US Economy: who is wrong: the Fed or the Markets?

Posted: May 4, 2015 in Uncategorized

There are two side story in the US economy – one is wrong.

The correct one will make or bust the ongoing share market rally.

Which one is the correct one – it is the hardest decision.

Story A – Positive for the market

The US GDP came in at +0.2% -a long way down from the previous +2.2%.

Market reaction was quite muted as the US economy always slow down in the first quarter due to bad weather.

But there could be other two factors that could point to an US economy really slowing down.

The strength of the US Dollar.

Usually this “issue” has always played down by the fact that the US exports only 13% of GDP – but this has never been tested recently as the last “strong dollar” period was pre-2000 in a completely different economy. So there are no hard data to support this theory.

The demise of the oil price.

The shale oil and gas industry has been the engine of the US recovery. The effect of the slowdown of this fledgeling new industry it is not known.

So, if really there is a slowdown in the US economy the Federal Reserve will have to push in the future any rate hike (last prediction September 2015) and fuel this “free money” addicted rally to higher highs.

This scenario seems to be what the market thinks: The swaps for the  Feds Fund Rate (FFR) for 2017 is at 1.7%

Story B – Negative for the markets

Each Federal Reserve member median forecast instead agrees to a FFR to 3-3.25% for 2017.

And at least some large institutions like Blackrock agrees with this scenario

 

This divergence of “opinions” is really staggering and never seen before.

Practically the market says that the US is in a long term stagnation scenario, while the Federal Reserve sees the US economy in recovery mode and it is preparing to normalize the rates in light of this “normal economy scenario”.

 

These two scenarios bring two completely different scenarios.

As bond yields are more maths-based the difference is easier to calculate on bond.

25%!!!

So if the Federal Reserve really increase the rates the yield will jump up 25% and the capital value of fixed interest US Bonds (Eg Us T-Bond 30 years- let’s not make a bundle of every bond as the media always  does) will be crashed.

The share market will be crashed of the same amount (or more, depending by animal spirits).

 

Per converse, if the FED is wrong the reverse will happen with a mega rally.

These two profoundly different visions have deep repercussions in any markets – share market, bond, currency and commodities.

Probably the reality will be in between this two extreme scenarios – but it is interesting to note that, historically, there has never been such a difference – so we just proceed with the usual caution

 

NOTE1 : you are invited not to assume that the FED is always right as it is not. More often than not, historical data show that the FED overshot/undershot the target. But, even when they are wrong, the ball (interest rate decision) is in their field.

Note 2: this strangeness is on top of various strange situations introduced by the meddling of the Reserve banks in the market (such as negative yields on “up to 5 year German Government bond (it is like if a bank paid you in order for you to get a loan…really hard to explain!) or Italian Bond being priced as being less risky than the equivalent US Bond (Italian Bond 10y yield: 1.43%pa vs US Bond 10y yield 2.11%pa

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