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How to Play the Fed

Written By Briton Ryle

Posted January 29, 2015

America’s central bank socked and rocked the markets yesterday, which will likely continue reeling from the blow today. As soon as the Federal Reserve’s Federal Open Market Committee’s press release was issued at 2 pm yesterday at the end of its two-day meeting, all the major indices fell like a boxer knocked over with a blow he never saw coming.

During those last two hours of trading, the broader market S&P 500 index fell 33 points, or 1.62%, to close the day down 27.39 points, down 1.35% on the day. For their parts, the Dow and Nasdaq indices fell 1.54% and 1.53% respectively on the news, ending their day down 1.13% and 0.93%. All three indices closed within about a point of their session lows, indicating continued fall-back is likely today.

While investors were pulling out of equities, they were pouring into bonds, sending the U.S. 10-Year Treasury yield falling 7 basis points from 1.78% to 1.71% within 30 minutes of the FOMC’s press release, before closing at 1.72% near its lowest level since April of 2013.

What did the Fed say that triggered this rush toward the safety of bonds? The markets are worried that the Federal Reserve does not have its finger on the true pulse of the economy, as investors and traders have recently grown much more wary.

“Bond yields dropped dramatically, signalling that the economy is not doing as well as the Fed is suggesting,” Joseph Saluzzi, co-founder and co-head of equity trading at Themis Trading, informed Market Watch.

Is the Fed out of touch with the real state of the economy as investors seem to believe? Will the FOMC raise interest rates too soon for the economy to handle? Does this spell disaster for the economy and the markets ahead?

What the Markets See

For the past few days U.S. markets had already been under pressure, with the S&P falling 1.6% from Thursday’s close to Tuesday’s close, and the 10-Year’s yield falling 12 basis points from Thursday’s high of 1.95% to Tuesday’s close of 1.83%. Yesterday’s plunges doubled the S&P’s loss over the past week, and extended the 10-Year yield’s loss by more than 50%.

Why have the markets been under pressure? Primarily due to atrocious earnings reports during the still ongoing Q4 2014 earnings season:

“As we continue along through fourth quarter earnings season, the results thus far have not been as positive as previously hoped,” Value Walk informed its clients two days ago. “Overall earnings per share [have] fallen from around $31 to its current level of $28.33. After 25% of companies in the S&P 500 have reported, we have seen earnings per share come in 3% less than what was expected… and Goldman Sachs Group Inc (NYSE:GS) sees this trend to continue throughout the rest of the fourth quarter earnings season. Additionally, companies are increasingly becoming wary of 2015 earnings results, which have seen some negative revisions, putting pressure on shares.”

In particular, Caterpillar (NYSE: CAT), the world’s largest construction and mining equipment maker, gave the market a real scare late after hours on Monday which started the dominos falling all throughout Tuesday, as it missed its Q4-14 earnings estimate by 12.9%, causing its stock to plunge 7.56% by Tuesday’s close.

Why is this significant? Because CAT has a powerful overseas presence, and is a well looked-to gauge of industrial activity globally. It’s poor Q4 results and downward revisions to future projections indicate the global economy is not very healthy to say the least.

“Caterpillar said it expects only a modest improvement in the global economy in 2015,” Reuters reported. “The nearly 60 percent drop in oil prices since June will not only affect Caterpillar’s energy business, but will also hurt construction projects in oil-producing regions, the company said.”

Of the companies that have reported so far, 29% have reported lower than expected revenues, and 19% have posted negative earnings (shrinkage).

Other indicators have also been showing a U.S. economy is trouble. The Philadelphia Fed Manufacturing Index (compiled by one of the Federal Reserve’s own branches) fell from a recent multi-year high of 40.2 in November to 24.3 in December, and further down to 6.3 in January – its lowest level in 12 months.

New orders for America’s manufacturers have shown their fourth consecutive monthly decline since July. The Chicago PMI put-in its second consecutive monthly decline and third-lowest level in 12 months. The Manufacturing PMI for January posted its fifth consecutive monthly decline since August to its lowest level in 12 months. And the strong U.S. dollar has been slowing America’s manufacturing machine.

