Watch What the Fed Says, Not What It Does

This article was originally published on at 4:00pm EST on September 14, 2015

These are the possible Fed outcomes being considered by the investment community, as I see it:

1) Fed raises its benchmark Fed Funds rate, citing “It’s time” and/or the need to have ammunition in place (i.e. the ability to lower rates) should they need it in the near future. The latter reasoning being the equivalent of putting on a jacket when it’s hot outside so you have a layer you can take off if you get too warm.

– Half the community is expecting this already, and I don’t think the other half would really be that surprised.
– Market reaction would likely be negative, at first.

2) Fed does not raise, citing global weakness and currency concerns on international trade, but leaves a hike later this year (December) on the table should conditions permit.

– The other half of the community is expecting this….
– Market reaction would likely be positive, at first.

But it seems to me that market participants are overly focused on what the Fed does, as opposed to what the Fed says. An option that doesn’t seem to be getting much consideration is as follows:

3) The Fed hikes—or doesn’t hike—but expresses an acute awareness of exactly what has been plaguing and could continue to plague equity and fixed income markets:

– The strong US Dollar (one result of which is weak commodity prices, exacerbating the strain on Emerging Markets’ economies and currencies). Another result of a strong USD is stress on US large caps who rely on sales in foreign countries (whose currencies are weakening in relative terms). And then there is the impact on domestic employment—weaker foreign currencies in relative terms incentivize dollar-using companies to outsource as much work as possible.

– High Grade and High Yield Corporate Credit markets—as higher short term rates provide [very slightly] more incentive to reduce risk on the fixed income side of things. I’m not sure it can be quantified how much money would flow out of higher yielding (riskier) securities in order to capture the new risk free rate of 0.25-0.50%. My guess would be none. Keep in mind that a rate hike makes dollar-denominated debt even more attractive to foreign companies and governments looking for a place to park short-term cash—this would almost certainly keep a lid on how high our rates really get.

– UNCERTAINTY (the biggest of the three). And this uncertainty does not apply solely to what the Fed Funds rate is, but also what the Fed is seeing and thinking. As food for thought, what kind of market reaction do you think we would see from a Fed statement like this:

“We are aware of [all the above], and would like to assure you (i.e. The Market) that we have the ability and willingness to reverse course if need be, and/or to stimulate the economy in other ways than merely zero interest rate policy (ZIRP). In addition, despite weakness in certain segments of the economy (i.e. Energy), we believe these are transitory and unrelated to ZIRP; the underlying fundamentals in the labor market continue to improve across the board. Taking rates off zero will not be a hindrance to this pattern and our inflation goal of 2%; rather it will more likely be a contributing factor to its effective continuation.”

Is the concern really whether the Fed raises the overnight rate from a range of 0-25bps to 25-50bps? Or is the concern that the Fed is somehow unaware of the risks associated with such a move? Let’s be honest with ourselves—how likely is it that Janet Yellen and the rest of the Fed governors are just completely unaware of what could happen to the US Dollar, the High Yield market, International Markets, home affordability, and the domestic job market?

I’m not particularly concerned whether the Fed announces it is “raising rates” on Thursday—I’m going to be focused solely on the language associated with the announcement, as I think that’s where the market’s real reaction should, and will, come from.

Please don’t hesitate to reach out with questions about anything investment-related, whether you are a client or not.

Adam B. Scott
Argyle Capital Partners, LLC
10100 Santa Monica Blvd, #300
Los Angeles, CA 90067
(310) 772-2201 – Main

Adam Scott’s profile on RealMoney can be found here.

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