What’s happening now – before this afternoon’s U.S. Federal Reserve interest rate announcement – reminds me of where I was last week and what happened there.
I was in Las Vegas, baby!
Throughout the casinos, you could hear folks saying: “Ladies and gentleman, place your bets!”
And the same thing is happening right now in the stock and bond markets.
Traders are handicapping what’s next for interest rates.
As a result of this, some big – but mostly tentative – bets are being laid down in advance of today’s 2 p.m. announcement of the policymaking Federal Open Market Committee (FOMC).
The bet itself is a simple one: Will Fed decision-makers raise rates… or won’t they?
The wheel is spinning, and all the bets that are being placed – as far as I can see – are on red or black.
In short, either “yes” or “no.”
However, there’s another bet to place… another trade to make.
No one except me – and now you…
We Interrupt This Disruption…
You’ve heard me talk a lot here about market “Disruptors.” In our search for what I refer to as “extreme profit” opportunities, Disruptors are the news events, financial catalysts, market triggers or other “agent of change” forces that lead to the biggest moneymaking plays you’ll find.
And the “zero-interest-rate policies” (ZIRP) the Fed deployed to combat the credit-market collapse of 2008 were one of the biggest market Disruptors in history. ZIRP – coupled with a bond-buying initiative known as “quantitative easing,” or QE – ignited one of biggest bear-market rebounds in modern history.
Quantitative easing ended on Oct. 29, 2014. And at the meeting today, Fed policymakers may raise the benchmark short-term interest rate for the first time in nearly a decade.
Call it the “inverse” of one of the greatest market Disruptors in stock-market history.
And that would mean an interest-rate hike is a major Disruptor, too.
The stakes are huge all around.
There’s a problem here, of course: No one really knows whether a rate hike – or no rate hike – will be good or bad.
The Fed’s “wealth effect” is at stake if the central bank boosts rates and the stock market crashes.
It’s the wealth effect that makes consumers feel better when rising stock prices show up in the headlines and in their retirement accounts.
It’s the wealth effect that makes them feel better about the economy and that motivates them to spend, baby, spend in a cycle that keeps the economy healthy.
The belief in the Fed is also at stake.
It’s this belief in the Fed – that the central bank can engineer rising asset prices and can engineer an escalation in gross domestic product (GDP) growth – that allows consumers/investors to spend by day… and sleep at night. A rate increase that short-circuits this consumer confidence and growth will send damaging ripples throughout the financial system.
The smooth-and-efficient functioning of the interconnected global economy and globally correlated stock and bond markets is also at stake.
A rate increase that causes any or all of this to seize would be devastating.
Let me show you why this would happen…
Let’s say policymakers boost the benchmark federal funds rate by a quarter percentage point – 25 “basis points” in Wall Street parlance.
This would have a negative impact on global markets because of its effect on currencies – specifically the U.S. dollar.
An increase in U.S. rates would strengthen the greenback – which, in turn, makes other currencies cheaper on a relative basis.
Foreign companies or governments that borrowed in dollars would have to come up with more of their home currencies to make interest payments or repay principal in a currency that’s appreciating.
That increases the cost of their debt at a time when debt is a bad, bad word.
But what if the Fed doesn’t raise rates?
If policymakers don’t boost rates today, there may be a stock-market “relief rally” that pushes stocks higher – and does the same for bonds.
But here’s why I say that no one really knows how the markets will react to whatever decision U.S. central bankers make.
Stocks and bonds could rally if the Fed leaves rates alone.
Or they could both sell off.
The reason markets would rally is because – if rates are kept low, as they have been – stocks might get back to what they’ve been doing during this long run of low rates.
If stocks sell off, it will be due to the investor realization that the lack of a rate hike now is merely a delay of the inevitable.
Under that scenario, traders could view a delay as nothing other than more hot air entering an already overinflated market.
In that case, markets will do what they sometimes do: discount the future and sell off now in anticipation that that a bigger bubble will only lead to steeper future price declines.
So investors sell rather than stick around to see where things might settle.
The Wager I’m Making
The “right” Fed fix might avert some of these nastier scenarios.
Because the Fed has no way of knowing how domestic and global markets will react to a rate hike – or not hiking and risking asset bubbles inflating further – policymakers should “rig” the outcome by having the roulette ball fall between red and black bets.
The Fed should raise rates by 10 basis points. That’s the smart play.
An unexpectedly tiny hike tells the world that U.S. central bankers understand they can’t raise rates much while global conditions are so precarious. But it also demonstrates that these policymakers want to eventually “normalize” rates – and are willing to take “baby steps” to get that journey started.
I don’t know anyone else who’s expecting the scenario I’ve just detailed for you here. But I believe it’s the perfect middle ground.
Then again, because I am a gambler (and, yes, I did come away from Vegas with a pocketful of cash) – and because I don’t think the Fed has any idea how to calculate odds, and that they won’t make the smart play – I’m going to place my own bet.
Either way – with a rate hike or without a rate hike – I don’t like where stocks could go. A hike could send them down. A decision to delay an increase could inflate the bubble further, until it pops and falls harder.
So I’m placing my bets on “inverse ETFs” – exchange-traded funds – that will rise in price if the market indexes fall.
These inverse plays will give you protection – and profits – should markets fall.
Of course, I’ll have tight stops on them… in case they go against me.
After all, I’m a smart gambler… not a good loser.