My Trading Response to the Fed Chief's Friday Talk

by: David Andrew Taylor

In a forum where markets were certain the Chairman was to confirm the most recent interest rate weather, we got comparisons of Wasau Wisconsin and Wuhan China.... and nothing more. So, although we don't know much more about potential interest rate increases... we don't know any less, either.

What we do know is that Wasau and Wuhan are still a smidge over 7,000 miles apart yet closer than ever before. Interestingly, I've been to both and am traveling to both areas over the course of the next couple of weeks. I'm off to see Sammy play a game next weekend, and then off to China (Hong Kong and Shanghai) for a few hedge fund symposiums. I'll give my own analysis of how cheese curds compare to mien when I get back and let you know how the Chairman's position is relative to how close these two worlds actually are. My guess is: Still worlds apart.

My take on interest rates is that it's still a mixed bag when future rate increases/decreases are considered. We could still see some upward pressures in inflation. I don't think we're out of the woods entirely yet, just because we've seen recent softness. At the same time, average hourly earnings are increasing while there is a simultaneous flattening in the productivity levels. This is something that the Board has highlighted as a concern. Neither of these trends has moved in the opposite direction, regardless of core and headline CPI and PPI. That could still be the driving impetus of future interest rate increases. At the same time, the lagged affects of interest rate increases are starting to work their way in, as recent data has shown signs of softening.

My Trading Plan:
All-in-all, it's anyone's guess. With that much uncertainty, the best policy for trading is to look at the biggest picture possible, and ignore these smaller fine-tuning steps. Think about that for a second: The markets are so tightly wound up parsing every word a Board Governor makes, they are missing the biggest picture, and all the while the markets are as choppy as Bearing Strait in a stormy Deadliest Catch episode. How many more interest rate increases could there possibly be? One... maybe two at best? I'd say no more than one. What further affect will that increase have on the economy? Probably not as much as some would imagine as most of the biggest increases that we've already seen are going to have the biggest impact.

With Regards to FX:
That being said, how many increases are the Europeans likely to make? Probably not that many, keeping the interest rate differential in favor of the U.S. dollar. The perception of higher interest rates with respect to a trade partner is one of the bigger factors in determining the direction of the currency rates. There are billions in hard money sitting on the ready waiting on the perception to change in favor of one interest rate differential to move the currency. These traders move money at large clips, borrowing in one country and depositing in the other for overnight increases. That's hard money in action. That's one of the big drivers in short-term currency fluctuations. So, what is one interest rate increase going to do at this point considering the Europeans are as far behind as they are in their interest rate movements? Inflation is more contained over there, and will likely remains so. With that, the interest rate differential, and the potential of profit for hard money traders, favors the dollar.... for now. I've been moving managed accounts into long dollar positions, and doing well with it. For now, that trade will continue to work out. Soon, I'll have to reassess as to how inflation and interest rate decreases will affect Europe, Japan, Canada, Australia, and of course here. The first to lower rates loses.

With regards to the S&P 500:
No news is no good. I get the sense the market would have liked to get its final clarity from this speech. Again... what's it matter at this point? We've gone so far, one more isn't going to have an increased affect on this particular market. The index should start looking forward towards the future outlook for the U.S. economy, and they don't need to look any further than the man himself: Bernanke. The latest FOMC release made it fairly clear that the Fed believes that the U.S. economy is moderating, and will continue to do so. The housing market is cooling at a controlled pace, which is fine by them. Going forward, the economy is cooling. I expect our current quarter (Q3 2006) we will see a slowdown that will be followed by an increase in growth in Q4. There will likely be another decline in Q1 2007. This is based on the premise that the cooling effect will kick in while simultaneously there is an increase in average hourly earnings currently underway. The equities markets need not worry about whether or not there is one more interest rate increase. There are bigger obstacles ahead, and they all spell slower growth... which spells out lower equities markets. Going long the equities markets now should be looked on as a short-term trade. Going short will likely pay off in the long run, and pay off in a big way. I'm beginning to eye up short S&P 500 trades for my managed accounts. I'll be looking to take these off somewhere around the end of the year, beginning of next. We'll know more as time goes by.