What is more, while falling energy prices have helped consumers, they have hurt countless companies in the energy space – with the energy sector being the worst performer of all nine sectors tracked by the SPDR group of sector ETFs in the last six months, and with all sectors except one showing negative returns over the past one month, as graphed below.

best etfs fed overreaction


fed overreaction chart 2


What the Fed Sees

Yet the FOMC’s press release seems to paint a more optimistic picture of the nation’s economy:

“Information received since the Federal Open Market Committee met in December suggests that economic activity has been expanding at a solid pace,” reads the press release’s opening line. Just on that one sentence I could see thousands of economists slapping their cheeks in disbelief. But there’s more:

Regarding the Fed’s first of two primary objectives – fostering maximum employment – the Committee declared:

“Labor market conditions have improved further, with strong job gains and a lower unemployment rate. On balance, a range of labor market indicators suggests that underutilization of labor resources continues to diminish.” – That assessment is questionable, since the labor participation rate is continuing to decline, meanings there are still plenty of “labor resources” (workers) who are still “underutilized” (out of work).

Regarding the Fed’s second primary objective – coaxing inflation to maintain price stability on an upward slope of 2% growth annually – the Fed’s does acknowledge some headwinds:

“Inflation has declined further below the Committee’s longer-run objective, largely reflecting declines in energy prices.” – The Fed acknowledges that its second primary objective of coaxing inflation is not being met at the present time. But it goes ahead and gives itself two check marks anyway:

“The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.” – The FOMC is thus putting a check mark next to its labor objective.

“Inflation is anticipated to decline further in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate.” – The Committee hereby also puts a check mark next to its inflation objective, as it expects the deflationary pressure caused by falling energy prices to lose their effect soon, allowing inflation to resume its upward trajectory at 2% per year before long.

Market’s Misinterpretation Presents Buying Opportunity

At first read, then, investors and analysts walked away believing that the Federal Reserve is sticking to its plan of raising rates later this year – minimizing the recent downturn in not just the U.S. economy but the global one as well, minimizing the impact of falling energy prices on the energy sector’s health, and even ignoring the impact of the strong dollar on the entire U.S. economy as a whole.

Quincy Krosby, market strategist at Prudential Financial, revealed to Market Watch the general impression the press release gave: “The Fed is very careful with their language in the statement, and they are signalling to the markets that they want to start raising rates sometime this year.”

“Stock markets would like to see zero [interest] rates forever,” added Saluzzi, “but the Fed statement did not give them any hopes of that.”

The reaction was, “Are these guys out of their minds? How can they say things are going well and expected to continue improving over the medium term?” Hence, the exit from stocks and the rush into bonds, as many believe the Fed is not seeing the real danger to the economy, and has not altered its interest rate timetable.

However… and this is a big however… the markets are reading more into the FOMC’s statement than is actually there. And this provides investors with an excellent buying opportunity.

In no place does the FOMC state it is in a hurry to raise interest rates this year or at any other fixed time. In fact, it said the opposite:

“The Committee judges that it can be patient in beginning to normalize the stance of monetary policy,” it reassures. “In determining how long to maintain this target range, the Committee will assess progress… toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.”

As it has stated all along, the Fed has no timetable for raising rates, and is playing-it-by-ear, so to speak, as it monitors incoming data and remains flexible:

“If incoming information indicates faster progress toward the Committee’s employment and inflation objectives… then increases in the target range for the federal funds rate are likely to occur sooner… Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later.”

The end of the matter is this: the Fed sees the economy improving overall, employment improving, housing improving though slowly, with only inflation moving in the wrong direction. Yet the inflation picture will be fixed soon as the effects of lower energy “dissipate”.

So, yes, the Fed is still on track to raising interest rates at some point. But it has not indicated when, and it is still insisting on consulting incoming data before making that decision. Investors can rest assured that as incoming data continue to be as bad as they have been for a few months already as noted above, the Fed will take that poor data into account at future meetings, with an indication that it is still going to be “patient” regarding the first rate hike.

This means the markets’ panicked reaction was uncalled for. Indeed, the recent sour earnings misses are upsetting, and a slight adjustment of stock prices to lower levels is in order. But we must not factor in the expectation of rising interest rates any time soon, because that is NOT what the Fed revealed yesterday.

There is no need to panic sell. In fact, the markets’ overreaction is a great opportunity to pick-up some beaten down names. The Fed is keeping rates near zero for the foreseeable future. That is a major gust of wind in the economy’s sails.

Joseph Cafariello