“Excuses change nothing, but make everyone feel better.” – Mason Cooley

The most highly anticipated Fed decision (since the last one…and the one before that…and the one before that) is coming next week. Endless debate over whether the Fed will raise rates now or later seems to be the norm. I suspect if/when the Fed ever does decide to raise rates, it will be a cathartic moment for the vast majority who have been arguing rates would soon rise for over three years. Expectations for central bank tightening have increased markedly in the last several weeks not just in the US, but in Europe as well. Suddenly, in the blink of an eye after futile attempts to spur inflation, it appears market expectations have shifted into thinking central banks have finally won.

Hold the phone – it’s not that simple. Growth in the US and Europe (NYSEARCA:VGK), for lack of a better term, has been nothing more than “meh.” Despite extraordinary monetary easing, nominal GDP figures remain lackluster. What about jobs and payroll growth? While unemployment has fallen and wage pressure does appear to be rising, the counter-factor is the labor participation rate, which is essentially at historic lows. The unemployment rate appears healthy purely because the number of people seeking employment has fallen relative to the number of discouraged workers who are unable to find strong job prospects. Indeed this can change as more and more employers hire, but the Fed may use that as an excuse to keep rates lower than the market anticipates despite their desire to “normalize” monetary policy. This is essentially the argument that the Fed wants to overshoot on inflationary pressure on the hope that such an environment will soak up new job entrants who otherwise would re-enter and actually cause the unemployment rate to rise because of their re-entry.

Having said all that, certainly there are members of the Federal Reserve who are desperate to raise rates, and raise them now. The argument is simple – if not now, when? The market appears to have prepped for it, the yield curve in June has steepened as seemingly out of nowhere long duration Treasuries have sold off, and all of this “cheap money” has fueled a stock market which Yellen herself admits appears overvalued. The movement in Treasuries (NYSEARCA:TLT) is important near-term, as shown in our award winning paper (click here to download it). It would be quite welcome for the economy if capital had cost and savers were rewarded for prudent personal financial management, rather than speculation in financial assets. However, as we have learned from numerous other times, the Federal Reserve tends to err on the side of easing, not tightening. Between the labor participation rate and continued uncertainty over Greece, the market’s expectations for a rate hike may be at odds with what the Federal Reserve does at this next meeting and the ones to come. Those betting on a continuation of the Dollar’s rise may soon be disappointed as a result.

This has been a strange year so far as bonds, commodities (NYSEARCA:DBC), and currencies have all increased in volatility alongside emerging markets and Europe, while the happy-go-lucky S&P 500 (NYSEARCA:SPY) remains in a tight trading range. Something big is likely to happen to US equities as this range eventually breaks and money either positions aggressively for further gains, or defensively for the long-awaited correction which has the makings of being rather severe given complacency and margin. Should the former occur, the relative correction in emerging markets presents a meaningful opportunity for long-only traders and asset allocators. Should the latter take place and US stocks finally break down, market participants will likely be reminded that it is far more important mathematically to avoid major declines in broad beta than participate in advances.

Either way, we stand ready as the cycle begins to favor the anomaly we are trying to capture in our investment strategies – volatility predictability, and positioning before it happens.

Small Sample On,
Michael A. Gayed, CFA
www.pensionpartners.com

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.