Sitting on a trading desk you are bombarded with information all the time. There is a constant steady drone of economic releases, company reports, commentary by company and government officials, opinions and analysis by both buy and sell side analysts, and finally, the peanut gallery of market commentary – the blogopshere never seems to quit spitting out useless drivel (like this post for example).
In this day and age, getting the information is not the problem. Deciding what really matters is the real riddle.
Yesterday was one of those days where the financial landscape changed dramatically, and therefore as Keynes once noted, “when the facts change, I change my mind. What do you do, sir?”
Fed Chairwoman Yellen’s speech yesterday was astonishingly dovish. I was going to try to put it into words how dovish it was, but I decided that the always colourful strategist David Zervos from Jeffries did a much better job than I could ever do:
Ok, I just read Janet’s speech in Chicago today. Holy dovish deepdish pizza batman!! I have no recollection of a Fed Chair’s speech where the lives of three down-on-their-luck job seeking individuals were discussed in detail. This is one loving and caring Fed Chair – I must send her a “no haters” hat immediately! If anyone doubts Janet’s commitment to fighting for more job creation – read the tape. If anyone doubts Janet’s belief that there is excessive slack in labor markets – read the tape. And if anyone doubt’s Janet conviction that there are no material inflation risks on the horizon – read the tape. This could be one of the most dovish speeches I have ever read from a Federal Reserve official.
After listening to the speech, I have scoured over it again, trying to decipher whether it really was as dovish as Zervos claimed. After taking a deep breath and thinking about it, I can’t do anything but agree with the Jeffries strategist.
This was Yellen’s first public speech since becoming Chairwoman and she wasted no opportunity to outline her dovish bent.
The market reacted, but not as much as you might have forecasted given the dovishness of her speech. I believe that month and quarter end played a big role in muting the reaction. Fund managers are hesitant to put on big directional changes right at quarter end. Not only that, many of the aggressive funds that were in the high flying stocks were beat up quite hard in March, so they might have been a little gun shy.
But this gives us an opportunity to react.
My thesis had been that the market underestimated the Fed’s resolve in removing the QE accommodation. Market participants were mistakenly assuming that the Fed would blink on the QE at the first sign of trouble and would quickly re-instate the easing. Last Fed meeting, when the Fed continued the taper and then Yellen outlined the 6 month time line for the first hike, the market was faced to deal with the reality that Fed was not going to be quite as dovish as the market hoped.
To demonstrate the importance of this last FOMC meeting, let’s go through some charts where I have outlined the FOMC meeting date with a red oval. First let’s have a look at the short end of the bond market. The 2 year Treasury note is very sensitive to the Fed’s short term guidance:
US 2 Year Treasury Yield</a> </div>
The June 2016 Eurodollar is the contract that seems to have the most action in terms of discounting the first hike:
June 2016 Eurodollar</a> </div></p>
The FOMC meeting also ushered in the correction for the most speculative US stocks. Have a look at the Russell 2000 small cap index – which had been leading the charge higher:
IWM Russell 2000 Small Cap ETF</a> </div>
It has been pretty well straight down since the FOMC meeting last month.
Let’s have a look at gold – which correlates very closely with real interest rates:
Gold since the FOMC meeting</a> </div></p>
And finally, let’s finish up with the US Treasury 5/30 yield spread:
US Treasury 5/30 Year Spread</a> </div></p>
The past two weeks have basically been a re-pricing of the Fed’s interest rate path.
The situation is made more complicated because the winding down of the QE program is being handcuffed to a more hawkish Fed interest rate policy. Previous to March’s FOMC meeting, there was no doubt that the market was overly optimistic about the Fed’s policies regarding QE. There was a near unanimous belief that the Fed would taper the taper at the first hiccup.
I have spoken about this before, and I will repeat it today. The Fed understands that QE is no longer helping achieve their goals and that at the margin, it is contributing to social inequality. QE as a policy to fine tune the economy is gone. Yes, it might return in a crisis, but the Fed views (correctly) that the time for QE is behind us.
