The interest rate sensitive investing world is waiting to see what the Federal Reserve will announce this week. Bets are being made in the biggest casino on earth – the financial markets. Everyone has a recommendation and most are saying the Federal Reserve should wait until there is more certainty about the economy and stability in the markets.   There never will be.

Most commentators believe the markets are anticipating another delay. If so, look out below if they hike. The technical pattern for every index looks like a perfect pendent which usually means a continuation of recent market action (a decline). Sometimes pendants reverse and a market friendly Fed announcement would help this outcome.

Waving Pennants

To be fair, true pendants exhibit declining volume as they progress and the indexes are reporting normal volume. Although the SPY ETF that tracks the S&P 500 does indicate declining volume, but then I do not trade technical patterns since they are unreliable.   It is only an observation that the markets are exhibiting an interesting pattern leading up the FOMC meeting and the S&P 500 is now walking a tight rope at the 1950 level.

Since everyone is making predictions, why don’t we imagine being the Fed Chairwoman for the day. The economic data is neutral and here are the options presented to you.

1. Announce more QE: Instant loss of credibility and signals things are really bad in the financial sphere. And if you really want support for more Quantitative Easing, you need a larger market decline.
2. Push rate hike back until well into 2016: Fed loses what little credibility they have, but this is the only way to get one last boost in the financial markets. Will not improve the underlying economic conditions since it never did in the first place. Then we have to go through this again next summer.
3. Delay rate hike and remain “data dependent”: No better way to maintain market uncertainty and turmoil. Since their data will never support a rate hike, the Fed will lose credibility later than sooner. China will continue to struggle so the National Security Council likes this option.
4. Announce a very small hike now and also a slow rate hike schedule such as “no hikes until the data comes in from this one”: Maintains what little credibility they have, reduces uncertainty in the markets, and creates the expectation of the one-and-done rate hike schedule which provides some market support.
5. Announce a normal rate hike and a normal rate hike schedule: Global financial markets crash.

I would pick “E”, but that is just me. I like to invest at much more favorable valuation levels and the sooner the better. Of course, I do not expect this outcome.

If the financial markets and Goldman Sacs are really calling the shots instead of the economy, expect “B” or ‘C”. If the National Security Council gets a say, expect “C”. Goldman Sachs which feeds off the financial sphere created their very own Goldman Sachs Financial Conditions Index that, of course, includes no economic measures.  It measures turmoil in their profit center financial sphere and Goldman Says Tighter Conditions After Market Sell-Off Equates to Three Fed Hikes.  Based on “their” index, the Fed would never hike and needs to begin feeding the financial sphere more free money (QE) now in order to continue the transfer of wealth from the average American’s future to them today.

I think “D” is a possibility and supported in the Bloomberg Business Article “Fischer’s 2014 Why-Wait Wisdom Points to Fed Liftoff This Week” that highlights the Fed’s number two official’s thinking last June… “Don’t overestimate the benefits of waiting for the situation to clarify”.  I agreed. If they raise rates this week, I would expect to revisit the recent lows at a minimum. The markets expect another delay, so get your popcorn ready just in case the fireworks start early.

Perspectives is all about placing the current situation into historical context so I was happy to find the following.   Three Deutsche Bank strategists found that the three most important assets combined across 15 nations (looking back a mere two centuries) were at peak valuation. But the main take away was their answer to the question what could cause the markets to decline is not just a failure to maintain near zero interest rates but a failure of the central banks to continually accumulate assets via QE.

Peak Peaks

The following is an excerpt from DEUTSCHE BANK: We examined 200 years of data and concluded stocks, bonds, and housing are at ‘peak valuation’

The most likely driver would be something that changes the current policy orthodoxy where central banks are continually keeping rates at close to zero and accumulating assets at a pace never previously seen through history. Anything that changes this will likely be a negative for assets…Perhaps this time this will be more extreme given the weaker economy and higher asset prices leading into the tightening.

QE had a marginal impact in the economic sphere, but an enormous impact on the financial sphere. The calls for more QE are coming from the financial sphere as the distress moves from the periphery to the core. The periphery includes both emerging markets and the higher risk bond market, both of which are signaling trouble. The US is the financial core and has benefited from the initial flow of funds to our “safe haven” markets. This may continue, but I cannot imagine that the smart money is not reducing exposure regardless of whether the Fed hikes or does not.

It could go either way this week and it does not matter.  All my models are out of the market and my popcorn is ready.  Invest smart.

Categories: Perspectives, The Smart Bird