Deconstructing the Myth of the All-Powerful Fed

Can the Fed single-handedly move markets via rate hikes?

by Bernie Schaeffer

Published on Dec 28, 2015 at 9:34 AM

The following is a reprint of the market commentary from the January 2016 edition of The Option Advisor, published on December 17. For more information or to subscribe to The Option Advisor, click here.

There's no shortage of conventional wisdom surrounding the implications of a Federal Reserve interest rate hike on various asset classes. A Fed rate hike, say pundits, is good news for banks and the U.S. dollar, but bad news for gold and home prices (and, judging by the way traders tended to respond this year to even mildly hawkish comments from Fed officials, one could not be blamed for assuming a tighter monetary policy was murder on stocks, as well).

To dispel some of these myths out of the gate, here are two graphics showing how some high-profile assets performed following the Fed's June 2004 rate hike -- which was its first after a lengthy period of accommodation, and marked the start of a roughly two-year tightening phase. As you can see, gold managed to do quite well for itself, while the U.S. dollar softened and the S&P 500 Index (SPX) charted a cautious path higher.

151216fed1

151216fed2

Given that these returns represent, in essence, a sample size of one, we're not suggesting that we can draw any significant conclusions regarding how these assets will perform following Wednesday's rate hike. Rather, we're pointing out the futility of attempting to divine "how will the Fed's rate hike affect asset class XYZ" without a full consideration of the many other varied fundamental factors that come into play.

For example, say oil prices should rise over the next two years, perhaps even mimicking their near-double during the two-year period after the June 2004 rate hike. Does this mean that oil futures will necessarily head skyward after any Fed tightening move -- or would it simply represent a partial recovery of crude's 67% drubbing from its June 2014 high, now that traders have spent the past several months furiously pricing in their oversupply concerns?

Meanwhile, the U.S. Dollar Index (DXY) enjoyed a breakout year in 2014, finally cracking through resistance in the $88-$90 region -- but 2015 has been a bit of a slog, with DXY churning endlessly in a range between $93 and $100. Will the Fed's shift to a tighter policy be the catalyst to push DXY up and out of this sideways channel?

151216fed3

It would appear that many investors think the answer is "yes." As the international investing community prepared for the Fed rate hike, shorting the euro against expected dollar strength became an increasingly popular trade. Commitment of Traders (CoT) data shows net shorts on the euro near the highest level of the last five years, with total positions among large speculators at a five-year high.

And yet, while the dollar surged higher in the minutes immediately following the Fed announcement, the currency retreated almost immediately -- against not only the euro, but the yen and the Swiss franc, as well. Per Reuters, "While the implied pace of four quarter-point increases in 2016 should have led the dollar higher, the Fed's verbal cues that it would follow a gradual pace of hikes weighed on the greenback against the euro, said Jason Leinwand, managing director at derivatives advisory firm Riverside Risk Advisors in New York" [emphasis my own].

Thus, even within the context of a "supportive" Fed move, we find a mitigating factor to tip the conventional wisdom on its ear. And beyond Wednesday's policy shift, it's worth noting that the euro has charted a steep path lower against the dollar since May 2014, as expectations for an eventual rate hike were gradually priced into the currency. In fact, in a mirror image of DXY's year-long bump against the century mark, the euro has bounced along the $1.05 neighborhood throughout 2015. Those who expect a drastic move lower in the common currency only now that the Fed's plans are underway may be seriously underestimating the ruthless efficiency with which the market can price in these types of widely anticipated events.

151216fed4

And what about market volatility? Many analysts have been calling for higher volatility into 2016 as the Fed embarks on its tightening endeavor -- but again, we look to 2004 to dispel the notion that a surge in the CBOE Volatility Index (VIX) should be a foregone conclusion in the year ahead. VIX averaged 17.4 in the 12 months leading up to the June 2004 rate hike, and cooled to a mean reading of 13.8 in the following year.

151216fed5

We certainly can't rule out the possibility of a higher VIX in 2016, as the "fear index" appears to be slowly awakening from the dormancy that (aside from a few notable spikes) has more or less defined the last few years' worth of volatility. As evidence, the average VIX reading so far in 2015 has been 16.65, up from 14.18 in 2014. But with that highly anticipated first rate hike now out of the way, effectively eliminating one of the dominant "uncertainty" storylines of Wall Street's recent past, it seems unlikely that it will be the Fed in the VIX driver's seat.


A Schaeffer's exclusive!

The Expert's Guide

Access your FREE trading earning announcements before it's too late!


 
 

Partnercenter


NEW! Explore Schaeffer’s Partners' deals and get connected to top online brokerages with deals tailored exclusively for our readers.  Get answers to your questions regarding transfer fees, commission rates, programs and available discounts related to online trading services.

MORE | MARKETstories


The Nevada Discovery That Could Jeopardize Chinese Dominance
Click to continue to advertiser's site.
Puts Popular as GM Stock Rallies
GM puts are all the rage lately
JetBlue Stock Surging Despite Sector Skepticism
J.P. Morgan Securities downgraded JBLU to "neutral" from "overweight"
The Nevada Discovery That Could Jeopardize Chinese Dominance
Click to continue to advertiser's site.