Stocktake: Will the US Fed finally hike rates?

Will Fed hike rates? One question will dominate financial markets this week: will the Federal Reserve hike interest rates on Thursday?

The odds of a rate increase – the first since 2006 – hit 54 per cent in early August before plunging to 24 per cent three weeks later, following the sudden upsurge in volatility.

The International Monetary Fund and World Bank have called on the Fed to hold off, as have other influential names such as hedge fund titan Ray Dalio and former US treasury secretary Larry Summers.

A hike remains possible, however, and many see it as desirable. Zero interest rates, they say, is an emergency policy, but the emergency has passed. With strong jobs growth and US unemployment falling to 5.1 per cent, it is time for normalisation. The Fed can show it is not governed by stock markets.

However, Stocktake would be shocked if the Fed agreed. Bank of America last week noted that in four tightening periods since 1990, stocks were always near all-time highs in the run-up to the first hike. That contrasts with the current fragility, and a hike would be akin to throwing a match into the fire.

Deutsche Bank points to other reasons to hold off – low inflation, the strong dollar, the fact a hike is not priced into markets. Besides, the Fed can always raise rates in October or December; a wait-and-see approach seems more prudent. If the Fed does hike? Expect the mother of all stock market tantrums. Soaring Nikkei reflects nerves The Nikkei soared 7.7 per cent last Tuesday, its biggest one- day jump since 2008. One must ask: why?

Commentators cited China’s promise to “accelerate” fiscal stimulus. However, no specifics were offered; besides, Chinese stocks rose only 2.3 per cent. Others noted Japan’s promise to cut corporate taxes. In truth, this was old news, having been first promised last year. The World Bank’s recommendation that US interest rates be kept on hold helped global sentiment that day, but why should Japanese stocks be the big beneficiary?

My take: the above factors boosted sentiment in a deeply oversold market. Short selling had reached record levels in Japan in the previous weeks, with hedge funds buying the yen and betting against the Nikkei. As the shorts rushed to close their positions, they got squeezed, pushing prices higher.

Unsurprisingly, the Nikkei tumbled the next day. It's unsurprising because as we keep saying, sharp rallies are as much a feature of nervy markets as sharp declines; they should not be viewed as evidence that the panic has passed. All-or-nothing days for stocks Mr Market's mood swings have been similarly evident in the US, as evidenced by the frequency of "all-or-nothing" days.

All-or-nothing days, says Bespoke Investment Group, occur when at least 400 S&P 500 stocks move in the same direction. Such days reflect indiscriminate selling or buying. No one is looking at individual stocks, they are either fleeing the market en masse or stampeding into it.

Before mid-August there had been just 13 all-or-nothing days in 2015. Since then, there have been 11 in 15 trading days.

That's extraordinary: since 1990, there has never been a 15-day period with as many all-or-nothing days. The previous record (10) occurred at the height of the global financial crisis in late 2008, indicating just how uncertain investors feel at the moment. Global assets at 'peak value' A basket of global stocks, bonds and housing is more expensive than at any time over the last 200 years, Deutsche Bank cautions in its latest Long-Term Asset Return Study.

Don't worry, says Reformed Broker blogger Josh Brown; comparing current valuations with those of 200 years ago is "as meaningless an endeavour as you can think up".

Perhaps, but surely it’s relevant that a combination of global assets is more costly than it was at past market peaks in 2000 and 2007?

This same point was made recently by hedge fund manager Cliff Asness. US stocks are pricey, but they were more expensive in 1929, 2000 and in 2007. However, bonds are usually cheap when equities are expensive. Not today – Asness says bonds are in the 97th percentile in terms of valuation.

It’s rare for different assets to be so elevated at the same time. There are specific reasons for today’s elevated valuations but the prudent planner should surely prepare for lower future returns.