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Riding the Rate

Riding the Rate

Lately, there has been a lot of talk about Deflation, Bubbles, Currencies, Oil and Greece (again). All these signs point to an ailing global economy amongst which China recorded its slowest annual growth since 1990 at just 7.4 per cent in 2014, Crude's low price continues to hurt many economies with some falling into negative growth, Sweden, Denmark and Switzerland have dropped their monetary policies into negatives and U.S. companies have been issuing earnings warnings ahead of the Q2 earning season with the threat of an "earnings recession" in the making.

Currently, with the low prices on most commodities, you'd expect economies to be booming and profits rising. But what we have instead is a real and present threat of Deflation.

After a four-year decline, Copper is languishing at lows not seen since June 2010 and Oil is ranging between $44p/b and $53p/b, a range not visited since 2009. Lumber, Steel and Iron Ore have all fallen since 2014. Corn is off its five-year lows but still hanging within its lower range. Wheat and Soy are still declining after two years. Sugar and coffee have been declining since 2011. Even Rice fell 32% in the last 18 months.

Bubbles are another worry although analysts would say otherwise. As of the close of Thursday 2 April 2015, 383 (76.6%) of the 500 S&P500 companies wore PE Ratios higher than 15. 231 (46.2%) of the S&P500 companies are over 20 on their PEs. These stats are all higher than what we saw in August 2007 just before the Dow Jones Industial Average fell from 14,000 into Sub-Prime hell. As stats go, this is the third biggest bubble in stock market history.

Treasury yields have stayed low in spite of the six-year bull run suggesting that the smart money is still largely tied up in safety rather than risk. The 10yr Treasury Yield fell from 3.5% in January 2009 to close at 2.5% on Friday 3 April 2015.

This would explain why volumes in risk (equities) have been consistently falling away as the market ran higher between 2009 and 2014 in what has become the most prominent price-to-volumes divergence that I have ever seen.

By the end of 2014, volumes on the NYSE were averaging less than 1 billion daily.

Currencies are another concern. In March this year, the U.S. Dollar index topped 100. The last time it did that on the way up was ahead of the 1997 Asian Financial and 1998 Russian Financial Crises and on the way down after the bubble burst in 2002.

The Dollar's strength has brought the EUR/USD from 1.3927 down to 1.0463, the GBP/USD from 1.7166 down to 1.4635 and sent the USD/JPY up from 101.17 to 122.01 all within the last year.

These currency fluctuations have done nothing to improve the stability of these countries. Instead, it has only exacerbated their deflationary woes.

Then we have the on-going saga of Greece. Five years after fighting to keep the defaulting country in the euro currency union, a Greek exit may have become inevitable as a result of Germany's rejection to a request to extend its expiring bailout agreement. The possible fallout of its exit has been touted to be far worse than the demise of Lehman Brothers.

Amidst all this chatter is one very volatile market that doesn't seem to know where it should go from one day to the next. After three months of trading, the Dow Jones Industrial Average is in the red for the year.

From The Noise, Clarity Emerges

Out of all the noise and confusion, there is one real opportunity on the near horizon that offers a really mouth-watering prospect. The chatter that is getting me excited is the promise of rising interest rates.

FOMC Chairwoman, Janet Yellen has been eager to start raising the Fed Fund Rate ever since she ended Ben Bernanke's legacy of purchasing Mortgage Backed Securities at the end of 2014. Since then, she had broadly hinted at the possibility of raising rates in 2015. However, the effects of the strong U.S. dollar and the low price of Crude Oil has curtailed this move with some speculators saying that it could happen in July while others are mooting the move by the end of this year.

I reckon it could be sooner rather than later especially after Yellen removed the word "patient" from the latest meeting minutes in March 2014.

So why does higher interest rates excite me?

There is a little known pattern that exists in the U.S. markets in relation to its monetary policy: As rates rise, so does the market in the same timeframe.

The blue areas on the chart clearly show that as the Fed Fund Rate increases (red chart, left Y-axis), the Dow Jones Industrial Average rallies.

The period between 1973 to 1983 was the exception as the U.S. went through a series of macroeconomic changes as a result of their unilateral termination of convertibility of the US dollar to gold, also known as the Bretton Woods Agreement of 1944. The U.S. dollar thereafter became a fiat currency. The "Nixon Shock" brought about various monetary policies around the world and currency wars erupted. The 1974 Oil Crisis, stagflation and the Great Inflation of the 70s and 80s made the model unreliable.

Normality seemed to have returned in 1983 as the trend reestablished its reliability again. By the 1990s the "normal" range of the Fed Fund Rate returned to around 3% on average.

