Will we Test the Fed.

Wed 05 Jan 21

Markets are already adjusting into the second day of the new year - it has everything to do with inflation and the interest rate path.

Last month, the Fed calmed markets by suggesting it would indeed start a tightening cycle - they projected a shallow path for interest rates (never needing to exceed the Fed's long-term target Fed Funds rate of 2.5% over the coming years). Stocks liked that, particularly the high flying, high multiple stocks (i.e. big tech "innovators").

So, staring down the barrel of 7% inflation, the Fed told us, just a few weeks ago, that they would tame inflation, to land close to their 2% target, by this year (2022). They would do so, this year, while producing a 4% growth economy (well above trend) at 3.5% unemployment (near record levels) - all while keeping the Fed Funds rate under 1%.

Those are the expectations the Fed attempted to set for the market.

The market is now beginning to price in a more realistic scenario, entailing hot inflation, and a more aggressive rate hiking campaign.

With that, over the past two days, the interest rate market has been on the move. What was priced in to be a June liftoff in rates is now looking like March.

As we discussed into the end of the year, a rising rate environment all sets up for money to move out of the high flyer/no eps stocks, and into value stocks with strong cash flow. A more aggressive Fed would only amplify this rotation.

When you think of value and cash flow, energy fits the bill. This is the only sector in the S&P 500 that is in the red over the past five year period. With an anti-fossil fuel regulatory environment restricting new investment, the survivors of the storm are selling production at higher prices, and instead of ploughing money into exploration, they are producing cash and returning that cash to shareholders. With that formula, no surprise that oil stocks have been on a tear to open the year.

With a sharply steepening yield curve over the past two days, the bank stocks have been on fire. Bank of America is up 8% in two days, Wells is up 10%, Goldman is up 6.6% in two days and Citi is up over 5%.

Now, with the above in mind, we shouldn't underestimate the power of the calendar. With a new year, markets often go through a regime change - we're seeing signs of it.

This will be the year the Fed is tested - and bad policy may be exposed -  we should keep a close eye on these three spots (gold, the dollar and bonds).

If you came in last year loading up on gold (the historic inflation hedge), in anticipation of hot inflation, you got the hot inflation but gold lost 4% on the year. The dollar didn't unravel under the pressure of extravagant deficit spending and money printing (in the face of a hot economy). The dollar went up in value against major currencies, not down. Treasuries, which would, in theory, be dumped under inflationary policies, did very little on the year.

But it's a new year.