The Fed's Epic Mistake

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by: Ivan Martchev

Pondering the worst start to the year for U.S. and Chinese stocks, I came upon a January 22, 2016 Bloomberg story ("Market Volatility Did the Work of Four Fed Rate Hikes: Morgan Stanley"). Before we started the year about four quarter-point rate hikes were priced into fed funds and eurodollar futures markets, so if the Morgan Stanley analysis is right, the Fed should be about done with their rate hikes. As stocks and junk bonds have sold off in 2016, those rate hike probabilities have notably diminished.

Fed Funds Futures Chart

This rate hike probability screen, taken from Bloomberg.com on January 21, 2016, shows that fed funds futures went from implying a small probability of a rate hike for this week's FOMC meeting to zero probability of a rate hike and a 6% probability of a rate cut! Now I do not believe that the Fed will cut interest rates this week at the FOMC meeting, as doing so would indicate that they are admitting their mistake in hiking the fed funds rate in the midst of the worst global deflationary shock since the Great Depression, only this time driven by China.

Economics 101 teaches that central banks should fight deflation and not add to it via rate hikes. I think the Fed will realize the error of their ways some time in 2016, hopefully before making another monetary policy mistake as markets are already tightening financial conditions by delivering the worst sell-off since the 2008 crisis for the riskiest of junk bonds.

Ten Year Treasury Note - Weekly OHLC Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

There are ways to trade the path of Federal Reserve policy other than with fed funds and Eurodollar futures (which are more appropriate for institutional investors). Playing the surge in Treasury prices in January is one way. Too many investors were positioned for Treasury bonds to go down and their yields to go up due to the expected future rate hikes by the Fed. Instead the opposite happened: Treasury prices surged in 2016 and the 10-year Treasury yield fell last week to 1.93%, closing the week at 2.05%. In other words, the 10-year Treasury yield traded just 54 basis points (0.54%) from its all-time low set in 2012 at 1.39%. As the year progresses I think there is a good chance for taking out that low of 1.39%.

What does well when long-term interest rates are falling? The obvious answer is utility stocks as they on average provide dividends supported by investment-grade balance sheets. Those dividends are not economically cyclical. The utility sector in 2016 is up while the overall stock market is down.

The other less-obvious answer is zero-coupon bonds. Zero-coupon bonds have maximum duration leverage to a move in interest rates. As they have no coupons, the interest rate is implied as a discount to the bond price. I won't get too much into the mathematics of this manufactured bond - the U.S. government does not issue them but Wall Street banks strip interest and principal and repackage them as separate securities - but zeros can have dramatic moves as interest rates rise and fall.

Vanguard Extended Duration Zero Coupon Bonds Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

When the 10-year yield rose from 1.65% in January 2015 all the way up to 2.49% last summer (due to Treasury liquidations by oil producers that needed to get access to their petrodollars and the liquidation of forex reserves due to the flight of capital out of China), the Vanguard Extended Duration ETF (NYSEARCA:EDV) that holds zeroes went from $136 to $103. In 2008, as the 10-year note yield fell to 2.10%, EDV went from $60 to $105. Then, as the 10-year note approached 4% in 2009, EDV fell to $55.

The EDV ETF does not completely follow the rise and fall of the 10-year yield due to the shifting maturities of the bonds in the portfolio and the normal turnover of the portfolio at times of different interest rate levels due to the mandate to maintain maximum extended duration; but if one wanted to capitalize on a rapid fall in U.S. long-term Treasury yields, the EDV would be a good choice. (Please note: Ivan Martchev does not currently own a position in EDV. Navellier & Associates has not in the past and does not currently own a position in EDV for client portfolios.)

The surge in Treasury prices that I envision should not necessarily be taken as an extrapolated negative forecast for the S&P 500, which was doing fine in 2012, the last time we made all-time lows in Treasury yields. As I have maintained consistently, I do not believe that the generational economic unraveling in China can cause a recession in the U.S., which is a service-based economy. For us to get a nasty bear market in the U.S. of the type we saw in 2008 we need an economic problem here that, frankly, I do not see at the moment.

That said, what we just experienced is the same type of sell-off in U.S. stocks we saw in late August. The difference is that the August decline happened over three days while this time it took about two weeks. So the Chinese stock market can hit the U.S. stock market as its epic bubble unravels. My target remains 1000-2000 for the Shanghai Composite in the next 12-24 months, but external shocks are much easier to rebound from if they don't cause economic problems here.

Ten Year German Government Bond Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The other point is that the collapse of German long-term interest rates in 2014 caused quite the spike in German stock prices as investors simply had no other alternatives. So as long as the U.S. economy does not get hit by the situation in China, U.S. long-term interest rates can decline precipitously and this may not be necessarily bad for U.S. stocks.

The Broad Dollar Keeps Making New Highs

Even though we have been flirting with the 100 level on the U.S. Dollar index (DXY) for nearly a year now, it is not well known outside of professional circles that the broader measures of the U.S. currency, like the Broad Trade-weighted U.S. dollar, have been blasting away to new highs. I think in 2016 we will take out the high at 130 that was registered by the Broad Trade-Weighted Dollar Index in 2002.

Trade Weighted United States Dollar Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

For economic aficionados, when this broader measure of the dollar was near 130, the U.S. Dollar Index (that is today near 100) was near 120 at the time. It is normal for commodity-linked currencies to lead the way and make fresh lows as the CRB commodity index is making fresh 40-year lows. But the point is that this is a trade-weighted index. So the more you trade with a country, the bigger the impact.

Total Trade Weights Table

The table does illustrate how trade affects this calculation. I think the coming Chinese devaluation and a further decline in commodity prices as a result of a Chinese economic hard landing will push the U.S. dollar much higher than its present levels in 2016.

Disclosure: *Navellier may hold securities in one or more investment strategies offered to its clients.

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