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The Fed is Betting Big That... image

The big focus in the market last week revolved around the possibility that Janet Yellen and her merry band of central bankers may need to change their tune at this week's FOMC meeting. More specifically, the issue is if there will be tweaks to the Fed's forward guidance language, with most of the concern focused on the likelihood that the FOMC may drop the phrase "considerable time" from its post-meeting statement.

To review, these two simple words relate to the amount of time the Fed is expected to keep rates at current levels after QE ends - which is currently expected to happen next month. If you will recall, Janet Yellen made a bit of a gaffe at her first press conference by stating that the Fed's view of "considerable time" is about 6 months.

The Problem: Two Little Words

Here's the problem. The general consensus for when the Fed will begin hiking rates is June 2015. However, the buzzer on the QE game clock will sound next month. And some quick math suggests that six months after October is April, not June.

Now toss in last week's release of a paper published by the San Francisco Federal Reserve Bank, which basically suggested that investors may be underestimating the pace of Fed tightening, and boom - you've got some adjustments being made in the markets.

As Exhibit A, we present the fact that the yield on 10-year Treasury Bonds spiked from 2.461 percent to 2.614 percent last week and has moved up from 2.334 percent (an increase of 12 percent) in the last 10 trading sessions alone.

10-Year Treasury Yield Daily

Granted this is a pretty big move in rates in a very short period of time. However, as anyone who has attempted to play the short side of the bond market will attest, trying to game when the big, bad bear market in bonds will actually commence has been a tough road.

ProShares UltraShort 20+ Year Treasury ETF (TBT) - Weekly

The bond bears have been saying for quite some time now that the bond market is NOT the place to be. The argument is pretty straightforward. The Fed is going to stop buying bonds, which will dramatically reduce demand for bonds (which should cause rates to rise). In addition, the Fed will then begin raising interest rates in order to "normalize" monetary policy.

In English, this means that the Fed will take the Fed Funds rate from zero to somewhere around 3 to 3.5 percent over a period of time. And everybody knows that when rates rise, bond prices fall.

As the chart below illustrates, rates certainly have a lot of room to rise.

10-Year Treasury Yield Weekly

In the near-term, a move back up to 3 percent on the 10-year would appear to be a cinch. This is simply where rates were at the beginning of this year. And in looking at the weekly chart of yields, a move back toward the 4 percent level - a level last seen in 2009-2010 - would be logical.

Next, traders are looking at where rates were the last time the economy was healthy. Intuitively, this would seem to represent an ultimate stopping point for rates once the Fed has finished "normalizing" monetary policy. And as the chart above shows, the level seen in 2007 was 5.2 percent, which is just about double where the yield on the 10-year is now.

The Fed's BIG Bet

So, everybody knows that the Fed is going to end QE. Everybody knows that the Fed will then wait a while before starting to raise rates. And everybody knows that returning rates to "normalized" levels will be a long, gradual process.

However, what investors don't know is if the Fed will be able to keep the markets from freaking out once the normalization process begins.

Remember, the Fed hopes that by communicating their plans to raise rates slowly and gently over time, the markets won't freak out. The fear, of course, if that another market meltdown would cause the economy to stop on a dime (again) and that the Fed would then be forced to deal with the possibility of recession (again).

The Fed is betting (and betting big) that by communicating exactly what will happen and when, markets will remain calm. The Fed is betting that since the increase in rates will be slow and steady and that the rate-hike campaign is intended merely to get things back to normal, the markets won't freak out.

When considered objectively, the Fed's plan/big bet certainly makes sense. The reason that rates are being increased is that the economy is finally improving and is no longer in need of stimulative measures. The thinking is that the markets will see this as a good thing.

Remember, an improving economy means better earnings. Better earnings mean better valuations and in turn, higher stock prices. As such, the thinking is that investors should be cheering the Fed's move and not dreading it.

Here's the Rub

The bottom line here is Fed's plan has never been implemented before. As such, the plan represents a bet - a VERY big bet - on what the economic outcome will be.

