So The Fed Raised Rates...Now What?

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Includes: OI, TLT
by: Elite Wealth Management

Summary

Markets and managers are expecting two or three interest rate hikes in 2016, likely to occur on a meeting date with a press conference.

The U.S. is leading the charge on higher rates, while China is slowing and the ECB is expected to actually cut rates further into negative territory.

Default risk is indeed higher globally, likely due to the commodity bear market, but other measures of risk such as implied volatility show little signs of uncertainty.

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Janet Yellen is in a tight spot. Domestic economic indicators seem to be strong compared to the rest of the world, but a backdrop of diverging international economies complicate the Federal Reserve Chair's job.

Despite these concerns, the Fed stuck to its plan of raising interest rates in December to 0.25%, kicking off a new interest rate regime. Going forward, investors will need to look at the 2016 calendar for clues as to when the Fed will raise again. While there is nothing clear cut, plenty of speculation is in the market. The new age "briefcase indicator" seems to be FOMC meeting dates that have a press conference associated with them. There are four opportunities for this in 2016. One of the largest asset managers in the world, Pacific Investment Management Company (PIMCO), foresees a base case scenario that includes three 25 basis point rate hikes, "consistent with where the central bank's core leaders have indicated they are leaning for 2016, but greater than the two rate hikes that the bond market is priced for."

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Markets are currently assigning a 14.1% chance, as of 01/13/2016, that PIMCO's base case is correct by year-end. Interestingly enough, traders are actually predicting that only one raise is most probable. The CME Group's Fed Fund Futures are suggesting that a target rate of 0.75% has the highest probability of playing out, at 34.7% odds, followed closely by 1.00% at a 30.2% likelihood, by the December 2016 meeting. While these stats are interesting, most traders are focusing on the front month contracts, considering that the December 2016 expiration only has roughly 16K in open interest (NYSE:OI) vs. 98K in OI for the April 2016 contract.

U.S. rate expectations seem to be pretty tight and widely accepted, especially given the trajectory of the U.S. economy. However, the global backdrop is anything but clear. Key economies are heading in vastly different directions in 2016. Sweden, Denmark, Switzerland, Germany, Japan, Austria, Netherlands, and the ECB (European Central Bank) all have negative interest rates at some duration on their respective yield curves. A number of these areas are expected to cut rates further, going deeper into negative territory in an attempt to spur growth, while the U.S., U.K., Hong Kong, and Canada are expected to raise interest rates in 2016. Have these changes and uncertainty come without consequence?

According to data provided by Bloomberg, there have been consequences. Year-over-year credit default swaps (CDS) on the U.S. and Asia-Pac countries (ex Japan) have rallied over 30%. Aggregate CDS protection rallied 22% year-over-year for European countries and approximately 12% for Japan. Heightened fear in the credit markets raise the question as to whether these economies are actually getting stronger after historic moves in monetary policy.

While worldwide central bank policy uncertainty is an explanation for CDS expansion, the downdraft in commodities is also a likely reason. A number of companies and economies, both international and domestic, depend on higher oil prices. Many players have certainly been affected by the continued slide in oil, down 30% in 2015 and another 17% in 2016. The absolute answer remains to be seen. If the U.S. economy starts to gain traction, above-trend economic expansion and increasing medium term inflation expectations will indeed push rates higher and perhaps end the zero bound negative feedback loop of underwhelming growth and inflation.

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Inflation is at the core of any expansion cycle. The Fed has admitted that they have not been able to hit their target, but, "in light of the current shortfall of inflation...the Committee will carefully monitor actual and expected progress toward its inflation goal." According to PIMCO, Core Personal Consumption Expenditure (PCE) will be the key economic indicator to watch in order to gauge the Fed's progress on the inflation front. The Fed is shooting for 2% in the long run and for 1.5%-1.7% for 2016.

On the other side of their mandate, unemployment seems to be trending in their favor; U.S. unemployment is currently within the Fed's long-term goal of 4.8%-5%. Ultimately, the bond market will bear the load of the success or failure of the Fed. Current prices are actually suggesting that the fixed income market is relatively certain the Fed will succeed in terms of tightening in 2016.

The iShares 20+ Year Treasury Bond (NYSEARCA:TLT) is a popular exchange traded fund that tracks the long end of U.S. Treasuries. The fund owns mostly 30-yr bonds, which are yielding roughly 2.86% now and trading at $124.99. Options on TLT for Jan 2017 are currently indicating that the fund will have a 12.8% range from now until expiration, or a 68% (one standard deviation) chance the fund will be within up or down 13% by the third Friday of January 2017. Overall, the volatility of bonds is generally low, despite the uncertainty surrounding the Fed as normally suggested by the media. Implied volatility, a quantitative measure of risk derived from the price of options, is near a midpoint between the 52-week high/low on the TLT - currently at 14.37%. The 52-week low, implied volatility-wise, is 11.21% and the high is 17.99% for the TLT.

"Mixed signals" is the best way to describe the world economy at the moment. The painfully challenging situation the Fed is facing will only get harder in 2016, as European economies attempt to gain traction on the lower bound and China seemingly stalls. The U.S. economy still looks to remain the cleanest dirty shirt going forward.

Fariba Ronnasi
CEO, Elite Wealth Management

Full Disclosures: http://elitewm.com/disclosures/
This article is not intended as investment advice. Elite Wealth Management or its subsidiaries may hold long or short positions in the companies mentioned through stocks, options or other securities.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.