06/15/16   Fed On Hold As It Mulls Brexit

Editor’s Corner

Ron Rowland

The odds of the Federal Reserve taking any action at today’s FOMC meeting fell precipitously after the release of the May employment reports. Just a few weeks ago, June and July were thought to be the most likely months for the next increase. A year ago, a second increase for interest rates by this time was considered a sure thing. Based on Fed Fund futures trading this morning, the probability of a rate increase occurring today was only 2%, and the December probability at 56% was the first month exceeding the halfway point. Later in the day, after the FOMC meeting concluded, the December probability dropped as low as 45%.

Therefore, it came as no surprise when the Fed announced there would not be any changes to its interest-rate policy today. Even though the financial media diligently follows every movement the Federal Reserve makes, the Fed does not control the interest rates that are important to you and me. Although the Fed is on a path to raise interest rates, the yield on 10-year Treasury securities fell from above 2.3% in December to below 1.6% this morning. Unlike to Fed Funds rate, the 10-year Treasury rate is important to us. We can choose to lend the U.S. government our money for 10 years by buying these 10-year notes and holding them to maturity. However, waiting 10 years for a 17% cumulative return does not seem like an exciting prospect. The 10-year Treasury yield is also important to us because it indirectly determines the interest rates we pay on our home mortgages.

For Germany, the yield on its 10-year government bonds went negative this week. Instead of paying bond buyers interest for lending it money, the German government is now effectively charging a fee if you want to lend them money for 10 years. Unfortunately, this (or any negative interest rate) does not work in reverse. No one is going to pay you to borrow money from them; this is a trick only large governments are likely to pull off.

Besides economic concerns, another reason for the recent decline in global interest rates is the growing probability of Britain’s exit (“Brexit”) from the European Union. What was once nearly unthinkable has mushroomed into a very real possibility. The June 23 referendum is just a week away, and very few can agree on the resulting ramifications. Today’s FOMC policy statement did not make any mention of a Brexit, but the topic did come up in Janet Yellen’s press conference. She said the subject was indeed discussed, and as most of us already realize, she said that an exit would increase global economic uncertainty.

Investor Heat Map 6/15/16

Defensive sectors mostly moved higher, and Utilities climbed two spots to take back the leadership position. Utilities began the year at the top, lost that spot in March, fell as low as 10th in April, and has now completed its steady climb back to the pinnacle. Energy and Materials, the former leaders, did not fall far, as the rise of Utilities pushed them only one spot lower. Real Estate, Consumer Staples, and Telecom jumped four places higher in unison as investors appear to favor their relatively higher yields. Health Care, historically a defensive sector, has been going its own way all year, and was once again the odd man out with its three-position fall in the rankings. Financials dropped five places and is now dangerously close to slipping into a negative trend. Consumer Discretionary, on the bottom for three of the past four weeks, lost its last sliver of positive momentum and today sits on the red side of zero.

All of the style categories lost strength last week, with an average momentum decline of 13 points. There was some minor shifting in the relative-strength ranking order, but the inverse-capitalization theme still dominates the landscape. Small-Cap Value and Small-Cap Growth switched places. This puts Small-Cap Value at the top today and leaves the three Small-Cap categories in control. Three additional swaps occurred lower in the chain, but in each case, the larger capitalization category came out ahead: Mid-Cap Value moved ahead of Micro-Cap, Large-Cap Value edged out Mid-Cap Blend, and Large-Cap Blend pushed Mid-Cap Growth lower. The bottom two categories remain unchanged, with Mega-Cap doing only slightly better than Large-Cap Growth.

Six of the global categories flipped to red, and three others are in jeopardy. The global rankings have taken on a dismal hue, with North America being the last bastion of strength. Canada is at the top for the fifth consecutive week, and the U.S. moved two positions higher to secure the second-place spot. Emerging Markets slipped two places, while World Equity and Pacific ex-Japan held their positions. However, all three now sport low single-digit momentum scores and are vulnerable to becoming part of the majority of global categories that are already in the red. China sits at the top of this dubious grouping. Latin America jumped out of last place and landed four spots higher despite posting a miserable week. Japan also managed to improve its ranking status while losing momentum. The problem, in a word, is Europe. The U.K. and the Eurozone plunged, and their large weightings in the EAFE benchmark pulled it lower as well. The fear and uncertainty of the potential exit of the U.K. from the European Union is weighing heavily on the region. The U.K. was on the bottom eight weeks ago, climbed all the way to second place three weeks ago, and completed its round-trip back to the bottom today.



The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.


“The fact that Brexit is now perceived as a possibility is a total game-changer, and it’s very difficult to estimate the macroeconomic impact.”

 Franck Dixmier, global head of fixed income at Allianz Global Investors


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