The Fed's July Failure

| About: SPDR S&P (SPY)

Summary

The Fed failed in July in not having prepared the market for an appropriate interest rate hike.

With market expectations overwhelmingly anticipating no action into the meeting, the Fed likely would have stirred a violent reaction in stocks had it moved on rates.

But with its more positive Monetary Policy Statement implying rate action is more likely now for September, stocks that might have been free to ride through December now face overhang.

July presented the Fed with a brief window of opportunity, where September brings with it a history of volatility on seasonal issues.

The U.S. Federal Reserve did not fail in not raising interest rates in July given expectations were so heavily weighted against it. An action would have been highly disruptive due to its surprising nature. Rather, the Fed failed in not preparing the groundwork for a July rate hike ahead of time so that it might have acted. I believe wholeheartedly that July presented a window of opportunity that the Fed has now missed. The next two months bring with them issues that did not exist in July, and so they present risk of even greater volatility than we would have seen this week.

We noted in bold in our preview to the Fed announcement Wednesday that it had historically proven foolhardy to bet against Fed Funds Futures with regard to FOMC decisions. Fed Funds Futures indicated just a 2.4% probability for a July rate hike the day before the announcement. In fact, it did prove foolhardy again this time, but I was willing to eat small loses for the immense reward that I would have enjoyed had the Fed acted in surprising fashion; and I will do it again.

The Fed was precluded from acting on rates because of market expectations. The reaction would have been violent had the Fed surprised the market, and the Fed, like a physician, has a responsibility to first do no harm. If the Fed had caused an abrupt adjustment to stocks, we might have seen the ripples reach through to the economy in future months, just like we saw in the spring of this year when financial market turmoil weighed on consumer and business activity in February and March, and on jobs in May. So the Fed did the right thing in not acting this month, but it also did the wrong thing in not better preparing the market for an action that it might then have followed through on effectively this month.

The ground was fertile for a rate hike. The economy is humming relative to recent history, with GDP estimates for Q2 sitting at approximately 2.4%. June's employment data (+287K nonfarm payrolls) put to rest fear about May's lull. Consumer confidence is high and housing and auto sales are strong. The banks are freely lending now, after further clearing the Fed's capital hurdles. And stocks are trading near their all-time highs. It would have been the right time to act on Wednesday if the market was ready for it.

But after Brexit came to pass the Fed allowed media and markets to build in expectations for no new Fed action this year. That was even despite expectations that Brexit will not weigh importantly against the American economy. I suppose the Fed had concerns about possibly talking up the dollar, given it was already appreciating versus the euro post Brexit. Also, late developments had oil prices coming under new pressure unrelated to Brexit on renewed supply glut worries.

Still, had the Fed said earlier what it stated in this week's Monetary Policy Statement, the market would have been prepared for a potential action on interest rates. Notably, the Fed indicated that the economy and labor markets were improved, which implies monetary tightening may be coming soon. Rather, because of its delay in doing so, the market will now worry about a potential action into the September meeting. That will weigh on stocks and limit upside as Fed members now add insult to injury, talking up the prospect of a September action between today and the meeting. And the Kansas City Fed's annual Jackson Hole event in August will weigh as well.

Had the Fed acted, we would have seen some volatility, but then been freed to ride through to December. The next several months present a period that historically has exhibited greater volatility than other periods of the year. Add a potential Fed rate hike to that fact and you have the makings of trouble that did not exist in July. Thus, the market can only meander, if not test lower technical supports.

Security Sector

Tuesday's Close thru Thursday

SPDR S&P 500 (NYSE: SPY)

Unchanged

SPDR Dow Jones (NYSE: DIA)

-0.1%

PowerShares QQQ (NASDAQ: QQQ)

+1.0%

iShares Russell 2000 (NYSE: IWM)

Unchanged

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

-4.0%

Click to enlarge

* Performance period covers from the close the day before the FOMC decision through Thursday July 28.

The Fed has only raised interest rates one time since telling us for a year it was about to do so. Then after telling us in December that it would be doing so again another four times this year, it still has not acted. There will never be a perfect time to act to normalize monetary policy, but I believe July was good enough if only the Fed had prepared the ground ahead of time. While it is true that the Fed has a responsibility to first do no harm, what good is a Fed to us that is so afraid of doing its job that it fails to do its job effectively? I cover the economy and markets 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 position is through derivatives and short short-term in nature.