Fed Begins Meeting. But Bitcoin!

The Federal Open Market Committee begins its final meeting of 2017 today. With the special election in Alabama and Bitcoin, does anyone really care about the Fed? For today, the stock market certainly doesn’t! With the Fed announcement that short-term interest rates are going up by .25% tomorrow at 2 pm, the market usually has a quiet day today with a slight edge to the bulls. More new closing highs in the Dow and S&P 500 but the same divergence in the S&P 400, Russell 2000 and NASDAQ 100. So much for the mild seasonal headwind so far.

Of my four key sectors, only semis continue to concern me. The others remain strong. Most of the secondary sectors are behaving just fine as well. High yield bonds are lagging, but they are not rolling over, at least not yet. The NYSE A/D Line continues to score all-time highs. The bull market remains alive and reasonably well my broken record theme of buying any and all weakness remains in place.

Bitcoin continues to be all the rage. Friends, clients, media, Uber drivers, barbers. They all want to know how to buy it. I will be writing an article about it before the holidays. So glad I mortgaged my house and put everything in Bitcoin at $50… ­čÖé

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But, But, But Say the Bears

Another month, another strong employment report. 228,000, new jobs were added in November, stronger than expected, as the impact of the hurricanes continues to weaken. The unemployment rate remain at a 17 year low while wages grew at an annualized rate of 2.5%, still frustratingly short of where the Fed and government wants it to be. Thankfully, it’s still slightly ahead of the inflation rate. Every month it seems like the bears get all hyped up into this report with all kinds of negative forecasts, only to be disappointed time and time again. Don’t worry. At some point, they will be right and I fully expect them to crow how they got it right all along.

As I have said all year, the theme of reality over rhetoric continues to be in play and accurate. If you get caught up in all the nonsense on Twitter and congressional infighting and North Korea, etc. you would think that things cannot be good. However, the economy is growing faster than it did in 2015 and 2016 and we all know what the stock market has done.

The Dow and S&P 500 finished the week at new closing highs, but did not make new all-time highs. That won’t matter for more than a week or so, max. The other three indices performed fine and should see new highs this month. The only serious concern I have right now is that the semis have ceded leadership and are struggling. The market can continue higher with that group, but it makes it easier if they went along for the ride. We’re seeing really nice behavior from many other sectors.

In the very short-term, there are two small headwinds to deal with. One continues to be that stocks have a very mild seasonally weak period for another week or so. Two is that rallies, especially to new highs on an employment report day often are signs of some short-term exhaustion. By that, I mean we could see a 1-3% soft patch, nothing really significant although with volatility at all-time lows, it would feel much worse than it is.

The week ahead will be squarely focused on the Federal Reserve’s final meeting of 2017 with the expectation for another 1/4% rate hike. That meeting ends on Wednesday at 2:00 pm. More on that during the week.

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The “Secret” Reason Yellen Doesn’t Want to Raise Rates. Special Fed Meeting Update

I believe there is a “secret” behind the Fed being slow to hike short-term interest rates. I will get to that in a minute.

Today’s Meeting

Let’s start with non-controversial items first. The Federal Reserve Open Market Committee concludes their two day meeting with an announcement at 2 pm that interest rates will not change today. That’s what the markets are expecting. There has been all kinds of hot air coming from several Fed officials that rates need to rise now, but Chair Janet Yellen has been on the other side, sticking with her more accommodative stance. It would be very hard to believe that the majority of voting members would overtly vote against their chair.

The statement comes next and because it’s not one of the quarterly press conference meetings, it’s even further unlikely that Yellen & Co. will raise rates without releasing their updated forecast and answer questions. Regarding the verbiage, there is no consensus on what will be released.

Looking at the calendar, the most likely opportunities for the Fed to raise interest rates are at the June and December meetings which include the quarterly update. I took September off the table because it’s too close to the election and without a clear and present crisis to fight, it’s unlikely the Fed would move so close to election day.

My own stance remains unchanged since 2008. That is that the Fed should not raise rates at all until the other side of the next recession. I wasn’t referring to getting through the Great Recession. I meant the mild one that should come next this decade. After that recession, I believe interest rates will go on a 25-40 year bull market with inflation finally becoming commonplace again.

That forecast also coincides with the final crisis in Europe later this decade. One way or another, with or without the Euro, Europe’s rubber meets the road this decade. Kicking can is no longer possible. There will likely be defaults and reorganizations, but Europe should become a great place to invest in the 2020s.

Yellen & Co. Set a Precedent
Getting back to the subject line of this update, I firmly believe that the Fed’s main reason for not raising rates isn’t all that transparent. However, the “secret” I call it isn’t nefarious or with some conspiracy laden ulterior motive.

Yellen is in a tough spot. The U.S. economy is certainly strong enough to withstand a rate hike or two. It’s hard to argue that although the Fed did set all kinds of precedents in December with that increase.

