I was riding into work this morning, listening to Bloomberg Radio, as currency strategists and economists discussed the U.S. Dollar (USD) and the Euro going through parity as monetary policy between the Federal Reserve and the European Central Bank (ECB) diverges. Additionally, one of the guests spoke of the USD, as measured by DXY (Bloomberg U.S. Dollar Index), strengthening another 20% by 2017. I agree with both these predictions.
While I personally believe that the U.S. economy should be able to handle a mere 25 basis point raise in the Fed Funds rate (which is why I thought The Fed should have gone in June or September, before the rest of the major central banks signaled easing), large sectors of the financial markets no longer can handle it. As I noted last week, a rapidly appreciating USD negatively affects sectors such as a large portion of the companies in the S&P 500, Investment Grade and High Yield bonds, Commodities, and Emerging Market assets. Many of us have lived through what I would call “Financial Crises.” What happens in financial crises, like the one we had in 1997–98, is liquidity in the affected markets goes to zero. What happens next is, market participants sell what they can sell. They sell S&P futures; they sell crude oil futures; they sell anything that they can actually have somebody—or some machine on the other end—say “done” on. Financial crises, like the one I think we can have if the Fed tightens as the rest of the world eases, is not surgical for the reasons I just stated above. Rather, it is a mess.
That brings us to our across-the-board impressive employment this morning. As dreadful as last month’s report was, this month’s report is fabulous. The Fed has put themselves further into the corner this week with their public statements concerning “liftoff.” I am going to assume that the odds are now massively in favor of a tightening at the next FOMC meeting on December 16, 2015. I think The Fed needs to understand that in the month between now and the next meeting, there is going to be tremendous chaos in the markets that I mentioned above.
At this point, you need to ask yourself, “Why wait ‘til December 16, 2015?” While understanding that a lot of damage can be done leading up to that meeting, the move on the date of the meeting will be significant, amplified by the severe lack of liquidity. A move on December 16 would leave only three or four real trading days left in 2015. Dealers’ appetite for risk and balance sheet usage is already poor. In the last real week of the year, multiply poor by 10. If The Fed is going to hike, just do it now, and get it over with. Get the hike out of the way and get “The next hike may be well off into future” speech out there.
As far as market view, I think risk assets are in for a very rough ride. As far as duration, I believe a 91 basis point two-year (the level as I write this) takes into account at least one hike. I wouldn’t get in front of the “sell train” this morning, but I wouldn’t mind being long two-years at a .91% and three-years at 1.23%. I also believe that the long end (10-year at 2.30% and 30-year at 3.05%) will, after this morning’s panic, rally back to 2.25% and 2.95%.