The Markets Can’t Handle a Rate Hike

The Fed has been “talking its book” for nearly three years now.

It began in May 2013, when then-Chairman Ben Bernanke announced the Fed would begin tapering its bond-buying program.

Global markets reacted swiftly in what has since been called the “Taper Tantrum.” Ten-year Treasury rates jumped 80% higher between May and September that year.

Now, more than 30 months later, two important questions are consuming the minds of investors around the world.

First, “Will the Fed actually raise rates in December?”

Second, “What will be the impact, if rates are hiked?”

I’ll tell you straight away that I don’t have the answers to these questions. The Fed, despite its vow of transparency, always keeps the market (and analysts) guessing.

But there’s a lot to learn from how global markets typically anticipate rate hikes… and how they’re anticipating this one.

By some measures, there’s a strong argument that the stock market can’t handle a rate hike right now.

According to Guggenheim Partners’ Chief Investment Officer, Scott Minerd, the S&P 500 has typically traded higher in anticipation of a rate hike, returning an average of 23.5% during the nine months leading up to the first increase. This comes from data collected since 1980, covering six tightening periods.

Problem is… the S&P 500 is down 2% over the past nine months – a far cry from the double-digit gains it has historically mustered heading into a rate hike.

What’s more, Minerd explains that junk bonds have outperformed investment-grade bonds by an average of 4% in this nine month period.

But the credit landscape looks starkly different this go-around, as junk bonds (JNK) have underperformed investment-grade bonds by nearly 8%!

This gap – between historical pre-hike performance and current pre-hike performance – drives at the competing narratives surrounding the Fed’s mid-December decision.

On one hand, a rate hike theoretically suggests the U.S. economy is strong and getting stronger.

That’s an optimistic conclusion, which should prompt investors to have higher hopes for the future.

Thus, they should be willing to pay higher prices for stocks today… with expectations of increasingly positive trends tomorrow.

And those positive expectations indeed drove stock prices higher during the “anticipation” period of the last six tightening cycles. But not this time around.

This time, severe underperformance from global equity markets and junk bonds suggests investors are not optimistic about a post-hike world.

Instead, investors are downright scared of it.

This points to a conclusion that falls in the “this time is different” category. And Rodney recently put his finger on why – even though markets have pleasantly absorbed rate hikes in the past.

He wrote…

“We don’t have precedence for the Fed raising rates at this point in the business cycle (low rate of growth) at odds with other central banks, and certainly not when the world of capital is so interconnected.”

That’s a poignant statement, with three main points to break down.

For one, the Fed typically raises rates only after the U.S. economy appears to be on the verge of overheating. Today though, economic growth is nowhere close to overheating.

Secondly, most central banks around the world tend to move in the same direction – either lowering or raising rates together. Today though, U.S. monetary policy is set to go headlong against the grain of all other central banks, which are still lowering rates (many of them into negative territory).

Lastly, and now more than ever, global markets are eternally intertwined. That’s why even though there are valid arguments that the U.S. economy could handle higher rates… everyone is concerned about emerging markets imploding as soon as the Fed makes its move.

So while it’s typically a no-no to say “this time it’s different,” I believe we truly are in uncharted territory this time around.

And judging from the market’s performance over the last nine months, investors have very little confidence in the Fed’s ability to smoothly transition out of one of the most accommodative periods in financial history.

This paints a pretty bleak picture of what’s ahead. But even if the Fed has been backed into a corner, with no good solutions to the problem it created, I’m still optimistic about our ability to find opportunity in today’s wacky markets.

That’s because volatility and divergences create opportunities for active trading strategies, like ours. And the Fed’s decision next week will no doubt put many markets on the move… in different directions.