March Rate Hike Probability At 13% Is Underpriced

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Includes: CNY, DUST, DXGE, DXJ, FXI, GDX, GDXJ, GLD, JDST, SLV, SPY, TBT, TLT, TMV, USDU, USO, UUP
by: Michael Roat

Summary

Fed fund futures are only assigning a 13% chance of a March increase.

Two Fed presidents have said that March is in play. Monetary policy is still accommodative even with rising rates.

Early is the correct approach to raising rates, as later and steeper rises in interest rates can cause recessions.

The market effects of a March increase would be significant.

A March hike is gold and oil price negative.

According to CME Group, there is a 13% probability of the Federal Funds rate (NYSEARCA:TBT) (NYSEARCA:TLT) (NYSEARCA:TMV) being in the 75 to 100 basis point range in March 2017. This would indicate one 25 basis point rate increase from the current 50 to 75 range.

I think this is underpriced. The Fed is forecasting two or three 25 basis point increases this year. The first could realistically be in March. An earlier hike gives the Fed time to pause if need be and still raise multiple times this year. Also, moving earlier will prolong the expansion because it could prevent a steeper rise in rates at a later time, that could prove recessionary. It's best to move preemptively on inflation (NYSEARCA:GLD) (NYSEARCA:SLV) (NYSEARCA:GDX) (NYSEARCA:GDXJ) (NYSEARCA:DUST) (NYSEARCA:JDST), as it could greatly overshoot after years of zero rates and QE.

By raising rates the Fed is not becoming restrictive. The Fed is being slightly less accommodative. This supports the expansion. The recovery from the financial crisis until now is significant, and despite a soft stretch in the data, the economy seems to be on the upswing in recent ISM data, Fed surveys, employment numbers and other data. Household net worth, home prices, retail sales, industrial production, car sales, consumer confidence and private sector credit measures have all recovered since the Financial crisis - with household debt to GDP falling and deleveraging. Jobless claims are also at a very low level historically, signaling a tight labor market.

Federal Reserve (NYSEARCA:SPY) presidents Patrick Harker and John Williams have both given speeches in which they specifically referred to the March meeting. Harker said, March "should be considered" and is expecting three rate increases this year. Williams said "From a risk management point of view there's an argument to move sooner, rather than wait".

The markets continuously insist on ignoring the Fed. I think there is a lot of complacency. It would be wise of the Fed to re-align the markets view with the Fed's view on policy and the expected path of rates, through a March hike. The Fed is clearly intent on trying to moderately increase treasury yields, in essence an orderly deflation of the U.S. bond bubble and normalization of monetary policy.

The market effects of a Fed move in March would be fairly significant and provide many trading opportunities. One effect would be the appreciation of the U.S. dollar (NYSEARCA:UUP) (NYSEARCA:USDU). This is the result of divergent monetary policies with the Fed raising rates, while other central banks lower rates or ease further (NYSEARCA:DXJ) (NASDAQ:DXGE). An improving U.S. economy, leading the global growth cycle, allows this normalization of policy.

Another effect would be in emerging markets, specifically China. This would be largely negative. Speculative pressure on the yuan will likely increase causing capital outflows from China. China is facing an overheated property market, a non-performing loan issue, a recent stock market rout, slowing growth, overcapacity, and extremely high corporate debt. The Chinese banks are going to lose capital. The Fed raising rates is just the catalyst for everything to begin unraveling in China. It would really only be a matter of time before economic and financial conditions deteriorate in China anyway. These issues in China are present and need to be addressed by policy makers with a comprehensive plan, whether the Fed is raising rates or not.

I won't be optimistic on the Chinese economy until after China ends up restructuring its corporate sector (NYSEARCA:FXI), economy and banking system. In the near term, the PBOC is likely to move into a much more dovish policy stance than where they currently are at and will likely lower rates in response to poor economic fundamentals and heightened financial concerns. This will place downward pressure on their currency (NYSEARCA:CNY).

This all, also, fits with my view on oil prices. A Fed hike would cause U.S. dollar appreciation which historically trades inversely with oil prices (NYSEARCA:USO). I'm quite bearish on oil in the near term, but long term I am optimistic. I just don't anticipate oil prices moving sharply higher right now as there is clearly no shortage. Inventories are historically high and keep showing a persistent build. U.S. rig counts are climbing. If the demand outlook is downgraded because of Chinese economic concerns this could lead to sharply lower oil prices. China is a major demand center for oil and other commodities and oil forecasters are likely factoring in fairly strong Chinese demand. I think the near term risks to oil prices are tilted to the downside. In the long term, oil will rise, as lack of investment in new production will lead to supply shortfalls.

Disclosure: I am/we are long JDST.

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.

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