Monday, December 14, 2015

December Fed: A Study in Ornithology

That time when you can't really tell a dove from a hawk!

December Fed is mostly settled, with a good old 25bps rate hike priced in. However, the real question will be then what!

If it is just a 25bps hike, market will perhaps focus mostly on the subsequent press conference - for clues on future rate hike path. And I am certain the Fed chairman will make an extra effort to explain that bit. And if there is a hike, the press conference will be certainly dovish. I think the primary motivation for any hike at this point in time is more an effort to return to a resemblance of normality, than inflation worries. The Fed will definitely maintain that policy action works with a lag and this hike is just being on the cautious side. While that is true and the labor market is definitely showing early signs, the split in goods and services inflation across the globe makes it difficult for central banks, including Fed. And I doubt they have a very strong conviction on that.

We have no comparable history of this potential first rate hike in almost a decade. But we do have something close. The taper of QE program was announced in 2013, in a very similar manner. The market was mightily perturbed mid year, then the Fed backed off in September. Finally it went ahead with cautious taper in December and life went on (deja vu?). Below are some charts that capture how asset classes reacted during entire 2013 and especially around December 17-18 FOMC in 2013, compared to this year's move (click to enlarge).

The points to note here: the rates moved a lot more in 2013, and after taper tantrum, again sold off after the actual taper, till market realized around late January 2014 that taper is NOT tightening. Compared to that, we had quite feeble move in rates this year, despite it being possibly the actual tightening year! On equities again, the taper in December was quite a good risk-on move, but of course on P/E basis, S&P was much cheaper back then. And dollar, well, dollar sold off, mostly, in 2013 or in 2015. Note, this is Bloomberg DXY index, which given the correlations (CHF, SEK etc), is almost 65% Euro!

Now let's take a look at the same thing, in relative value terms (again, click to enlarge).

Well, now things do look a bit different. For one, in terms of excess yield (inverse of forward P/E less 5y yields), the S&P now and then are more or less in the same territory. Yes S&P was much cheaper in P/E terms then, but we also have to remember how much the rates rallied since. On the dollar chart, well it is more or less similar, except the recent sell-off looks a bit too sharp. This perhaps got little to do with dollar itself and mostly re-pricing of Euro after the Dec ECB. And finally, rates! Yes in general a start of the hiking cycle puts flattening pressure on the curve, but see the difference then and now. In fact the USD curve is so flat (despite the solid commodities thump) that some complain the risk premium (like calculated by the ACM method) is historically low compared to any other hiking cycle in history.

The key here is less about predicting what the FOMC will decide, and more about how the market will react to different outcomes.
  • A no hike will be quite surprising and will almost surely have a negative outcome ("they know something we do not") - unless it is properly explained in the subsequent press conference. Risk-off rally in rates and sell-off in equities.
  • The other outcome of 25bps hike will hardly be surprising. As mentioned earlier, then the entire focus will be on the press conference, which is most likely to be quite dovish on the future rate hike path. And overall this should mean a relief rally for equities. Mild risk-on for equities and rates will have limited response. Given the recent flattening, a very dovish press meeting will also mean some asymmetric positioning in steepener in USD rates makes sense.
  • And another outcome, something in between - say a 15 bps hike. That will be really interesting. Given the charts above, it is highly likely the market will really understand and trust the Fed's point on slow pace of rate hike much easily with this outcome. And with a proper press conference it will be nowhere near "what do they know that we do not" risk-off argument. In a word, it will accentuate the risk asset reaction from the second point above. And a possible steepening in rates as well.
Trades Here: So overall looking from above, the probability weighted tactical positioning is:
  • long equity (perhaps Dec expiry calls to leverage gamma to optimize payout ratio)
  • convex steepening in USD rates in limited size (and/ or against Euro)
  • long dollar to hedge above

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