6/7/2019 Weekly Update: A Change of Heart
by Zach Marsh on Jun 7, 2019
S&P 500 +4.47%
10 Year Treasury +0.29%
Weekly Update: A Change of Heart
Late, last December, the Chairman of the Federal Reserve pushed forward with an interest rate hike at a time of escalating trade tension and falling global stock markets. In my update letter on December 21, I described his actions as a dereliction of duty. I believed at that moment, while it is of utmost importance that we, one day find ourselves weened off of perpetually low interest rates, that the Fed’s actions actually called into question their ability to raise rates in the future.
The Fed, by artificially pushing rates higher, against prevailing market conditions, ultimately painted themselves in a corner, where they would be left with only one direction left to travel—back in the direction from whence they came. Now, less than six months later, with the Fed set to meet in 11 days, the question before them now will be: should they cut rates, or simply pause? Currently, the prevailing market prediction is that there is only a 25% chance of a rate cut at the next meeting, but by the July meeting date, the futures market is pricing in a near certainty that the Fed acts to lower rates.
So, why such the change of heart? After all, markets are actually up almost 20% since the Fed last raised rates. I suppose this gets to the heart of market dynamics—something that can be defined as first derivative and second derivative thinking or projection. The market, via millions and millions of participants with intersecting and conflicting ideas on market valuations and interest rates, ultimately and unintentionally, creates a better model than one that can be developed in an academic vacuum. The market, by its price action, recognized, beginning in January, that the Fed had painted themselves in a corner, and that the only action left would be for future easing, not contracting, i.e. second derivative thinking. This can explain why markets are up significantly since the last Fed rate hike in December, even though there has been no actual rate cut, nor has there been an answer to the building trade wars.
The difference between first and second derivative thinking is sort of like the George Bernard Shaw quote on how he sees the world. He said, “You see things; and you say ‘Why?’ But I dream of things that never were; and say, ‘Why not?’” Yet, instead of the why’s and why not’s, second derivative thinking sees things as they are and ponders about what we will see next—whereas first derivative thinking simply adheres to the current environment. The market, because of the collision of models and ideas achieves second derivative thinking more naturally. The Fed seems helplessly stuck in first gear.
What is the market now telling us? Over the last couple weeks we have seen gold and treasury bond prices rise dramatically, while oil and copper have fallen. Copper and oil prices falling, and Treasury Bond prices rallying, typically indicates slumping growth, or a potential recession. Rising gold prices is a bit of a wildcard signal, in concert with other rising asset prices, this typically would signal inflation concerns. However, gold also can act as a safe haven trade when stock markets are in turmoil. The consensus from these signals would have to be, in the face of rising stock prices this week, for potential stock market tremors later this summer and early fall.
Thanks for reading,
Zach and Dave
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 Sorry Robert Kennedy, the original goes to Shaw