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Why 95% of Traders Fail

Junk Bonds Slump - Will 2016 be The Year The Fed Fails?

Interest-Rates / US Interest Rates Jan 19, 2016 - 10:30 AM GMT

By: Clif_Droke

Interest-Rates

To many economists, the biggest mistake the Fed has made has been a lack of aggression in raising interest rates. After all, they reason, the U.S. job market is as strong as it has been since 2007 and the economy, even if sluggish, is at least back on an even keel. These same observers cheered the Fed's decision to raise the Fed funds rate in December by a quarter percentage point.

Yet there is even more reason to worry that the raising of the Fed funds rate last month may have been a policy blunder of major proportions. In this commentary we'll briefly examine the distinct possibility that the Fed has put the U.S. financial market on the cusp of another troublesome year ahead.


Many investors and analysts believe that the quarter percent rate hike enacted by the Fed at its December meeting is inconsequential. Some analysts, however, believe otherwise. One such analyst is Bert Dohmen, editor of the Wellington Letter. In a recent article he points out that in order for the Fed to achieve its goal of raising the benchmark interest rate to 0.25% from virtually zero, it has to drain reserves from the banking system. It does this through "reverse repos," which means it sells Treasury bonds to banks and receives payment via the bank's reserves. In short, it amounts to decreasing the amount of liquidity in the banking system.

On December 31, 2015, the Fed did almost $475 billion of reverse repos, according to Dohmen. "Of course, this is not permanent," he writes, "but usually measured in a few days or less. But it does reduce the ability of banks to lend to each other for that time. The above was a record amount, exceeding the prior record of $339.48 billion on June 30, 2014, 1.5 years ago. On Jan 5, 2016 the fed did a reverse repo of almost $170 billion for one day."

He points out that the Fed must continue doing this in order to keep the Fed Funds at or above 0.25%. In doing so, the Fed is draining liquidity from the financial system at a time when liquidity is in great demand. E.D. Skyrm, managing director of Wedbush Securities, has calculated that starting at zero, the Fed's rate hike to 0.25% is "infinite" in percentage terms. He further estimates the Fed needs to drain between $310B and $800B in liquidity to achieve this.

As if that weren't enough, comments by St. Louis Fed President Bullard this week suggest the Fed is completely oblivious to the effects that rate increases are having on the financial market. Incredibly, Bullard suggested that four more rate increases were likely in 2016, underscoring the Fed's total blindness to the global market crisis.

The Fed, duly chastised by its dilatory response to the 2008 crisis, claimed for years that it would vigilantly prevent another bubble from forming in the credit market. Yet there is growing evidence that it has failed miserably in that duty as well. Credit analysts Edward Altman and Brenda Kuehne, in an article entitled "Credt Market Bubble Building" (Business Credit, March 2015), observed last year that a bubble was building in the high yield corporate debt market. They pointed out that the corporate high yield (HY) and investment grade (IG) sectors had been refinancing and increasing their debt financing continuously since 2010 when the Fed began ramping up its loose money policy. They also wrote that "new HY issuance topped $200 billion in 2012 and almost matched that in 2013," adding that corporate debt issuance was even more substantial in Europe in 2013-14.

"In a nutshell," Altman and Kuehne concluded, "market acceptance of newly issued high-yield junk bonds has been remarkable, with record amounts issued at relatively low interest rates. This reinforces that a seemingly insatiable appetite exists for higher yields in this low-interest rate environment." Further, the authors found that HY corporate bonds in 2015 carried a higher default risk than those outstanding in 2007. The outcome of this can be clearly seen in the following graph of the SPDR High Yield Bond ETF (JNK), which is testing levels not seen since the depths of the 2008-09 credit crisis.

JNK Daily Chart

And so it would appear that after feeding another credit market bubble with its persistent zero interest rate policy of the last few years the Fed is committing a far more grievous error by raising rates at the worst possible time.

Perhaps the biggest danger for central banks this year is hubris. The Fed spent the better part of last year insisting that benchmark rate would be raised at some point in 2015. It also consistently (and correctly, I maintain) passed on raising rates in meeting after meeting. Only when December's policy meeting came around did the Fed finally see fit to raise the benchmark interest rate. There was essentially no justification for raising the rate; it seemed merely a case of the Fed feeling obligated to keep a promise it had made months earlier. In other words, the Fed was merely trying to save face.

