The Normal, The Odd, and The SupernaturalSubmitted by Wespac Advisors, LLC on May 23rd, 2016
In a much too familiar movie, the Fed is once again signaling that all is well and they will resume their tightening cycle at the June meeting; having watched this movie 4-6 times a year for the last several years, I think we have a pretty good idea what the ending will be.
The great bugaboo for the Fed’s attempt to end its ZIRP policy is that the rest of the world is still caught in the NIRP/QE horror show; the Fed’s relative tightening has and will continue to send the US dollar flying. That is not good on two key fronts – exports and the oil patch.
Over the coming days there will be countless articles about the Fed raising rates and what it means for everyone and everything; I think it is important to understand that the relationships between equities, the US dollar and crude oil have been changing, so concluding what will happen is not quite that simple.
In the chart below, examine Phase 1. The S&P 500 (red) and crude oil (green) are highly correlated. The US Dollar Index (blue) is generally negatively correlated. Phase 1, or the Normal Phase, pretty much ended in 2011.
In Phase 2, something odd happened. Crude oil and the US dollar were nearly perfectly correlated. The SPX, in this odd phase of QE, went on its merry way with no real relationship to the US dollar or crude oil. Let’s call this the Odd Phase.
In Phase 3, something supernatural happened. Crude oil and the US dollar resumed their correlation in a spectacular way; the US dollar index climbed +26% while crude oil fell an incredible -77%. If we were in the Normal Phase, the SPX should have followed crude oil into a huge bear market. It did not. If we were in the Odd Phase, the SPX should have continued on its merry way. It did not, it stalled in a 2-year sideways pattern. We are in the Supernatural Phase.
So, what happens now if the Fed resumes its tightening cycle? The first question would be, what Phase will we enter then? Normal, Odd, Supernatural, or a new phase?
I suspect that we will stay in the Supernatural Phase; if the Fed raises rates, the US dollar will climb back to the top of its range in the 100 area, and crude oil will take another run lower. But what of the equity markets? If the Supernatural Phase persists, it would suggest that we continue sideways in this 1800-2100 range.
The bears of course, believe that we will eventually return to the Normal Phase and the Fed will inadvertently trigger the third major bear market in 15 years. Could that happen in an election year when everyone in the establishment is laser focused on not rocking the boat? It happened in 2008…
I personally doubt the Fed will raise in June, so this entire debate is probably moot and the Supernatural Phase it will be; however, keep a sharp eye on the US dollar index. That will be the tell if change is afoot