In her testimony today, Janet Yellen stated a rate hike is “appropriate relatively soon” mentioning it could be dangerous to keep rates lower for much longer. While this language is stronger than previous statements, I have to ask when relatively soon is. If you compare relative to earlier this year, then of course a rate hike will come sooner than then. Yellen is the master of crating new phrases to change market forces without guaranteeing anything. The second question I have is how not raising rates soon could be dangerous, but keeping rates near zero for the past 8 years isn’t dangerous. As you can see from the chart below, the Fed Funds Rate has been way below the Taylor Rule since 2008. This difference in the mid-2000s was partially responsible for the housing bubble. The length of interest rates being kept too low has been longer this time.
The market forces have had an astounding response to the election. The dollar index had been range bound for a couple of years. It is now breaking out of that range to levels not seen since January 2003. This is while the Fed hasn’t even raised rates since last December. The market has already lifted rate hike expectations in 2017. The question is when some of these forces begin to collide. The dollar increasing hurts multinational corporations and exports. S&P 500 EPS is expected to increase 11% in 2017, this won’t happen if the dollar keeps rising.
Fed rate hikes cause the dollar to rally because of how dovish other global central bankers are. The best case scenario for the Trump economy would be for the U.S. growth to boost global growth, so that the Fed isn’t alone on its rate hikes. The problem is Trump’s policies are anti-immigration and ant-free trade. Protectionist trade policies could limit global growth which could cause the dollar to rally versus other currencies. The U.S. wants a stable dollar; it doesn’t want the dollar to skyrocket.
The chart I have below shows the historical trends in globalization. Trump supporters along with the President himself talk negatively towards globalism. This is a political criticism more than it is a criticism of globalization, but there is an overlap. Given Trump’s usage of the ‘fair trade’ term and the possibility of him pursuing high tariffs, a decline in globalization is likely. The chart’s future prediction is based on Elliott Wave Theory. While I’m not a big follower of this type of analysis, I did find it interesting to see graphically how globalization declined by two thirds in the early 1900s.
On the other side of the coin, we have inflation possibly increasing during the Trump administration. The Core CPI has been above 2% for 12 months. The Fed has been able to move the goal post by not raising rates even with this uptick in inflation, but an acceleration in this trend would probably necessitate a rate hike. This could prick the asset bubbles, so this is why I have said the Fed will raise rates gingerly, meaning lower than the Taylor Rule would necessitate.
I think it’s important for me to differentiate how the dollar reacts within the dollar index and how it reacts to gold. The dollar being compared to other currencies can increase while it decreases relative to gold. This can happen with slow interest rate hikes. If the Fed raises rates slowly, but faster than other central banks, the dollar index will rally. If the Fed raises rates slowly even as inflation rears its ugly head, than gold can increase. Gold rallied in the beginning of this year after the Fed rate hike because of uncertainty which caused the market to price in a pause in rate hikes. If we consistently have large pauses in between quarter point rate hikes, gold can rally. Ironically, a rising dollar causes uncertainty because it decreases corporate profits significantly. Rising equity volatility caused by this could also cause traders to bid up gold. With gold having such a rough couple weeks, it certainly makes sense to look at the potential positive catalysts.
The chart below is the 10 year bond yield. It has been rising since July. Low bond yields are the cause of TINA investing which stands for there is no alternative. The higher yields go, the more pressure stocks should face. In the past few weeks stocks have broken their correlation with bonds as both had been selling off. Now stocks are rallying as bonds sell off. This is unlikely to continue. Looking at the situation holistically, the rising dollar should hurt earnings and rising bond yields should hurt the multiple stocks get. This is a recipe for lower prices.
Conclusion
Inflation is pressuring the Fed to raise rates while the strong dollar and equity bubble are pressuring the Fed to remain steady. We will see the culmination of these forces play out in a few weeks at the next meeting. I am with the market which has a 90.6% chance of a rate hike in December. If it is a rate hike with dovish language, the stock market may handle it better than the first one because of expectations about Trump’s stimulus. The stock market is also in a tough spot because valuations will be pressured by rising yields and weak earnings which will be pressured by the rising dollar.
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