Since my last Chart of Week post, the market has staged an impressive comeback. Now, we are basically trading unchanged for the year. The reversal has been powerful and has caused a lot of performance anxiety because market participants have cut back risk in January and February. As someone who is bearish, I am surprised but not too surprised. This happened twice last year, in January and October. The market structure has worsened since the financial crisis, with the sharp reduction of bank balance sheet capacity and the increased growth of rule-based funds such as CTAs (Commodity Trading Advisor), risk-parity, and volatility-controlled funds. This market structure is prone to V-shaped moves.
During last week’s Federal Reserve (Fed) meeting, the Fed surprised the market by being more dovish than expected. This is almost a replay of the meeting held on March 18, 2015; the Fed gave a similar dovish talk and lowered the dot plots last March. Back then, the risk market rallied sharply and the U.S. 2-year and 3-year Treasury increased 15 basis points that day. Eventually, the Fed still moved ahead and started the hiking cycle in December.
I recently attended an event with Ben Bernanke. His intelligence is impressive, and he is funny when he is not in the limelight. One thing he said (I cannot remember the exact words) is: Talk is a more important tool than action for central bankers. He used Draghi’s “whatever it takes” speech as an example. I think the current Fed is doing the same thing here. By talking dovish, the Fed eased financial conditions without any action. The Fed lowered dot plots from four hikes to two hikes for the year, but, the Fed fund futures have only priced in one to two hikes for 2016 all along.
One thing worth noting is the recent increase of inflation, if you look at today’s chart, you can see Core CPI, Core PCE and average hourly earnings are all showing an uptrend. If this trend sustains, the Fed has to make a choice between overheating the economy or hiking the rate more quickly. Neither of these two scenarios is good for asset returns.
Key Takeaway: Risk rally is the pain trade because of market positioning. The risk rally, the rotation from growth to value, dollar weakness and the reversal of the commodities are causing widespread underperformance of active managers. However, this doesn’t mean we should buy for the short-term gain. The risk-reward in the market is not favorable. Stay cautious.
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