The Fed is Signaling a June Rate Hike

Posted by Chris on May 21, 2016 in Uncategorized | Leave a comment

The US Dollar and treasury yields moved sharply higher this week in response to successive signs from the Federal Reserve that interest rates are likely going higher this summer. The fervor started on Tuesday as two moderate Fed regional presidents said that June should be considered a live meeting. Two year treasury yields rose by their most in two months on these comments, moving from 0.785% on Monday to 0.83% by late day Tuesday. Lockhart and Williams move markets because they’re seen as bellweather moderates, and both men’s offices are surrounded by a construction boom as real estate has been red hot in downtown San Francisco and Atlanta for almost two years now. They made the following remarks:

*LOCKHART SAYS HE WOULDN’T TAKE MOVE IN JUNE OFF
*FED’S WILLIAMS SAYS JUNE FOMC A LIVE MEETING IN HIS VIEW
*LOCKHART: MKTS MAY BE MORE PESSIMISTIC THAN I AM AT THIS STAGE
*WILLIAMS: WAGES PICKING UP BY MORE THAN SUGGESTED BY AVERAGES

US 2 Year Treasury Yield May 16th – May 20th

The hawkish positioning continued on Wednesday as the release of the Federal Reserve minutes from the April 26th meeting sent 2 year yields soaring again from 0.83% to 0.891%, the highest level seen since just before the March FOMC when Janet Yellen signaled the Fed was lowering its projection for 2016 hikes to 2 increases from 4. Traders honed in on the following headlines:

*MOST FED OFFICIALS SAW JUNE HIKE `LIKELY’ IF ECONOMY WARRANTED
*FED: RANGE OF VIEWS ON WHETHER DATA WOULD SUPPORT JUNE HIKE
*FED: MANY OFFICIALS NOTED GLOBAL RISKS NEED `CLOSE MONITORING’
*FED: OFFICIALS WANTED TO KEEP `OPTIONS OPEN’ FOR JUNE

New York Fed president William Dudley picked up the torch on Thursday reiterating the sentiment of his colleagues, pushing the idea that June is a live meeting and the markets should take heed.

DUDLEY: JUNE IS DEFINITELY A LIVE MEETING
DUDLEY: QUITE PLEASED WITH MARKET’S JUNE-JULY VIEWS
DUDLEY SAYS BIGGER UNCERTAINTY IS WHAT’S GROWTH GOING TO BE
DUDLEY: I’M PRETTY CONFIDENT WE’LL GET BACK TO 2% INFLATION
DUDLEY: MKT PRICING OF FED HIKE ODDS WAY TOO LOW PRIOR MINUTES

It would seem highly unlikely that this is a coincidence that Fed regional bosses are suddenly all saying the same thing in the same week the meeting minutes are released echoing the exact same sentiments. As of Monday rates futures were pricing only a 3% chance of a June hike, and even by Friday we are still only at 30% chance. In my view the FOMC is realizing that the downward pressure on consumer prices is quickly evaporating as oil has now doubled off the lows of $26 a barrel on February 11th. The FOMC is weary about the bond market being totally complacent about their intentions and they want to adjust expectations after this past weeks CPI data showed the quickest headline inflation in three years. Rent increases have been the main driver of core CPI, which currently sits at 2.1%, but now that energy prices are rising rapidly all major central banks are taking note. ECB governing council member Nowotny commented this week that oil could push Eurozone inflation higher in the second half of this year.

I think the Federal Reserves ultimate fear is losing credibility on inflation, which would mean a loss of control of long term bond yields. I have observed in my own workplace just in the last 12 months that the tightness in the labor market is getting extremely obvious, and from an HR perspective this can push wages higher rapidly as businesses throw in the towel on maintaining all time high profit margins and start bumping salaries by double digits just to get employees in the door so the business doesn’t fall apart or existing workers quit from being overworked. Once employees realize the labor market is tight they can begin shopping offers and job hopping for relatively large pay increases. To sum up, current economic data is actually deteriorating from a growth standpoint but the Fed’s primary concern is now inflation.

My personal bets for the last week have been long volatility(put options) on dividend stocks like Mcdonald’s, Johnson & Johnson, AT&T, The Coca Cola Company, and Proctor & Gamble. Most of these companies are included in the Consumer Staples Sector SPDR (XLP). These high quality stocks have risen to extremely rich valuations close to 30 times trailing earnings as investors search out safe, low volatility bond like stocks with dividends around 3%. Ironically these companies have minimal growth potential, high exposure to a stronger US Dollar and their stock buyback programs are funded by the prevailing near zero interest rates that have been prevalent since 2012. If the stock market is to decline significantly these stocks must drop in response to higher bond yields. Implied volatility on these specific stocks is low relative to how rapidly these names could drop in response to a surprise rate hike, this trade is essentially a leveraged way to bet on rising bond yield in the 2 to 5 year area of the yield curve.