The Federal Reserve Has Created This Market Monster

Focus on Money Investing from a newspaper

September isn’t a month to disappoint, is it?

We’ve been expecting a pick-up in volatility, and it came on Friday in the US — big time. The S&P 500 volatility index, the VIX, jumped 40% on the day!

That wasn’t a bad hedge on a day when the benchmark index, the S&P 500, fell 2.45%, and US 10-year Treasuries saw yields rise, too, which means prices fell (the price moves inversely to yields in the bond market).

After opening Thursday at 1.51%, 10-year Treasuries closed Friday at a yield of 1.67%. That’s quite a move but, as you can see in the chart below, the 10-year yield is still very low. A move above resistance at 1.7% could signify that the bottom is in for bonds…at least for the short term.

Source: Optuma

[Click to enlarge]

Eight years of central bank manipulation has this market on tenterhooks. Yields will rise as long as the market thinks central bankers want to increase interest rates. And that will happen until economic data comes in that’s weak enough to reverse the groupthink…and bond yields will go back down.

Because I can almost guarantee that, if the Fed raises rates a few times without a pickup in inflation, it will lead to a recession. The business cycle is already long in the tooth…higher rates will likely push it over the edge.

But the Fed appears determined to raise rates anyway, years after they should have done so. What spooked the market especially on Friday were comments from Boston Fed chief Eric Rosengren. From Bloomberg:

Federal Reserve Bank of Boston President Eric Rosengren moved more firmly into the camp of hawkish policy makers, warning that waiting too long to raise interest rates threatened to overheat the U.S. economy and could risk financial stability.

There are two things to consider with a statement like this — neither of them good.

Firstly, the Fed is so far behind the curve it is not funny. Have a look at the chart above again. In late 2013/early 2014, the US 10-year yield hit 3%. The bond market was saying that the economy could handle higher interest rates back then.

Instead, the Fed held off and persisted with their policy of quantitative easing.

And now, with bond yields at recessionary levels, the Fed is worried about overheating and risks to financial stability? Seriously…

Secondly, you have to wonder whether the Fed is merely playing a game with the markets…a game soaked in ego. That is, the Fed is determined to show the market who is boss. That being the case, you’re seeing Fed officials line up to ‘jaw bone’ the market into submission.

This will simply add further damage the Fed’s credibility. In today’s financialised world, the market leads the economy, not the other way around. Big falls in the market will soon panic the Fed into an about-face.

Friday’s price action on Wall Street tells you investors and speculators alike are worried about the Fed’s state of mind. They’re increasingly aware that these guys really don’t know what they are doing. They are making things up as they go along.

It is quite rare to see a big selloff in both the bond AND equity markets. That’s a sign of panic. In healthy markets, rising bonds yields indicate a strengthening economy, which should be good for equities. Conversely, in weak markets, when equity prices fall (because of a weak economy), it usually indicates falling bond yields as well.

So the fact that bonds AND equities both sold off sharply on Friday tells you the market is quite worried.

Have a look at the chart of the S&P 500 below. You can see the surge to new highs that occurred in the aftermath of the Brexit vote (remember that?). Last week, I asked whether this breakout was a bull trap. By that I meant: Was it a false signal that got everyone excited about a new high, only to reverse and panic buyers out of their positions?

As you can see by Friday’s sharp down day, this looks to be the case. The selloff broke down through the old highs of May 2015. The S&P 500 now sits right on the 50-day moving average (blue line) and just above some other important market tops.

Source: Optuma

[Click to enlarge]

My guess is that the selloff will continue. This bearish phase could last a few months before the Fed cries uncle and puts off any interest rate rise — again.

I’m not expecting another credit crisis…they don’t come around all that often. But another sharp, panicky selloff would not surprise, especially given the big run up from the January lows.

On the commodities front, Brent crude fell nearly 4%, while gold held up well, falling just 0.53%. On a day when stocks and bonds sell off, you would expect gold to do well, if only in a relative sense. However, gold stocks fared poorly, with the HUI index down over 5% on Friday.

The US dollar is the main ‘safe haven’ on panic days, and the Aussie dollar sold off against the greenback. This resulted in gold (priced in Aussie dollars) rising to $1,760 an ounce, one of the few assets to finish in the black on Friday.

But I doubt this will protect Aussie gold stocks from today’s rout. With the ASX 200 futures pointing to a fall of around 80 points, I can’t see many stocks escaping the sell orders.

Short term leveraged traders will not like this latest turn of events. My guess is that this marks a bit of a turning point. I expect the bears to be in control for the next few months. Or for as long as the Fed gets spooked out of its tightening rhetoric.

If there’s one thing I know about this business (and there aren’t many), it’s this: As soon as you think you’re bigger than the market, the market will take you down. The Fed is about to learn this lesson. It’s created a monster, and the monster is about to turn on them.


Greg Canavan,
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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