We like the old adage, “Don’t fight the Fed.”
Rather than fighting or doing the opposite of the Fed, we’ve found that the best way to survive choppy market conditions that arise from their moves is to follow their lead and trade accordingly.
Now, here’s what the Fed is doing, why they’re doing it, and how you can follow suit…
The Fed is trying to unload the $9-trillion balance sheet that it racked up in an attempt to prop up the 2020 pandemic economy. It slashed interest rates and began buying government bonds and mortgage-backed securities during that time, and without getting too technical, that liquidity led to the inflation we’re seeing now.
Now the goal of this balance-sheet reduction is to begin draining this liquidity out of the system to relieve inflation. The strategy includes selling Treasury bonds, corporate debt, and mortgage-backed securities, which has the potential to rock the market. But we also see some opportunities to profit for savvy investors who follow its lead.
The Fed is selling bonds, which will send interest rates higher. Historically, interest rates and stocks trend together so this wouldn’t normally be a problem. However, if inflation and interest rate levels are increasing very quickly, like they are now, it is an issue for stocks.
We had some hope that today’s CPI report might give the market a little breathing room and pause the trend of interest rates. However, the latest release now shows inflation last month at a 40-year high. So, for now, we don’t expect the S&P 500 to head towards new highs. Our focus on income is the best strategy at this point.
Can Stocks Survive 3% Treasury Yields?
The European Central Bank (ECB) shook things up a bit yesterday when they released their monetary policy statement and the expectations they set for their plan with interest rates. Combine that with what the Fed is looking to do with interest rates, and we saw a bit of a selloff yesterday.
And with the ECB raising interest rates later this summer, after holding off for quite some time, we will see an impact on bonds as well. One of the critical things with the European economy is this that when the Fed raises interest rates, it only impacts the bonds for one country, the U.S. but when the ECB says it is going to raise interest rates, it impacts bonds for all of the countries in the Eurozone, and they don’t all react the same.
When traders got this news, they started to process through it, and we started to see some traders trying to get out across the board. Be sure to check out the recording of last night’s livestream on our YouTube channel as we take a looker deeper into what happened yesterday.
Livestream Q&A
As we do every week, we welcomed viewer questions about investing, specific stocks, and whatever else is on your mind when it comes to the stock market. Here are a few we addressed this week…
1. Any advice on selling or holding oil/gas stocks if they have been held for a few years? I hate to sell since they are paying for all my stock sins. – Doc E.
Knowing when to sell will always be tricky, but we always say that you should let winners run. In this case, we don’t see an end to the run in oil stocks until there is more progress towards a resolution in Ukraine or economic fundamentals shift downward. In our view, both scenarios seem unlikely to appear this summer.
2. How do the Russell 2000 and small-caps IWM perform during high inflation times like the present? – Rajesh S.
Small caps tend to be more sensitive to inflation because their cost of capital is higher. Smaller companies pay higher interest rates as inflation rises. Because they lack market power, they can’t raise prices quickly to offset their rising costs.
3. What would be a time frame for buying a put? One month… three months? – Norma A.
Options are a “wasting” asset, meaning they fall in value closer to expiration. If you think a macro-economic factor is going in your favor, then the more time, the better.
4. Does the Fed selling bonds have any effect on the U.S. dollar? – Thomas P.
It should strengthen the dollar versus other currencies. If the Fed is selling bonds, they will be removing a supply of dollars from the economy, which should drive its “value” up relative to other currencies. The Fed is doing this to raise the cost of capital (interest rates), which usually also increases demand for the dollar. A side effect of a rising dollar is that imports become cheaper, which would be anti-inflationary, so it would be in the Fed’s favor to try and boost the dollar’s value in the short-term. However, we don’t think the pendulum will swing too far. A rising dollar is bad for US exports and services, which would drag on the economy.
Awaiting More Data…
The push-pull between expectations for growth and fears that the Fed will hike rates too quickly continues this week. As we mentioned yesterday, this back and forth is likely to persist this week while traders wait for more inflation data.
Just this morning, the CPI report for May was released with U.S. consumer inflation reaching its highest level in more than four decades. The Labor Department reported the consumer price index increased 8.6% in May for the same month a year ago. We may start to see some pressure on the Fed to lift interest rates quickly in an effort to control rising prices.
And remember that for now, we continue to recommend focusing on maximizing income from our long positions.
To ramp up our income as much as possible, we are looking for good opportunities to close our covered call positions when prices drop and sell more premium once a stock hits resistance.
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