Yesterday was looking like a simple continuation of Tuesday’s grinding rally higher until the Fed minutes were released at 2pm.
Nasdaq trading over the past few days</a> </div>
The Fed minutes caught the market off guard as they showed that Yellen had made a rookie mistake when, during the post FOMC meeting press conference, she indicated the 6 month period for first rate hike. The minutes showed that the committee is very divided in terms of the timing of the first rate hike, and that they were worried about the messages they were sending with their forecasts. This was hardly the minutes of a committee that was ready to pull the trigger on higher rates.
We now know that Yellen did indeed want to backtrack on her perceived hawkishness when she made her first public speech. Since that extremely dovish speech the market was in the process of re-pricing their earlier mistaken belief of the Fed’s hawkishness, and yesterday’s Fed minutes accelerated that process.
Here is the trading for the Sep 2016 Eurodollar contract:
ED Sep 2016</a> </div></p>
The short end of the curve has been battling back, trying to recover all the ground lost from Yellen’s 6 month comment.
Yesterday when the minutes hit the tape, as would be expected, stocks and gold rallied, the yield curve steepened and the US dollar sold off.
Proving that even a blind rat stumbles on some cheese every now and then, I was lucky enough to be set up nicely for this move.
The real question is where do we go from here? What does the Fed’s conflicting messages mean?
The answer is that the Fed doesn’t know any better than most Wall Street economists where we are going from here. Given the monstrous balance sheet expansion of the past 5 years, many Fed Governors are rightfully worried about inflation running out of control if they mistakenly stay too easy for too long. Therefore these FOMC members want to exercise caution about further balance sheet expansion and would like to normalize monetary policy as soon as possible.
However, another group within the Fed correctly understands that given the massively over indebted nature of the financial system, any increase in rates will be disastrous for the economy. This group desperately wants to avoid a Japanese style decade full of starts and stops.
My response is that they are both correct. The monstrous balance sheet expansion is going to eventually create inflation but that the Fed (and government) have no choice as any significant increase in rates would indeed cause the economy to immediately slump, and thereby only make the over indebtedness problem all the worse There is only one way out of this morass – that is to inflate.
The one nuanced aspect of this argument where I differ from the market is that I do not believe that QE is going to return without a dramatic event. This Fed understands that QE is exacerbating the increasing inequality problem. Have a look at this great infographic from Bloomberg:
This problem has never been worse and the Fed pumping money into the markets through QE is at the very least not helping, and indeed might be causing this problem.
Therefore in the coming days as you listen to market pundits speculate about a potential taper of the taper – ignore them. The Fed is going to continue winding down QE. Yes, they are hugely divided about what comes after that, but absent a market/economic crash, the QE is going to be wound down.
If that is the case, then what does a dovish Fed do? I think that eventually we are going to have a cut of the Interest Rate on Reserves. But more importantly, I believe that their solution will be to simply keep the short end of the curve anchored much lower for much longer. They are going to be slow to raise rates. Super slow. Slower than the 2004–2006 tightening cycle.
Which is why I love my steepener trades.
I am not saying that rates can’t rise. Far from it. I think eventually the Fed loses control of the bond market and rates skyrocket. I just think that this Fed is going to be exceptionally slow to get out in front of the rise. And given the massive amount of monetary stimulus that has been applied to the system, this will be a lethal combination that very quickly spirals out of control.
But that is a story for another day.
What do we do today?
As I love to tell the guys – some people were lucky enough to be born smart, while others were smart enough to be born lucky. I am probably in neither category, but I was fortunate enough to catch this rally in stocks.
At the end of the day, I am not really that bullish on US stocks (and most especially not US Nasdaq stocks) as I view them as egregiously over priced. I am therefore a very uncomfortable long. Given the rise of the past few days, I am going to start unloading my long position in the Nasdaq calls. I will sell half today and half tomorrow. It will be off the sheets by the end of the week.
As for the other positions, I continue to love the precious metals. Given the Fed’s dovishness, I only love them all the more.
Apart from selling my long Nasdaq into strength, I am not going to over think this latest move. Many of my positions are moving my way and now is the time to sit tight.
As Jesse Livermore once said, “It was never my thinking that made the big money for me, it always was sitting.” I know my thinking seems to never make me any money, so I am going to give the sitting a whirl…