Friday, June 16, 2017

Fed Normalization

The crowd has interpreted a lot from the FOMC meeting on Wednesday.  The consensus is that the Fed is hawkish and barring a big correction in the stock market and/or lower inflation, they will remain on the war path towards "normalization".  I put quotation marks around normalization because I think ZIRP is the new norm, and should not be considered extreme policy anymore.  This isn't the 20th century.  In the 21st century, ZIRP should be considered the baseline.  NIRP should be considered accomodative, and PIRP (positive interest rates, even 1%) should be considered tight.

I believe the crowd has overreacted again to the Fed.  In the statement, they stated they are monitoring inflation closely.  Codeword for they are worried about not reaching their inflation target.  Or Fed speak for they will probably not hike in September.  The Fed was boxed into a corner this meeting.  The Fed funds futures were pricing in a 90+% chance of a hike, and of course, they will hike if the market prices it in.  They don't want to spook the market in either direction, but especially in a hawkish direction.  What if the Fed funds futures were pricing in just 50% odds of a June hike?  Then I think they would have gone their normal dovish route, and not hiked rates.

You had the 5-30 yr Treasury yield spread shrink from 109 bps to 102 bps since the meeting.  The bond market is pricing in more hikes into the belly of the curve, and saying that will lead to lower long term rates.  I believe this is an overreaction.  Despite what the dot plots say, the economic data is telling you that the Fed will have a hard time pushing forward with normalization.  The Citi Surprise index has been dropping like a rock.  CPI, retail sales, and NFP have been lower than expectations.  It seems like the rate hikes are starting to work in slowing down credit growth.

Don't even get me started on balance sheet normalization.  The hints they are giving are of a turtle like pace of reducing repurchases that you will likely see another recession before they can even reduce the balance sheet 10%.   Then in that recession, what took them 2 years to reduce will be made up in 3 months of QE.  It is like worrying about how you will spend all your stock market gains in 20 years when the S&P goes to 10,000.

Right now, the stock market still doesn't show any overt signs of weakness, but its a matter of money flows into equities, a FOMO trade gone into overdrive.  But the signs are starting to creep in that the equity uptrend is near an end:

- The suddenly spastic one day dumps that happened on May 17 and again June 9.
- The lagging Eurostoxx despite continuous heavy inflows.
- Crude oil trading at $45.
- 10 year yields rising yesterday despite S&P being down 15 points intraday.

Just like 2015, it is not going to collapse without giving the dip buyers a few pullbacks to snap up.  Then suddenly the next pullback turns into a trench, like August 24, 2015.  I see a similar situation here.  I see the pullbacks becoming more frequent, the resistance above more defined, and then the bottom falling out into a panicky selloff down to SPX 2260-2280.

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