Here's Why The Fed Was Wrong To Hike

Whatever we said on 5 November came true. For the first time in 9 years, the Fed hiked the Fed Funds target interest rate by 25bp to 0.25-0.5%, ending an eon of zero lower ground rates and marking the start of a new paradigm. A paradigm that is, much as most would hate to admit, unprecedented in terms of scale and bredth.

Does dovish rhetoric from Europe’s ECB, continued stimulus from China’s PBoC, the reluctance of Japan’s BoJ to step up QQE despite headwinds, New Zealand’s RBNZ policy being put on hold signal a soon imminent Fed rate hike?

This has been on our minds since more than 2 weeks ago, when ECB head Draghi unleashed yet another canary to charge at a deflationary spiral in the single currency bloc.

While correlation might not necessarily be causation, especially in the ubiquitously tangled web of central banking, we believe this development is too significant to turn a blind eye on.
— Business Of Finance, 5 November 2015

As we approached 16 December, markets had increasingly discounted a Fed liftoff, but there was still some element of uncertainty. That uncertainty now shifts to what the Fed will do in 2016. Will it continue to gradually hike rates? Will it reverse on its path of monetary tightening and start to ease? These are but a multitude of questions that everyone is asking, but no one can really answer.

Markets are forward looking and are always factoring in expectancies of future events in pricing. What we're seeing so far seems to tell us that markets believe that any future rate hike will occur extremely slowly; with each increase being unevenly spaced out.

However, the question that beggars answering is if the Fed has made a policy error by hiking into a pretty extraordinary environment both inside the U.S., and globally. As mentioned earlier, we believe there is no set precedent for what we find ourselves in today. There are a few tightening cycles that come close to today's, but none are similar enough.

One word: Liquidations. An exodus of capital from debt across the board. For the second consecutive week, high yield funds saw massive outflows the size of which eclipsed that seen during the August crash. Even high grade (IG) funds saw the largest single weekly outflow in more than 15 months, also eclipsing that seen during the August crash. Fixed income funds as a whole experienced a nearly $10bn outflow last week, the largest in more than 2 years! Levered bank loans saw their second largest weekly outflow since August 2011! Money has been rushing out from all kinds of debt funds and into cash at a furious pace. Do bond investors and traders believe the Fed has made a major Policy error? The answer is pretty obvious. Charts courtesy of BofAML

One word: Liquidations. An exodus of capital from debt across the board.

For the second consecutive week, high yield funds saw massive outflows the size of which eclipsed that seen during the August crash.

Even high grade (IG) funds saw the largest single weekly outflow in more than 15 months, also eclipsing that seen during the August crash.

Fixed income funds as a whole experienced a nearly $10bn outflow last week, the largest in more than 2 years!

Levered bank loans saw their second largest weekly outflow since August 2011!

Money has been rushing out from all kinds of debt funds and into cash at a furious pace. Do bond investors and traders believe the Fed has made a major Policy error? The answer is pretty obvious.

Charts courtesy of BofAML

It was Ben Bernanke who slammed rates to zero and unleashed a torrent of liquidity via QE. Janet Yellen now has the arduous task of "normalizing" monetary policy from ground zero. As you would suspect, that isn't the easiest thing to do in the world. It's fair to say that there's a lot of weight placed on the current FOMC. They are playing with weights on a very fine balancing scale, and they've got to get it right.

Both camps are equally matched and honestly, we'd like to sit on the fence for now. We have included some graphics and captions from Bank of America, which does a nice job laying down the case of a policy mistake.

