Yesterday Yellen testified in front of the Senate in what used to be called the Humphrey Hawkins hearing but is now called the more Orwellian sounding Monetary Policy Report. Last time Yellen spoke the market was burned by assuming that Yellen would try to strike a balanced tone, and when the true Yellen dove revealed herself, there was a melt up in risk assets. This time Yellen learned her lesson and did indeed try to straddle the line a little better.
It was an interesting session as Yellen showed her dovish tendencies, but also raised some nuanced concerns. As I listened to her testimony I came to the conclusion that although her true colours are indeed dovish, the market was underestimating her willingness to come off ZIRP (zero interest rate policy). She might favour easy money but she is not a complete baffoon. She understands that zero is not the right interest rate for eternity. Not preparing the markets for this move is only going to make the ultimate move all the worse.
Therefore I think that yesterday’s testimony was Yellen’s attempt to gently walk the markets closer to this rate rise inevitability.
What makes me feel that way?
When she was asked about the timing of the first rate hike, instead of completely ducking the question, she was actually surprisingly forthwith. She noted that almost all FOMC participants expected the first rate hike at some time in 2015 and that the median projection for the fed funds rate at the end of 2015 was around 1%. It is tough for her to be more clear than that. Rates are going up next year and should be at least 1% by the end of the year.
She also stated:
If the labor market continues to improve more quickly than anticipated by the Federal Open Market Committee, resulting in faster convergence toward our dual objectives, then increases in the federal funds rate target likely would occur sooner and be more rapid than currently envisioned.
Not only did she clearly set out the possibility for higher rates than the market expects, but she also warned about frothy markets getting out of control:
In some sectors, such as lower-rated corporate debt, valuations appear stretched and issuance has been brisk.
… signs of risk-taking have increased in some asset classes. Equity valuations of smaller firms as well as social media and biotechnology firms appear to be stretched, with ratios of prices to forward earnings remaining high relative to historical norms. Beyond equities, risk spreads for corporate bonds have narrowed and yields have reached all-time lows. Issuance of speculative-grade corporate bonds and leveraged loans has been very robust, and underwriting standards have loosened. For example, average debt-to-earnings multiples have risen, and the share rated B or below has moved up further for leveraged loans.
According to economist Diane Swonk, yesterday was the 3rd warning in less than 3 months from Yellen regarding this “reach for yield.”
The Committee recognizes that low interest rates may provide incentives for some investors to “reach for yield,” and those actions could increase vulnerabilities in the financial system to adverse events. While prices of real estate, equities, and corporate bonds have risen appreciably and valuation metrics have increased, they remain generally in line with historical norms. In some sectors, such as lower-rated corporate debt, valuations appear stretched and issuance has been brisk. Accordingly, we are closely monitoring developments in the leveraged loan market and are working to enhance the effectiveness of our supervisory guidance. More broadly, the financial sector has continued to become more resilient, as banks have continued to boost their capital and liquidity positions, and growth in wholesale short-term funding in financial markets has been modest.
Diane speculates that there might be some regulatory changes coming to address this concern.
On the whole Yellen did indeed strike a more balanced tone of a Central Banker that understands that allowing the markets to continue to spiral upward with no regard to the inevitable raising of rates is in no one’s interest. Don’t get me wrong – she is still extremely dovish and repeatedly emphasized that the Fed’s objectives have not yet been met. But there was a slight shift towards hawkishness.
The markets understood this (at least in the morning they did) and stocks and gold sold off, while the US dollar was bid.
Trading like a chump
Recently I seem to be trading with about as much intelligence as these two characters:
I have been doing stupid things like trying to fight the orgiastic rise in the stock market. And although for a brief period last week it looked like I might be right, we have subsequently exploded higher. Not only have we rocketed straight up, but the other positions that were previously saving me (GDX, gold, oil, etc…) started to work against me. My favourite trade of short financial assets while being long hard assets started hurting on both sides. During this last week, I definitely lost my mojo.
