By Tom Luongo
The Federal Reserve’s Open Market Committee chose not to raise interest rates six days out from an election. The statement was also clear as mud on whether it would raise rates at the December meeting.
Bond traders, however, are very clear in their interpretations of the statement; boosting the odds of a December rate hike to near 80%.
There is deep division within the FOMC between those focused on domestic needs — served by higher rates — and those playing at being Central Bank of the World. The Fed has held back on raising rates all year on fears of sparking a massive rally in the dollar.
Ignore talk of a strengthening U.S. economy. Most of the statistics are noise, if outright fabrications. The problems the Fed faces are tied up with consequences of nearly eight years of zero-bound interest rates destroying risk-pricing the world over.
And now, those imbalances threaten a massive dollar rally.
From Rate Hike to Global Recession
An overly strong dollar spells real trouble for the over-leveraged European Central Bank and Bank of Japan. More than $10 trillion in European and Japanese sovereign debt is exposed to a falling Euro and Yen versus the dollar.
All of that over-priced debt is subject to currency hedges unwinding if the currencies sell off. Trillions in swap derivatives are incredibly sensitive to changes in exchange rates. A selloff in the currency begets a selloff in debt denominated in that currency.
And the whole house of cards begins to spiral down.
This is why the Fed is terrified of raising interest rates. It fears a massive breakdown of European and Japanese sovereign debt creating a massive run into dollars sparking a worldwide recession as the value of dollar-denominated debt rises rapidly.
Despite coordinated behavior from the major central banks post-Brexit, to hold the dollar down, the dollar continues to threaten a bull move higher.
The misnamed trade-weighted dollar index, the USDX, bottomed in the first week of January and has traced a very bullish chart ever since. The pullback of the past two days is likely over now that the Fed has spoken.
This will clear the way for the USDX to take another run at 100 later this month.
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It’s important to remember that central banks can only guide interest rates as long as they have the faith and trust of the markets. Sovereign debt yields are tied directly to the efficacy of the government institutions issuing that debt.
So, when that trust fails, that’s when the things get dicey. The central banks have to get ahead of the problem. But, in this case they can’t without torching that credibility.
Zerohedge noted that as Donald Trump has risen in the polls since Friday’s bombshell announcement by FBI Director Jim Comey, U.S. default risk has plummeted. Credit Default Swap insurance rates on U.S. Treasury debt have cratered since the news hit the wires.
This says that bond traders are betting on an avalanche of capital is getting ready to flow into U.S. assets in the case of a Trump victory next week. This means lower rates on U.S. bonds in the near term and a stronger dollar.
If anything I’ve seen recently tells me we’re staring at one more major bull run in U.S. Treasuries it is this data point.
Markets are bigger than central planners. And they are in the process of assessing the reality of a Trump Presidency right now.
If the market sees Trump as a path to regime certainty, something we haven’t had since QEII, then as we come into 2017 the rising rate of Europe’s political uncertainty will help trigger that rout in Eurobonds I discussed above.
Gold Doesn’t Fear Higher Rates
A Treasury rally on European capital flight will be good for gold in the long run. After today’s announcement gold’s rally stopped cold at resistance near $1308 per ounce. While impressive, being unable to hold that levels through the close should be disheartening for gold bulls.
Gold will need a daily close above $1306, at a minimum, to negate October’s breakdown to $1250.
If it can’t achieve that this week, then this rally has been nothing more than short-covering.
But, in the larger picture, gold is setting up for a big move in 2017 as confidence in the Fed wanes. For now it remains trapped between falling dollar liquidity and rising fear of political chaos.
In the end, it is the Fed that has the biggest problem of all, how to keep together a monetary system grown unresponsive to its tools to manage it.
Tom Luongo is a contributor for Planet Free Will.com. He is also a Senior Financial Editor at Newsmax Media, Author of the Resolute Wealth Letter and former contributor at AOL Sports. Professional chemist, amateur dairy goat farmer and outspoken Austrian Economist. You can follow him at:”