The Federal Reserve is meeting this week to discuss the adjustment to the Fed Funds rates that everyone expects to take place. The expectation is that the Fed is about to increase the target fed funds rate by 25 basis points.
This prognostication does not represent news. Everyone in the financial media expects it. The highly compensated member of the open market committee carefully digests the analysis provided to them by the army of Ph. D.s employed by the Fed to tell them what the economy is doing and what they should do to guide the economic ship forward. But in the end, after writing a multimillion-dollar ticket to these learned individuals, they ultimately do what the bond market tells them to do.
The chart above shows that the Fed Funds rate tracked the 2-year US Treasury bond rate. But as you can see, the 2-year TSY YTM has dipped below the Fed Funds rate. This graphic tells us that the Fed should do nothing following the Open Market meeting. But the Fed has promised the investment community that they would direct the target Fed Funds rate to combat inflation. On its face, this may not seem like such a big deal, but we think things break when the Fed conducts monetary policy contrary to institutional investors’ demand.
From our vantage point, we think the Fed is about to commit a monetary policy error. But let’s readjust our thinking for a moment. A 25 basis point increase in short-term rates means nothing to investors or the economy. They are trying to figure out how to earn 15%+ on their money. But the impact of rate increases on the banking industry is another matter.
The chart above shows the differential between the Fed Funds and bank deposit rates. The difference is so significant that we think a powerful force is pushing people to take money out of banks and put it into money market funds. This phenomenon can potentially cause additional bank runs in the short term, putting the banking industry at risk. Intermediate term, these higher rates hammer bank profitability which is likely to cause them to cut banks on lending. Not suitable for the economy or the stock market.
The chart we are kipping a close eye on is this one. It compares the level of SPY with the VIX. And you can see, the last time SPY topped what when the VIX was depressed as it is now. This exited our “Spidy” sense alerting us to the potential for a sell off. Secondly, check out the blue line. The uptrend that started back in August was broken in March and now the prices are about to kiss the underside of the trend line. We suspect the SPY will get close to this line and then fall back, taking is down 10 to 20%, perhaps more. But if it breaks to the upside all bearish beats are off.
We do not plan to offer trade ideas before the Fed does its thing. It is not the change in the target rates we are concerned with now. It is the language around how they justify their action. Further, we believe investors are telling the Fed that enough is enough. More short-term rate hikes are unproductive and dangerous for the financial services industry. The Fed statement and JPo’s presser should reveal what to expect from the Fed in the months ahead. Those statements are likely to push share prices sharply higher or lower. Our money is on lower equity prices, so we suggest traders lighten their bullish positions or add hedges. Time will tell if we are right.
