Fed-Watch Is In Earnest, But Will Fed Tightening Portend A Dismal 2017?

The general slide in the value of the Dollar versus other major currencies is readily apparent. It began in the seventies, when Nixon jettisoned the Gold Standard and a floating foreign exchange system began to take shape. Subsequently, the Fed literally expanded credit on a global basis, thereby enabling the growth of international trade and its ultimate consequences. From this longer perspective, the USD appears to have hit a diagonal ceiling of strong resistance at its present valuation. In other words, if the Dollar continues to strengthen, it may be putting sensitive international trade balances in jeopardy. Something will have to give, a concern shared by members of the FOMC and central bankers across the globe.

Everyone and anyone that has ever heard of the Fed is expecting a 25 basis point hike in its Federal Funds Rate target, following the completion of meetings on Tuesday and Wednesday of this week. The current target is 25 to 50 basis points, and the expected move would move the ceiling to 75 (current rates are actually a little above the 40 range). It is rare that the prevailing consensus is nearly 100%. In fact, it is difficult to find a single contrarian, who is willing to stake his or her reputation on the prediction that the “herd” has misread the tea leaves for this December.

The recent report out of the Department of Labor was right on target, 178,000 net new jobs were created last month, and the unemployment rate fell to “4.6 percent, in November, the lowest rate in monthly rate in nine years.” More importantly, the Fed has also been gradually reducing excess banking reserves in the system through its open market activities, a process that it also followed a year ago before the historic rate hike in December 2015.

For all intents and purposes, it would truly appear that the Fed has the “green light” to proceed. Per one analyst, “As far as the market goes, I would argue that the market has already priced in most of this increase in market interest rates. Furthermore, I believe that the foreign exchange market has also priced in this increase in determining the current level of the U.S. dollar.”

What could deter Fed action now? A strengthening USD is one possibility, but it has followed the rise in stock prices in lockstep. Otherwise, international tensions or the unknown could upset this apple cart: “Of course, something else could happen in Italy, in Venezuela, in Syria, in Greece, in India, or somewhere else in the world, or, in the United States, that would change the picture. But, then we have the question…what is the Federal Reserve going to do about interest rates in 2017?” No one has yet been willing to go out on a limb to suggest an answer to this poignant query.

Sir John Templeton would have viewed “Trump-phoria” with trepidation.

The recent market rally in stock prices has renewed a feeling of optimism among investors, bordering more on euphoria, if you check sentiment gauges and basic fundamentals. Before you run out and get fully invested, you may want to check insights of wisdom from the likes of Sir John Templeton, an American-born British stock investor, who became a billionaire by being a pioneer in globally diversified mutual funds.

Known as a savvy businessman and one of the leading philanthropists of his day, Sir John was never shy to share his prudent thoughts on market behavior. He actually shunned technical analysis, preferring to trust the fundamentals and his own intuition when it came to assessing trends in the financial marketplace. One of his observations most often cited is: “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” We doubt if Sir John would be “all in” at this stage.

Templeton would not be alone. There is a growing throng of doubters that see 2017 as a pivotal year, where equities may finally lose ground. The nature of the current euphoria became suspect after analysts began to take a closer look at its contributing factors. The rise in stocks was primarily a U.S. phenomenon. Global stock indices had actually remained flat or gone a bit negative. The S&P 500 reaction was predicated on a more business-friendly environment under a Trump administration, consisting of tax cuts, less regulatory red tape, and increased government spending on infrastructure projects and an expanded military presence.

Senate leaders are already claiming any tax amendments will be revenue neutral. Tax cuts to smaller domestic businesses may do nothing for the economy. Analysts believe the small changes will quickly be dissipated by competition. Multinational corporations have already figured out how to beat the tax code. Their effective tax rates are below other global competitors. In other words, the benefit of business tax cuts could be ephemeral. As for reducing regulations, this process will take time, and the benefits could take time to materialize, as well.

The Trump group will be hard pressed to deliver immediate job wins for their supporters. Any measure that smells like a stimulus package will only deal with the supply side of the ledger, but the continuing saga of the present economic doldrums is one that is lacking on the demand side. Repatriating corporate profits from foreign jurisdictions in hope of re-investment may be ephemeral, too. Previous attempts to tap into this $2.5 trillion treasure chest have only renewed efforts related to stock buyback programs, large bonuses and dividends, or M&A activity that resulted in job cuts, not the reverse.

That leaves the bulk of the work of carrying a populist tide to victory in infrastructure spending and a military build up that may ignite global tensions. Both measures will require deficit spending, unless matched with spending cuts. If the latter occurs, the economic benefit may again be, as with the other ideas, ephemeral. In other words, if it were easy to create new jobs in a hurry, it would have been done by now.

If you have followed the reasoning to this point, you might be seeing the handwriting on the wall for 2017. The headwinds are building, right in line with what has been termed “Presidential Election Year Principles”. In order to cut to the chase, the last dictum in this historical perspective states that an all-encompassing euphoria drives stock prices north, before the new president can even assume office. His first year in office is then plagued with making headway immediately, when reality resists him at every turn. The inevitable outcome is a depressed stock market and all that goes along with that collapse.

Is there another leading indicator, which foretells this outcome? As a matter of act, there is. Margin debt has a way of predicting possible pullbacks in stock valuations. Here is a representative chart that depicts this correlation: