An Unexpected Fed Christmas Present?

By Traddr

This Wednesday the FED is expected to raise the FED Fund Rate by 25 basis points from 0.25% to 0.50%. If this happens it will be the first rate hike since the summer of 2006, nearly 10 years ago.

This very short piece tries to analyze the effect this hike may have on risk assets as measured by the S&P500.

The Wednesday decision by the FED is probably the most discussed financial event for a very very long time.

Students and historians of financial markets and simply those who just have been in the financial markets for any length of time know well that any widely analyzed event is ‘priced’ into asset values. This is the reason market participants state and know that markets are predictive in nature.
In other words markets are anticipatory as opposed to reactionary.

This rate hike must be the most anticipated rate hike ever.

What if the FED hikes? What effect will this have on the S&P500?
The index made a recent high in the middle of May just below the 2150 level. It is currently trading just above the 2000 level, a fall of circa 6%. The question we must ask ourselves is “Is a fall of 6% big enough to have ‘priced in’ the rate hike and if it is how will the index respond?”

My view is that precisely because the hike is thoroughly anticipated market participants may indeed view the correction as adequate bar the immediate knee jerk reaction. The view may be that because the FED feels comfortable hiking its view on the economy is sanguine, positive and relaxed.
Opinion may be that the FED is returning to a normalization of interest rates after a 10 year hibernation.

What is the potential upside for the index if the above scenario works as outlined? My guess is that it initially falls perhaps to below the 2000 level before beginning a quick, surprising Christmas rally taking it potentially higher than its recent high but not by much. Perhaps to 2175 for a gain of 8%?

A by product of the rate hike may be a spike higher in the USD Index. This will help the S&P as USD denominated assets catch a bid.

Now what if the FED does not hike? Does it necessarily mean the opposite of the above?
Perhaps it does and perhaps it does not. Market participants may view this as a sign that the FED is worried about the economy, that near zero percent interest rates for 10 years have not helped and that therefore the 6% correction to date is only the beginning.
On the other hand the market may view it positively feeling that continued low rates continue to be risk asset positive. This is the least likely scenario in my view.

We therefore have three likely scenarios:
1.       FED hikes and risk rallies post a knee jerk reaction lower. We will call this the ‘Santa Rally’.
2.       The FED does not hike and the market rallies. We will call this the ‘Least likely Rally’.
3.       The FED does not hike and the markets do not like it and risk falls. We will call this the ‘Beginning of the End’.

So how should you respond as a trader?
For the Santa Rally buy the dips.
For the Least Likely Rally buy the dips and also buy gold as an insurance.
For the Beginning of the End scenario buy gold and sell short any S&P rally.

Happy and Merry #trading Traders!

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