a brand new high. Gold has pulled back about 6% and US Treasuries are down slightly. I expect this recent price action in all 3 markets to reverse course post haste if the Fed disappoints.
The one oddity is the US Dollar. You would expect that the recent strength might give way to further weakness, but not so fast. I think the recent strength in the US Dollar will continue, possibly after a slight pause should the Fed fold on a second hike.
Keep in mind, the US doesn’t exist in a vacuum, no matter how much the Fed and CNBC would like to convince you of that fact. This is the added benefit of the playbook that I’ve outlined above. The current picture of the world economy only adds fuel to these trades.
The S&P is facing a level of US corporate debt defaults not seen at this pace since the Crisis and corporate earnings have been falling for multiple quarters and look as suspect as Keyser Soze. The S&P 500 also has diverged from emerging markets (EM) over the last 6 weeks. This is the third time in the last 12 months that the S&P has rallied higher even though EM was rolling over. The last two times this occurred, the S&P “caught down” to emerging markets, losing 10.7% and 10.8% respectively. SHORT ‘em if got ‘em.
Gold is a trade on interest rates or yields. Gold performs best in falling or lower interest rate environments. Central banks around the world are running out of things to throw at their economies and are restoring to negative rates at an alarming pace. If low rates are good for gold, negative rates are great. LONG gold, ‘nough said.
US Treasuries are obviously impacted by the trajectory of US policy. But what we’ve seen so far this year is that the primary catalyst for US Treasuries is growth expectations. In the US, the spread between 10-year and 2-year Treasuries, is used as an indication of what investors are expecting from the US in terms of growth. It’s currently trading at the flattest since 2007. Ouch. Global growth concerns abound because none of the major players can seem to put together more than just a month or two of decent data points. All of this is extremely bullish for US Treasuries.
These same dynamics are at work to push the US Dollar higher even if the Fed balks in June. Central banks around the world are attempting to burn their currency like a Salem witch. This type of policy isn’t going anywhere soon. Slowing global growth, negative rates and easing policies worldwide will place a very nice tailwind at the back of the Greenback. LONG US Dollar.
Now please, if the Fed raises rates and the S&P goes up and Treasuries and gold fall, please don’t blow up my email inbox telling me I was wrong.
I’m about to let you in on the secret to earning types of returns that’ll get Michael Lewis to write a book about you.
Sun Tzu said over 2,000 years ago, “I dare not make the first move but would rather play the guest; I dare not advance an inch but would rather withdraw a foot.” If you want to earn biographical worthy returns, you must be willing to be in an uncomfortable place so that you can exploit other investors’ inability to see beyond the immediate.
Every great trade begins with losses because the best trades begin by fading against the consensus view at the time.
Now, I’m not talking about the kind of losses that make you feel like you’re on the candy cane tilt-o-whirl at your local amusement park. Or the type of losses that your Ed Jones guy delivered you during the Financial Crisis after charging you 2% to help you navigate those rough waters.
I’m talking about slight losses on trade ideas until the market finally figures out what you knew all along.
If the Fed raises rates in June, you can be certain that there is a high likelihood that gold and long-dated US Treasuries get sold. That’s a good thing!
Most investors won’t be able to see beyond the rate hike. But you aren’t most investors. You’ll see their selling as an opportunity to run our playbook, at a discount, and position yourself for what’s to come. By the time everyone else figures out the Fed has just run the Pinto into the cinder block wall, it’ll be too late, for them.