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Confusion About Fed Policy Causes Erratic Market Behavior

Bob Lang
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As investors and traders try to game the Fed and their next move, we find that a lack of clarity and vision about policy once again have players on edge. It’s playing out like a game of ‘chicken’ and ‘musical chairs’ all at once, who wants to be left holding the bag when the exit doors are used, but who wants to be left out if the rallies continue? Further, it seems everyone wants to be first and fast, but rarely does the early bird get the worm. Trying to game the Fed’s next move is fraught with pain and regret, but it really doesn’t have to be like that.

March was an amazing month of volatility, 16 of the 22 trading days had the Dow Industrials moving triple digits. Yet, the VIX never exceeded 17 on a close! Why is that significant? A majority of those days were down, and that usually means players are buying protection for their portfolios. Why not this time around?

In fact, if you just followed the committee’s words then we can see plenty. They have been fully transparent about policy and their intentions, and we have talked about the perils of trying to get in front of their moves. The turn in rates is going to happen sooner rather than later, and while some will interpret that move as hawkish, I would say it is just being ‘less dovish’. There is a difference. Even if the Fed raises rates 1% they still remain very accommodative to markets. It’s only if/when inflation expectations rise that we could see hikes to higher levels. So far, the bond market is not giving us those signs.

As we know, a very aggressive Fed policy has helped to drive markets higher, boosting investor confidence with soothing words and liquidity that ultimately winds up as investment capital. Yet, how they proceed with policy going forward with respect to rate hikes is still a mystery. Do they go gently or bold? How will the market react? After all, these gains since 2009 all belong to the Fed. They will not do anything to jeopardize those gains, and will not force a recession – the economy is not that strong and inflation is at such a low level.

So, how should one position and get set for a reaction to ‘new’ Fed policy? I would keep an open mind over what may be coming with the notion they will not likely do harm. We saw how they wound down the QE program in a way that did not jolt the markets (remember the taper?). I suspect the discussion is over how they can remove some of the extreme accommodation without a major disruption.

Currently, the markets are showing some concern and even some confusion. The VIX term structure has a rather steep slope but with elevated levels in the back months. This tells us market players are betting on higher volatility down the road. As information, those future bets have mostly been sold and been losing bets over the past couple of years. Looking at market expectations for Fed Funds Futures, the earliest we see a fully-priced in rate hike is November 2015. The market is not believing the words of the Fed, yet they have not really come forth with a determined date, either.

The VIX also is in a quandary. If there is some fear over a rate hike the VIX is not telling us there is any fear whatsoever. With a current spot VIX at 15% the market is telling the Fed to ‘bring it, we don’t care’. Is that sentiment correct? We’ll find out eventually!

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