Thursday, November 19, 2015

Preparing For The Fed

We've reached the point where the market now seems fully prepared for Fed policymakers to make a move at their December meeting and lift the Federal Funds interest rate by 25-basis points.  The Fed Funds futures market is now pricing in a high probability of this happening.  Per the minutes from their most recent meeting, Fed officials believed that the targeted conditions for an initial hike "could well be met" but they were certain to hedge that stance with the need to stay flexible and keep all options open.

There are many who believe that the Fed made a mistake by not raising rates at their September meeting and that crowd now seems convinced that action at the December meeting is a forgone conclusion.

Not everyone agrees, however.  DoubleLine's Jeff Gundlach might just be the most prominent of the dissenters.  This week, he cautioned that certain parts of the market are flashing yellow lights and asking the Fed to pump the brakes on a rate move.  For one, he highlighted the high yield bond market.  He observed that recently the rate of credit-rating downgrades were outpacing credit-rating upgrades.  When this ratio has gone inverted like this in the past it has preceded some of the market's more volatile periods.

His worry here is that if the Fed does choose to hike in December it could spark some degree volatility and force them to loosen again down the road.  A messy ordeal no doubt.

The US dollar is another area where Gundlach has been vocal.  He's argued frequently that continued strength in the USD could wipe out any Fed plans for a hike.  "If the dollar gets any stronger, we may see further volatility in markets, which might get the Fed nervous."  He's watching the DXY and thinks that if it goes above 100 and closes there for more than a couple of days, it could cause the Fed to delay.

“I’m against the Fed raising rates on a coin flip,” he said. “It should be something that is analyzable and defensible. One economic report is a bad reason against the context of a new low in junk bonds and nearly new lows in banks loans, plus weakness in emerging markets, the fact that the global Dow chart is very weak and commodity prices are on their lows.”

All that being said, it does appear as if Fed officials are eager to rip the band-aid off and get the first move out of the way.  This is what their recent language suggests albeit they've left themselves some wiggle room in nearly every statement.

If they do indeed initiate lift-off on December 16th, Convergex's Nick Colas suggests that Financials could be one area poised to rally.  In his words:

One group worth a look is the Financials. On the plus side are two factors.  The first is that the Federal Reserve seems set on raising interest rates at its December meeting.  Fed Funds Futures give this a 64% chance of occurring and the minutes of the September meeting out today should give more clarity.  The Financials have rallied 2.6% in the last month on the back of prospects for this event, but if you pair up the Futures market handicapping with the move in stocks, there should be more room to run if the Fed does move. Catalyst (Fed meeting) plus the start of a reaction (near term outperformance) is a good argument to own the Financials.

Compelling arguments are coming from both the hawks and the doves on this issue.  It will be interesting to see how the market reacts to the various reports and shifts in tone over the next month.  Move or no move, a pick up in volatility should be prepared for.  We have no bias in which way the market ultimately resolves itself off of this event but we will be prepared for added fluctuations.

Ryan Worch is the Managing Director of Worch Capital LLC. Worch Capital LLC is the general partner of a long/short equity strategy that operates with a directional bias and while emphasizing capital preservation at all times.

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