  • First rate hike ever with inflation under 1%.
  • First rate hike ever with the annual social security COLA at 0%.
  • First rate hike ever with wage growth needing to jump 100% to hit the Fed’s target.
  • First rate hike ever with industrial production on the verge of recessionary levels.
  • First┬árate hike ever with GDP barely 2%.
  • First rate hike ever with inflation expectations close to 0%.
  • First rate hike ever with retail sales closer to recession than escape velocity.
  • First rate hike ever with non-farm payroll job growth continuing to decelerate.
The “Secret”
Anyway, if Yellen & Co. hike rates now or soon given what’s going on in Europe and Japan with negative interest rates, the Euro and Yen would likely fall precipitously, meaning that the U.S. dollar would strengthen dramatically. This would almost certainly lead to an enormous flight of capital out of Europe and Japan and into the U.S. Remember, capital always flows to where its treated best.

Before the financial markets were truly global, you can see how this occurred in the early to mid 1980s as the dollar soared to its highest levels of all-time. Massive capital inflows would first go into the dollar and then typically into shorter-term treasury instruments. In the 1980s, we also saw flows into large cap, blue chip stocks, which I can see happening this decade and fueling the Dow into the 20,000s.

In the 1980s, these capital inflows helped fuel the nearly vertical rise in our stock market. However, eventually, when there are enormous capital flows to one system and out of others, market dislocations grow and grow and grow. Look at how sharply the dollar began to collapse from 1985 to late 1987.

When newly appointed Fed chair, Alan Greenspan, raised rates in August 1987, the dollar still fell as stocks peaked. As the stock market began to unravel in mid-October, then Treasury Secretary, James Baker, famously warned on the morning of the October 19th crash that the U.S. was not going to intervene and support the dollar. With portfolio insurance to add fuel to the fire, our stock market crashed.

I believe the Fed fears a much worse inflow of capital into this country which may be good in the short-term, but disastrous long-term. There is much more global capital today and our financial system is much more linked than ever. Money can flow around at warp speed.

Should we see a torrent of capital flow into the U.S., these kinds of events rarely, if ever, end well. See Japan since 1990 as one piece of evidence. Should our dollar resume its secular bull market, which I think it will by 2017, we may be looking at a major global financial market dislocation later this decade as a result, something the Fed doesn’t want to contribute to.

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***SPECIAL Fed Meeting Alert… A March Surprise?***

Whether you like Dolly Parton’s, “Here You Come Again”, Kenny Loggins’, “This is It”, or Europe’s, “The Final Countdown”, it’s Federal Open Market Committee (FOMC) statement day again. Boy did those 6 weeks fly by. And the markets have basically done a 180 since January 27 with the Dow going from vertically down to up and advancing from 15,940 to 17,250.

Yellen’s Cover for Standing Pat is Gone

After raising rates in December, the Fed prepared the markets for four more rate hikes in 2016. Almost to the day of that announcement, global markets began to sink on fears that the worldwide economy was slipping into recession. With that, the Fed quickly backed off the rhetoric and so went any discussion of a rate hike in January.

Yellen cited China, Europe and even lower than expected economic output in the U.S. along with collapsing oil prices are reasons for keeping interest rates unchanged.

My oh my have things changed.

  • Our stock market not only stabilized, but rallied sharply
  • Oil prices are up 50% from the bottom
  • Q4 GDP came in stronger than expected although up just 1%
  • February employment report printed a reasonably strong and better than expected increase of 242,000
  • China’s stock market calmed down and began to rally
  • European markets gained
  • ECB chief, Mario Draghi, announced an increase in bond buying and more stimulus

What will Janet Yellen say now?

She basically lost the cover to keep rates unchanged although markets expect no action from the Fed today with 90% certainty. However, they do expect a more hawkish statement and press conference. The likely path forward is that Yellen & Co. lay the groundwork for a June rate hike and let the markets digest and prepare for that.

“What If?” – Focus on the Banks

If Yellen pulled a March surprise, stocks, bonds and commodities should fall precipitously with staples, REITs, telecom and utilities being the hardest hit.

Of all the sectors, the banks look like they want to move most and here are four scenarios to watch for.

Fed stands pat & banks rally – Actionable trade for a few weeks to a few months

Fed stands pat & banks continue in line or worse with the S&P 500 – Ignore banks

Fed raises rates & banks rally – Actionable trades for the rest of the year

Leave Rates Alone

I won’t rehash my trail of comments since 2008, and you are probably tired of hearing and reading them anyway, but ever since Q4 of that year, I am on record as saying that the Fed should NOT raise short-term interest rates until the other side of the next recession. The U.S. survived the Great Recession, but our economy is far from thriving.

As I have also pounded the table for the past 7 years, we are living through a very typical post-financial crisis recovery which is very uneven and frustrating. It sometimes teases and tantalizes on the upside, but occasionally terrorizes on the downside. Think Japan since 1990. In the end, few are pleased with it and blame is easily fanned around.