Bank of America Merrill Lynch on why the Fed was wrong hiking rates this week:

As Fed hikes rates for the first time in 3,460 days, officially ending the era of extreme, abnormal monetary policy in the form of QE and zero rates, what do we see?
As Fed hikes rates for the first time in 3,460 days, officially ending the era of extreme, abnormal monetary policy in the form of QE and zero rates, what do we see? Risk assets were very oversold going into the Fed hike... they now bounce.
But the Fed hike follows significant tightening of liquidity; negative blowback is more and more visible, e.g. credit crunch causing less stock buybacks.
And global banks being at all-time relative lows indicate Fed tightening into deflationary expansion, as does the narrow breadth of economic growth, wealth and asset price gains.
The Fed hiked 25bps, thus officially ending an unprecedented era of ZIRP and QE. Some quick thoughts:
The Fed's hike still leaves US and global interest rates close to "depression era" levels (Chart 9) and history is littered with examples of central banks struggling to escape from zero rates (Fed 1937, BoJ 1994 & 2000). We will turn sellers of risk in early '16 because rising rates and falling profits are ultimately not a good combination for asset prices.

The Fed's hike still leaves US and global interest rates close to "depression era" levels (Chart 9) and history is littered with examples of central banks struggling to escape from zero rates (Fed 1937, BoJ 1994 & 2000). We will turn sellers of risk in early '16 because rising rates and falling profits are ultimately not a good combination for asset prices.

The BofAML Global Breadth Indicator is on the verge of a tactical "buy" signal. Combined with high cash levels (5.2% in the Dec FMS = "buy signal") and the largest UW of US stocks since Jan'08, this suggests the final "pain trade" of a painful year is a squeeze higher in the most oversold risky assets.

The BofAML Global Breadth Indicator is on the verge of a tactical "buy" signal. Combined with high cash levels (5.2% in the Dec FMS = "buy signal") and the largest UW of US stocks since Jan'08, this suggests the final "pain trade" of a painful year is a squeeze higher in the most oversold risky assets.

The rate of growth of global liquidity (CB balance sheets + global FX reserves) is now shrinking. In the past 15 months, liquidity has unambiguously tightened as Fed QE3 ended, US real rates rose (see USGGT05Y INDEX), and China/OPEC FX reserves fell. Excess liquidity caused excess returns. But returns have been low and volatile in 2015 (cash is outperforming stocks and bonds for the 1st time since 1990) and we think the Fed hike will simply extend this backdrop... at least until stronger US data signals Quantitative Success.

The rate of growth of global liquidity (CB balance sheets + global FX reserves) is now shrinking. In the past 15 months, liquidity has unambiguously tightened as Fed QE3 ended, US real rates rose (see USGGT05Y INDEX), and China/OPEC FX reserves fell. Excess liquidity caused excess returns. But returns have been low and volatile in 2015 (cash is outperforming stocks and bonds for the 1st time since 1990) and we think the Fed hike will simply extend this backdrop... at least until stronger US data signals Quantitative Success.

Credit and commodities were two big "QE winners". The Fed hike coincides with a marked deterioration in the credit cycle, as evidenced by the widening of credit spreads. Rising rates and spreads means lower debt issuance, which in turn means less money for stock buybacks. Last week's S&P downgrade of Yum was driven by its announcement of a stock buyback program likely to be funded by even more debt. If companies cannot now issue debt to fund buybacks, this marks an important turning point for the stock market. Note wider credit spreads have gone hand in hand with underperformance of the stock buyback theme in recent months. We would thus take profits in any short-term bounce in stocks.

Credit and commodities were two big "QE winners". The Fed hike coincides with a marked deterioration in the credit cycle, as evidenced by the widening of credit spreads. Rising rates and spreads means lower debt issuance, which in turn means less money for stock buybacks. Last week's S&P downgrade of Yum was driven by its announcement of a stock buyback program likely to be funded by even more debt. If companies cannot now issue debt to fund buybacks, this marks an important turning point for the stock market. Note wider credit spreads have gone hand in hand with underperformance of the stock buyback theme in recent months. We would thus take profits in any short-term bounce in stocks.

In every cycle, higher rates punish financial excess. The commodity crash of 2015 was driven by the combo of tighter liquidity (thus strong $) and excess supply (driven by tech disruption and the zero rate policies of recent years). The widening of Saudi Arabia's CDS indicates the crash and its secondary impact are still being felt.

