It Came in Through an Open Window
According to the CME FedWatch Tool, the probability of a rate hike next week stands at 93%. A window has opened allowing the FED to raise rates; unemployment is down to 4.7%, hourly earnings continue to rise (2.8% y/y), and inflation in January was 2.5%. The FED has been preparing the markets for a hike since December ’16 when inflation started to accelerate, so they are not about to waste two months of effort — they will raise rates, and the market won’t mind.
To be honest, we think the main reason the FED will raise rates next week — apart from the desire not to fall behind the curve which would require bigger and faster tightening later on — is to have a cushion in the event that a future problem necessitates a rate cut. The FED has two tools; control over the cost of money it lends to the banks (FED funds rate), and quantitative easing. The former tool was totally spent with no room to cut rates, and the latter requires increasing the money supply which risks causing inflation. If the economy needs help in the future, rate cuts are favored over QE because QE carries inflation risk.
A rate hike now, is not expected to hurt the market in the same way that rate hikes affected markets between 1980 and 1998. During that period, rates and the SPX had a negative correlation; rates up, SPX down (Chart below).
Between 1998 and 2011, rates and the S&P 500 moved in tandem; rates up, SPX also up (chart below).
Between 20011 and today, the relationship has been more random, although since November the SPX has been rising along with rates (green arrows in the chart below). This makes it probable that a further rise in the FED funds rate will not hurt the S&P 500 in the short run.
The bull market continues…for now.
Equities
Markets are proxies for Human emotional behavior, just as casinos are, and as such, they tend to reflect sentiment more often than they do fundamentals (although fundamentals always have the last word). Market tops rarely, if ever, coincide with low bull sentiment. Fear and uncertainty are emotions most common in bull markets — bulls climb a wall of worry — while complacency and confidence are the hallmarks of market tops, and the harbingers of bear-market panic. This week, the AAII investor bull-sentiment indicator dropped 7 points down to 30%, and the bear-sentiment jumped 11 to 46%. This level of fear is not how bear markets begin.
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The put-to-call ratio also is a reading of market sentiment — low ratio implies complacency, while a high ratio means participants are hedging out of fear. Down-spikes in this ratio correspond to tops. At the moment, this ratio is neutral (chart below).
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The Rydex Funds bear/bull asset allocation ratio also measures sentiment by recording where fund managers are putting their money; they tend to be more bullish at market tops, and more bearish at market bottoms. They have been historically bullish for some time now (low ratio), but the average has yet to turnaround and start to rise to signal a top (chart below).
As previously mentioned, fundamentals eventually have the last word in the market, and the next two graphs show that price action and GAAP earnings are saying that the market has further to go.
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Gold
The true drivers of the gold price — the USD, rates, USD/JPY ratio, and inflation — continue to point gold in the down-direction. The 2-year rate, unlike the 10 and 30-year rates and the dollar, made a new local high as the gold price collapsed down to support at $1200 (chart below).
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The USD/JPY FOREX ratio is recovering and the price of gold is dropping (chart below).
Inflation, as measured by the Pring Inflation Index, continues to drop as the reality of a FED rate hike sinks in (chart below).
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