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Yesterday the Fed began its long-awaited monetary policy “normalization” at last.
The Federal Reserve began its first interest-rate tightening cycle since 2004 with a 0.25% hike in the Fed funds rate. It’s a small first step, and almost certainly won’t be the last move.Â
In fact, before yesterday’s FOMC decision, the Fed’s now-famous “dot plot” projected four interest-rate hikes in 2016. Meanwhile, financial markets are forecasting a more dovish path, expecting just two increases in Fed funds next year. That’s what makes it a market, after all.
And you can bet expectations will keep shifting considerably in the months ahead based on every twist and turn in the economic data and financial markets.
What do we have to fear from this rate-tightening cycle?
The conventional wisdom suggests that commodities and emerging markets will get hammered by a stronger dollar. And clearly Treasury bonds are doomed in a rising interest-rate environment, as everyone knows.
But history suggests otherwise
Granted, the stakes are higher in this rate-hike cycle than ever before, so the history of Fed tightening cycles in the past may not apply as well this time around.
Never before has the Fed hiked rates with such a huge balance sheet, bloated with $3 trillion worth of securities purchased through multiple rounds of QE.
And never before has the Fed raised rates with so much liquidity sloshing around in the financial system. Banks currently hold $2.5 trillion in excess reserves at the Federal Reserve.
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These are just two of the complicating factors that could spoil the Fed’s best-laid plans. That said, there are still some flaws in the conventional wisdom as this tightening cycle gets underway.
Let’s take a closer look at fears about a stronger dollar that are perhaps unfounded. Here’s the conventional logic: The U.S. is the only major economy with rising interest rates while nearly every other central bank around the world is easing monetary policy.
As a result, the interest-rate differential between the U.S. and the rest of world will trigger huge capital inflows into U.S. dollar assets in search of higher yields, or so the argument goes.
But in reality, the dollar has declined during the last three rate-tightening cycles in 1994, 1999 and the last time around in 2004.
The culprit: Markets had already priced in the likelihood of rising interest rates. So when the Fed actually got around to making its first rate hike, the move was already baked in the cake.
Buy the rumor; sell the (dollar) news!
Look, the Fed has spent more than a year preparing investors for this move. It’s been the worst kept secret on Wall Street and came as a surprise to no one.
And when you look back at previous rate-tightening cycles, the same pattern repeats again and again.
When the Fed first hiked rates in 1994, markets were expecting it. Rather than sending the dollar soaring, the buck slumped for 11 of the next 14 months into 1995.
In June 1999, the Fed started hiking rates again as the dot.com bubble began overheating. The U.S. dollar index fell 3% the very next month.
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And when the Fed embarked on its last tightening cycle in 2004, the dollar dropped 9.3% over the next six months.
In fact, the conventional wisdom about dollar strength as
interest rates rise appears dead-wrong.
Each time, the dollar rose in advance, by an average of about 9% during the six to nine months BEFORE the past three rate-hike cycles, according to Bloomberg.
But the buck dropped by an average of 6% in the six months AFTER the first Fed rate hike. And sure enough the Dollar Index is already up 7% year to date, as markets have once again priced in the Fed’s move well in advance.
And if the conventional wisdom about dollar strength is all wrong, then the conventional fear of an emerging market and commodity sell might be dead-wrong too.
After the Fed began tightening in 2004, emerging-market stocks were one of the best performing asset classes, soaring 135% over the next two years.
And making this trade even more unconventionally appealing today is the fact that emerging market stocks are one of the world’s most-hated asset classes right now.
According to a recent survey by Merrill Lynch, fund managers are 27% underweight emerging markets, leaning way too bearish at just the wrong time.
Buying commodities could very well be another
unconventionally profitable trade right now.
Gold for example soared 56.7% in the two years after the Fed’s last tightening cycle began in 2004. And sure enough, investors are also extremely bearish on gold at the moment.
Gold net shorts are at an extreme right now because the conventional wisdom says gold will keep falling as interest rates rise. In fact, the positioning by gold futures traders is the most bearish it’s been in thirteen years (see chart below)!
You have to go all the back to the start of the gold bull market in 2002 to find a more bearish sentiment reading than today. The conventional wisdom was dead wrong back then, when they were net-short gold at $300 an ounce … and they’re just as likely to be proven wrong again this time!
Bottom line: Don’t buy the conventional wisdom that dollar strength is automatic in a rising U.S. interest-rate environment, or that emerging markets and commodities are doomed.
