Surprise - A Violent And Imminent Fed Rate Hike?

| About: SPDR Dow (DIA)

Summary

The media and market are in near perfect agreement that the Fed is highly unlikely to raise interest rates on Wednesday, but what if they are all wrong?

Market and media expectations may be way off-base, as recent Fed qualifiers have been satisfied.

There will never be a perfect moment to raise interest rates, and now may be as good a time as any.

The best argument against a rate hike might be that nobody expects it.

Expect a violent reaction to such a surprise, and a severe downside reaction for stocks.

Almost nobody expects the Federal Reserve to hike interest rates on Wednesday. Yet, based on some of what the Fed has told us, it is not so farfetched a possibility. What might happen to markets if the Fed surprises everyone on Wednesday? Are you ready for the possibility? I am.

According to the media, there is absolutely no chance of a Fed interest rate hike on Wednesday. According to Fed Funds Futures or market expectations there is just a 2.4% chance of a Fed rate hike this month. I often disagree with the media, but in the past it has proven foolhardy to bet against Fed Funds Futures so take solace in that. Nevertheless, I did so this time because I think the media and the market have diverged too far from the Fed's perspective. Besides, the risk/reward is simply too attractive to pass on with volatility priced so cheaply today. If the unexpected does happen, for those unprepared and susceptible to fear, the risk is immense. However, I expect loses would eventually be recovered, if not sooner, for the patient holders among us. It's the opportunity in between that would be missed.

Why do I think there's a chance for a Fed rate action this month (or soon enough) despite the market's disbelief and the overwhelming expert consensus expectations against it? Well, it's because I've been paying attention to the Federal Reserve, for one reason. In fact, it's my view that the Fed would have raised rates in June if not for the poor May Employment Situation Report and the U.K. referendum uncertainty.

Most would argue that those were two important factors that continue to weigh against Fed action today. It's my controversial view that they do not weigh as significantly as the market estimates they do. Why is that?

June s Employment Report blowout more than made up for May's disappointment. Let me remind you that June's jobs report showed an increase of an astounding 287K net nonfarm payrolls (read a lot of jobs). Sure May's increase was just 11,000, but averaging the two months still provides healthy enough job growth given the low 4.9% unemployment rate. Most importantly, June provided the evidence of a May anomaly that our fair Chairlady said at her last press conference the Fed was looking for in order to be confident the economy was progressing positively. That would seem to imply the Fed could go on Wednesday. Some of us watch the press conferences carefully and actually read the Fed statements critically, and as a result, see a decent enough chance for a Fed action this month.

What about Brexit you ask? Yes, Brexit was unexpected and will have economic repercussions, but those will be mostly for the United Kingdom to bear and for the European Union to stress about. CNBC s Steve Liesman showed the channel's Fed survey indicates economic repercussions are expected from Brexit, but they are clearly focused on the U.K. Even so, he says it still leads expectations for Fed action further out on the calendar according to those surveyed. Does that make sense? How do you suppose the Fed will think about this?

I believe it was somewhat clear at the last Fed press conference that the Fed was concerned about acting on rates ahead of the U.K. referendum for several key reasons. First and foremost, it wanted to avoid negatively impacting financial markets ahead of an uncertain outcome for the critical vote. I believe the Fed was only secondarily concerned about economic costs to the United States' that might result from a possible Brexit decision. Given a better perspective now, I believe the Fed should go ahead and raise interest rates, though the central bank should have better telegraphed it if it is about to move. In fact, the mere issue that nobody expects it might be the best case against a rate action this month, and I wonder if the Fed will consider this. However, if it does, it might also look at stocks trading at all-time highs and see a window of opportunity nonetheless.

Many market participants believe the Fed is now considering future implications from the break up of the EU and the UK. I believe, while it must consider everything, the U.S. Federal Reserve will not be precluded from acting to normalize U.S. monetary policy because of what appears will be a negligible issue for us, and one that will be diluted for all players because of the long and careful timeline for its unveiling.

So if you take jobs concerns and Brexit fears off the table, what do you think the Federal Open Market Committee (FOMC) does on Wednesday afternoon? I think there's a strong enough chance it raises interest rates a quarter point. Let us recall that the Fed s economic projections published in June still showed the possibility of two rate hikes this year, though the projections were released before the Brexit vote. The Fed is probably not wise enough to foresee capital flow issues in August and September, but I hope it does and acts now instead, because this is a window of opportunity it should exploit.

Security Sector

SPDR S&P 500 (NYSE: SPY)

SPDR Dow Jones (NYSE: DIA)

PowerShares QQQ (NASDAQ: QQQ)

iShares Russell 2000 (NYSE: IWM)

Vanguard Total Stock Market (NYSE: VTI)

iPath S&P 500 VIX ST Futures (NYSE: VXX)

ProShares VIX ST Futures ETF (NYSE: VIXY)

ProShares Ultra VIX ST Futures (NYSE: UVXY)

VelocityShares VIX ST ETN (NYSE: VIIX)

Click to enlarge

So if the entirety of the market is not expecting the Fed to act on interest rates, what do you suppose happens to stocks if it does? A violent reaction would be expected, with a volatility spike as stocks test technical supports and probably fall through one or two, or three of them. I suggest investors have cash stores at the ready for each of the next three Fed meetings, including this one, and with volatility instruments so nicely priced today, it doesn't hurt to hold some for short-term protection. If we get a Fed surprise and an investor should find himself fully invested, he might want to avoid looking at his portfolio for a few days or weeks. Before long, though, losses will be recovered and the vista improved.

If we want to make a list of reasons why the Fed shouldn't act on rates, we should also include recently dipping oil prices and their relative risks to the economy, as well as the relatively strong dollar. Still, the energy sector and the dollar are in better shape today than they were in the spring. The Fed is likely growing more and more aware of the fact that there will never be a perfect time to raise interest rates, and that now is probably as good a time as any. I've got enough money in place to make out well if it happens, and little enough to not shed a tear if Fed Funds Futures are right again. I cover market factors closely and invite relative interests to follow my business column here at Seeking Alpha.

Disclosure: I am/we are long VXX.

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: My risky position is through derivatives and very short-term in nature.