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Don't Fight The Fed?


Old investing adage needs clarification.

There is strong correlation between bonds and the Fed rate.

There is little correlation between equities and the Fed rate.

Ex-Goldman Sachs CEO, Lloyd Blankfein, felt compelled to hop on Twitter yesterday to remind people of this investing platitude.

The assumption by most readers is that he is referring to being long or short the stock market. However, you would be deeply mistaken (and poor) if you followed this adage and applied it to stocks.

Take five minutes and review the Federal Reserve's actions on interest rates since 1970 to see for yourself how useless it is against stocks.

Or, just take a look at the following chart which tracks the Federal Funds Rate vs the S&P 500 and decide if it makes sense to be short stocks when the Fed is raising rates, and be long stocks when the Fed is lowering rates.

If you need any more help, you can take a look at the follow chart which shows the Fed lowering rates from 2007 - 2009 vs the VIX.

Yes, that's right. If we apply this adage to equities you would buy stocks in Sept 2007 and keep on buying as the S&P gets cut in half and VIX spikes to 80 in late 2008.

I don't recommend you do this.

Instead, apply this adage to elsewhere. As you can see from the chart below, this rule really only applies to bonds.

When the Fed is on a tightening course (that is, they are raising rates) don't be long bonds. You need to be short bonds since their prices fall as yields rise.

When the Fed is lowering rates, don't be short bonds. You want to be long bonds since their prices rise as yields fall.

The Fed Funds rate will generally line up pretty well with the U.S. 10-year bond's yield. As of yesterday the Federal Reserve set its rates to a range of 1.75 - 2.00% vs a 10-year yield of 1.77%. At this point we probably have to assume rates at headed back to at least the 0 - 0.25% range as the Federal Reserve does everything in their power to delay the next recession.

As for what we can expect from equities there is less of a guarantee. Generally rate cuts happen just before or during a recession and equities move steeply lower.

Disclosure: I am/we are long TLT.

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.