Don’t Fight the Fed
May 17, 2016
The FOMC minutes from the April meeting had an unmistakable hawkish tone. Not only was a rate hike discussed in April, but members indicated their concern that the market was vastly underestimating the chance of a rate hike in June. Holbrook has been pounding the table, given the labor market strength and the recent uptick in wages, as well as incipient inflationary pressures, that the Fed could tighten in June, and will very likely move at least three times in 2016. If there is one piece of investment advice that has rung true over the years, it is “Don’t Fight the Fed.” The market continues to doubt the credibility of the Fed, and more importantly, it doubts the credibility of the underlying economic data.
In a prior perspective, “Wage Growth, the Fed, and Market Hubris,” Holbrook outlined its playbook for rates in 2016. We forecasted that given the tightness in labor markets, wage growth and inflation would continue to build momentum and that the Federal Reserve would employ the proper policy of raising rates in response. We also stated that the Fed Funds Futures market was ignoring the Fed, and that longer term treasury investors were demanding no premium for holding ten year treasuries. The fixed income market is so diametrically opposed to the proper path of Fed policy, that there is likely to be a dynamic recalibration of interest rates, and the direction is higher.
After the data, interest rates spiked higher, the ten-year moving from 1.77% to 1.88% currently. I suspect that in the short-term, barring a horrendous Initial Jobless Claims reading tomorrow, it will continue to move higher as traders who are positioned on the wrong-side of this market sell. The two year treasury jumped from .83% to .91% and the probability of a rate hike in June (as priced by the Fed Funds Futures market) went from 12% to 32%, which is still too low.
The surprising aspect of market action today was the steepness of the yield curve. The difference between the ten-two spread widened 2 bps. Pay close attention to this metric. A steepening yield curve is better for equities as it indicates market participants do not view a rate hike as a policy mistake. A flattening yield curve means the opposite and brings with it the type of uncertainty that equity markets hate. If the curve continues to steepen from these levels, I think equities have room to rally, especially given the bearish sentiment as indicated by AAII (below). If, however, the curve continues to flatten, all bets are off, and further downside is likely.
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