94 months of zero-bound interest rates, 3 full rounds of QE, a Fed balance sheet north of $2trn, a stock market that has nearly tripled, and a lot of volatility. All this might change in the next couple of days.
This Thursday's (17 September) FOMC interest rate decision and statement is perhaps the most intensely scrutinized and anticipated in the last 15 years. It's probably also the hardest single Fed event to properly trade, in our opinion and of many others.
After almost exactly 108 months since the Fed started its grand entourage of cutting rates to create a global macro environment of easy money (also known as ZIRP, or zero interest rate policy), it's now faced with a cesspool of indications; some morbid, while others a tad more palatable.
How are we trading the 'most important Fed event ever'? Read on to find out.
The All Important Context
The health of the global economy doesn't look too green, because it isn't. The elephant in the room remains China and many of the EMs, as we've discussed in detail before. Financial markets have been trading eccentrically and continue confound even the big players, let along the poorly equipped retail trader (us included).
We wrote in August about how the Fed already missed its golden opportunity to embark on operation liftoff. The consequences of that have been evident, but not more so than in the overly crowded long dollar trade which partially blew up in April. The question on everyone's mind is whether the Fed will deliver on market expectations to hike rates in September, or if they choose to blow another opportunity again like they did earlier in 2015.
While there is basis to support both camps, matters are still extremely ambiguous mostly because of recent developments in economics and the financial markets.
In the U.S. economy, the pace of job creation has slowed (still growing, but decelerated markedly). Wage growth is on par with most recent expectations, but still remain susceptible to stalling in low air. Inflation is clearly a sticking point that will likely persist until oil and commodity prices see medium to long term respite (unlikely until 2016, in our opinion). The FOMC has acknowledged all of this.
Outside the labor market and prices, other economic indicators that we've been following tell us that the U.S. economy is in a phase of decelerating growth, not helped by low input prices. Consumer demand (or aggregate demand) isn't growing as one would expect when a central bank earnestly embarks on a tightening path.
Then we have China. The economy there isn't pretty at all. Chinese stocks are still struggling to not make lower lows, while he Chinese central bank (PBoC) has been reluctant to go all out applying the kool aid. China, like almost all EMs, is clearly on the other side of the business cycle. Nothing on this scale can be fixed in short order, and conditions there are still deteriorating.
In short, there are clearly more headwinds than tailwinds at this juncture, even from the FOMC's dominant perspective on the domestic economy. We therefore believe that the market has never been more confused, ever since the Fed hinted (back in 2014) that this day would come.
And if you think this is a singularity, you'd better wake up because it isn't.
Know The Market's Consensus
The consensus expectation is for a 13bp (0.13%) rate hike during this September's FOMC meeting. The current FF (Fed Funds) rate stands at 0-0.25%. The aforementioned expectations is the average of estimates by analysts Bloomberg polls.
Of those who expect a hike, most are calling for a 10bp hike (commonly believed to be the smallest increase the Fed will effect). Some are calling for a 15bp and even a 20bp hike, but the base estimate for this camp is a 10bp hike.
Remember that as of writing, only about a third (38%) of polled analysts believe the Fed will liftoff in September. Whether the markets have fully, partially, or not at all discounted this expectation is an open question for debate. We won't bother about that for now.
Most analysts believe the Fed will liftoff in 2015. The possibilities are for any permutation for hike(s) in September, October, and December. Only a minority believe that the Fed won't hike in 2015 at all.
For now, betting on both the size and sequence of the Fed's policy path is akin to gambling. That's because we don't yet know the contents and language of the FOMC's September communication. Ever more so than before, Thursday's statement will be squared and cubed in any possibly to extract any forensic clue to the Fed's future actions.
If history is any guide, the markets are extremely adept at figuring out such complexities, and they start discounting for future events very quickly. So what do we do? We listen to the market for that it believes the Fed will do beyond September. Screw our believes. They don't matter here.
But for the sake of keeping a tab on what we said, we are sticking to our baseline of an October liftoff, as we wrote all the way back in April.
Some Of The Narratives
Before we get on to talking about our approach to this mega event, let's first look at some of the most common narratives floating around in the markets. Obviously, most are taking this a step at time. That's the most logical way to manage expectations and react accordingly.
- Any rate hike will be in the smallest increments and will be as granular as realistically possible. This isn't really a narrative because it has been commonly agreed upon by analysts. The Fed itself has communicated in the past that it plans to adopt a gradual path of tightening, and that should conditions change, said tightening may be halted.
