The Fed Concedes Economy Not Perfect

By Greg Tolpigin | More Articles by Greg Tolpigin

The Federal Reserve has backed away from its projection of four rate hikes this year, something we failed to see possible given the state of the US economy. They now only believe there will be two rate hikes this year.

The Fed in my opinion has lost credibility in much the same way the RBA did when I wrote “Ctrl-Alt-Del the RBA” in June last year. Since June the stock market had fallen by as much as 1000 points as the RBA made every mistake possible. Now it’s the Fed’s turn. And it’s not like the Fed (or any central bank for that matter) has any real success in engineering the economy and markets through the cycle successfully. Ben Bernanke told us there was no major issue with subprime mortgages and Alan Greenspan, the worst of them all, told us the stock market was in a bubble, then it wasn’t and ignored everybody who warned it him about the looming housing crisis.

But I digress. The current Fed has missed yet another opportunity to raise rates. They missed one in September last year and again so this week. The first question asked during question time was “with GDP at 2%, core inflation ticking up and the Fed not raising rates – when will the Fed ever have the right conditions to lift rates?” Exactly. Let me explain my thought process and why I would have raised rates.

The Fed has told us many reasons why they have refused to increase rates in the past six months:

1) Fears of the US dollar getting stronger
2) Global market volatility
3) Patch economic data
4) Weak commodity prices
5) China slowdown and stock market weakness

Following the market drop in January, much of the above 5 factors had dissipated or at the very least stabilized. The US dollar has dropped sharply against the Yen and Euro following the adoption of negative interest rates. The US dollar has even weakened against the commodity currencies as commodities have enjoyed a revival. Equity markets have rebounded circa 10-15% and even the Chinese stock market and Yuan valuation have stabilized.

Markets are very fickle and circumstances can change very quickly, so missing a window of opportunity like this one can mean one won’t return for months, years. By raising rates now, they would have moved further away from zero rates (and risks of negative rates) giving room to ease if the above 5 factors surface again. Furthermore, a rate hike while causing some negative reaction from markets would only unwind some of the rebound seen in the past month. It would not have created a “panic” because the conditions just are not ripe for a major sell off as they were at the end of 2015.

If the current market momentum tires and the US economy hits another soft patch, there will be no window or opportunity to raise rates at all. The Fed had to take the opportunity. The RBA failed to do as they said they would in the 1st half of 2015 and the stock market tumbled hard as soon as it viewed the RBA with no credibility.

In reality the Fed is scared. Policy tools are running thin. Negative rates for Japan and Europe are not having the desired impact and the side effects of crippling bank profitability are doing more harm than good.

So while the market has rebounded and the initial impact from no rate rise has been positive, investors need to be cautious with regards to the medium-term outlook. So leading on from last week when I pointed out that I like to look at trades where I can positioned to cover as many different market outcomes as possible. Buying gold on dips is one and the other is being long US Treasuries via the Nasdaq-listed ETF – TLT – the iShares 20 Plus Treasury Bond.

Here is the logic to why once again US Treasuries are a great buy. Firstly, if the Fed is unable to raise rates and the economy tumbles the safe haven status of Treasury Bonds will be the go to destination as they were in January. If the Fed is more aggressive in tightening rates than the market believes the yield curve will continue to flatten as the longer-term concerns of short-term rate hikes have on the US economy. Short-term bonds will rise in yield (fall in bond prices) but the increased risks of a recession will drive long term yields lower (and higher in price).

Add to this that European and Japanese long-term bonds have yields approaching zero. The relative attractiveness of obtaining yields above 2% in safe Treasuries will continue to see strong demand for them, keeping any rises in yield in check.

Technically I see this pullback in the TLT ETF as complete. Price action is showing the end of a downward sloping wedge with a breakout to the upside likely to trigger a sharp rally, potentially coinciding with the short-covering rally in stocks tiring. But it doesn’t have to. The environment exits for both to occur. The US dollar against the Yen looks very vulnerable to new lows as showing in the second chart so volatility anywhere – equities, currencies, commodities – can lead to a rotation into Treasuries.

As I have stated before, I like trades where multiple combinations of world events still lead to profits.

Greg Tolpigin

About Greg Tolpigin

Greg Tolpigin has over 20 years of experience as a proprietary trader and high-level strategist for the major investment banks including Citigroup, Bankers Trust and Macquarie Bank.

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