Consider These Unconventional Bets On Rising Rates

ratesMike Burnick: Yesterday the Fed began its long-awaited monetary policy “normalization” at last.

The Federal Reserve began its first interest-rate tightening cycle since 2004 with a 0.25% hike in the Fed funds rate. It’s a small first step, and almost certainly won’t be the last move.

In fact, before yesterday’s FOMC decision, the Fed’s now-famous “dot plot” projected four interest-rate hikes in 2016. Meanwhile, financial markets are forecasting a more dovish path, expecting just two increases in Fed funds next year. That’s what makes it a market, after all.

And you can bet expectations will keep shifting considerably in the months ahead based on every twist and turn in the economic data and financial markets.

What do we have to fear from this rate-tightening cycle?

Click image for larger view

The conventional wisdom suggests that commodities and emerging markets will get hammered by a stronger dollar. And clearly Treasury bonds are doomed in a rising interest-rate environment, as everyone knows.

But history suggests otherwise

Granted, the stakes are higher in this rate-hike cycle than ever before, so the history of Fed tightening cycles in the past may not apply as well this time around.

Never before has the Fed hiked rates with such a huge balance sheet, bloated with $3 trillion worth of securities purchased through multiple rounds of QE.

And never before has the Fed raised rates with so much liquidity sloshing around in the financial system. Banks currently hold $2.5 trillion in excess reserves at the Federal Reserve.

These are just two of the complicating factors that could spoil the Fed’s best-laid plans. That said, there are still some flaws in the conventional wisdom as this tightening cycle gets underway.

Let’s take a closer look at fears about a stronger dollar that are perhaps unfounded. Here’s the conventional logic: The U.S. is the only major economy with rising interest rates while nearly every other central bank around the world is easing monetary policy.

As a result, the interest-rate differential between the U.S. and the rest of world will trigger huge capital inflows into U.S. dollar assets in search of higher yields, or so the argument goes.

But in reality, the dollar has declined during the last three rate-tightening cycles in 1994, 1999 and the last time around in 2004.

Click image for larger view

The culprit: Markets had already priced in the likelihood of rising interest rates. So when the Fed actually got around to making its first rate hike, the move was already baked in the cake.

Buy the rumor; sell the (dollar) news!

Look, the Fed has spent more than a year preparing investors for this move. It’s been the worst kept secret on Wall Street and came as a surprise to no one.

And when you look back at previous rate-tightening cycles, the same pattern repeats again and again.

When the Fed first hiked rates in 1994, markets were expecting it. Rather than sending the dollar soaring, the buck slumped for 11 of the next 14 months into 1995.

In June 1999, the Fed started hiking rates again as the bubble began overheating. The U.S. dollar index fell 3% the very next month.

And when the Fed embarked on its last tightening cycle in 2004, the dollar dropped 9.3% over the next six months.

In fact, the conventional wisdom about dollar strength as interest rates rise appears dead-wrong.

Each time, the dollar rose in advance, by an average of about 9% during the six to nine months BEFORE the past three rate-hike cycles, according to Bloomberg.

But the buck dropped by an average of 6% in the six months AFTER the first Fed rate hike. And sure enough the Dollar Index is already up 7% year to date, as markets have once again priced in the Fed’s move well in advance.

And if the conventional wisdom about dollar strength is all wrong, then the conventional fear of an emerging market and commodity sell might be dead-wrong too.

After the Fed began tightening in 2004, emerging-market stocks were one of the best performing asset classes, soaring 135% over the next two years.

And making this trade even more unconventionally appealing today is the fact that emerging market stocks are one of the world’s most-hated asset classes right now.

According to a recent survey by Merrill Lynch, fund managers are 27% underweight emerging markets, leaning way too bearish at just the wrong time.

Buying commodities could very well be another unconventionally profitable trade right now.

Gold for example soared 56.7% in the two years after the Fed’s last tightening cycle began in 2004. And sure enough, investors are also extremely bearish on gold at the moment.

(…)Click here to continue reading the original article: Consider These Unconventional Bets On Rising Rates
You are viewing an abbreviated republication of ETF Daily News content. You can find full ETF Daily News articles on (