Now that the Fed's rate hike is in the history books and Yellen is eager to demonstrate that the Fed is confident enough in the US economy by unleashing the first tightening cycle in nearly a decade, market participants are dramatically shifting their attention, from the rate hike as a bullish key catalyst in the "renormalization" timeline ("buy stocks" because the Fed wouldn't risk recession if it wasn't confident in the economy), to the actual consequences of the Fed's dramatically changed reaction function, which as we explained previously [11], was far more hawkish than the market initially expected.
Most important however, as we have repeatedly discussed ever since August, is the market's obsession with whether the Fed just made a critical "policy mistake." As Bank of America's Michael Hartnett, one of the foremost skeptics that the Fed is doing the right thing, explained previosly, "the “tail risks” to “deflationary expansion” are high. Like a game of Jenga, a bull market built by central banks can collapse if further BoJ/ECB QE and Fed hikes engender US dollar spikes & US EPS & EM/commodity swoons, FX-wars & volatility rather than a fullblown recovery."
The threat, therefore, is that after "Quantitative Success" pushed up stocks from 666 to over 2,100 in 6 years, the opposite may be on deck now, hence the neo-narrative of Quantitative Failure and the dual risk that:
- Fresh attempts at QE in Japan & Europe are met with investor rebellion in the absence of clear signs of economic improvement.
- Fed tightening into a “deflationary expansion” proves a “policy mistake” by causing harmful US dollar appreciation.
For signs of the first look no further than the market's profound disappointment with the BOJ announcement on Friday morning, which sent the Japanese Yen plunging at first, only for the carry currency to soar once the market realized that the BOJ's ability to intervene in markets may be far more constrained than had been anticipated, as we showed yesterday [12]...
[13]
... and of course, the ECB's historic disappointment on December 3 when Mario Draghi promised the sun, moon and stars and delivered... almost nothing, likewise sending the EUR soaring and crushing countless macro hedge funds.
But how to determine if the Fed made a mistake, and more importantly if the market thinks the Fed made a mistake? We presented Hartnett's answer to that key question as well [14], saying that upon a rate hike:
- Watch the long-end
- If the long-end concurs with the Fed’s view of economic recovery, then banks, cyclicals and value stocks will receive a bid. Asset allocation toward “strong
dollar” & “Fed tightening plays” will harden, with the exception that value will likely outperform growth - If the long-end rallies, signaling a policy mistake, then cash, volatility, gold & defensive growth will be the way to go.
So what happened since the Fed hike? Well, after a one-day kneejerk rebound in risk, coupled with a drop in vol, gold and virtually no reaction in the long-end, the result, as shown below, has been a very disturbing one for the Fed.
As can be clearly seen, the market has responded not only by endorsing a deflationary outcome with the 30Y jumping, WTI sliding, but also stocks tumbling, with the Thursday and Friday drop in the S&P matching the worst plunge in the market since the ETFlash crash of August 24.
In short, the market has spoken: this is a "policy mistake", or as Bank of America - which also explained recently in 8 very charts [15]why the Fed just launched the next Bear Market - called it "Quantitative Failure."
The question then becomes: what happens next when the "boxed in" Fed realizes it has erred, and scrambles to undo the damage, any last trace credibility be damned? Here is Hartnett's answer to that as well:
Since the risk of Quantitative Failure brings with it the risk of more extreme policies/politics in 2016, the natural hedges are gold & volatility. Gold in particular will be interesting to watch in coming months. The Fed’s determination to raise rates means gold prices should fall. If in contrast gold rises with Fed hikes that’s a clear sign of a “policy mistake” and investors anticipating the need for more inflationary policies next year.
In other words, as we have said for the past 2 years, since the Fed does not ever have the option of waving the white flag of surrender and admitting defeat (at least as long as there is fiat currency left for its to print and debase) it will have no choice but to unleash even more violent, "unorthodox", inflation-stimulating policies in the coming months (such as the monetary paradrops we discussed here in September and October). When that happens, the biggest winner will be the one asset class that as of this moment has never been more hated, the one whose hedge fund net short position has never been greater [16]: Gold.
[17]
Gold rose 1.5% on Friday while risk was turmoiling, but is still below the FOMC announcement price. That means that while risk assets have started pricing in the Fed's misstep, gold and its record hedge funds shorts are still mostly unaware.