Lest we forget, the "Don't fight the Fed" strategy has worked both ways for a very long time. On the rate-hike side of the equation, historically it's "three steps and a stumble" for the stock market. Granted, selling stocks after the Fed has hiked rates three times (without an intervening rate cut) hasn't always worked. But the record of this particular strategy is fairly impressive.

So fed is basically betting that this time will be different.

Time For Investors to Place Their Bets?

As far as the stock market is concerned, the big bet is that any "adjustments" made to the major stock market indices will prove to be temporary and that the corrective declines will be relatively shallow. And so far at least, the stock market does seem to be taking the most recent spike in rates in stride.

Currently, it appears that traders are watching the moves in rates and the dollar very closely. And as one can see from the chart of the Dow below, it appears that some very modest "adjustments" may be taking place.

Dow Jones Industrial Average - Daily

With stock market investors having enjoyed a stellar move over the past 3 years and one of the best bull markets in history since 3/9/2009, those seeing the glass as half empty are concerned that it is time for the market to go the other way and that the "normalization" process will end badly.

But on the other sideline, the bulls contend that the improving economy will win out in the end. Our heroes in horns argue that stocks have entered a secular bull market and that the move from 2009 is just the beginning.

So there you have it. From a macro point of view, it is time for investors to size up the situation and place their bets.

Our Plan Is To...

After this type of analysis, we tend to receive lots of inquiries about what our plan is. To be sure, there are lots of ways to play the current situation and investors need to make their own decisions. But at our shop, the plan is to simply pass on making any kind of bet about what happens next.

In short, we don't make "market calls" or "bet" on our macro view or projected outcomes - ever. We learned a long time ago that Ms. Market doesn't give a hoot about what we think "should" happen next! No, our plan, as always, is to follow the guidance provided by our unemotional market models and to try to stay in tune with what "IS" happening in the market.

Such an approach may be boring. And we will never make headlines or get those prime interviews on the financial channels (which, apparently, no one is watching anymore!). But employing a disciplined methodology to managing the risk/reward environment on a daily basis, does allow us to sleep quite well at night.

Turning To This Morning

New pledges to fight ISIS, Scotland's independence vote and the ramifications thereof, and weaker than expected China economic data are in the news again this morning. However, the primary focus remains on the Fed and this week's two-day FOMC meeting, which will include a post-meeting press conference with Janet Yellen. Reports indicate that Ms. Yellen is busy seeking a consensus on the Fed's next steps and that the committee is currently discussing whether to take a start-early tact with smaller rate-hikes or a start-late approach with more rapid increases. Foreign markets are mixed and U.S. futures are pointing to a slightly lower open on Wall Street.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
    - Japan: Closed
    - Hong Kong: -0.97%
    - Shanghai: +0.30%
    - London: -0.01%
    - Germany: +0.22%
    - France: -0.08%
    - Italy: -0.82%
    - Spain: -0.32%

Crude Oil Futures: -$0.62 to $91.65

Gold: +$6.00 at $1237.50

Dollar: higher against the yen, euro, and pound.

10-Year Bond Yield: Currently trading at 2.603%

Stock Indices in U.S. (relative to fair value):
- S&P 500: -1.99
- Dow Jones Industrial Average: -1
- NASDAQ Composite: +0.12

Thought For The Day:

Always do right. This will gratify some people and astonish the rest. - Mark Twain

Important Reminder: In order to keep pace with our growth, better serve our advisors and clients, and to provide scale for future growth, Heritage is teaming up with CONCERT Global - an SEC Registered Investment Advisor with more than $2 Billion in assets under management. CONCERT will provide more robust back-office, compliance, technology, and trading infrastructure. Client packets to make the transition will be arriving in the coming weeks.

Positions in securities mentioned: None

Wishing you green screens and all the best for a great day,

David D. Moenning
President, Chief Investment Officer
Heritage Capital Research
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