Assessing The Fed's Next Moves

by: KCI Research Ltd.

Fed fund futures are pricing in multiple interest rate cuts.

The long bond has rallied too, sending long-term interest rates lower, and the iShares 20+ Year Bond ETF higher.

The yield curve is already steepening, which is going to have a big impact on FOMC policy in the months ahead.

"A 60:40 allocation to passive long-only equities and bonds has been a great proposition for the last 35 years… We are profoundly worried that this could be a risky allocation over the next 10." - Sanford C. Bernstein & Company analysts, January 2017

"Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria." - Sir John Templeton

"Life and investing are long ballgames." - Julian Robertson


2019 has been a remarkable year, with both the U.S. stock market and the U.S. bond market levitating higher, similar to the price action over much of the past decade.

However, with the broader U.S. stock market reaching rare valuation extremes, and the broader U.S. bond market being embraced like never before, ironically as long-term interest rates have dipped to their lowest levels since 2016, how much more room is there for the current trends to continue in place?

Building on this narrative, most market participants have, rightly, in my opinion, come to the conclusion that central banks follow the lead of the financial markets.

If that is true, what is the market telling us now?

What will that mean for future FOMC decisions, where multiple rate cuts are already priced into the markets?

Investment Thesis

The almost 40-year bull market in bonds has already ended, and higher long-term interest rates are going to have significant ramifications for the major asset classes of bonds, stocks, and commodities.

Multiple Interest Rates Cuts Remain On The Menu

Following the June FOMC meeting, the financial markets started pricing in an increased probability of a 50 basis point federal funds interest rate cut at the July FOMC meeting, with this probability peaking at roughly 40% in recent days, before retreating back to an approximately 1 in 4 chance. Having said that, a 25 basis point interest rate cut at the July FOMC meeting is virtually a lock right now, at least as far as the financial markets are concerned, according to the CME Group's (CME) FedWatch Tool.

(Source: CME Group)

Adding to the narrative, three 25 basis point interest rate cuts are priced into the market through the January 2020 FOMC meeting.

(Source: CME Group)

Clearly, the financial markets are telling the Federal Reserve to cut interest rates on the short-end of the yield curve.

Long-End Is Sending The Same Signal

Longer-term interest rates are sending the same signal, with both 30-Year and 10-Year U.S. Treasury Yields plumbing depths that have not been seen since 2016.

(Source: Author, StockCharts)

This plunge in longer-term interest rates has boosted the iShares 20+Year Treasury Bond ETF (TLT) to the verge of new highs, when adjusted for dividends received.

(Source: Author, StockCharts)

The unadjusted TLT shows the same picture as longer-term interest rates, meaning we are not back yet to the 2016 lows in rates, or high in TLT.

(Source: Author, StockCharts)

This is an important distinction, meaning despite the record enthusiasm for bonds, as shown by the Bank of America (BAC) Merrill Lynch Fund Manager Survey below, longer-term interest rates in the U.S. are still materially above their 2016 lows.

Let me repeat that again, longer-term interest rates are still materially above their 2016 lows in the United States.

Yield Curve Is Actually Steepening

Quietly, the 30-Year/2-Year Treasury spread is steepening.

(Source: Author, StockCharts)

On a percentage basis, the steepening in the 30-2 spread is actually greater than what we saw in late 2016.

If the yield curve is steepening the most it has since 2007 on a percentage basis, amidst an environment of extreme pessimism among investors, what does this mean for the financial markets?

Closing Thoughts - If The Fed Follows The Financial Markets, Maybe Too Much Tightening Is Priced In Right Now

Strength in U.S. equities is being driven by defensive names, specifically yield-oriented investments, which have flourished alongside expectations for lower interest rates, including Utilities, as measured by the Utilities Select Sector SPDR ETF (XLU); REITs, as measured by the iShares U.S. Real Estate ETF (IYR); and hallmarks of safety and consistent growth in dividends, including individual equities like Procter & Gamble (PG) and McDonald's (MCD), and Coca-Cola (KO), which have all recently made new all-time highs.

Perhaps both the broader large-cap U.S. stock market, as measured the SPDR S&P 500 ETF (SPY), which itself is at all-time highs, defensive yield-oriented equities, and the bond market, particularly the short-end of the curve, are all relying too much on the almost universally accepted belief that Fed funds futures will be cut materially over the next seven months, currently priced in at a cumulative 75 basis points in interest rate cuts.

What if the current probability scenario priced into the financial markets is wrong, and instead, the yield curve keeps steepening, as it is already doing quietly, perhaps from a round of better-than-expected economic data that boosts longer-term yields, and the Fed chooses to follow the market and not cut short-term rates as much as is priced in right now?

What would that do to the stock market, which is being led by defensive yield oriented equities and longer-duration growth stocks, which benefit from lower long-term interest rates (as they are the longest duration assets), like Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX), and Alphabet (NASDAQ:GOOG) (GOOGL)?

What would that do to yield-oriented equities that have surged on the "lower for longer" narrative?

What would that do to the bond market?

Bigger picture, commodities are historically undervalued compared to equities and bonds, and bonds are at a dangerous precipice even compared to the building mania for passive investments. Fundamentals still do matter, fundamentals were always the wrong scapegoat, and I still believe 2019 is going to be a banner year for value equities, similar to 2000, as price discovery, after more than a decade of growth outperforming value, is poised to return with a vengeance.

To close, even though it has been a very difficult, almost decade-long stretch for value-oriented investors, with pockets of significant outperformance, including 2016, I think we are about to enter a golden age for active value investors who do the fundamental work, who can find the future free cash flow-leading companies in the most out-of-favor sectors, and the most out-of-favor equities, including this public write-up, will be at the forefront of this opportunity.

Disclosure: I am/we are short TLT VIA PUT OPTIONS AND SHORT SPY AS A MARKET HEDGE IN A LONG/SHORT PORTFOLIO. 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: Every investor's situation is different. Positions can change at any time without warning. Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.