Rates are Up but the Road is Long

December 18, 2015
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- The Federal Reserve did it: They hiked rates for the first time in nearly a decade. And markets are still here, nothing has collapsed.

- Global markets have largely rallied after this rate hike, and while counter-intuitive, this is likely due to the perception that the Fed felt the global economy is strong enough to bear a rate hike combined with the insertion of some rather dovish commentary (lower dot plots for 2017/2018 + multiple inclusions of the word ‘gradual’ in pertinence to future rate hikes).

- But this is still early. 2016 will see the global economy counter a number of risks, and investors/traders are going to need to stay vigilant.

This morning felt a bit like January 1st, 2000; the morning after the Y2k ‘issue’ turned out to be nothing at all. Doom and gloom were feared, but and the end of the day everything turned out to be ‘ok.’ Well, maybe we’re not quite yet at the ‘end’ of the day, but you get the gist. This morning feels as if the world is rejoicing that leaving ZIRP behind didn’t lead to a catastrophic system collapse immediately after rates were hiked. But I urge you to exercise caution, because 2016 is loaded with risks and this will be the first year that the world gets to counter these risks without the luxury of the largest national Central Bank sitting on especially accommodative monetary policy.

As a matter of fact, the elephant in the room that we mentioned yesterday still exists: The Dot Plot projections of Fed member rate expectations for the coming quarters are still considerably divorced from market expectations. The Fed is anticipating four rate hikes next year while markets are only expecting two. We did see the bank soften their expectations for 2017, with the median expectation falling to 2.375% from 2.625%; and 2018 was downgraded from a median of 3.375 to 3.25. But this continues the pattern of overly-bullish Fed expectations that can create considerable dissonance in markets. But that’s a matter for another day (or another Fed meeting), and we’ll likely be wrestling with this theme for much of next year until something gives in either way (either equity markets set new highs as data (and inflation) improves, or markets fall lower and the Fed backs down, similar to what we saw in 2015).

Performance across markets post-rate hike has been very encouraging thus far, and this just highlights what an excellent job Ms. Yellen did during the press conference yesterday. I’ve seen some analysts/pundits out there saying that this was a ‘hawkish hike,’ but I’m having difficulty agreeing with that sentiment. This might not have been the ‘extremely-dovish’ hedge that many were looking for to accompany the hike, but the evidence does indicate a tad of dovishness here. The dots dropped for 2017 and 2018, and while this wouldn’t have been as market-supportive had we seen 2016 downgraded, it may have been enough to assuage investor fears that the Fed was dead-set on hikes regardless of the context. And further to that point, Ms. Yellen reiterated numerous times that the bank was anticipating ‘gradual’ moves to interest rates. That word ‘gradual’ came up quite a bit; and to my ears this sounded like a perfect hedge from the bank that gives them the flexibility to back down should the global economy begin to cough on this tighter monetary policy out of the US. This also points to the fact that the dot plot matrix is merely a guess, and by Ms. Yellen accompanying that dot plot matrix with such commentary, it serves to show that she probably doesn’t carry much loyalty to those prognostications that have remained so divorced from actual market expectations.

There was considerable volatility during the press conference, and many markets felt very illiquid around the release (which was somewhat to be expected); this is a concern moving forward, but as the dust settled global stocks were throttling higher and rates began moving up. US Stocks popped near-immediately around the rate hike and continued to drive during the presser, and this move wasn’t just relegated to the United States as Asia and Europe both enjoyed the ride after their market opens.

Since testing the 2,000 level earlier in the week, the SP has put in an 85-handle move off of the lows (one handle = 1 ‘point’ on the SP). A full 85 points in three days is a bit silly to anyone that has traded in this asset for more than 5 or 6 years. To put this in scope – the lows of the financial collapse was set in the 660’s, and this 85-handle move would’ve been 8.7% move in less than week. And again, this move has happened as much of the world was expecting a rate hike.

So, while the move in equity markets over the past 24-hours might not make a lot of direct sense (markets are rallying on tighter monetary policy), this highlights the relative nature of markets. It’s not what happens, but it’s what happens relative to expectations and historical scope that amount to price action movements. And for now, the SP is bullish, so bears beware. On the below chart, we’re looking at the current setup in the SPX500, and notice how 2065, that vaulted Fibonacci level that we’ve been discussing over the past few months, has set support yet again. As the SPX500 has been putting in lower-highs over the last seven months, this opens up the door for considerable resistance levels that can be used for profit targets (each is drawn below as ‘black lines’ above current price action).

Created with Marketscope/Trading Station II; prepared by James Stanley

The Larger Concerns are Still Looming

Markets don’t just collapse on their own. Not usually, anyways. Most of the time there is some type of catalyst that creates risk aversion that compels investors to pull their money out of markets and tuck it under their mattress for fear of even bigger problems, and this creates a negative feedback loop that leads to even more selling and even lower prices. This is precisely what happened during the Financial Collapse; trouble initially began to show in July of 2007 when IndyMac blew up. IndyMac was an offshoot of Countrywide Financial, and was very much emblematic of the loose mortgage standards that provided much of the air for the bubble of the housing market. This was also the largest savings and loan in the Los Angeles area, and the 7th largest mortgage originator in the United States. So when they blew up in July of 2007, the world knew that something was wrong. Markets even moved lower to reflect this blow-up and this inclusion of fear, but that was short-lived. Just three months later the SP had set a new all-time high (which at a level of 1576 now looks weak). But we all know how that story turned out, right? July of 2007 wasn’t an isolated event; it was a sign of things to come.