The Fed has tried mightily to spark some “healthy” 2-3% inflation, but has not been successful overall. And I don’t believe they will see success until we get through the next recession which I forecast to occur early on in the next president’s watch. It should be very mild as corporations are sitting on roughly $3.5 trillion in cash with more than $2 trillion on bank balance sheets. It’s almost impossible to experience a significant recession with the banks having such a dramatic cushion of cash.

After that, inflation should begin a secular bull market along with interest rates going higher for decades. Our economy will finally get back to trend or average GDP growth of at least 3% which has not been seen since pre-2008. This could also coincide with Europe getting its fiscal act together after another sovereign debt crisis.

Did Yellen REALLY Want to Set Precedents
The December rate hike sets all kinds of precedents.

  • First rate hike ever with inflation under 1%.
  • First rate hike ever with the annual social security COLA at 0%.
  • First rate hike ever with wage growth needing to jump 100% to hit the Fed’s target.
  • First rate hike ever with industrial production on the verge of recessionary levels.
  • First┬árate hike ever with GDP barely 2%.
  • First rate hike ever with inflation expectations close to 0%.
  • First rate hike ever with retail sales closer to recession than escape velocity.
  • First rate hike ever with non-farm payroll job growth continuing to decelerate.

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Will They or Won’t They

I truly cannot wait until September 17th at 2:01 PM. At that time, the Federal Open Market Committee, aka, the Fed, will make a decision about interest rates. I don’t know anyone who isn’t completely exhausted from all of the Fed talk over the past few months. It’s enough already. How many times do we need to see “Countdown to the Fed Decision”, “Special Report: The Fed”, “Breaking News…”, etc. Are there no other business stories worthy of being discussed in the media?

Here’s the deal. Unlike almost every other interest rate cycle change, the odds of a rate hike on Thursday are really about 50-50. The Fed has laid the groundwork for the markets to expect a rate at some point since Ben Bernanke’s famous Taper Tantrum speech more than two years ago. However, something keeps getting in the way.

Should the Fed raise short-term interest rates?

The market has already done so on the 10 year treasury note to the tune of 37%. Yes, you read that correctly. The 10 year yield has risen from 1.675% in February to 2.30% as I type this. And that’s not counting the move from 1.40% back in July 2012.

Since 2008, my thesis has been and continues to be that the Fed should not raise interest rates until the other side of the next recession. This is your “typical” post-financial crisis recovery that’s very uneven. It teases and tantalizes on the upside and frustrates and terrorizes on the downside. Another recession, albeit mild, is coming over the next few years. That’s okay. We’ll get through it. On the other side of it, our economy should get back to trend or average GDP growth, not seen since pre-2008. This could also coincide with Europe getting its fiscal act together after another sovereign debt crisis.

Anyway, I don’t believe the Fed should raise rates and I will guess that they don’t raise rates today. Inflation is nowhere to be found. Rumor has it that the Social Security Administration is using 0% for the 2016 COLA increase to social security benefits. Yes, I know all about the conspiracies to limit COLA increases to help the budget, but just look around you. Transitory things like energy and grains have collapsed. Wage growth is woefully pathetic. Money velocity has been in the perfect downtrend since 1998.

While the dollar has been very stable for the past six months, that comes on the heels of a 20% rally (huge in the currency market) over the prior 9 months, which can be considered a quasi-rate hike. The very dovish IMF and ECB are begging and pleading on hands and knees for Janet Yellen to leave interest rates alone. Think of all that emerging market debt denominated in dollars that has been hammered by dollar strength and will likely get much worse. Think about the currency imbalances with the dollar appreciating so mightily. A rate hike here will not be good for our struggling trading partners in Canada and Mexico.

Why raise interest rates?

I have heard some pundits use the word “credibility”. The Fed needs to hike rates to either preserve or establish credibility. I am sorry, but that’s idiotic and doesn’t need any further rebuttal. Some believe that an unemployment rate of 5.1% represents “full” or “maximum” employment and that a rate hike is necessary to cool the jobs market. Another reason I totally dismiss as unfounded. How about the labor participation rate at 62.80%, a 38 year low?!?!

Finally, there are those who believe our economy is growing strongly enough to warrant a rate higher than 0%. To me, that argument at least has merit and I can’t easily rebut it. The recovery remains uneven, but GDP is growing. I wrote a strongly worded piece after Q1 GDP printed so poorly that I totally dismiss it as yet another bad seasonal adjustment and that I thought Q2 and Q3 would print between 2% and 3%. I was wrong. It’s even better. However, with that, let’s not forget that wage growth remains awful and inflation is non-existent.

Interestingly, while Fed members have given speeches all over the place all year, Chair Janet Yellen has been uncharacteristically silent of late. You would think that if the Fed was about to raise rates, Yellen would be stumping with at least some trial balloons or hints. The rate hike argument has persisted for two years and without it, there hasn’t been any negative consequences. Why not continue to wait…

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