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Volatile Moves Coming if Global Investors Lose Faith in Fed’s Ability to Revitalize US Economy

James Hyerczyk

The four main asset classes:  Equities, Treasurys, Gold and the U.S. Dollar were brought to life on Tuesday as investors reacted violently to a report showing weaker than expected U.S. factory activity. Some were even whispering “recession” after this thought was put to bed about a month ago.

Throughout September investors were told by the Fed and several Fed speakers that although there were signs that the economy was slowing, the two rate cuts in July and September were probably enough to protect it from further weakness, or perhaps too aggressive, suggesting the central bank may have to hit the pause button in late October.

Some traders even suggested that central bank policymakers were bowing to pressure from the White House to cut interest rates.

These thoughts quickly evaporated on Tuesday with the release of the Institute for Supply Management’s manufacturing index, which fell to its lowest level in 10 years, moving deeper below the 50.0 level which separates contraction from expansion.

Over the near-term, the focus for traders should be on the movement in the asset classes. It doesn’t do you any good as a trader to try to predict a recession, which may or may not occur for 18 to 24 months. The opportunity will be in reading the price action in equities, Treasurys, gold and the U.S. Dollar.

In my opinion, it all starts with reading Treasury yields. The internet was bombarded with recession predictions when the 2-year and 10-year Treasury yields inverted in August. These reports were too late, however, and the phenomenon corrected itself. Those who bet on a recession at that time were burned when yields returned to normal. Talk that the Fed may skip a rate cut in October also drove yields higher. However, conditions changed on Tuesday and now may be the time to start reapplying your recession theory. Don’t wait for the yield curve to invert again.

This time, the inversion could stick for a longer-period of time because there is growing concern that global investors have lost faith in monetary policy and consequently the Federal Reserve’s ability to revitalize the economy with more aggressive rate cuts.

As of Tuesday’s close, the yield on the benchmark 10-year Treasury note fell to 1.55%, the lowest since September 6 and down from last month’s high of 1.80% on September 13.

Additionally, the probability of two more Fed rate cuts before the end of the year jumped from 20% to about 35%, according to data compiled by Bloomberg.

Traders should also watch for opportunity in the stock market. Investors have been buying stocks because of low interest rates, but they have ignored the reason for low rates. If stock market investors start to believe that low rates are not helping to revitalize the economy then they will trim positions.

There is also opportunity in gold. We’ve already seen this year what a low interest rate environment can do to gold prices. Imagine if global traders start to low faith in the Fed’s ability to stimulate the economy?

Finally, the U.S. Dollar is the strongest currency at this time partly because traders believe the Fed will pass on an October rate cut and of pockets of strength in the economy. However, this could change rather quickly if, for example, Wednesday’s ADP private sector jobs report and Friday’s U.S. Non-Farm Payrolls report show cracks in the labor market.

This is not a recommendation to trade nor a prediction of a recession, it is merely a “heads up” article on what could happen if the U.S. economy starts to weaken further and global investors start to lose faith in the Fed’s ability to revitalize the U.S. economy.

This article was originally posted on FX Empire