Another FOMC minutes release has passed. There was the usual media excitement leading up to it, and the usual muted response from the market that follows. People get very riled up when talking about interest rates and the implications of raising them. I turned off the TV this morning when I realized that the segment was being dedicated to speculating on whether today's minutes would include adjectives used in previous minutes releases. Apparently economists are going to have to get PHDs in linguistics if the Fed stays heavily involved in markets much longer.
Let's do a quick reality check. What does the labor market have to do with interest rates?
Most would say something along the lines of "low interest rates are important at times of economic slowness because it makes borrowing cheaper. In turn, people are more likely to start businesses, take out a mortgage, or hire new employee". I think that comes at least somewhat close to capturing the general perception of how raising interest rates changes the economy.
If you are someone who thinks this way, I would encourage you to consider the idea that the labor market has very little to do with this, and that a 25 basis point raise would have almost zero effect on an individual's decision to take on a mortgage or start a business. Neither would a 1% raise in the cost of borrowing.
Someone who is considering taking out their first mortgage is not concerned with 25 basis points nearly as much as they are their own sense of security about their future cash flows. Imagine a couple with a combined annual post tax income of $100k shopping for their first home. How big is the difference between a mortgage that requires $25k in annual payments and 30k?
One payment is 25% whereas the other is 30% of annual income. Is 25% clearly a reasonable amount to spend? Is 30% too much?
You can't answer the question until you know more about this couple. If you learned that both members of the couple were high school teachers in a well to do town, the mortgage at 30% might be very reasonable. If only one member of the couple works, and he happens to be an options trader, 25% is probably too much risk.
In this example, 5% is a minor consideration among the other risk factors that will ultimately guide this couple's decision. 25 Basis Points is only 5% of 5%. It is a rounding error when it comes to real people making real financial decisions.
So don't buy into all this rate hike hype. We all need to be a little smarter than to take the Civics 101 explanation that the Fed minutes provide. 25 basis points is statistically insignificant to the vast majority of individual or small businesses considering taking on a loan. The question then becomes, if "labor market slack" really isn't what is at stake with this potential rate hike, what is?
Derivatives with price sensitivity to interest rates.
While 25 basis points means little to me, it might mean the difference in millions to companies who have outstanding floating rate debt. If companies take on debt with exposure to rising rates (particularly leveraged exposure), small raises in rates could be their death knell. The derivatives market is enormous. Trillions of dollars enormous. While the gold options I trade every day are cleared on an exchange, a great number of outstanding derivatives are private deals between companies (banks, insurance companies etc). Following the economic collapse in 2008, our entire system of commerce was thrown into panic. Stabilizing the banks, and probably more importantly, their ability to meet their obligations to their creditors became paramount. When leverage gets involved, small differences in interest rates can turn into economic landmines. We cannot know for sure what motivates Fed policy, but there are a few simple things I would suggest we all keep in mind.
1)Derivatives were at the heart of the Financial Crisis of ~2008
2) Derivatives' (options, futures, private contracts) value can be highly sensitive to interest rates
3) Federal Reserve (along with the Treasury) market intervention has increased drastically since the beginning of the financial crisis
4) The Federal Reserve sets the discount rate, which effects all interest rates, and therefore, the price of derivatives.
I am no economist, but I have traded every FOMC minutes release for the last two years, and I can say first hand that over time markets have begun to care progressively less about them. The options action in gold really tells the story best.
It used to be that hype would surround a Fed meeting, and options would get bought and volatility would firm in the days leading up to the event. If nothing happened, the options would get crushed following the minutes/meeting, and life would go back to normal. The perfectly executed strategy would involve buying options in the days leading up to the event, and selling them all and getting short right before the release. It worked for months.
Some people realized this pattern of excitement manifested in options buying was exploitable. As more Fed meetings passed, the sellers started selling earlier and earlier. Those who started buying days in advance were buying into an onslaught of volatility selling....I was one of those people at least once. At a certain point, it became clear that there was a paradigm shift.
What was once the meaningful event that brought fear and options buying to the market, has become a time for traders to sell options. In many ways it makes sense. Nothing has really changed except the warning the rate rise is happening by the end of the year. And the fact is, we've been told that. Does it make a difference if its next month or the month after? The only way it would fundamentally make a big difference is if the derivatives out there could somehow blow up as a result of the rate raise and cause calamity.
We might not all know about the loan exposure of a firm that is essential to our economy's stability, but Janet Yellen does. There has been ample time (about 7 years) to let some of these contracts expire, and figure out to do with the other ones. Remember, the government bought a lot of these derivatives itself. The Fed knows what they are doing, and if they are going to start raising rates, that means it is probably safe to.
There will be no drastic economic slow downs due to a few 25 basis point bumps in the discount rate. If a lot of money moves in markets and the liquidity is not there to take the other side of orders, there could be some chaos. But the Fed has telegraphed their intentions so clearly that anyone with major blowout risk from a rate rise has had plenty of time to hedge appropriately.
As for gold, while it has made multi-year lows since breaking support at 1142, it has held its own. With managed money now net short gold, we are seeing gold hold up pretty well given the new short interest in the market. Since gold's 50 dollar dive two Sundays ago (low 1080) gold has only managed to push 8 dollars lower, and that was met with strong buying. The trend is unquestionably down, and nothing has taken place that negates that. With open interest building from the short side, short covering rallies are always a possibility. However, resistance has been strong near 1104. In fact, while gold has spent little time as low as 1080 (the Sunday low) it has not been able to test the recovery high it made off that low that same night (see picture below).
This is a 20 day chart with each candle representing one hour of time. Notice how the move down to 1080 happened in a flash. That same night it rallied all the way back to 1118, but it has since failed to retest that high (or even get close). You can see in the chart above how I drew a horizontal line around 1086. This seems to be a pivot point for the short term chart. I see the bears as maintaining control for now because while there has been some short term support at 1086, it has been unable to hold a rally of any consequence. If it were to rally above 1110, I think you would see some short covering and a likely retest of 1130, and possibly quickly. If you are short gamma, be careful not to get caught if we trade above 1104 as I don't see much to stop it from an extended rally if it gets above 1110. All that being said, this is just not a good risk reward here to get long. If you want to play this market from the long side, I think you want to be buying when you see the buying come in, not trying to get in front of it. For people who haven't traded gold before, if you are impatient, don't put anything on at all. Gold often makes you wait longer than you ever thought humanly possible.
On a longer term outlook.....
Above is the 3 year chart. Notice the big down channel I've drawn. The tops connect remarkably well. The bottoms look good, but right here we sit on a decision point. While it briefly broke the line two times, it has not settled below it on a weekly basis. The more gold sits here and consolidates, the more bearish it will become. If you look at the previous 3 points on the down channel you will notice that they all saw strong rallies off the lows back up to the top of the channel. If you see gold consolidate here, it will be a sign that the strong buying presence at this level has evaporated. If a longer term downtrend like this were to break it could lead to a drop of hundreds of dollars rather quickly. However, there are multiple banks out there with targets of $1000 (over different time periods), and that alone makes me think there would be some medium term support at the millennium mark. If gold were to rally and put in yet another bottom at this level, 1130-1145 would serve as major resistance. A rally above ~1145 could produce a retest of the May high near 1235 (that is approximately where the top of the channel would come in if the rally took place in the next few weeks). If you want to play the market with an outlook of a couple of months, you could get short here around 1095 looking for 1000 and stopping out at 1140; While it is probably a positive expectation bet in this spot, I personally will be watching the price action into at least the middle of next week before taking any strong directional stance.
-Ben Ryan
