foxex: Rate Hike Motivates the Bears

Focus on the Price

Wednesday, December 19, 2018

1. Fed Raises Rates - Disappoints Traders

3. Yield Curve Heads Back Down

Major Moves

The Fed completed what could be called a "dovish raise" with the rate hike today. The FOMC raised the Fed funds target rate to a range of 2.25% to 2.5% and they also increased the discount rate (the interest rate at which banks can borrow from the Federal Reserve). The dovish part of today's announcement was included in the economic statements and estimates provided by the Fed.

The Fed is now looking at two rate hikes in 2019, which is a change from their last statement, where they expected three hikes in 2019. However, the Fed did not eliminate a reference to "further gradual increases" in the announcement which is probably why some investors were disappointed and selling ensued.

S&P 500

From a technical perspective, the S&P 500 inched below the lower boundary of the support range it had been defending over the last few days. If there is some good news in the next few days, the index could jump back up into its support range, but the Fed's announcement didn't do much to increase the odds of that in the short-term.

What I thought would be interesting for today's issue would be to discuss an intraday pattern that appears very reliably on Fed days. The FOMC releases their interest-rate announcements at 2 PM EST and there is usually an immediate reaction over the next 5 to 10 minutes in both stocks and bonds.

Where this gets interesting is what happens after the first 5 to 10 minutes following an FOMC announcement. Over the last 10 years, the initial move in the stock market (or bond market) is subsequently erased nine out of ten times. In seven out of ten times, the market closes in the opposite direction of that initial reaction. For example, if the market dropped right after the FOMC report for the first five minutes, the odds are very high that the first move will be erased within an hour of the announcement and the market will close higher for the day.

In the studies that I've done, the behavior on "Fed minutes days" is very similar. Fed minutes days are when the minutes of the FOMC meeting are released to the public: three weeks after the FOMC announcement.

As you can see in the following chart, the initial reaction to the news was negative. Most analysts are assuming this means that the dovish comments in the statement weren't dovish enough. However, the market rallied after the first five minutes, which is what we would expect based on history. What was different than the norm today was that the initial move was not completely erased nor did the market close positively. This break with historical patterns could indicate that investors are more bearish than we realized.

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Risk Indicators

Even if the market had closed positively today, I would remain concerned. As I've discussed before, high-yield bonds are an important leading indicator of risk appetite. As you can see in the following chart of the iShares high-yield corporate bond ETF (HYG), bond investors are becoming increasingly concerned about risk.

What has a lot of investors flummoxed was the reaction of other risk indicators. Although I usually defer to what we see in the bond market, the VIX actually declined today, which is an unusual divergence even on a Fed day.

There are versions of the VIX for other indexes, like the Russell 2000, that did not exhibit the same behavior. However, the NASDAQ version of the VIX was also slightly lower today. So how should investors interpret this data? If volatility indexes had been uniformly lower today, I think that would've been a good sign. However, in my view, this behavior merely illustrates the high level of uncertainty in the market and a rising probability for additional downside in the major indexes.

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Forex Trading for Beginners

What is the Federal Open Market Committee Meeting (FOMC)?
What is the VIX?

Yield Curve Heads Lower

One of the easiest ways to think about the Treasury yield curve is to just subtract a short-term yield (like the interest rate on 2-year Treasury bonds) from a long-term yield (such as the interest rate on 10-year Treasury bonds) and look at the difference. If long term yields are higher, the curve is more or less normal, and if the result is flat or negative, then the yield curve is inverted.

As you can see in the next chart, today's announcement from the Fed was negative for stocks and long-term interest rates. However, the Fed raised the shortest term interest rate, which keeps pushing up the short end of the yield curve while the longer end is getting lower. Traders don't like to see an inversion like this because it typically precedes recessions. Even if the average lead time is a year or more (from inversion to recession) negative news like this can keep a lid on prices and increase volatility.

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Predictive Power of the Yield Curve

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Bottom line: Is the Fed a Leading Indicator?

The only way we know that the Fed announcement was "more hawkish" than expected is by looking at the market's reaction. While this seems logical, making estimates about the FOMC's impact longer than a day or two is probably not going to be very useful. Historically, the market's movement over the 30-days following a Fed announcement has a very low correlation with what the market did on the day of the announcement. With that said, investors still probably should remain very cautious about the short-term now that the S&P 500 is clearly below support.

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