But if we examine the financial collapse, what really made it severe was credit risk. The housing bubble drove prices higher, and investors continued to absorb risk as a constantly rising housing prices made the prospect of ‘flipping’ or investing in real estate attractive. Eventually, anyone that wanted to buy a house had one (and in some cases had two or three so that they could ‘flip’ them), and there was nobody left to buy. So prices come down, and that negative feedback loop was started. It didn’t end until TARP and QE came into the picture.

But the parallels to today are frightening. Over the past six years of extremely low rates, we’ve seen investors, similar to the lead-up to the financial collapse, take on considerable risk in their portfolios. And as long as the Federal Reserve is supporting US markets, this isn’t necessarily a bad thing. This is like being long real estate while the bubble was still forming. But as we all know, bubbles don’t build forever. And for this current run, unlike the financial collapse, investors are significantly loaded up into equities and high yield debt. With rates extremely low, they had to take on these types of risks to introduce any element of return into the portfolio; but this isn’t relegated to just individual investors as hedge funds and institutions had the same dearth of attractive yield-based investments to build a portfolio around.

Perhaps more troubling are the moves in commodities, and relevant for the United States the movements in Oil. Now that the US is a net-producer of Oil (and a potential exporter), the US economy is exhibiting a more direct correlation with Oil prices. For a long time, many (including the Fed) considered low oil prices to be a positive for consumers, under the premise that cheaper gas prices meant more money in consumer’s pockets which meant more consuming. But what we’re seeing now is that the negative impact of oil-extracting and producing companies more than offsetting that benefit of lower gas prices.

And perhaps more pertinent to our current situation, as Oil prices were driving higher for much of the past six years, significant investment was made in energy extraction and production. Much of this growth was funded by debt while rates were really low, and a lot of this debt, at least in the United States, is of the high-yield or ‘junk’ variety. Now that Oil prices are driving lower, the feasibility of that debt being paid off has come into question; and perhaps more troubling, with higher interest rates kicking up in the United States, it’s going to become more difficult (and more expensive) for these companies to re-finance that debt. This is an unavoidable situation, its simply a matter of mathematics. If a company is unable to produce oil at above break-even prices, they’re essentially a negative cash flow business. Combine that negative cash flow with debt service, and the prospect of recovery is basically impossible unless some exogenous stimuli brings capital into the company.

The big question now is whether a collapse of high-yield debt can be contained. Some prognosticators say yes while others say no, and the real answer is likely somewhere in between. The big difference from this situation and the Financial Collapse is leverage. Leverage is what made that blow-up so absolutely severe in 2008; and because mortgages had traditionally been a ‘safe’ investment class, banks were able to push the leverage considerably higher than they would have on other investments. This likely isn’t the same in high-yield debt right now. Yes, banks and investors are struggling with the harsh reality of lower oil prices for energy companies; but while they were taking that debt on, they knew it was junk in the first place so they likely didn’t lever up 30:1 like we saw during the financial collapse.

But the prospect of contagion is there: As in, should lower oil prices continue to drive lower, it’s unlikely that the US economy will remain unfettered. This could hit a quite a few American companies, and should those companies take a hit, the people that have loaned them money (and are forced to take a loss) will take a hit as well. The question is what happens to who they owe money to.

Lower oil prices plus higher interest rates means a big portion of the American economy will be facing pressure on future quarterly earnings announcements, and this, ultimately, is what drives stock prices lower: Corporate earnings. And should any of the plethora of concerns pop-up between now and then (Asian economic slowdown, oil prices, carnage in high yield, geo-political pressure in Syria, Russian/US relations, etc.), stock prices could take a hit as investors duck for cover for fear of another 2008.

But for now, risk is on in a big way as markets are rallying like its 2011. 2016 is going to be a big year, but to make it a good year, traders need to avoid fighting the tape. No matter how many factors indicate something that ‘should’ happen, if price action doesn’t line up those prognostications don’t matter. The price is always right.

On the chart below, we’re looking at the 2016 ‘pain trade.’ This chart has the SPX500 (in blue), along with High Yield bonds (represented by HYG, in red), USOil (in orange) and Emerging Markets (represented by EEM, in yellow). For much of the post-financial collapse period these assets moved in-line together, and this makes sense. QE adds a ton of capital into the environment, and this brings capital flows into many asset classes, so this coordinated rise makes sense. But where logic begins to break down is when we begin to witness this divergence taking place. As the SP rose, emerging markets began to break down. This led to pain in Oil which began it’s collapse last year, and this has led to pain in High-Yield debt which has really picked up this year. The one thing on this chart that hasn’t yet come down, the SP, is probably the most vulnerable.

Created with Tradingview; prepared by James Stanley

— Written by James Stanley, Analyst for DailyFX.com

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