Wednesday, December 13, 2017

Fed Optimism and Rate Hikes

The market loves to make the same mistake over and over again.  The key to making money in the market is not trend following or being a contrarian.  It is to repeat a strategy that keeps working because of a market bias.  For example, all of the gains for the S&P since 1993 have been from overnight gap ups.  If you only went long during regular market hours in the S&P, you would have made no money, despite the market going up 500% during that time period!  That is a simple strategy of just going long S&P at the close and selling at the open.  The reason the strategy has worked so well is because stock traders are afraid of overnight gap risk, and those who take that overnight risk collect the premium. It is an irrational fear, because the market can easily go down rapidly during regular market hours, as the flash crash in 2010 or even the massive dump in the S&P on Flynn news a couple of Fridays ago. 

This brings me back to the Fed.  There is a market bias of believing the Fed and not believing the interest rate markets when it comes to future rate moves.  The Fed has always been overly optimistic on raising rates, and usually they fail to deliver on their promises.  In the few times that they do deliver those rate hikes, it is because the S&P is screaming higher.  And no, the S&P isn't always going to trade like it did this year.

The market bias now is that the Fed is going to hike 3 times next year and flatten the yield curve.  The market has fallen into the trap of believing the Fed again.  The Fed is always going to try to cheerlead the market by giving overoptimistic projections of the economy and interest rate hikes.  They are in the business of providing confidence to the market, not in correctly predicting future rate moves. 

Betting on the Fed hiking rates 3 times in 2018 is like betting that the S&P will go to 3000 next year.  Because if the S&P isn't going up, the Fed will stop their rate hiking cycle dead in its tracks.  I have a much more bearish view on 2018 than most so I am bullish on bonds.  The fear of inflation is still present in the market, and that is keeping yields higher than they should be given how late cycle this economy is.

Do not be surprised next year if Powell comes in and is dovish as the stock market struggles to go higher.  If for some reason he wants to try to raise rates as the stock market struggles in 2018, he will invert the yield curve in a hurry, exacerbating the downfall of this market.

Looks like it will be a no touch market for the S&P for the rest of the year.  Its fitting to cap off the year with more of the same boring grind higher.


shzhning said...

here's my question if you have a minute: the fed raised rate, mathematically bond price should drop. but we're seeing the opposite. is it because rate hike is already priced in, and the market is expecting the rate to drop down the road?

Market Owl said...

Rate hike was already priced in, and there is a difference between raising the Fed funds rate and the rate on a 10 year bond. 10 year bond prices off of longer term view on interest rates and term premium, or the risk to holding a longer term bond.