Capitalize On Changing Interest Rate Expectations

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Includes: CBU, EZU, KRE, SPY
by: Eric Parnell, CFA

Summary

Remember when markets were aflutter a few weeks ago about the Fed raising interest rates this summer?

Turns out, not so much.

Investors should pay attention to expectations for future interest rate movements from the Fed.

Not because they should react to what the Fed might do.

Instead, because of the opportunities that might arise from the wild overreaction by the market to what it thinks the Fed might do.

Remember when markets were aflutter a few weeks ago about the Fed raising interest rates this summer? Turns out, not so much. Investors should pay attention to expectations for future interest rate movements from the Fed. Not because they should react to what the Fed might do. Instead, because of the opportunities that might arise from the wild overreaction by the market to what it thinks the Fed might do.

Whoa There Traders

Back on Wednesday, May 18, the U.S. Federal Reserve released the minutes from their most recent FOMC meeting on April 26-27. From the moment of the release, it suddenly became apparent to an otherwise asleep market that the Fed might actually raise interest rates in June or July. Never mind that the market shouldn't have needed the Fed to remind them of this possibility anyway, but now traders were awake to it. And the immediate market reaction was sharp. Over the next several trading hours, the U.S. stock market as measured by the S&P 500 Index (NYSEARCA:SPY) shed -35 points, or nearly -2%.

At the same time, the expectations for Fed interest rate increases in the coming months increased dramatically.

For example, the probability for a 25 basis pint rate hike at their June 14-15 meeting jumped from 15% on May 17 to 34% on May 18. Never mind the fact that the British were going to the polls to vote on whether to remain or leave the European Union (BATS:EZU). The Fed won't be concerned about moving interest rates in advance of such a pivotal event, right?

A good number of traders did give a nod to the Brexit vote by increasing the probability for a 25 basis pint rate hike at their July 26-27 meeting from 33% on May 17 to 56% on May 18. In short, a majority of traders just over a month ago believed the Fed would raise interest rates by a quarter of a point by the end of next month.

Let's go one step further. Following the release of those shocking Fed minutes on May 18, the market was pricing in the 67% probability of at least one 25 basis point interest rate hike coming out of their September 20-21 meeting, up from 49% the day before. This included a 22% probability for two -- count 'em, two -- quarter point rate hikes from the Fed by then, which was double the 11% expectation from the day before. Once again, two-thirds of the market believed that the Fed would have given us at least one more rate hike by September with another one-fifth thinking that two rate hikes were possible. Extraordinary.

How Quickly Things Change

So where do we stand today with the market's expectation for interest rate hikes from the Fed? On an entirely different planet. The latest news headlines are proclaiming "no interest rate increases from the Fed until at least 2018."

Wow. The year 2018 is long way away. Roughly 79 weeks in fact. And this is despite the fact that just 5 weeks ago we were expecting to see at least one rate hike if not two by the end of the summer. Where do the probabilities stand today?

Of course, the 34% probability for June went to zero as the Fed understandably did not hike rates ahead of the Brexit vote the next week.

For July, the better-than-half 56% probability for a Fed interest rate hike had not only gone to 0% by the day after the Brexit vote on Friday, June 24, but the markets are now pricing in the modest probability of a 25 basis point interest rate cut by the Fed. And the same holds true for September, with the once two-thirds probability for at least one rate hike including the one-fifth probability for two rate hikes both going to 0% replaced by the small probability for an interest rate cut. It is now not until December where the possibility of an interest rate hike is even considered, and the probability is a mere 16%.

How quickly things change.

Click to enlarge

The reality is that the forecasts for Fed interest rate increases and $2.38 will get you nothing more than a cup of coffee when it comes to determining the actual course of future interest rates (remember when the idiom was "that and 50 cents will get you a cup of coffee?" Thankfully the threat of inflation is not a problem in our deflationary environment of today, right?). Yet the market still reacts sharply and sometimes wildly to what it things the Fed is going to do with interest rates at some point many weeks in the future.

Capitalizing On These Reactive Market Swings

In the end, the market swings induced by these capricious changes in Fed interest rate expectations can be used to the advantage of investors seeking long-term investment opportunities or even short-term trading windows in many instances.

For example, a market segment that is highly influenced by changes in expectations around the Fed's interest rate policy is regional banks (NYSEARCA:KRE). These stocks have the tendency to rejoice when expectations for Fed rate increases suddenly rise. For example, regional banks jumped by nearly +6% in the days following the release of the Fed minutes in May. Conversely, they are prone to getting obliterated when sentiment moves toward the Fed not raising interest rates. Once again, regional banks dropped by as much as -13% in the immediate wake of the Brexit vote once the believe was quickly assumed that the Fed would not be raising interest rates until "at least 2018."

The Bottom Line

Is it likely that the Fed will wait to raise interest rates until 2018? Not any more likely than it was that they were going to raise interest rates as soon as July just five weeks ago. Neither outcome is likely to prove correct at the end of the day. But the one thing we do know is that hyper reactive capital markets are likely to dramatically change their expectation about what the Fed is likely to do several more times between now and then.

At present, the market is at an extreme in terms of its dovish expectation that the Fed is not going to do anything with interest rates until the end of time and is more likely to cut instead of raise. And asset prices have reacted accordingly.

Thus, investors with an appropriate risk tolerance have an opportunity to trade against this market reactivity. This includes exploring buying opportunities among those high quality securities that have been sold off most dramatically amid expectations that the Fed has been sidelined forever following the Brexit vote. Building on the regional bank example above, Community Bank Systems (NYSE:CBU) is an example of a growing high quality financial institution with a more than 3% dividend yield that has steadily increased its payout to shareholders for more than two decades and was sold off by nearly -10% in the wake of the Brexit vote. But since bottoming on Monday morning, it has already recovered by more than +4%.

In the end, even if the beliefs that interest rates won't rise until 2018 turn out to be correct, the market was already expecting it and it has been largely priced in. But if it turns out that the Fed starts to think about raising interest rates again at some point in the future, these typically high income generating securities that were sold off sharply stand to benefit most.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: I am/we are long CBU.

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.