Money Matters

How The Federal Reserve Can Derail The ‘Trump Train’

(Source: www.forbes.com)

Hypothetical situation: Assume the recent tax cuts add 0.7% to economic growth this year, based on numbers from the Tax Policy Center in Washington. And assume interest rates go up another 0.75% this year. What does that do to the pro-growth fiscal stimulus plan?

It’s a moving target for sure, but let’s take something away because of rate hikes. When you add rate hikes plus new government spending and a heavy dose of cowboy volatility traders playing with exchange-traded notes, you have some interesting tension here. But within the general push and pull, the Fed is the strong man that can derail the Trump train.

The stock market rose over 6,000 points in Trump’s first year as investors liked tax cuts, regulatory roll-back, and economic growth forecasts on the rise worldwide.

The last time the Fed raised interest rates was in December. The Federal funds rate is now 1.5%. Ten year Treasury bond yields—a general predictor of things to come—are now at 2.85%. Just a week ago, the general consensus was that the line in the sand for rates was 2.75%. Anything over that would give some extra juice to volatility.

“The line in the sand can’t be 2.75%,” says Tony Roth, CIO of Wilmington Trust, an $83.5 billion asset management firm in Delaware. “It has to be 3% and probably higher. Investors are misguided if they think Treasurys are going to 4%,” he thinks.

Forget those crazy VIX ETNs, the Fed is the blindspot.

The market went haywire after Janet Yellen, chairwoman of the Fed, stepped down. Her departing words were that market valuations were a “source of concern.”

Jerome Powell, the new Fed chairman, is more hawkish than Yellen.

What does that tell the market? It tells the market that the Fed is willing to throw a monkey wrench into the equity market locomotive that’s been on high speed since 2009.

Consensus estimates forecast three rate hikes of 0.25% this year, with some bulls looking at just two hikes of the same basis points. But new tax cuts and wage growth are worrying everyone on the inflation side. January saw an increase in average earnings growth of 2.9%, the fastest rate since 2009.

The Most Important Day Of The Week

That makes Wednesday a very important day for the stock market.  The U.S. inflation report comes out Wednesday morning before the opening bell. If it is higher than expected, the market will tank on the expectation that Powell’s Fed will want to stay ahead of rising prices. The 10-year would likely touch 3%.

“We could see the Fed erasing pro-growth fiscal stimulus by pushing up rates,” says Vladimir Signorelli, founder of Bretton Woods Research in New Jersey.

Everything is hanging on the Fed. Markets were mixed on Monday, with Shanghai up and Hong Kong down. Brazil was down again, but India was up. This may shape up to be the best day of the week unless inflation comes in low.

Contrarians, and the financial conspirators out there, are all itching for more than a mere “welcome correction,” as IMF director Christine Lagarde said over the weekend. They are waiting for their market call to be proven valid. And that is that historic central bank stimulus has been driving the equity markets in the U.S., Europe, and Japan since at least 2009. Once that stimulus rolls back, the market will dial back. Just how much it dials back is anybody’s guess.

On the other hand, the economy is growing. The central banks can go back to being instruments of monetary policy, rather than nurse maids to security markets.

The Bank of England is raising interest rates. Bank of Japan is expected to roll back its QE program this year. Meanwhile, in the confusion, China is ordering companies to buy their own stocks, and for mutual funds there to limit selling. (Davos showcased China last year as their darling of free-market capitalism, mind you.)

Inflation and interest rate worries prompted a blow-up in the CBOE Volatility Index (VIX), a proxy for market risk and a bet on markets remaining stable.

See: Here’s How Much The S&P 500 Has To Fall Before It’s A Bear Market — Forbes

The blow up in these volatility index funds has been encouraged, whether intentionally or not, by the Yellen Fed’s dovishness, says Neil MacKinnon, a senior economist at VTB Capital in London.

“The proliferation of ETF products betting on VIX volatility remaining lower has surged,” he says, blaming Yellen for the low volatility. When VIX volatility shot up after she stepped down, this forced some investors to sell underlying equity assets in order to maintain the low volatility targets required to keep the VIX from exploding. In other words, they were using all 10 fingers and 10 toes to plug up the holes in the sinking volatility index funds once the markets began crashing on Friday, Feb. 2.

The S&P 500 Index closed 2,619.55 down 5.16% for the week. The Index is down 2.02% in 2018, undoing its strong January performance, but still 2% higher than it was three months ago. It’s barely up on Monday.

The postive, global, synchronized growth story got ovewhelmed by a short-term jump in volatility and the blow up in the ETN volatility funds.

Once the VIX rubble is clear, the blame for the sell-off will rest on the Fed. How long that correction will last, and whether it leads to a bear market remains to be seen. A bear market requires a 20% or more correction in the Dow over a two-month stretch.

In 2008-09, the market was crashing even as the Fed lowered rates because U.S. employers were laying off, banks were shutting down, and a record number of foreclosures were pulling people from their home. Considering most American wealth is tied up in their homes, the market was looking at a picture of complete wealth destruction. That is not the case today.

Over the last 10 years, the U.S. equity market has fallen as much as 19%. The last major correction occurred in 2011. Prior to the 2008-09 bear market, the S&P 500 fell 49% during the dot-com crash and the Sept 11, 2001 terrorist attacks. It would take seven years to recover before the housing bubble popped. If the U.S. market corrected to 2008-09 levels, it would take the S&P 500 all the way down to around 1,480 points.

“If Powell is smart and strong, he will stay on message that they need to be ahead of inflation,” says Roth. “The market will understand and will calm down. We think 2% to 2.25% inflation over the next few months is likely. The market will respond in kind, but I think it will all calm down once we get a better sense of Fed direction. The changing of the guard at the Fed is causing some confusion right now.”

More Info: www.forbes.com

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