A unique opportunity is upon us. The FED has signaled to the market that it will not raise rates in 2019 and they say there will only be one hike in 2020.
Anyone who has been in the game long enough will tell you that the bond market precedes the equity market. I would just like to expand that it precedes all markets including the Federal Funds Rate “market.”
The Federal Funds Rate (FFR) is what the FED uses to “fight” recessions.
The rest of the yield curve (2-year, 10-year, 30-year bonds) has many pricing mechanisms, but if the FFR is moving then they will move with it.
The smart money sees that the FED has ceased rate hikes, and that the next logical step will be rate cuts. With this in mind, they will begin to front run the FED’s move.
We do not know exactly when the FED will go to zero again with the FFR, but what we do have is a strong conviction towards that it will cut rates when bear market and recession talks heighten.
Pay attention to the beginning of the smart money forecasting the inevitability of the FED going to zero again. Once the FOMC release occurred on Wednesday at 2PM, the 10-year and 30-year tanked.
For historical reference, you will notice that the 10-year and 30-year tend to initially lower in anticipation of the cut to zero. This usually occurs during the pause phase. Then, the rest of the move occurs once the rate cut announcement is made or becomes fully baked into expectations.
You may say well why would I want to buy a 30-year for a 2.87% interest rate. The answer is not that you will hold it to maturity, but you will sell it when the market yield for 30s is 2-2.5%, thus locking in a capital gain.
Only on reparations did Germany seem able to fight back. It discovered what every large debtor at some point discovers: that when one owes a large amount of money, threatening to default can give one the upper hand.
Today, March 20, 2019, a FOMC rate hike decision was made. It is official-the FED can’t keep its spoiled child in check.
First, you will find below the FED’s dot plots from December and today. The dot plot is a tool that the FED uses to convey to the market what the Federal Funds Rate will be in the future.
Using the upper range of the current Federal Fund’s Rate of 2.5%, we can analyze the swing in the projection. On December 19, 2018, 15 of the 17 dots were above the 2.5% line for 2019 projection. Today, only 6 of the 17 dots are above the line for 2019 projection.
Below, you will find a graph of the FED Funds Futures. The first one is for what the market was predicting the FED Funds Rate would be on March 20, 2019 over time. After the December stock market meltdown, the market began projecting that the FED would be close to capitulating, employing the “Powell Put,” or saving the market…whatever you want to refer to it as.
Think of the market as a spoiled child and the FED as its parent. In December, the market sold off violently. Essentially, the market threw a tantrum and the FED came in and said it would be less hawkish going forward like a parent getting its child to shut up by buying it a present. The child liked this and as you can see by the chart below, the probability of the FED Funds Rate being 2.75% by the March meeting plunged from around 40% to 0% and the probability of it remaining at 2.5% skyrocketed from around 50% to 100%. This led to the market appreciating by roughly 20% since the December lows!
So what’s the issue? Below, you will find that the FED Funds Futures chart for January 20, 2020. The market expects the FED Funds rate to be 2.5% with a probability of over 60%. In short time, I expect this number to reach near 100%.
Each time the market throws a tantrum, the FED has less presents to give. The next present that will be given is most likely a rate cut. Once that game begins, the FED only has presents for the market from 2.5% to 0%.
However, when the Reichsbank was being formed in 1871, his [Count Otto von Bismarck] own private banker and confidant, Gershon Bleichröder, warned him that there would be occasions when political considerations would have to override purely economic judgements and at such times too independent a central bank would be a nuisance.
Determined never again to be held hostage by moneymen, Napoleon changed the Bankque’s statutes so that henceforth the governor and the two deputy governors would be appointed directly by the government, which at that time meant Napoléon himself. He declared at the time, “The Banque does not only belong to its shareholders, but also to the state…. I want the Banque to be sufficiently in government hands without being too much so.”
When a bear and a bull meet at a crossroads, a debate ensues. In the amateur world, the debate will end with the bull saying something along the lines of “the market always comes back.”
The first issue with this statement is that the time it takes for the market to come back is not specified.
Let me clarify that I am assuming that the bull would claim anytime is a good time to buy stocks, since the bull says, “The market always goes up over time.” This clarification allows me to illustrate some times the bull should have kept his or her mouth shut without the hindsight dismissal of “You cherrypicked the worst times.”
The best current example is the Nikkei 225. This is one of the headline indexes out of Japan. Immediately, those with the home bias of the US will say, “This is irrelevant. That is Japan.” Anyways, this illustrates that in the modern era a country’s major stock market index can exhibit an inability to “always come back.” If you invested in the Nikkei 225 in 1989, you are still underwater. It is now 30 years later.
Historical Nikkei 225 Historical Nikkei 225 (Log)
Below, is a historical Log scale chart of the S&P 500. If you had invested in 1929, it would have taken you 25 years to get back to even. If you had invested in 2000, and did not sell for a minuscule gain in 2007, then you would have been underwater for approximately 12.5 years. Also, I have attached the standard scale chart of the S&P 500 just to demonstrate the parabolic nature of the recent move and its similarity to Japan years ago.
Historical S&P 500 (Log)Historical S&P 500
Next, I would like to stress an important point that is misunderstood by many. This point is the proper use of opportunity costs. Those who say you cannot take your money out of “the market” due to giving up on gains are confused. Opportunity cost is not a function of…
[Returns you could have had in the market-ZERO]
This function would be correct if the money that comes out of the market does not re-allocate towards anything at all. Cash is an allocation. If cash returns 2% (1.8% in 2018), and if the S&P 500 returns 10%, your opportunity cost is not 10% for being “out of the market.” Your opportunity cost is actually 8%. Also, I will not get into it, but cash is not the only alternative when getting out of “the market” as many seem to think.
The other camp that understands the market can take very large amounts of time to come back, may say “you can’t time the market.” This statement is said with so little backing. To those who make such a statement, have you ever even calculated the amount of time you have to time the market? I am simply going to use the past 2 cycles as precedent in the US for market timing abilities. I think this is fair, since if the bulls can extrapolate into the forever future, shouldn’t a bear be able to?
If you determined that the tech bubble of 2000 was a bubble, then you had a nearly a 6 year window to time it right. For example, if you exited “the market” in May 1997, then you could have bought in at February 2003 with no opportunity loss via “market” investments. Theoretically, you could have never invested in the housing bubble cycle, since the subsequent trough in the housing bubble cycle was lower than that of the trough of the tech bubble cycle. You could have even exited “the market” in December of 1996 and entered in February 2009 with no opportunity loss via “market” investments. That is a little over 12 years. If past is prologue, and the S&P 500 falls the average of the past two bubble cycles, then the S&P 500 will fall 48.6% (44.6% in 2000 and 52.6% in 2008). If the S&P 500 fell 48.6% from an assumed peak in September 2018, then it would land at about 1506. With that in mind, you could have theoretically sold in February 2013, with no opportunity loss via “market” investments.
I would like to leave those in the camp of the market always comes back with one last thought. Have you considered the risk that nominal “market” values come back, but real “market” values do not?