The market is sometimes like a spoiled child who always thinks his parents will give in. This is what happened over the last couple of months when the Fed tried to give guidance that QE was scheduled to wind down absent a severe economic or market disruption. The market listened to the Fed Governors’ speeches outlining this wind down and concluded that they didn’t real mean it. Therefore just like a parent, Chairwoman Yellen was forced to raise her voice to get the market’s attention. That is what happened at the last FOMC meeting. She spelled it out unequivocally that QE was going to be wound down and that the Fed meant business. The market, which had assumed she was an uber-dove, was startled and the correction of the past two weeks has ensued.
However, like a parent that feels bad for scolding their child, Yellen has now tried to be extra accommodating in her first public speech since taking the Chairwoman role.
The market had thought Yellen a dove, and that is why they were reluctant to take her too seriously when she was issuing warnings about higher rates. That made the mid March FOMC meeting hawkish talk all the more surprising.
However yesterday’s speech confirmed the market’s assessment of Yellen as a dove.
I am not going to bother getting into the politics of her policies. Right now I am not judging whether it is wrong or right, but am more interested in what this means for the market.
Her speech made it clear that the Fed is going to be highly accommodative for some time to come. This will not be in the form of more QE, but will most likely take the form of low short term rates for longer than would be expected, or maybe even a cut on the interest on reserves. Whatever she does, it means a dramatically easier Fed than the market is now expecting.
Given that the market has corrected, and to a large degree is now pricing in a Fed that tightens 25 basis points ever meeting once QE winds down, I think there is no reason to play for higher rates in the short end.
Yellen has told you that the Fed is not going to be in a rush to raise rates.
This changes everything. Whereas over the last couple of weeks I have been trading with a tighter Fed bent, I need to abandon that stance.
Yesterday after the speech, I covered all my long USD positions. I also covered my short 2 and 5 year US treasury bond position. For my short 10 year futures positions I hedged them up by buying 2 and 5 year futures, putting on a 5/10 and a 2/10 steepener. Finally, I bought more gold and silver.
Yellen has showed her true stripes. She is as dovish as the market feared, they have just been shaken off their trade by last month’s FOMC meeting.
My trading has ben a little jumpy lately. I have being doing a little too much on, then off – wait maybe the first time was right, back on again. This is the nature of the way I trade as I try to figure out where we are headed. It ain’t pretty, but it is the way I do it. Then, when it becomes clear to me, I stick with it.
This speech has given me the confidence to stick with it. My belief that the economy will continue to be better than expected and that inflation will very soon rise sharply has only been reinforced by Yellen’s dovish speech.
This ultra accommodative policy will eventually result in run-a-way inflation and one of the steepest yield curve on record. No need to overthink this. Stay clear of equity shorts, put on bond steepeners and own real assets. Don’t touch the US dollar from the long side and buy the equity markets of the commodity countries.
Buying gold at a discount
Yesterday I bought some more gold and silver futures. However for my retirement accounts I also bought some Central Fund of Canada. CEF is a closed end fund that hold gold and silver. Ever since the start of the precious metals bull market in 2002, the fund has traded at a premium to NAV.
However since the start of last year’s correction, the premium has slipped to a discount.
CEF Premium to NAV in bottom panel</a> </div>
This is a great way to buy gold and silver at a discount. I fully expect that eventually this 6% discount will morph back into a 6% or 10% premium.
Returning to the GDX trade
At the beginning of the year, I was trading the GDX Gold Miner ETF from the long side. It was a good little trade and for once I actually managed to take a little money out of the gold market.
Given the change in my investment stance, I have decided to return to the long side of the GDX trade as well.
If you have a look at the chart, it looks like a good risk reward from the long side.
GDX Gold miner ETF</a> </div>
The move above $27 sucked in a lot of late longs, and then when it failed, the damage was all the worse. We have now moved down to $23.60 and long term support is only $0.80 lower.
I believe the trend is still higher and that the move over the past couple of weeks was merely a correction in the longer up trend.
I think that we will move back up to the $26 level fairly easily. I am getting long, and will add to it below $23.