The Fed’s first rate hike in almost a decade this week could be the mother-of-all “sell the news” infection points for these markets. And being unconventionally long gold and emerging market stocks could pay off in a very big way next year and beyond.
Good investing,
Mike Burnick
P.S. Weiss Research Senior Analyst Larry Edelson wants to make sure you own the supercycle investments you need to protect yourself and profit in 2016 … And he’s set to release the most critical investment recommendations of his entire 38-year career.
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Mike Burnick, with 30 years of professional investment experience, is the Executive Director for The Edelson Institute, where he is the editor of Real Wealth Report, Gold Mining Millionaire, and E-Wave Trader. Mike has been a Registered Investment Adviser and portfolio manager responsible for the day-to-day operations of a mutual fund. He also served as Director of Research for Weiss Capital Management, where he assisted with trading and asset-allocation responsibilities for a $5 million ETF portfolio.
{ 12 comments }
this is a great article. as good as anything edelson or larson writes.
gold likes easing by the fed. the fed just tightened. i see no change in gold. same slippery slope until the fed eases again.
commodities follow a simple supply & demand model. the supply/demand curve is coming in balance as we speak, so a bottoming process will take place next year.
we’re entering a long-term rising rate environment that will last for decades. that means the dollar will strengthen over time.
we’ve reached full employment. this means demand for goods and services will gradually increase over the next few years. we’ve finally turned the corner.
is it possible that the reason for raising rates is they have to ………… to create the illusion that they have ammo in case of a recession believe me this economy isn’t going anywhere all this economy has been is promises of growth with lackluster results.
if we have reached full employment ………. WHY IS IT …………. THAT THE UNITED STATES HAS THE LOWEST PARTICIPATION RATE ITS EVER HAS you know Obama likes to brag about the 13 million jobs he has created first of all 8 million jobs were lost due to his time being in office he never mentions that nor does he mention that over 25 million baby boomers retired in the same time frame, manufacturing is in a verified recession 55% of all companies are guiding lower and another 25 % are flat for 2016
Edelson has become like Trump.Say anything to get customers.
So what you are saying is the dollar will likely become weaker against other currencies? That should mean an increase in US exports and a decline in imports as US made becomes cheaper and imports more expensive compared to each other. Okay so what if the countries like China that are very dependant on exports revalue their currency again?
I see huge differences between between now and the past, making comparisons to the past like trying to compare apples to oranges. Everything is relative, and today’s excessive dollar denominated debts in foreign countries need to be serviced in dollars bought by weak currencies in the country of the debt. Over recent years extensive dollar loans were made in many countries because of lower interest on the USD. These must now be repaid in US dollars, which now must be bought at ever greater cost in the currency of the country where these USD loans were made.
Buying dollars using foreign currencies is what drives the dollar up, and the increased demand to repay dollar loans in foreign countries will exasperate the exchange rate. Of course there are other considerations, but the excessive foreign dollar denominated loans exist today like never before. BUT having said this, I think this situation is for the short term and eventually I expect the dollar to go down because a stronger dollar will cheapen imports and exasperate exports which will weaken US industries like autos, airplanes, tourism etc. If this whiplash that I expect comes about too soon, then the Fed will be forced to again tighten; and that will lead to party over very quickly. Why: Because the Fed will not get the inflation they need to ease repayment of excess debts in the US that came about from low interest loans within the US.
Although I read a lot for insight, my opinions are also influenced from living overseas, where I can see the other side of the coin while still trying to keep an eye on my American side of the coin. Everyone needs to think in their own way; and this is my way right or wrong, and for what it is worth to someone else.
Great chart but poor analysis. Take another look at it and note that it’s the points where the Fed began taking interest rates LOWER that correspond closely to the turning points in the Dollar Index.
Also a good note about the Gold sentiment. However, few people mention the fact that the Gold/Silver ratio helps with pinpointing their turning points. Look at a long term chart of it and you’ll note when it gets really high (around 80) that generally corresponds with a low point in the prices. And such high ratio readings were hit twice in the last 12 months and it currently hovering near that level.
Mike, as much as history can tell us what to expect to happen next, I think we’re in a period of economic change that has never been seen before. So history cannot be our guide if the current global economic state is drastically different than it was in previous Fed tightening cycles. Larry Edelson has dedicated an entire section of his Real Wealth Report in opposition of Dollar inflationism. I personally am not too worried about the dollar falling. It’s important to recognize how small the Fed’s influence actually is since all Yellen and co. do is respond to the market in anticipation of flight capital and the demand for hard assets in the immediate short-term.