Notes on The Fed
The Federal Reserve decided on March 16th not to raise interest rates. This came as little surprise, as that is exactly what Federal Funds futures had predicted. The surprise was the statement from the Fed that accompanied the announcement. In it, the Fed suggested that it was not particularly worried about inflation pressures, and in fact they expected that they’d only hike rates two times this year instead of the four hikes they forecast back in December 2015. They cited world credit conditions as a motivator. All of this had a big impact on global markets. It reinforced the current “risk-on” atmosphere by giving market participants the confidence that the Fed would not act prematurely – precisely what many feared after the December hike. Furthermore, it negated the argument for being long the dollar (widening interest rate spreads), which took pressure off emerging market currencies. This has driven a surge in emerging market debt prices this month.
These are the trading implications as I see it:
- Bullish for emerging markets and risk assets
- Bullish for gold and economically sensitive commodities like base metals
- Favoring inflation protected securities (TIPs) over regular coupon bonds
I believe the Fed will have to reassure markets that they have not gone too soft on inflation if not at the next meeting then certainly by the one in June. Continued improvement in the labor markets and rising consumer prices could put pressure on high quality bonds. Because the recent rally in risk assets has been very sharp, I would wait for a pullback. Almost all are technically overbought.
Other Things of Note
- One of the most important things about the stock market’s performance in 2016 is that value has sharply outperformed growth for the first time since the first quarter of 2014. This reflected a preference for dividends and defensive sectors earlier this year when the market was very weak and also the poor relative performance of the health care sector. At this point, I would make sure my portfolio was not over-weighted toward growth, but I would resist having more than a slight overweight to value. One quarter does not make a trend change, as 1Q14 showed. Value typically asserts itself after a correction has begun and lasts through the early stages of an economic recovery. That might be going on in the short term as a “mini-cycle” but certainly not in the larger, business cycle sense.
- It is interesting to me that in March (clearly an “up” month with S&P 500 up 6.1%) that the Dow Jones Utility Average is up 5.8%. This brings its year-to-date return to 12.63%. See Figure 1. Essentially, utilities rose when the overall market was falling and continue to rise as it recovered. I would have expected utilities to lag this recovery badly as they typically do during strong market phases. Does this reflect the market’s lack of conviction in the stock rally, or is it due to investors piling into low volatility strategy ETFs? I’m not sure at this point, but it is one of those things I’m keeping a close eye on.
- The most recent move from the European Central Bank is being interpreted as a “pay ‘em to lend” program. Apparently, banks are going to be paid up to 40 basis points to lend money to non-financial companies. This removes the negative interest rate penalty that was hurting European banks (previously, they were earning a negative 30 basis point yield on money they had to hold on to in order to meet capital requirements). This is expected to be very stimulative, so European stocks have responded. Let’s see how it plays out in the real world.
- High yield spreads have contracted to 3.92% (BB) from a high of 5.82% on February 11th. That tells me that a great deal of money came in to buy the dip. BB credits now strike me as distinctly not cheap, especially since CCC bond yield spreads exceed 12%. At this stage of the market cycle, high yield bonds are a trade in my opinion. The window has closed unless you are willing to go further down the credit spectrum, where risk is higher but you are at least being adequately compensated for taking it.
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 Source: YCharts.com, 1/1/16 – 3/23/16
 Source: YCharts.com