After a massive easing program between July 13, 1990 and Sept 4, 1992 that brought the Fed Fund Rate down from from 8.00% to 3.00%, the then-Fed Chairman, Alan Greenspan began his tightening policy as he kept rates firm at 3% in 1993. By March 1995, Greenspan had tightened the rate to 6%.

The 10yr Treasury Yield had also resumed its convergent behavior with the Fed Fund Rate by rising in the same period.

Within that period, the Dow Jones Industrial Average ran from 3,450 to 4,150 for a gain of 20%.

The last rate hike was between May 2004 and June 2006. Greenspan famously raised the Fed Fund Rate 25bps each time from 1% to 5.25% in seventeen consecutive rate hikes over two years.

During that period, the 10yr Treasury Yield stayed above 4% and joined the hike towards the end of the run to peak at 5%.

And in the same timeframe, the Dow Jones Industrial Average rallied from 9,800 to 11,600 for an 18% gain in two years.

Keep It Simple

The investment strategy is a simple one with clear indications and targets. Eventually, when Janet Yellen announces that the Fed will be raising the Fed Fund Rate, I will be expecting a knee-jerk reaction that should send the market down into a short-term correction. This should be anywhere between two weeks and two months, depending on market conditions.

When the market returns into an uptrend with stronger volumes to support the trend, investors may choose to go long on either or both the SPDR DJIA ETF Trust (NYSE ARCA: DIA) or the SPDR S&P500 ETF Trust (NYSE ARCA: SPY), also known as the Diamonds and Spyders respectively.

Given that the Fed Fund Rate is now at 0%, it will be a rather lengthy hike to get it up to the average 3% or even the average high of 5% to 6% if warranted by then. This should give the investor ample time to get in on the ride, assuming Yellen doesn't hike up in a hurry by 50bps, something not seen in 15 years. The average timeframe for hiking is around 18 to 24 months.

Once in for the ride, keep tabs on every FOMC meeting minutes. The Fed always makes broad hints as to when it will stop raising rates. They even broadcast their target rate and by which time they expect to hit that target. Those targets and timelines serve as good exit plans from your investment.

The more adventurous investors may choose to go long on more aggressive sectors such as industrials, transports, technology, materials, housing and finance. The ride could get bumpy along the way so watch earnings and macroeconomic news closely for any signs of oncoming long-term weaknesses in those sectors.

One common query regarding this correlation between rising rates and a rallying U.S. market is why should higher rates be good for the market?

It is a chicken-or-egg situation; the market rises and things get inflated so the Fed raises rates to combat this increase in inflation or the Fed inflates the value of the U.S. dollar so that corporate America sees higher profit margins being a buy-based economy.

Either way, in normal circumstances for a buy-based economy like the U.S., history has shown that a higher valued currency tends to stand the economy in good stead as higher profit margins equals better earnings and better earnings equals a bull market.

The only foreseeable downsides to this method of investing are:

  • If deflation takes root in the U.S. economy. If so, we could be looking at a repeat of the 1973 to 1983 performance when monetary policy and market action became divergent and erratic.
  • PE ratios go higher while revenues stagnate and force this bubble into a balloon. Given that companies have been actively buying back stock and deleveraging over the last two years, this should give their EPS some reprieve and keep PEs fair. However, that sort of quick fix without better revenues can never be sustained in the long run. So keep watching those fundamentals closely.
  • If Crude stays below $50p/b while the dollar hovers above 90 on the index, this could have a devastating long term effect on the economy as jobs dry up in the Oil industries amidst a slowing global economy and U.S. exporters lose out in the global marketplace due to its high currency value. This will inevitably turn the U.S. GDP negative.

As much as I love this pattern, there is always more than meets the eye when it comes to putting your money on the line. Consider all the possibilities and measure your risk carefully. There are currently more reasons to be bearish than bullish. I will wait patiently for a sizeable correction before I consider buying into rising Fed Fund Rates.

The Fed may have taken "patience" out of their language but I intend to keep my patience firmly entrenched in mine.

To catch Conrad for more indepth research, please click here.

Happy Hunting!

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Conrad Alvin Lim
Conrad Alvin Lim

Conrad Alvin Lim is a Singapore-based online trader, bestselling author, financial trainer, public speaker, consultant, and entrepreneur.

He founded and created the Pattern Trader Tutorial, a complete and holistic finance and economics program and has been teaching in Singapore, Malaysia and other regional countries since 2006 to become a leading educator on finance and economics for trading, investing and business. His specialties include macroeconomics, seasonal and cyclical analyses, market psychology, trading and investing.

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