Fed to Spike Rates, Spook Market
Trick or Treat?
It’s October in an election year, which can mean only one thing: October Surprise. This year, we can count on Fed-speak to spook the markets as the man behind the curtains plans for a Democratic sweep of the House. So let’s jump right into pulling back that curtain.
Canary in the Coal Mine
In the financial world, when stocks rise, bonds tend to fall, and vice versa. This is the result of money flows from one sector to another with bonds representing a safe haven to stocks, typically viewed as the riskier asset class of the two. When both stocks and bonds fall in the same day, it’s a rare occurrence. However, if this becomes a trend, and both stocks and bonds go into general decline as the Fed continues to raise rates, investors will have few places to hide. The good news is that this is unlikely to become a trend. To understand why, let’s take a look at what may have caused the dual market decline of 800+ points (3.2%) on Wednesday, October 10th.
The $4T Balance Sheet
Much has been made of the Federal Reserve’s massive $4T fixed income balance sheet and how they intend to exit their position. Asset managers, like the Fed, are smart. They know that by selling large positions, they can move the market, giving back gains or exacerbating a losing position simply announcing their intent to sell — which is why large money managers generally do not announce such moves ahead of time. In the case of deleveraging their fixed income balance sheet; they need to create a market, and when the stock market is hot, the fixed income market is not.
Aggressive Rate Hikes Coming Soon
In theory, the purpose of central bank rate hikes is to manage the temperature of the economy. If it overheats, it could catch a fever, or at least so goes the theory. Circa 2018, hiking interest rates into a strong economy serves another purpose: to create a market for bonds by sparking a stock market correction and triggering a flight to the relative safety of the bond market. In doing so, the hot money flowing into the bond market puts a bid under bonds and thereby helps the Fed to sell their mortgage and T-bond portfolio into strength.
This is a brilliant strategy on part of the Fed provided that there are not too many more days in which the bond market sells off along with the stock market. If the broader investor market sees a trend in which both markets are in general decline, investors will seek the safety of cash rather than bonds, defeating the purpose of this Fed-engineered stock market correction. Since the Fed has such a massive balance sheet of long-dated bonds, they can monitor volume and sell into strength, unloading their massive balance sheet in the process.
Unfortunately for stock investors, this means that the Federal Reserve has every incentive to hike aggressively while the economy is hot. Faster, more aggressive rate hikes are likely to spur an equally aggressive selloff on the S&P and DJI indices.
The key to their success in this deleveraging operation will be the Fed’s ability to manage the long end of the bond yield curve. Typically, market corrections are indicative of a forthcoming recession, for which many pundits would argue that we’re long overdue. Recessions usually coincide with interest rate cuts, viewed as medicine to help the economy recover.
In this scenario, as the equity markets decline, investors seek to move money from stocks to bonds. Long-dated bonds do especially well in this environment as the market anticipates rate cuts to foster a recovery in the market. As a result, demand for long dated bonds frequently exceeds demand for short-term bonds causing an inverted yield curve, usually indicative of a forthcoming recession.
It’s a self-reinforcing vicious market cycle.
This Time It’s Different
No really, I know we’ve heard this before, especially if you’ve lived through the Dot-Com, housing, and commodity bubble bursting events, but this time really is different.
In normal market cycles, the Federal Reserve doesn’t have a $4 TRILLION balance sheet to unload. In other words, while the Fed aggressively hikes rates triggering an equity selloff and a bid for long-term bonds, they’re quietly selling their bond portfolio into bond market strength. Hence, a spike in demand for long-term bonds is unlikely to invert the yield curve as the Fed matches market demand with supply from their balance sheet. When the market recognizes that the curve is not inverting as a result of the stock market correction, cooler heads will prevail and see this as a buying opportunity. The bull market will live to fight another day.
What Do I Do?
You have three options, the same three options that you always have: buy, sell or hold.
If you have a dollar cost averaging strategy, stick with it. The market is likely to dip, perhaps even into bear market territory, but it will recover as the underlying market fundamentals continue to strengthen. If you actively manage your money, then we need to find the bull market. As Jim Cramer says, “There’s a bull market somewhere,” and he’s right. The market acts as a lever, when something comes down, something else is going up. We’ll cover more on that in a moment. The latter option is to do nothing. Since this rate hiking cycle is not likely to trigger a recession, it’ll hurt while the market corrects, but you can be assured that the Fed has no vested interest in seeing a prolonged recession result from their rate hikes. The market will rebound once it realizes that bond yields have maintained a healthy curve.
With that said, the standard process of moving out of stocks and into bonds is unlikely to produce gains this time around. I expect that the bond market will maintain value since the Fed does not want to scare the market into cash, as previously discussed. If the Fed sells into bond strength and does not cut rates to support a non-existent recession, then those who moved into bonds are unlikely to profit from the move. Instead, I recommend buying the greenback.
Buy Dollars
Currencies tend to act as a proxy for the economic health of a nation. Likewise, the US dollar also benefits from improving economic health, and unlike most other nations, from geopolitical turmoil too. With that in mind, let’s take a look at the underlying fundamentals of the US of A. If fundamentals are strong and supported by strong dollar policy, then we can feel confident about the prospects for the US dollar as an investment.
Strong Dollar Policy
Maybe you’re a fan of President Trump and maybe you’re not. While the debate rages on about our president’s intellect or supposed lack thereof, one thing is clear: he’s smart enough to listen to his economic advisory team, and that team is knocking it out of the park.
His fiscal strategy: tariffs and corporate tax cuts, is growing the economy while repatriating manufacturing jobs in the steel, aluminum and automotive sectors — a national security imperative. Yes, while these policies are likely to drive costs higher, higher costs support the traditional narrative for higher interest rates — a perfect case of fiscal and monetary policy supporting one another. Moreover, as the stock market corrects, and the Fed raises rates, tax receipts are likely to contract, putting the Democratically-controlled House into a budget bind.
A budget constrained Democratically-controlled Congress creates an opportunity for President Trump to force the Democrats to reform our two largest budgetary expenses: healthcare, in the 2019–2020 session, and Social Security after a 2020 re-election with Paul Ryan as his VP. Any reform to either of these programs will be decidedly bullish for the US Dollar — and we can bet that President Trump will not be shy about shutting down the government until he gets his deal.
Everywhere you look, fiscal and monetary policy point toward a stronger US Dollar. The actions of the Administration and the Federal Reserve seem to be brilliantly coordinated. If President Trump’s Fed-bashing tweets are any indication, we can count on out-sized Fed influence very soon and a stronger dollar too. Don’t get tricked into buying bonds. Treat yourself, instead, to US Dollars.
Joe McHugh is a fiat and crypto-currency manager and founder of Earth Loans. You can message him on Twitter (@joemchugh) and LinkedIn. Disclosure: This is not a recommendation to buy or sell any currency. Consult your advisor before making investment decisions.
