DailyFX

Picking Up Pennies in Front of the Steamroller

Paul RobinsonJames Stanley

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The Federal Reserve wants to raise interest rates. At this point, that much should be clear. But this doesn’t come without costs, or risks, and the premise of removing years’ worth of accommodation and easing has produced a real quagmire of a situation at the world’s largest national Central Bank.

As the Fed has talked up rate hikes over the past year, or perhaps more accurately, the prospect of ‘normalization,’ risk assets have sold off aggressively. This is precisely what we saw at the beginning of the year after the Fed laid out their expectation for a full four rate hikes in the calendar year of 2016. After spending much of 2015 bantering about a single 25 basis point move, the Fed set expectations exuberantly high for rate hikes in the New Year, and this is what led to our bearish call on equities ahead of Q1. But as global risk markets collapsed on the first trading day of 2016, that expectation for higher rates began to moderate as the sell-off deepened until, eventually; the bank did a backwards-shuffle on rate hike plans throughout the first half of the year in the effort of assuaging risk markets.

And it’s worked! At least so far, as the S&P 500 has rallied-up to another fresh all-time high in the most recently completed quarter. Likely, few would’ve expected this from the driver that got us there, as the response to the Brexit referendum seemed to elicit panicked buying from investors afraid of missing out on the next big Central Bank salvo in response to the referendum.

To be sure, the global stock buying bonanza hasn’t been driven solely by the Federal Reserve. In the recent quarter we’ve also seen a ‘bazooka’ of stimulus launched by the Bank of England in response to the Brexit referendum. In the quarter previous to that (Q1, in March), we saw the same from the European Central Bank; and in Japan it may just be a matter of time before we see even more stimulus launched from the BoJ as they try to head-off decades’ worth of deflationary pressure. And all of this is happening as Chinese regulators carefully attempt to manage the capital flows within their own economy.

So the biggest players in the world (global Central Banks) all seem to be vested in the same interest of keeping stock prices higher despite the fears of the unknown around what might happen when seven-plus years of liquidity and accommodation are removed by the inevitable prospect of policy normalization. This will likely keep stock prices supported, to some degree, as bearish moves in stocks can be offset by more dovish language from one of the ‘big’ Central Banks. This can also produce an asymmetric risk-reward ratio as price action may not have much room to run to the upside before resistance sets in; while also carrying the risk of a dramatic downside move should we see a flare of macro risk factors.

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