How Powell and Other Factors Affect Currencies, Bonds

10/30/2017 11:42 am EST


Don Kaufman

Co-Founder, TheoTrade

The two-year bond has been selling off at an accelerated clip since mid-September because inflation appears to be picking up and the Fed is expected to raise rates in December, writes  Don Kaufman, co-founder of TheoTrade.

One of the announcements I was expecting last week was who President Trump would pick as Fed chair. It’s one of the reasons I said this was the most important week in the market this year.

We didn’t get the pick, but we got rumors of who it will be which were then priced into the betting market accordingly. The president teased the announcement in an Instagram video saying he has someone in mind. The rumors are that it is Powell. With the way Trump stated he knew who he was going to pick, I doubt that the reports of him possibly changing his mind hold much merit.

At this point, I would be shocked if anyone other than Powell is picked. The PredictIt odds show Powell at 76% and Taylor at 13%. Because the market knows who it’s going to be and because it’s a dove who has continuity with Yellen, I don’t expect any stock market reaction early this week after it’s announced.

It’s tough to determine what the market thinks of this decision because you can’t isolate the point when the market knew it would be Powell. That understanding has been priced in gradually over the past few weeks. 

In the midst of this, there are countless other factors affecting currencies and bonds. The two-year bond has been selling off at an accelerated clip since mid-September because inflation appears to be picking up and the Fed is expected to raise rates in December. This week is the Fed meeting for November. I expect it to be a non-event because there’s nothing new to discuss and no policy change will be made.

The factor the Fed will be focusing on over the next 12 months is the rise of inflation. If it rises moderately, no major action will be needed. If it picks up considerably, it’s a game changer for the economy as the Goldilocks scenario will be over.

The most popular estimates for September 2018 are for one or two rates hikes. The way I see guidance, there will be two rate hikes in 2018 unless inflation picks up. Clearly, the risk of inflation outweighs the risk of a recession.

Even though Powell is a dove, the dollar has been rising in the past few weeks; it’s up from $91.35 to $94.81. I can’t read anything into this move because it could just be an oversold rally which will diminish in the next few months.

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This rally will diminish some of the currency benefits multinational firms will be receiving in Q4. Even though Powell is considered a dove, I don’t expect the dollar to fall as a result of him being picked because the U.S. policy is relatively hawkish and he is a continuity pick.

Everyone Is bullish

As I showed previously, the Investors Intelligence Survey has investors the most bullish since 1987. The average trader isn’t the only bullish group.

As you can see from the chart below, hedge funds are now overexposed to stocks. It’s amazing to see that hedge funds were underexposed in September. I guess they were worried about the debt ceiling, the hurricanes, the Fed pick and the ECB’s QE decision.

Looking at their bearishness in hindsight is weird because it looks so obvious that stocks are in an uptrend. However, it wasn’t obvious a month or two ago. Everything that could have gone right has gone right. I can’t think of any uncertain situation that hasn’t gone in the market’s favor other than the lack of a tax plan. The tax plan might still be in the works, so even that can go right.

It’s interesting to see that the hedge fund industry went from moderately overexposed this summer, to barely underexposed without stocks falling much.

It’s tough to gauge the effect of each constituency in the market because in selloffs most groups sell and in rallies most groups buy. The main takeaway from this chart below is that everyone is bullish. That’s implied by the sentiment readings, the exposure measurements, and the momentum indicators. The CNN Fear and Greed Index is at 70 Monday which represents greed. It’s amazing to see it fall from the previous week’s reading of 89 given the fact that the S&P 500 Index  (SPX) was up 0.23% this week. I might be biased towards being nervous because the Nasdaq Composite (IXIC) was up 1.09% for the week. It can continue going up if Apple (AAPL) and Facebook (FB) report good results even if it is overbought.

chart 1

Rates are important

It’s important to discuss inflation for two reasons.

First, long-term cash flows need to be discounted back to present value to come up with stock price estimates. If inflation is high, those future cash flows are worth less than if inflation was low.

Second, financing costs would increase because the Fed would raise rates and fixed income would sell off.

As you can see from the chart below, when net interest expenses increase as a percent of corporate debt, it is a great indicator that a recession is coming. All the covenant-lite debt that has been issued will be problematic when financing costs increase.

As you can see, the financing costs have not increased in the past few years. With interest rates rising, I expect this trend to reverse. That could mean a recession occurs in the next 1-2 years after 2018. It all depends on how much rates rise.

Small changes aren’t enough to bring down the economy. There needs to be a trend reversal to bring about a recession soon after. I would need to see this change and the yield curve be inverted to forecast a recession. Just after all the bears where getting flummoxed by the fact that the difference between the 10-year yield and the 2-year yield fell to 75 basis points, the yield curve steepened again to 83 basis points. The bottom held even though it was one basis point below the last bottom.

If the difference stays in this range instead of falls, no recession will be coming anytime soon.

chart 2

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