May The Force Be With Janet Yellen!

PaulNolte-2Good morning, Ms. Yellen. Your mission, should you choose to accept it, involves raising interest rates in the face of global easy monetary policy from other central banks. It is essential that you communicate clearly to the markets the Fed’s intentions without creating confusion. If you choose to leave rates alone, you risk the entire purpose of the Fed. Should anything go wrong, Congress will be at the ready to pull your authority. The markets could self destruct five seconds after the meeting. Ok, a little poetic license, but the Fed has a very narrow needle to thread, as global markets once again melt down (as they did in August), China devalues their currency (as they did in August) and commodity prices fall (as they have all year). The Fed opened the door at their August meeting to consider their decision in light of financial markets.

Could this be a repeat of the August “crash”? Wil the Fed swoop in and save the day? There are plenty of back seat drivers giving all kinds of advice ahead of Wednesday’s decision The stock market has been keying off of energy prices, which continue to make multi-year lows. The decision by China to devalue their currency Friday, piled onto an already weak market that ultimately pushed stocks down 2% that day alone. If there is a bright spot, the last two weeks of the year tend to be positive, but with the Fed standing between today and year end, that “positive” may not matter much. The market internals remain relatively weak and volume has been increasing on the days when stocks decline. The “safe” haven has been the largest US stocks that have weathered the past few months very well. Surprisingly too has been some of the interest rate sensitive sectors that should do poorly as interest rates rise. The only certainty in this market of late is the uncertainty, leading to increasing volatility of the markets. The Fed have painted themselves into a corner, which makes the Wednesday announcement and subsequent press conference much bigger than it otherwise would be. As a result, the markets will continue to be volatile throughout the coming week.

For all the talk about higher interest rates, the bond model has flipped to positive, pointing to lower interest rates in the future. After three weeks in negative territory, the rally in longer term bonds and decline in commodity prices have been enough to push the model back into positive territory. Of course, the final say about interest rates lies with the Fed meeting this week. Wednesday should produce the first hike in rates in nearly a decade. Of course, the meeting, announcement will be merely a prelude to the hyper analysis that will follow. How fast will rates rise, will the hike lead to a recession or will the Fed hike again at their next meeting? Similar to how many angels can dance on the head of a pin, the debating exercise is not likely to result in any answers. The lower and falling commodity complex is likely to allow longer term rates to fall further, while short-term rates are beholden to the Fed.

The temptation is to sell everything and sit on the sidelines while the chaos reigns all about. The current market decline may actually be working off the “fear” and whatever decision is made. Stocks may rise, if only due to a decision being made. In the short-term, the market decline has created a short-term “over-sold” condition, meaning the conditions are ripe for a rally. Further, expectations are for the dollar to strengthen due to the rate hike. That may also be turned on its head, as money flows away from the dollar to much cheaper international markets. Similar to the markets coming into 2015, the dollar and energy were big winners while the SP500 sputtered. While not a popular scenario, the very one-sided nature of the markets actually makes this plausible. In what has become a market dominated by central bank decisions, press conferences and stump speeches, it is unlikely the current spate of volatility will be ending soon.

Major investors are lining up on one side of the markets that could see huge swings in stocks this week. We have been positioned a bit more defensively and expect to hold onto positions through this week. Some tax gain/loss selling may be done the following week to square up taxable accounts before year end. This year is ending in a similar fashion to last year, when energy and international stocks were sold hard, only to rebound early in the following year. Could this be another “redo” of early 2015?

The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.