Sunday, April 14, 2019

How "patient" can the Fed be?

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, "Is the trend in the global economy expansion (bullish) or contraction (bearish)?"

My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don't buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Bullish*
  • Trading model: Bullish*
* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of the those email alerts is shown here.

What are the limits to "patience"?
The credit market may be setting up for an unpleasant surprise. According to the CME's Fedwatch Tool, the market mainly expects no change in the Fed Funds rate for the rest of this year, with the possibility of a cut later in the year. It is not expecting a rate hike. Politico reported that Trump's economic advisor Larry Kudlow went even further: "I don't think rates will rise in the foreseeable future, maybe never again in my lifetime."

The minutes of the March FOMC meeting tells a different story. Since the Fed made the U-turn and adopted the policy of "patience", the Committee is not expecting any changes in rates for the rest of 2019:
A majority of participants expected that the evolution of the economic outlook and risks to the outlook would likely warrant leaving the target range unchanged for the remainder of the year.
However, some members would not rule out another increase in interest rates this year. The strength in the labor market could raise economic growth in the months ahead, though not as rapidly as last year.
Underlying economic fundamentals continued to support sustained expansion, and most participants indicated that they did not expect the recent weakness in spending to persist beyond the first quarter. Nevertheless, participants generally expected the growth rate of real GDP this year to step down from the pace seen over 2018 to a rate at or modestly above their estimates of longer-run growth.
There was also some uneasiness over the use of the word "patient" as it could be viewed as handcuffing future actions if the time came to raise rates:
Several participants observed that the characterization of the Committee's approach to monetary policy as "patient" would need to be reviewed regularly as the economic outlook and uncertainties surrounding the outlook evolve. A couple of participants noted that the "patient" characterization should not be seen as limiting the Committee's options for making policy adjustments when they are deemed appropriate.
Who is right? The market or the Fed? If the bond yields start to rise, what does that mean for stock prices?

The full post can be found here.

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