In our opinion, the Fed’s worst nightmare is a scenario where they have lost credibility, risk assets enter a nasty bear market and the US economy hits recession next year. Of course, the Fed believe they have done a good job in guiding both the economy and financial markets through very choppy waters, equity markets are somewhere near fair value and the US economy is strong. We’ll touch below on the Fed’s credibility, but let’s get straight to the financial markets.
The first chart below is a daily chart of the S&P 500 since December 2014. Classical technical analysis considers, amongst others, factors such as support and resistance levels. In this instance, what we are looking at is previous support, once broken, becoming resistance. We have highlighted on the chart two levels of previous support near 2000 and 2050 that were broken during the late August waterfall decline and now appear to be acting as resistance.
The point to make here is that the vast majority of investors were probably comfortable up until mid August as the market was treading water despite growing concerns over Emerging Markets, commodity declines and deteriorating corporate profits growth. So long as the equity market was above important support, there was no reason for concern. However, the technical condition of the market deteriorated badly with the August meltdown, support levels were swept away, and anyone who had bought broad equity exposure at any point this year was losing money which is an uncomfortable position.
We have pointed out before that trading in bear markets is different. Rallies can be fast and furious, but ultimately need to be sold, especially when they fail at established resistance. The failure last week at established resistance looks like the end of a bear market rally. The pattern of the failure on Thursday, with an intra-day spike higher but with a down close on the day, and followed by another down day on Friday, is a very bearish pattern. On top of the technical failure at established resistance, the fact that the failure occurred the day that the Fed was perceived as being far more dovish than expected, can only be seen as adding to the bearish pattern.
Looking around developed markets, many appear to have seen a technical failure or breakdown in the last week. As an example, we have shown the Dax index below. As can be seen, the rally that commenced after the August meltdown has failed below the previous low, and on Friday, price broke below a small channel that had contained price during September. From a larger perspective, we would point out that ECB QE started in March and anyone who has bought since the start of QE is losing money, which as stated above is uncomfortable at best.
To be clear, we are now fully bearish of US equities again, holding PUT options on both the S&P 500 and Nasdaq 100. We expect to remain bearish so long as resistance highlighted above is not broken.
Moving on, the dovish Fed, along with their reduced forecasts for growth, inflation and interest rates, is bullish for the rates market in particular as well as for longer dated bonds. Our base case back in the Summer was that the Fed would raise rates twice and then stay on hold, and in that scenario, longer dated EuroDollar contracts that predict where short term rates will be in the future, offered good value. Our structural bullish thesis on rates trades has only been bolstered by the dovish Fed outcome, and why not when we look at the chart below, which shows the December 2016 EuroDollar contract at new all time highs.
Priced near 99, this equates (very broadly) to Fed Funds at 1% by the end of next year. Now, if the Fed were to raise rates twice, then this contract still offers upside potential. However, after the events of last week, the rate rising cycle has clearly been delayed, and depending on what happens in the next few months, may even be cancelled entirely.
Our last comment on markets is on the US Dollar which, as should be expected with a more dovish Fed than expected, ended the week on a downbeat note. With the support from higher interest rates less obvious now, the Dollar could easily suffer a hangover in the weeks ahead, especially as too many investors remain overweight and may need to reduce exposure. That said, with the likes of the ECB and Bank of Japan perhaps about to increase their QE programmes, over time the US Dollar may still be seen as the least ugly candidate in the FX beauty parade. Our plan is to buy Dollars against both G10 and Emerging Market currencies on the weakness we believe will be seen in the next few weeks.
With markets covered, let’s move onto the Fed. In a nutshell, they are losing credibility which is a negative for financial markets.
Zero interest rates and QE are emergency measures for very tough times. With unemployment at 5.1%, real growth of 2.7% Y/Y and financial markets arguably at their most expensive in 200 years (per recent Deutsche Bank research), how can they justify interest rates at zero. Keynesians will argue that to raise rates now could jeopardise the recovery that has been so hard fought for. However, perhaps the Fed is looking at the wrong sort of inflation today, just as the Greenspan Fed did prior to the financial crisis.
For the second time in a decade, the Fed are running ultra easy monetary policy because their preferred measure of price inflation remains below their self imposed 2% target. At the same time, their policies have created rampant price inflation in financial markets, just as was the case in the 2005/7 period. The Fed cannot control markets forever. During the bear market of 2007/9, they repeatedly cut interest rates until they reached zero and the S&P 500 still fell more than 50%. Now that QE has stopped, the risk here is that zero rates are no longer sufficient to keep investors’ risk appetites high enough. When investors preference turns from risk seeking to risk aversion, and especially when asset prices are in bubble territory, prices can fall a long way in a short period of time. Indeed, in the worst case scenario, falling financial prices will have a negative feedback loop into the real economy.
So, as we said at the beginning, the Fed’s worst nightmare is a scenario where they have lost credibility, risk assets enter a nasty bear market and the US economy hits recession next year. We have made the case for some time that financial markets were vulnerable, and events in recent weeks appear to be backing up that thesis. The Fed seems to be coming in for more criticism from all sides, and with markets falling after a dovish meeting, we believe that their credibility is now being openly questioned. What remains to be seen is whether they can recover their credibility and keep the US out of recession. Unfortunately for them, this may be simply a function of whether equity prices enter a bear market or not. Lower share prices can have a nasty habit of feeding into the real economy, and with executives highly focused on share prices, they could easily cut back on spending and jobs in a new bear market, thereby increasing recession risks.
Our bearish scenario here may not play out, but the risks are rising quickly that it will. If we are wrong, we don’t think the upside in risky assets is that great. If we are right, then markets have a long way to fall. We continue to believe that long term investors should be holding a lot of cash at this point in the cycle. Traders can be short equities so long as defined resistance remains intact. The next few months will be crucial for investors and policymakers alike.