FOMC Meets Next Week As Market Volatility Increases

Includes: DIA, MBB, MUB, SPY
by: Tim Taschler

With market volatility on the rise these past few weeks, it's worth thinking about how things might play out as we approach the FOMC meeting next Wednesday (June 19th).

The rate curve implied by the Fed Funds futures has steepened considerably over the past month. The market now anticipates the Fed beginning to raise the overnight rate in May of 2015. A month ago the expectation was for the end of 2015 - the implied rate hike has been pulled forward. But the Fed can't start raising rates before the end of the unconventional monetary policy measures - in other words, they can't be raising rates while buying securities at the same time. That means if the Fed begins to "taper" off bond buying in the next few months, it will have about one and a half years to go from $85 billion of securities purchases per month to zero.

Here are the 1-year charts of the interest rates on 5, 10 and 30 year Treasuries:

With rates jerking higher like they have, the people that have been chasing yield (i.e. looking for income) have gotten slaughtered as both mortgage backed securities (NYSEARCA:MBB) and municipal bonds (NYSEARCA:MUB) have given back 52 weeks or more of gains:

The stock market for the past month has trended lower (looking at the S&P500 and the Dow):

The U.S. Dollar has fallen off a cliff:

Crude (Brent) has gotten back near its high and gold has come off its low:

Finally, it's worth noting what has gone on in Japan as their stock market has plunged 22% off its recent high (while their interest rates have tripled):

Contrary to all the media rhetoric, I do not think that the Fed has any intention of tapering, exiting or raising rates. The media has been beating this drum since Bernanke said something about possibly 'tapering' in his Q&A in front of Congress last month. Since then, stocks have gone down and interest rates have made new 52-week highs, neither are outcomes the Fed is interested in seeing. I think that next week, Bernanke will make clear that Fed action is dependent on the overall economic outlook and more specifically, the unemployment rate.

Let's not forget that Bernanke prides himself on his work related to the 1930s depression. One of his common themes is that the Fed did not do enough back then and when they finally did, they stopped too early causing the economy to roll back over. I don't think that Bernanke will let his term in office be remembered as one in which the Fed printed $3trillion in order to help the economy, only to stop too soon and have the 2007-2008 market swoon repeat. Nor do I think the Fed as a whole wants to risk their credibility by having this grand experiment end in failure.

So, using the chart below as a guide, I think that the market pulls back early next week ahead of the Fed, and that will be a dip to buy as Bernanke will signal no tapering and stocks will head higher. At the same time, gold, commodities, miners, etc. should all outperform as the market realizes that the Fed is trapped and behind the curve. My guess is that they will print until we have an inflation problem. With the reflation trade back on, hard assets should outperform the second half of the year.

It is possible, however, that the market pullback may have ended on Friday. Hilsenrath from the WSJ issued a piece on Thursday saying that the Fed will probably not signal any tapering plans at next week's meetings. Since Hilsenrath is considered the Fed's mouthpiece, I can only assume this came out now, so close to the Fed meeting next week, because the hope is to stop the slide in Japan, the U.S., the bond market, etc. Maybe the Fed felt the markets would run into real trouble between now and Wednesday, so they decided to get the word out early. We'll know based on how things trade.

Either way, I think that things will start getting more volatile going forward as these markets have become even more overly managed by central bankers around the world. And, as Japan might be showing, things can get really chaotic if a central bank loses control of its markets.

Disclosure: I am long GLD, GDX, NGD, CVX, XOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.