The United States Federal Reserve (the Fed) will increase US interest rates for the first time in 9 years on December 17th. The long awaited “lift off” will be confirmed.
With 91% of economists now forecasting the Federal Funds Rate target range to be lifted by 25bp, the door is now wide open for the Federal Open Market Committee (FOMC) to confirm market expectations.
This is good news: we have finally made our way to the point where the FOMC believes the US economy, the largest in the world, can now do without both Quantitative Easing (QE) support and Zero Interest Rate Policy (ZIRP). They are right: the US economic data undeniably supports the case for “lift off”, in fact, in my view it has for the last six months.
However, what is more important than confirmation of “lift off” itself, it is the trajectory of the US interest rate curve.
I believe the Fed will embark on a “dovish hike”. They are right to be keen to get away from 0% cash rates, but they also don’t want to undo all their heavy lifting of the last decade by having markets fear that rates are going to rise quickly.
My very strong view is they will accompany the rate hike with VERY dovish commentary. I have been highly critical of the Fed’s mixed messages this year and its absolutely crucial to all of us they get the wording exactly right that accompanies the rate rise and will set market expectations from that point.
In my opinion, they will attempt to guide to very “gradual”, “data dependent”, “patient” rate rises in the future. The markets may even believe it’s “one and done” and if that happens, there will be some very tradeable price action in anything US Dollar denominated.
We need to put in context that the markets are now fully discounting in a 25bp rate rise. What they aren’t pricing in is the reaction to the “dovish” commentary I expect.
The world, led by markets, are very ready for the rate rise. The US Dollar is up +23% in a year, commodities denominated in USD have been crushed, emerging markets have been crushed, emerging market currencies have been crushed, and as we all know, commodity currencies have been crushed. Yield based equity sectors have started to underperform globally.
In the way I approach markets, the rate hike is a “known known”: the market reaction to it is the “unknown unknown” that professional investors, like myself, have to get broadly more right than wrong.
To confirm markets are now positioned for the “known known” of “lift off”, independent global macro research house Vanda Securities, who analyses overall investor positioning, published the following chart this week.
[1]What this table tells you is that investors are over 1.5 standard deviations long the USD, and 1.5 standard deviations underweight/short pretty much anything else denominated in USD.
This is highly believable because investors have had so much time to get ready for this event, “lift off”.
What could easily happen on confirmation of “lift off” is a reversal in many of these very crowded positions, led by some profit taking in the mighty USD, which in turn, would trigger short-covering in commodity currencies, commodities and emerging markets.
Recently we saw a classic example of “short the rumour, short cover the fact” when the ECB cut deposit rates further. The ECB, via their words, let EVERYONE know months ago that they intended to loosen monetary policy further to fight deflationary pressures. The EURO fell from 1.14usc to 1.05usc in anticipation of the ECB rate cut. EUR short positions got to 3 standard deviations away from normal positioning.
Where it gets interesting is when the ECB confirmed the rate cut, the EUR shot up from 1.05usc to 1.09usc, a massive and instant move that mostly has been held onto. The EUR is now being bought on dips by short-coverers on the view that was the last piece of monetary policy help from the ECB. Eurozone equity markets, which rallied hard into the ECB confirmation, have all fallen by around -5% on confirmation of the fact.
I tend to feel the ECB/EUR reaction could well be the market playbook for the reaction to confirmation of Fed “lift off”. It could easily turn into a profit taking event in the US Dollar and a short-covering event in dollar denominated assets. If that was the case, equity markets, including Australia, will have a solid end to the year. Under that scenario, I wouldn’t be surprised to see the S&P500 and NASDAQ end at fresh all-time highs.
However, as I say, this reaction function in markets all comes down to The Fed getting its message on the pace and scale of future rate rises dead right, and investors believing them.
To me, all the factors are aligned for this outcome. Everyone appears to be already positioned for “lift off” and hedge funds are sitting on very large unrealised gains in long USD/short everything else trades. The temptation to lock some of those gains in ahead of the end of the performance (and performance fee) year will be large.
Don’t start thinking I believe this is the end of the US Dollar’s dominance. But in big up moves, there can be violent counter-trend moves when extreme positioning meets a major event. This is particularly so when many hedge fund models follow momentum. Just as we have seen in the Euro, if momentum changes, they will chase it in the short-term when locking in trading profits.
What tends to happen is the extreme positioning is flushed out and then the trend returns. This is exactly what happened as the Fed turned off the QE tap in stages.
I broadly believe Fed “lift off” is a positive event. It ends a year of uncertainty and shows confidence in the US economy’s self-sustaining growth profile. I also believe it paves the way for US equities to ADVANCE in late 2015 and into 2016, after Wall St’s global underperformance in 2015, driven primarily in my view by Fed uncertainty and the Fed’s previously woeful communications policy that in itself trigger volatility in risk asset markets.
What I expect to see from December 17th and onwards in the USA is a rotation from long bonds to equities. The long awaited “great rotation” from bonds to equities might just be trigged by the Fed’s “dovish hike”.
While nobody can be certain of the market reaction to the Fed, my gut feel is to be positioned in portfolios ahead of the confirmation of “lift off”. As you saw in the Euro example, markets move so quickly nowadays that you have no time to react. You have to be positioned ahead of the confirmation of the event.
History suggests US equities continue to advance through the first four Fed rate hikes. I believe this will no different this time around and I truly hope we do get “lift off” on December 17th and end a year of uncertainty and volatility on a more positive and certain note.
Markets like certainty, that is one thing that is certain.
Let’s see what comes.
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