How To Prepare for the Fed’s Pause That Refreshes

The Federal Reserve’s Open Market Committee meets today and tomorrow, December 18-19, 2018 to discuss the health of the economy and best monetary policy for the continuation of the best possible economic conditions.  As part of the conclusion of their meeting, they will decide the rate to set for the overnight Federal Funds rate, which strongly influences all rates in the US and globally.  They will also decide whether or not to adjust the high level of reserves in the system that has accumulated from their unprecedented quantitative easing programs.

In a past article I posted on Zerohedge.com, “Obama, Bernanke and Yellen Rigged the Bond Market. Now it’s Trump’s Turn to Dance or be their Dunce.”, I made it clear that past hyperactive monetary policy reacting to the 2008 financial crisis was too much for too long and had great costs down the road to those that tried to reverse policy.  By responding to the 2008 financial crisis with zero percent rates and purchasing 5 Trillion of bonds, the Fed allowed politicians to avoid addressing the underlying economic problems.  The Fed reflated financial assets to some of the most extreme valuations.  Unfortunately, for the Fed officials and politicians on watch as these extreme monetary policies unwind, financial market volatility would increase as these assets came down to more normal levels.

Most do not realize more normal levels can lead to 40% losses in stocks to get to a longer run expected price to earnings ratios that compensate stock investors for the risks embedded in stocks.  And bond market investors are no better off.  US Treasury long bonds usually trade 2% to 3% above the rate of inflation.  If these bonds normalized with yields around 6%, there would be a mark to market loss of around 50%. 

Trump picked right by appointing Jerome Powell to head up the Federal Reserve.  Just like when Bush appointed Bernanke, questions were asked how would you respond to weakening demand and market losses.  Both appeared to be doves – with Bernanke assuring he would throw everything in including the kitchen sink.

Now that the stock market is racking up large losses which is creating worry about signals on the economy out 6 months to a year, politicians and Fed officials are worried this may be the end to the longest expansion in the US history. 

Taking a step back, recessions are part of the normal business cycle ensuring upward growth without systemic crisis if appearing on a regular basis.  Recessions limit risk in the system limiting the buildup of unforeseen systemic risks.  However, starting with Greenspan and due to political pressure, the Federal Reserve has perused easy monetary policy, stealing growth from the future to ensure a recession does not happen on their watch.  This has created additional unforeseen risks just like the buildup to 2008.

The Fed knows this and with increasing pressure not to stop the music from playing, is now considering and probably will implement a pause in their tightening cycle.  Most likely they will do this at this meeting catching the market off guard.  If they pass, they will have strong wording to anticipate a Fed pause in tightening at the next meeting. 

This pause will not avoid a recession, rather push it back from one to maybe two years out.  Yes, this pause that refreshes will only delay the inevitable and create deeper negative results stealing yet more growth from the future that would limit the severity of the next recession.

So what to do to prepare for the Fed pause or indication of a pause.  Rich assets that have been deflating should get a lift, maybe even making new highs.  Bonds will bear the brunt as securities that are a perceived security blanket sell off.  If investing in rich assets, stay to the most liquid sectors so you can be nimble and readjust after some positive appreciation in equities. 

Bonds on the other hand are so rich, they should sell off even into a recession after the first knee jerk reaction to rally to lower yields.  Unless the Fed goes on a very large quantitative easing program again (which is not out of the question), supply in conjunction with current inflation and the richness of the asset class ensures higher yields and losses in the bond market.  Use any rally in the fixed income market to sell into strength.  Now that cash is at a high enough level and very close to bond yields due to the flatness of the yield curve, sit on the side lines and watch the financial volatility unfold while getting a competitive yield in cash.  Cash, after all, is an attractive asset and has significant optionality to potential returns allowing you to enter other rich asset classes upon repricing to more normal valuations.

But if you can avoid the overvalued public markets and invest in your own business or other private businesses, though much more work, these opportunities can be attractive.  Private businesses allow entry into opportunities without meteoric premiums currently in the publicly traded markets.  But if you do not have access to these private investments, cash is a valuable asset.

So chose to dance with Powell and Trump, be nimble and get ready for the pause that refreshes publicly asset values – maybe even to values never before seen.  But at least acknowledge this is all based on musical chairs, with fewer chairs left every day.  I hope you take pause (pun intended) from this article and will not be looking for a chair when the music stops.

 

by Michael Carino, Greenwich Endeavors, 12/18/18

Michael Carino is the CEO of Greenwich Endeavors, a financial specialist and a hedge fund portfolio manager, trader and owner of more than 20 years.  He typically has positions that benefit from a normalized bond market, higher yields and value investments.