And although I have been somewhat disciplined at reducing some of the positions that were hurting, I have not done it nearly fast enough.
One of my favourite stories about George Soros is from earlier in his career. When he found himself in a funk, he would phone up Goldman Sachs on a friday afternoon and fax them over his portfolio. He would then ask for a price to liquidate the whole thing. George would hit the bid, go home flat for the week-end, and start over with fresh thoughts on Monday.
I have done this in the past, but I don’t think that my thinking is yet that polluted that this is called for.
But there is no doubt that it is time for me to focus on reducing risk and focus on my core trades.
Cleaning up the mess
I believe that the market has completely baked in Yellen’s insane dovishness. Any surprise will be her willingness to actually raise rates. Let’s not forget that by any traditional measure the Fed is already way behind the curve. Have a a look at the Taylor model forecast for proper Fed policy:
The model is indicating that the Fed Funds rate should be 3.63%! Even if you argue that this model is outdated, most other models are also showing that the Fed is extremely easy. Don’t forget that the Fed is a committee and that they are slow to make decisions. But at the end of the day, they actually follow these broad macro rules fairly closely. Yes, the Federal Reserve is set up to create a situation prone to easier monetary policy, but the Fed doesn’t simply ignore rate rise signals.
It feels to me like it has been so long since the Federal Reserve has actually raised rates that the market has forgotten that rates also go up.
Yesterday’s Yellen testimony has convinced me that she is much more ready to raise rates than the market believes.
Therefore I have made the following moves:
- I sold all my gold, silver, GDX and GDXJ.
- I kept my small platinum and palladium position.
- I also kept CRK as it is too illiquid for me to toss around easily.
- I cleaned up all my single stock equity names (except for Input).
- I bought USD against CAD, AUD and NZD.
- I covered my long EUR.
- I bought a little more crude oil.
- I have covered my long TIPS versus short Bonds
- I have taken off the steepener trades.
If I am correct about higher rates in the US I expect that gold will be under pressure. Although I am long term bullish, I expect that a slightly more hawkish Fed will put immediate pressure on precious metals. Maybe I am overthinking this move, but it won’t be until the Fed breaks something with their rate hikes that gold will be a screaming buy again.
I have sold all of my gold as the chart does not look constructive by any means:
And although it has been good to me, I have also parted ways with GDX. I had sold some a couple of days ago and I wish I had been smart enough to sell it all. But it is now completely off the sheets.
GDX – Gold Stock Miner ETF</a> </div>
It is with a little bit of a heavy heart that I part ways with GDX as cranking up that position last month was definitely one of my better trades this year. But I get the sense that the hedge funds are long these gold miner names and you know how much I like being in the same trade with them…
As for my single stock equity names. Many of them were solar stocks with the hopes of cashing in on the next bubble. Most of them were up from where I bought them. Although I am probably wrong to get rid of them, I want my position sheet to be a lot cleaner. A lot of the other names were tags that really should be sold as some of them I had already halved to the point of being irrelevant.
I think the trade for the summer is going to be long US dollars. I still contend that the US economy is going to outperform the rest of the world, and that if the Fed simply becomes halfway responsible, the market will be surprised by their hawkishness. Right now anything less than a drunken Yellen standing beside the punch bowl spiking it with MDMA is going to surprise the market.
If this happens, the US dollar is going to go bid.
This post is getting long so I am going to wait for another day to elaborate on my choices on currencies, but for now I will say that I have chosen the Canadian dollar as my biggest position:
USDCAD rate (higher rate means CAD weakness)</a> </div>
But for good measure I have added a little sprinkling of short AUD:
Australian Dollar</a> </div>
And finally, to spice things up, I have also shorted New Zealand:
Take all of this with a big grain of salt as this week has definitely not been my week. It seems like I might have taken some extra stupid pills this week. I seem to be zigging when I should be zagging, but hopefully these changes will get me back on track.
Meanwhile, I am heading back to the swimming pool for a beer…