Robert Campbell, in the latest issue of his Campbell Real Estate Timing Letter, made an observation about market forecasters that could easily be applied to central bankers. He wrote:

"It's [a] natural tendency for humans to stock to a given forecast come hell or high water. Instead of adjusting to changing conditions, most investors get married to their outlook for the markets - which only proves they would rather be right than change their positions according to changing realities and make money. I know it sounds crazy but it's human nature: most people would rather defend a bad idea (or investment position) - and prove they are right - than admit they made a mistake (and change and be happy)." [www.RealEstateTiming.com ]

Is it just possible that the Fed is oblivious to the bear market now underway in the equity market, along with the threat of additional weakness being imported from overseas? Could it actually be serious about wanting to incrementally raise interest rates (thereby tightening money availability) in 2016 when the data argues it should be doing everything to make liquidity more plentiful? While the jury is still deliberating those questions, the preliminary evidence would answer both questions in the affirmative.

Fed Chair Janet Yellen has been painted as a monetary dove by many Fed watchers, yet her actions since assuming control of the Fed have been anything but dovish. Despite the many threats posed by the global economic crisis, the Fed is acting as if the U.S. is perfectly insulated against any ripple effects from global weakness. She appears blithely unaware that her misguided monetary policy stance risks undoing the equity market rebound her predecessor helped engineer in the years following the credit crisis.

Wouldn't it be ironic if in 2016 the Fed's lack of sensitivity to the threat posed by the global crisis turns out to be its downfall? The Fed appears to have painted itself into a corner with its monetary policy decisions. Rates are too low to be used as an effective weapon against a further deflationary threat from overseas. To lower the Fed funds rate from here would be to admit that it made a mistake in raising it in the first place. It's unlikely the Fed would do this since it fears anything that would potentially undermine its credibility and smack of indecision. Moreover, it's unlikely that the Yellen Fed would risk the appearance of being unduly aggressive by increasing liquidity at this early stage of the crisis. History shows the Fed, like most institutions, to be a reactionary creature. If the Fed under Bernanke was late in aggressively loosening monetary policy in 2008 when the credit conflagration was in full flame, why should we expect anything different from Yellen.

The Fed isn't the only central bank that seems to be underestimating the potential danger of the global crisis. European Central Bank (ECB) President Draghi famously pledged his bank would do "whatever it takes" to reverse the deflationary undercurrents within the euro zone. Yet the ECB has failed to live up to that promise to date. Although the ECB recently lowered its deposit rate from -0.2 percent to -0.3 percent and extended its 60-billion-euro monthly asset purchase program, the ECB hasn't shown the necessary urgency commensurate with the magnitude of the crisis. The result of the bank's efforts to date has been an anemic euro zone economy and a lack of confidence among the region's investors.

The lack of urgency among central bankers and investors alike is troubling since it means - from a contrarian's perspective - that the global crisis likely has a lot further to run before it abates. In the meantime, traders and investors should continue to maintain a defensive posture and avoid new long commitments due to the continuing internal weakness.

Robert Moriarty's New Book

My old friend and colleague, gold mining stock analyst extraordinaire Bob Moriarty, has written an entertaining new book. Although a work of fiction, it's based on his real-life exploits as a Marine fighter pilot during the Vietnam War. Bob's avid followers will want to read this exciting and quick read, entitled "Crap Shoot" which is available for download at Amazon.com.

Mastering Moving Averages

The moving average is one of the most versatile of all trading tools and should be a part of every investor's arsenal. Far more than a simple trend line, it's also a dynamic momentum indicator as well as a means of identifying support and resistance across variable time frames. It can also be used in place of an overbought/oversold oscillator when used in relationship to the price of the stock or ETF you're trading in.

In my latest book, Mastering Moving Averages, I remove the mystique behind stock and ETF trading and reveal a simple and reliable system that allows retail traders to profit from both up and down moves in the market. The trading techniques discussed in the book have been carefully calibrated to match today's fast-moving and sometimes volatile market environment. If you're interested in moving average trading techniques, you'll want to read this book.

Order today and receive an autographed copy along with a copy of the book, The Best Strategies for Momentum Traders. Your order also includes a FREE 1-month trial subscription to the Momentum Strategies Report newsletter: http://www.clifdroke.com/books/masteringma.html

By Clif Droke

www.clifdroke.com

Clif Droke is the editor of the daily Gold & Silver Stock Report. Published daily since 2002, the report provides forecasts and analysis of the leading gold, silver, uranium and energy stocks from a short-term technical standpoint. He is also the author of numerous books, including 'How to Read Chart Patterns for Greater Profits.' For more information visit www.clifdroke.com

Clif Droke Archive

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