In every cycle, higher rates punish financial excess. The commodity crash of 2015 was driven by the combo of tighter liquidity (thus strong $) and excess supply (driven by tech disruption and the zero rate policies of recent years). The widening of Saudi Arabia's CDS indicates the crash and its secondary impact are still being felt.

The end of QE3 in the autumn of 2014 sparked a bull market in QE "losers" such as the US dollar, volatility and cash, and a bear markets in QE "winners", such as EM, commodities & credit. The bear market in EM, commodities, credit would be irrelevant were the Fed hiking into a strong economy and a strong EPS trend. But the Fed is hiking at the same time as global bank stocks are at all-time relative lows versus global stocks. The absence of a bull market in bank stocks and a bear market in government bonds indicates the Fed is hiking into a very "deflationary expansion", hints at Quantitative Failure, and puts great onus on corporate earnings to support asset prices in 2016.

The end of QE3 in the autumn of 2014 sparked a bull market in QE "losers" such as the US dollar, volatility and cash, and a bear markets in QE "winners", such as EM, commodities & credit. The bear market in EM, commodities, credit would be irrelevant were the Fed hiking into a strong economy and a strong EPS trend. But the Fed is hiking at the same time as global bank stocks are at all-time relative lows versus global stocks. The absence of a bull market in bank stocks and a bear market in government bonds indicates the Fed is hiking into a very "deflationary expansion", hints at Quantitative Failure, and puts great onus on corporate earnings to support asset prices in 2016.

Unfortunately US corporate profits are currently falling 4.7% YoY and this has historically been associated with negative US payroll growth.

Unfortunately US corporate profits are currently falling 4.7% YoY and this has historically been associated with negative US payroll growth.

And while the overall stock market looks healthy, it betrays a fragile, deflationary bull market with increasingly narrow leadership.

And while the overall stock market looks healthy, it betrays a fragile, deflationary bull market with increasingly narrow leadership.


Some of our live updates on the "most important Fed decision ever"

The #Fed has a long way to go after the first #FedRateHike in 9 years.

Posted by Business Of Finance on Wednesday, 16 December 2015

Here's the #Fed's latest "dot plot". More hawkish for the nearer term, unchanged further out. #FedRateHike

Posted by Business Of Finance on Wednesday, 16 December 2015

Whipsaw after #FedRateHike

Posted by Business Of Finance on Wednesday, 16 December 2015

Saxo Bank has some interim analysis on today's historic #FedRateHike:They did it. As near-universally expected, the...

Posted by Business Of Finance on Wednesday, 16 December 2015

Yellen is now an #oil strategist too...FED'S YELLEN SAYS SURPRISED BY FALLING OIL PRICESFED'S YELLEN SAYS THERE LIKELY A LIMIT TO OIL PRICE FALLSYELLEN SAYS OIL PRICES HAVE TO STABILIZE#FedRateHike

Posted by Business Of Finance on Wednesday, 16 December 2015

In the first #FedRateHike in 9 years, FOMC members separately forecast an appropriate rate of 1.375 percent at the end...

Posted by Business Of Finance on Wednesday, 16 December 2015

Key bulletin points from #Fed Chair Yellen's speech:---Here comes the doves---FED'S YELLEN - EVEN AFTER HIKE STANCE...

Posted by Business Of Finance on Wednesday, 16 December 2015

The immediate aftermath of the first #FedRateHike in 9 years. Markets are very confused and are jerking in all directions.

Posted by Business Of Finance on Wednesday, 16 December 2015

Full December FOMC statement:Information received since the Federal Open Market Committee met in October suggests that...

Posted by Business Of Finance on Wednesday, 16 December 2015

BREAKING: FED HIKES TARGET RATE TO 0.25-0.5%

Posted by Business Of Finance on Wednesday, 16 December 2015

BREAKING: FED HIKES TARGET RATE TO 0.25-0.5%

Posted by Business Of Finance on Wednesday, 16 December 2015