Don't Overreact to the Fed's Latest Move
The Federal Reserve makes it official... The 'Trump Trade' continues... The U.S. dollar surges while bonds and precious metals fall... Don't overreact to the Fed's latest move... More signs of trouble in the credit markets...
On Wednesday, the Federal Reserve raised interest rates for just the second time in a decade...
As expected, the Fed raised its benchmark rate by 0.25% to a range of 0.5% to 0.75%. But officials also noted increased confidence in the U.S. economy and said they now expect to raise rates three more times next year.
This was a much faster pace than the Fed forecast previously, and markets reacted strongly...
Bonds plunged to new lows...
The yield on the benchmark 10-year U.S. Treasury note hit a new two-and-a-half-year high above 2.6% this morning...
The U.S. dollar surged against major currencies...
In particular, the dollar rallied to a 10-month high versus the Japanese yen...
And hit its strongest level versus the euro since 2003...
And the selloff in precious metals resumed...
Pushing gold to a new correction low...
We suspect the market is overreacting...
After all, this time last year – when the Fed raised rates for the first time in 10 years – it said it expected to raise rates four times in 2016. How did that work out?
The Fed's latest forecast also wasn't as big a departure as many appear to believe. As Nick Colas, chief market strategist at brokerage firm Convergex pointed out in a research note last night (courtesy of the Reformed Broker financial blog)...
Was this market reaction warranted, given the Fed's track record at calling future interest rates (spoiler alert: no)? Here are a few points to consider.
- Back in June 2016, the Fed's Economic Projections put the appropriate level of Fed Funds for December 2017 at 1.6%, and 0.9% for this year.
- It then cut those estimates at the September meeting to 0.6% for this year (where today's meeting took us) and 1.1% for 2017.
- Today, the Fed essentially split the difference, raising its 2017 Fed Funds outlook to 1.4%. The actual number is 1.37%. This average of 1.1% (September's estimate) and 1.6% (the June guess) is 1.35%.
- Put another way, the Federal Reserve has actually not changed its basis perspective on the trajectory for interest rates through 2017 in the back half of 2016. A little nip here, a tiny tuck there... But today's change was far from a radical redo of its expectations.
In other words, yesterday's Fed announcement was a non-event.
Despite the market's initial reaction, we still expect a reversal in the ongoing "Trump Trade"...
As we noted on Monday, speculators are as bearish on U.S. Treasurys as they've ever been (meaning they expect interest rates will rise). This is the polar opposite of what we saw last July, when practically everyone was bullish on bonds and thought yields could only go lower.
Meanwhile, Treasurys remain incredibly oversold... and this week's plunge has only stretched the "rubber band" further. A sharp rebound rally could begin at any time.
We see a similar situation in precious metals...
They, too, are extremely oversold. And folks who were enamored with gold and silver last summer are throwing in the towel. In fact, while gold, silver, and mining stocks – as tracked by the VanEck Vectors Gold Miners Fund (GDX) – remain well above last year's lows, some measures of investor sentiment are even more bearish today than they were back then.
Of course, gold and silver could fall further from here... so keep an eye on your stops, particularly in more speculative vehicles. But we continue to believe a significant bottom is near, and precious metals could trade sharply higher in coming months.
Elsewhere, signs of trouble in the credit markets continue to appear...
The three-month London interbank offered rate (or "LIBOR") has quietly risen to 0.96%, its highest level since 2009.
As we've explained, LIBOR is an important benchmark of corporate borrowing costs... and hundreds of billions in junk-rated debt is tied to it. From the September 26 Digest...
Junk bond defaults aren't the only concern... Junk-rated companies have borrowed hundreds of billions via leveraged loans as well. And much of this money is benchmarked to the three-month U.S. dollar London interbank offered rate (or "LIBOR").
The first "domino" in a series of benchmarks is the 0.75% level... When that level is breached, a number of junk-rated companies are required to pay more on their floating-rate debt.
About $230 billion worth of debt is benchmarked to the 0.75% mark, according to Bloomberg data. But most of the debt in the $900 billion leveraged loan market is set to a LIBOR floor of 1%. When the 1% level is breached, the real trouble could begin.
On Wednesday, credit-reporting firm TransUnion warned of rising defaults in consumer loans...
In the report, the firm singled out subprime lending in credit cards and auto loans as the biggest areas of concern. As the Wall Street Journal reported...
A mix of increased subprime lending over the past few years and interest rates that are expected to keep rising will result in higher delinquencies in 2017, the report said. Credit cards and auto loans will be the most impacted as serious-stage delinquencies by the end of 2017 are expected to reach the highest level since 2011 and 2009, respectively.
Low delinquencies have been a bright spot for banks and other consumer lenders during the last five years but there are signs that this tide is starting to change. While missed payments on credit cards and auto loans remain very low, these figures have been gradually moving up as banks have been taking on more risk. Subprime auto originations increased each of the last six years through 2015, according to Equifax. Credit card issuance to subprime borrowers has been rising recently as well.
Of course, this report shouldn't come as a surprise to regular Digest readers...
We've been warning about massive risks in the credit markets for months. As Porter explained in the August 12 Digest...
Investors have become convinced – after a seven-year bull market – that they have nothing to worry about. They believe "the water is safe." Or at least, they have come to believe that the macro forces don't matter enough to change their investment strategy.
It's certainly possible they're right... No one can predict the future.
But we can assign odds. And the odds are NOT in our favor. Far too much bad debt has been issued to students, subprime car buyers, foreign companies (whose countries have devalued their currencies), oil companies, and corrupt governments (like Brazil and China). We are in the early stages of an enormous debt default cycle – a cycle policy makers are desperate to stop, just like they did in 2009. We know their playbook: They will issue new debts and a vast amount of new currency. The result will be crashing currencies and huge market volatility.
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