Don't Fight The Fed?

Ex-Goldman Sachs CEO, Lloyd Blankfein, felt compelled to hop on Twitter yesterday to remind people of this investing platitude.

The assumption by most readers is that he is referring to being long or short the stock market. However, you would be deeply mistaken (and poor) if you followed this adage and applied it to stocks.

Take five minutes and review the Federal Reserve's actions on interest rates since 1970 to see for yourself how useless it is against stocks.

Or, just take a look at the following chart which tracks the Federal Funds Rate vs the S&P 500 and decide if it makes sense to be short stocks when the Fed is raising rates, and be long stocks when the Fed is lowering rates.

If you need any more help, you can take a look at the follow chart which shows the Fed lowering rates from 2007 - 2009 vs the VIX. 

Yes, that's right. If we apply this adage to equities you would buy stocks in Sept 2007 and keep on buying as the S&P gets cut in half and VIX spikes to 80 in late 2008. 

I don't recommend you do this.

Instead, apply this adage elsewhere. As you can see from the chart below, this rule really only applies to bonds.

When the Fed is on a tightening course (that is, they are raising rates) don't be long bonds. You need to be short bonds since their prices fall as yields rise.

When the Fed is lowering rates, don't be short bonds. You want to be long bonds since their prices rise as yields fall.

The Fed Funds rate will generally line up pretty well with the U.S. 10-year bond's yield. As of yesterday the Federal Reserve set its rates to a range of 1.75 - 2.00% vs a 10-year yield of 1.77%. At this point we probably have to assume rates at headed back to at least the 0 - 0.25% range as the Federal Reserve does everything in their power to delay the next recession.

As for what we can expect from equities there is less of a guarantee. Generally rate cuts happen just before or during a recession and equities move steeply lower. 

This provides further evidence for the setup of our Once-A-Decade Volatility Trade that we discussed last week. It is time to properly prepare your portfolio and be ready for this trade by applying smart tail-risk hedges. 

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Spike in VIX Flattens VIX Futures Term Structure

Last Wednesday I discussed how a new VIX futures front month (March) which was priced much higher than forward implied volatility (VIX) and historical volatility would likely cause XIV to continue higher in the short term. After moving up from that time to over 7%  into yesterday's close, XIV pulled back hard today to close down -8.9% as the market sold off a bit and traders started looking for protection with put options with spot VIX moving up 19.25% to close at 14.68 (highest close since 1/2/13).

The VIX futures curve flattened notably today, with front month futures closing just 0.65 below second month futures and the difference between 1st month and 7th month compressed to just 3.7 points. This flattening often indicates that there is imminent downside in the broader market and could move VXX higher and XIV lower (although I don't like long being VXX without backwardation in first two months).

Term structure as of close today:

Coinciding with these technical signals,  the market expressed its displeasure of the FOMC when they suggested that they may need to reduce the $85Billion of QE that goes into the market each month, citing that continued QE may prompt excessive risk and that the economy is on a moderate growth path. But whether the level of QE can actually be reduced without causing an equity market sell off and a costly rise in interest rates remains to be seen.