The Fed will Strike Out

It has been said that the most difficult thing to do in sports is to hit a Major League fastball. A small object coming toward you at 95 miles per hour, with the potential to dart down, sideways or toward your skull is certainly a skill that few can master. And many excellent athletes train all their lives, reach the Major Leagues and find out even they can’t do it. And as that sport gets more scientific, strikeout rates are rising at an alarming rate. More complexity is being thrown toward hitters and even the best in the business find it more difficult than their predecessors.

The same goes for extracting yourself from the most aggressive monetary policy of this generation. The Federal Reserve Board, headed by Janet Yellen, is widely expected to raise overnight interest rates in the near future. For the past couple of years, the bond and stock markets have been riveted by anything that might offer a clue as to when and at what pace the Fed will raise rates for the first time since 2006. Many of the stock market’s best days this year have been “relief rallies” in which some news prompted traders to believe that the inevitable first rate hike would be pushed off a few months. And just the opposite has occurred too: a feeling that the rate-rising cycle is around the corner is an excuse to force stock prices lower for a day or two.

The key point is that whatever happens and whenever it happens, the Fed will be trying to accomplish something akin to hitting a Major League fastball. The Fed board includes some of the world’s top economists, but they have never stood in and faced a scenario like this one. The financial crisis is still in the public’s psyche, though it has faded. Unemployment has dropped, but many simply dropped off the job search ranks, so that’s a double-edged sword. Inflation has been dormant for years, but recent upward pressure in wages smells inflationary. And consumers have returned to their leveraged ways, with margin debt at all-time highs. The sources of complexity facing the Fed is as imposing as your first Major League at-bat. Yet here, the Fed is in charge of the timing. They can wait just outside the batter’s box and have the pitcher throw warmup tosses to the catcher until they (the Fed) are good and ready to step in the box. They have already waited a very long time to act, but when they do, the cheap money era which has powered innovation and progress, but also speculation and outright greed will likely change.

And that is the problem. The suspense has built and so have the expectations and emotions around this. At Sungarden, we are prepared for whatever the stock and bond markets throw our way and our investment process is geared up to identify medium- and long-term investment opportunities when the inevitable freak-out over rising rates occurs. It is a part and parcel of our Hedged Investing style.

However, most investors don’t look at the world as we do. They see stock prices rising and their optimism turns to excitement, then euphoria…and eventually distress and regret. And for bond investors, they have lived through 35 years of rising rates, so they have no experience and perhaps no clue as to what a turn in that tide means.

This week, comments from International Monetary Fund (IMF) President Christine LaGarde summed it up. She said the IMF hopes that the Fed will push off their first rate hike until 2016, until inflation picks up a bit. When a powerful central banker says something like that, it is like that great athlete saying they’d like more time to see if the wind shifts before stepping in the box to hit Major League pitching for the first time. It might work out, but it's best to plan for what happens if it doesn’t. The Fed is likely to strike out because the situation that has built up since the financial crisis should not have been allowed to spiral up like this. There has never been a better time in this generation for investors to have a well thought out approach to the aftermath.

(c) Sungarden Investment Research


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