Investors and traders are once again trying to game the Fed by figuring out its next move. Unfortunately, this combination game of “chicken” and “musical chairs” only does one thing: put the players on edge. Of course, no one wants to be left holding the bag when everyone rushes out the exit doors, but no one wants to be left out of a rally, either.
Instead of guessing – and being plagued with pain, regret, and erratic market behavior – you need to understand what’s going on in the markets – and how the Fed views them.
March was a month of volatility – 16 of 22 trading days saw the Dow Industrials move triple digits. Yet, the VIX never exceeded 17 on a close! Why is that significant? A majority of those days were down, and that usually means players are buying protection for their portfolios.
Meanwhile, the Fed has been fully transparent about policy and their intentions, and we have already talked about the perils of trying to get in front of their moves. The turn in interest rates is going to happen sooner rather than later, and while some will interpret that move as hawkish, I would say it is just being “less dovish.” Yes, there is a difference. Even if the Fed raises rates 1,% they still remain very accommodative to markets. It’s only if/when inflation expectations rise that we could see rate hikes to higher levels. So far, the bond market is not giving us those signs.
As we know, a very aggressive Fed policy has helped to drive markets higher, boosting investor confidence with soothing words and liquidity that ultimately winds up as investment capital. Yet, how they proceed with policy going forward with respect to rate hikes is still a mystery. Do they go gently or bold? How will the market react? After all, the market gains since 2009 all belong to the Fed. They will not do anything to jeopardize those gains, and they will not force a recession – the economy is not that strong. Plus, inflation is at a very low level.
So, how should an investor or trader position himself and prepare for a reaction to the “new” Fed policy? I will keep an open mind while reminding myself that they will not likely do harm. We saw how they wound down the QE program – their taper did not jolt the markets. I suspect the Fed’s discussion is over how they can remove some of the extreme accommodation without a major disruption.
Currently, the markets are showing some concern – and even some confusion. The VIX term structure has a rather steep slope but with elevated levels in the back months. This tells us market players are betting on higher volatility down the road. (FYI, those future bets have mostly been sold – and they have been losing bets over the past couple of years.) Looking at market expectations for Fed Funds Futures, the earliest we see a fully-priced in rate hike is November 2015. The market is not believing the words of the Fed, yet the Fed have done nothing to squelch the anxiety by sharing a date, either.
The VIX also is in a quandary. If there is some fear over a rate hike, you won’t see it in the VIX. With the VIX at 15%, the market is telling the Fed to “Bring it! We don’t care!” Is that attitude a prudent one? We’ll find out eventually!