Will The Fed Lay The Groundwork For More Hikes This Week?

|
Includes: XLF
by: Josh Arnold

Summary

The Fed's meeting this week won't produce a rate hike but it could lay the groundwork for hikes this year.

Inflation has picked up markedly of late and unemployment is very low.

I think the Fed will raise twice this year and that is good news for the banks.

Click to enlarge

The Fed has dominated headlines of late in a manner that is unlike any I've seen since the depths of the financial crisis. The Fed's December rate hike sent the market into a tail spin as participants were confused as to exactly what that meant. Then, in early 2016, the Fed set about telling us that it would raise rates four times in 2016, a move that set off an enormous, violent sell-off in virtually everything with the notable exception of bonds. On the eve of the April meeting, it is worth taking stock of where we are and what the Fed might say in order to understand the implications for different asset classes and in particular, the financials (NYSEARCA:XLF).
Click to enlarge

The XLF has remained in a downtrend in recent months despite the fact that the averages are knocking on the door to new highs. The financials have been unbelievably weak this year but have rallied in terrific fashion since the bottom was made in February. However, financials had fallen so far that even a 20% rally has failed to get within striking distance of former highs. So what could get financials back on track? I think if the Fed hints that it is going to raise twice this year and/or that it provides commentary that the risk of inflation has returned, financials should move higher. If the Fed backs off (again), the recent rally in the XLF will have been for naught and the downtrend will surely continue.

So what could get the Fed to offer up commentary that could move the XLF higher? I'll focus here on the Fed's dual mandate goals of maximum employment and long term price stability in addition to what rates and markets have done in recent months. While the Fed certainly looks at many more data points than these, this set should give us a robust picture of what the landscape looks like with respect to the Fed's willingness to raise rates.

As a note, I'll be using rate data from the Treasury and economic data from the St. Louis Fed.

First up, we'll take a look at the simple unemployment rate as reported by the Bureau of Labor Statistics.

Click to enlarge

This is the simplest view of unemployment and the headline rate that is oft quoted in the media. As we can see, unemployment has plummeted to around 5% (or even below that level of late) as the recovery has taken place over the past few years. What defines "maximum employment" depends on with whom you're speaking but in general, 4.5% to 5% is considered maximum employment. We are right there and have been for a few reporting periods now. By this measure, the Fed should be ready to begin its hiking regimen. After all, how much lower can we reasonably expect unemployment to fall when it is at or near what is traditionally considered to be full employment?

Next up, we'll take a look at inflation as defined by the CPI.

Click to enlarge

CPI had been consistently running at or above the Fed's long term goal of 2% until the energy complex imploded nearly two years ago. We can very clearly see the drop in energy prices on this chart beginning in late 2014 but as of late, with energy stabilizing, CPI has returned to the 1% area. While this measure is volatile, it is also picking up steam. While energy prices need to go higher for this measure to move appreciably higher, the Fed also looks at CPI ex-energy.

This is the same chart minus food and energy costs and it tells a rosier story than the full CPI above.

Click to enlarge

If you back out food and energy - essentially commodity costs - the CPI has been running at or near 2% for almost five years. By that measure, certainly the Fed should be ready to hike. While the commodity inflation outlook is important, there are many other factors as well and without commodity prices, inflation is running above the Fed's long term goal. This would also support the idea that the Fed could or should be ready to hike in the near future.

It certainly seems as though the data points are in place for the Fed to justify raising rates two times this year, as it has said it would do. No one believed the four hike guidance the Fed set earlier this year but two hikes is certainly plausible and given recent commentary from Fed officials, it seems that is the prevailing viewpoint. That being said, there is still a tremendous divide between some members of the FOMC regarding what to do and that is cause for confusion for bank stocks. However, the weight of the evidence suggests that the Fed can (or possibly even should) raise rates twice this year.

This shot of the yield curve is interesting and shows why financials have been in the doghouse for the past few months.

What we have here is a comparison of the yield curve at the beginning of August 2015 - before rates began to move due to Fed rate hike chatter - and today. The picture is interesting as the 3 year yield is exactly the same but around that pivot point the yield curve has flattened. The difference between the 1 month and 30 year on August 3 rd was 283bps and that measure is 255bps today. That means the yield curve flattened - by this measure - by 28bps in that time frame. The Fed's rate hike has brought up the low end of the curve but low inflation expectations has sent the high end of the curve down. That's a terrible situation for banks but if the Fed raises rates two more times this year, inflation expectations will have to have come up. Otherwise, the Fed won't raise rates as that is the primary driver of holding off on more hikes. It is a tail wagging the dog sort of thing but I don't think we'll see another rate hike where the market disagrees so vehemently as it did in December. In short, I think the continued flattening of the yield curve is the lower probability scenario right now as inflation is picking back up once again whether you view it with or without commodity prices.

That would be good news for the XLF as financials would certainly benefit from a steeper yield curve and if the CPI is to continue its positive momentum, we'll see a steeper yield curve, all else equal. And the fact that banks in general have been reporting higher NIMs for Q1 off of the December hike is also very positive because if the Fed hikes twice more, banks should be able to continue to squeeze margin from the deposit base.

When the Fed reports its statement this week it will be key to see what kind of language is used surrounding inflation. We all know employment is strong and will remain as such so there won't be any surprises there. However, the specific words the Fed uses to describe the risk of higher or lower inflation will be paramount. It is a foregone conclusion that no hike is coming at this meeting as that would send markets into a tailspin. But June is certainly on the table both from a data perspective and based upon commentary of several Fed officials. Indeed, if the Fed is going to raise rates in June, it will need to lay the groundwork now. With financial conditions having eased immensely since the Fed's last meeting, I suspect members are much more open to hikes at this point. My base scenario is two hikes this year and should that happen, the XLF could easily make new highs. While it is far from a certainty, I think the Fed backing off of its revised hike guidance is a lower probability and as such, the banks look like a good risk/reward here.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long components of the XLF but not the ETF itself.