This FOMC meeting is arguably one of the most prognosticated events in the recent past. The Fed’s decision is being forecasted with a wide array of opinions. As we approach the announcement, the odds remain a guess at best with regards to their ZIRP (Zero Interest Rate Policy).
We believe there are four major options that the FOMC will consider when they render their collective decision. They are:
- They do nothing. The Fed remains data dependent citing softness in recent domestic economic releases and global financial conditions deteriorating with emphasis on China, Brazil and the European Union. The immediate and short-term expectations would be positive for the risk-trade with equities bid, the USD offered, bonds flat to down and energies flat to up. There is a high probability of the risk-trade losing momentum and reversing, depending upon concerns shifting during, or immediately after, the Yellen press conference beginning one-half hour after the rate announcement. Those concerns may center on why the economy, after 6+ years of ZIRP, is not stable enough to withstand even a nudge off of “free money”. The emphasis may quickly revert to the equity market turmoil in Asia and the global currency wars emanating from those countries dependent upon commodity resource revenues. We place the odds of doing nothing at 50% with a more likely “liftoff” occurring in October (see option 2).
- The Fed raises rates. The only reason this may occur is to save face and try to avoid being labeled as the “boy who cried wolf”. If the Fed does raise rates, expect protracted language indicating that this step should not be perceived as linear going forward. The Fed will trip over itself to make clear that ensuing rate increases will only be warranted if the data remains robust AND there are signs that their inflation target of 2% is merely stuttering along due to transitory effects of lower commodity prices. They may even indicate that they will not hesitate to reverse trajectories if future data releases weaken and/or global economic conditions continue to deteriorate. IF they do raise rates, expect an increase of the Fed Funds rate by only 1/8th of a point (12.5 bps) to the high-end of the Zero Bound policy currently in effect, with an increase in the band from 0.00 – 0.25 bps to 0.25 – 0.50 bps. The biggest problem with raising rates is the potential unhinging of the carry trade and risk trades simultaneously, especially if global investors believe that this is the beginning of a much stronger dollar and higher US interest rates. The risk to the Fed is Janet Yellen being ambushed in the following Press Conference (scheduled 30 minutes after the rate announcement) especially if the stock market drops precipitously before, or while, Ms. Yellen is interrogated by an anxious media. We place the odds of raising rates at less than 30% while maintaining a more probable occurrence would be the October FOMC meeting which has no following press conference.
- The Fed lowers rates or establishes QE4. NIRP (Negative Interest Rate Policy) to succeed ZIRP (Zero Interest Rate Policy)? Not yet likely, however the Fed’s counterpart, Goldman Sachs, has been trying to influence such incantations. Goldman economic generals, past and present, including Larry Summers, Bill Dudley (currently voting member of FOMC) and Jan Hatzius have been beating this drum if for nothing else to move the needle to the “do-nothing” option. The pernicious Goldman will stop at nothing to maintain another round of free money including their table pounding about the “market has done the job for the Fed” citing their preposterous homegrown Financial Conditions Index which proposes that “free money” is too tight of an economic condition. IF the Fed does march to this drummer, then they will likely cite the disinflationary effects of the strong dollar causing decelerating wage pressures, disintermediation of global commodity currency countries and export weakness of US multi-nationals. We place the odds of lowering rates or establishing QE4 at less than 5%.
- Leaving rates unchanged while removing (or lowering) the interest paid to banks on reserves held at the Fed. This move could provide a spark to the risk-on trade (higher equities, etc.) AND save face with the more “hawkish” critics seeking liftoff from ZIRP. In theory, this should also provide impetus for the banks to circulate, in the form of loans, some of the $2.7T they are currently holding in reserves at the Fed whilst quietly being paid to do so. The theoretical increased lending would then be circulated throughout the system leading to an increase in the turnover or velocity of money in circulation. This of course would provide upward inflationary pressure which has long been the quest for the Keynesian central planners. The only problem with this theory is that there is $2.7T held in reserves and nary the demand for loans or the risk-taking interest in providing the same. Although this may be the least daunting or best option the Fed can choose, this policy decision is likely to stir a hornet’s nest of volatility as nervous money stands ready to shift in an electronic moment worldwide. We place the odds of this outcome at less than 20%.
We conclude with this quote; “In theory, theory and practice are the same. In practice, they are not.” Regardless of the well-intended policy decision of this FOMC, the rabbit hole is getting deep and the light above is rapidly losing illumination.
TRADING UPDATE: As a reminder, the indexes are off more than 10% from their highs, we are looking to hold what we have and put at least some cash back to work into stocks as conditions warrant. At this time we are not seeing clear indications of what areas of the market may lead in a recovery, so a more general approach is best at this time.
We continue to hold cash levels of 30-34% that are limiting the portfolios to about 60% of the market volatility. The cash can be put to work quickly should we see opportunities present themselves and the hedge positions will remain a trading tool to improve risk exposure in the portfolios.