- The Fed will hike in September because it has waited too little too long since it first floated the notion in mid-2014. Market expectations have already been egged up for a September hike and a failure to deliver on this will only create more uncertainty for future meetings. A U3 unemployment rate of 5.1% is very close to the Fed's mandated full employment. The Fed will use September's hike in conjunction with properly primed language to manage the market's expectations about the Fed's view of the economy, and financial conditions in general. The Fed understands that anticipation of liftoff has created great volatility and distress in many asset classes and markets including credit spreads, and equities in and outside the U.S.. If the Fed doesn't hike in September, its tightening path may be steeper later on, a negative for its plan to gently massage its intention to moderate short to medium term borrowing costs inline with an economy which has already recovered. Pushing back the virgin rate hike will also mean a continuation of turbulence in financial markets and the U.S. dollar - all negatives. Despite negative developments in China and most EMs, the Fed believes these external factors will have minimal impact on the domestic economy. A liftoff in September will serve as a boost to the Fed's confidence in both the momentum and resilience of the U.S. economy, which itself serves as strong message on top of September's statement.
- The Fed won't hike in September because recent negative developments across global financial markets and currencies have compounded the headwinds of a rather significant slowdown in the global economy, especially in EMs. The lack of renewed monetary easing by other major central banks such as the PBoC (highly crucial for China), BoJ (its most recent September meeting concluded with no extra QQE), and ECB means that if the Fed were to officially start tightening (even in the slightest manner) in the midst of heightened instability and uncertainty, it might be too much for the markets to bear. A September liftoff is probably going to bid up the U.S. dollar, further straining EM currencies which have already been battered hard by massive outflows from EMs and risk trades. The main reason here for the Fed not to hike in September is because current market and economy don't permit. Rather, the Fed will use September's statement to further manage market's expectations on continued progress of the domestic economy, focusing on the labor market and wages. The lack of momentum in inflation will also prevent a majority of FOMC members from voting for a September hike. The Fed will adopt a wait and see stance like it has been doing all year long.
- The Fed won't hike in 2015 at all. This is of course the most dovish of the narratives. The Fed believes that the slowdown in global economy growth and the lack of core domestic inflation are too strong a headwind to risk tightening financial conditions and raising borrowing costs for consumers and businesses. The the time isn't right, but not because of inherent weakness in the U.S. economy, but because external factors such as above average volatility in global financial markets, and deep concerns about China (EMs in general). The Fed feels any premature hike, a case when not all stars are properly aligned, will only spook financial markets and cause much needed confidence to be further eroded. To avoid complications of hiking in September but halting its path of tightening because of possible adverse reactions, the Fed will choose to wait until more certainty settles. The more dovish of the FOMC members will also wish to see wage and core price inflation pick up before embarking on liftoff. Further, liquidity in many money markets are at seasonal lows in September, and will worsen towards Christmas as funds are still rebalancing their portfolios and shifting to different strategies. A hike in early 2016 will be more appropriate; might as well miss this 'subprime' opportunity (as denoted by market expectations) to hike than to risk stumbling on a bad decision and possibly worse still, reversing on a bad decision. The Fed wants to preserve its credibility (which as already been damaged) by erring on the safe side.
How We're Trading This
If you're here for hard and fast answers, you're out of luck. Because honestly, we don't know which markets will move and which won't, how much they move and in which direction they move. We're playing it safe here. In such circumstances, the first rule of the book is to avoid loosing money, to preserve capital.
By playing it safe, we mean to stay out of the market almost entirely if possible. As we write, we have a few outstanding positions which we plan to square off as we approach Thursday's mega event. We're not going to bet on direction plainly because we really see a lack of structure within each market we track (currencies, equities, bonds, and commodities), and also a lack of structure across markets.
Correlations are breaking down left right and center. Implied volatility is lower than realized volatility for equities, but what does that mean? We hell don't know. We plainly don't feel comfortable having a sizable exposure to such markets. When we don't feel comfortable, we won't be trading or having a position. Staying in cash is a position in such cases. There is no point guessing on direction, it's gambling.
Rather, we wish to wait for the event to pass, analyze the result of the event and the market's reaction, and then take prompt action in whatever direction the market trades. No easy feat as we'd be expecting ludicrous amounts of volatility in the minutes pre and post 2pm EDT.
But do we have biases? Yes we do. Longer term we're bullish stocks and the U.S. dollar. Shorter term we have no opinion. Look at the markets now. Does it make sense to have a bias for the short term? If you do then sorry, we've wasted your time reading this snippet. We're staying save and enjoying the media banter and speculation over something that is still an unknown.
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