Fed policy: Riding the market sentiment pendulum and the tail wagging the dog

The pendulum of market sentiment swings from one extreme to another, and over the past several weeks, traders’ outlook on Fed policy has swung violently back toward the doves.

Less than two months ago, traders were split on whether the world’s most important central bank would raise interest rates at its September or December meeting, with almost no one anticipating that “liftoff” would be any later than that. After the return good ol’ financial market volatility (along with a dose of weaker-than-expected economic data) though, traders are now only pricing in a 30% chance of a rate hike at all this year, and a only about a 50% chance of an increase in March 2016.

Predictably, expectations for more ZIRP (zero interest rate policy) in the US has bolstered so-called “risk assets,” including commodities, emerging market currencies and stocks, and equity indices more broadly. To wit, the Dow Jones Industrial Average has surged over 1,200 points from its low under 16,000 at the end of September, while the relatively high-yielding New Zealand dollar has tacked on nearly 600 points, or about 9%, from its trough a month ago.

…but wait: wasn’t the return of market “volatility” (read: weakness) one of the major reasons that the Fed opted to hold off on raising interest in September in the first place? Therein lies the biggest issue for the Federal Reserve.

Like a petulant, spoiled child who has his parents wrapped around his chubby little finger, the markets’ recent temper tantrum has forced the Federal Reserve into doing exactly what traders want: leave the liquidity taps wide open. Instead of the Federal Reserve’s economic-based decisions leading to an appropriate reaction in the market, traders are front-running a potential liftoff from the Federal Reserve, creating the very market conditions that make a rate hike more difficult. In other words, the tail (markets) are wagging the dog (the Fed).

As our astute readers know, smart traders and investors are always one step ahead of the herd, and it now looks like the dovish-Fed / bullish-risk-asset pendulum may be reaching its apex. According to the most recent CFTC Commitment of Trader (COT) data, US dollar longs have dropped to just $22.8B, a 15-month low. More anecdotally, my father called me out of the blue this weekend to ask about the recent weakness in the greenback, a clear example of the classic contrarian “shoeshine boy stock tip” tale.

With most risk assets at or near multi-month highs, the Fed can hardly point to “financial market stability” concerns as a reason for holding off on raising interest rates. Therefore, the conditions are increasingly ripe for traders to start pricing in an increase interest rates, especially if economic data starts to stabilize or improve in the coming weeks. This development, if seen, would likely lead to a selloff in assets like stocks, commodities and high-yielding currencies...which could in turn make a rate hike less likely again.

Until markets or the Fed step away from this two-party tango, smart traders will keep riding the sentiment pendulum back and forth…and back and forth.