At 2pm this afternoon the Federal Reserve will release the Minutes from their July FOMC meeting. Mohamed El-Erian, Chief Economic Adviser to Allianz, had an insightful preview this morning for Bloomberg View (here). El-Erian concluded his list of what to expect with a topic that has lurked ominously in the background during the years of unprecedented accommodative monetary policy both here and abroad. With each passing day the stakes become higher and higher for any sort of return to normalcy:
The effectiveness of Fed policies. From day one, Fed officials have recognized that their experimental policies come with the risk of unintended consequences and even collateral damage. In signaling in August 2010 the beginning of QE2 — a second round of bond-buying aimed at stimulating growth — then-Chairman Ben Bernanke pointed to a “benefits, costs and risk” equation. The net impact becomes increasingly uncertain the longer the country relies on such extraordinary measures to address its economic ills. One big risk — which officials may be hesitant to discuss openly — is that such extended monetary stimulus will lead to financial instability, which in turn could undermine consumption and growth.
Some Fed officials have recently suggested, as was the message from the July statement that September is a “live’ meeting, meaning that the Fed could raise the Fed Funds rate for only the second time since June 2006, and the first time since December 2015. The data dependent Fed’s hand may be forced if August non-farm payrolls (released on Sept 2nd) come in hot for the third consecutive month. Many assume the looming presidential election in early November should take action off of the table for both Sept and their Nov meeting (just 6 days before the election). The risk that the non-partisan Federal Reserve would take a policy action that could tip the scales one way or the other in the most divisive presidential election in modern times seems preposterous. But the FOMC is floating trial balloons to make sure investors don’t get too complacent.
Fed Fund futures are currently pricing a 22% chance of an increase in Sept, a 24% chance of Nov and a 51% chance in December. My assumption (and the Fed Funds Futures) is that they continue to talk up each meeting as live but wait until after the election. And no matter what happens in the election, the Fed goes in Dec and continues to straddle that ready to go, yet overall accommodative stance:
I’ll remind you of Goldman Sachs strategy research from May, cited by CNBC:
Goldman found that going back to 1994, 90 percent of the 31 rate hikes were priced in at least 50 percent 30 days ahead of the FOMC meeting. Getting closer to the meeting, the median hike was 95 percent priced in, with only a few deviations, such as from the Alan Greenspan Fed in March 1997 and November 1999.
Its been my view that the Fed ain’t going in Sept or Nov, and at this point, who cares about Dec as a 25 bps point raise on a one a year schedule should not frighten equity peeps. To be clear, when the Fed raised last December, Fed Fund futures were pricing three raises in 2016, at this point they are pointing to a 9% chance that the Fed Funds rate is at 1% in December 2017.
So the question for traders is if and when rates are on their way to normalization. The lower probability bet right now is faster (Fed raises in Sept and stays aggressive through 2016), not lower for longer (the consensus). One of the obvious plays for faster and more aggressive is the U.S. Dollar, which should rise, Oil & Treasuries which should fall. Your guess is as good as mine as far as equities.
The main point here is simple, for big payoffs you have to go against the grain, and perhaps be a little early. At this moment, the relative bid in oil, gold & treasuries, coupled with U.S. stocks at all time highs, equity vol near all time lows and the DXY, (the U.S. dollar index) far closer to its 52 week lows than highs, means traders are positioned for continued depressed interest rates and equity market stability. If last summer and the market environment in Q1 tell us anything that these periods of complacency can create fairly epic trading opportunities.