Asset Allocation: It’s Still All About The FedJanuary 13, 2015
While plans change, the Federal Reserve has made it clear that it intends to begin raising interest rates in 2015. It spent most of 2014 laying the groundwork, managing the taper, and in 2015 it will continue to make preparations for lift-off. The Fed has made it clear that it intends to use the federal funds rate as its main tool for setting interest rates. Because it has decided to focus on the federal funds rate and because there are several trillion dollars in excess reserves floating around the banking system, the Fed must first make preparations to regain control of the federal funds rate. These preparations include issuing new liabilities like reverse repos, term deposits, etc., the net effect of which is to drain reserves from the banking system.
In 2014 we got a great glimpse of what the Fed’s liftoff plan looks like and means for asset allocation. For most of 2014, growth in the amount of non-borrowed reserves in the banking system decelerated and turned to outright contraction in October as the Fed completed the taper. What is important to understand is that certain sectors of the stock market are positively correlated to the expansion in bank reserves and certain sectors are negatively correlated. In the charts below, we start with the sectors that are positively correlated–the counter-cyclical sectors like health care and consumer staples. We plot the percent of companies in each sector outperforming the MSCI World index over the previous 200 trading days (the blue line) alongside the three month change in non-borrowed reserves (the red line).
Next, we show the same comparison for the late cyclical energy and material sectors. Here we invert the non-borrowed reserves series (red line) to illustrate the positive correlation between falling banking liquidity and relative underperformance.
Pundits seem to be casting about, coming up with complicated explanations for the drop in oil & copper prices, the widening of credit spreads, the flattening of the US yield curve, the underperformance of non-US markets, the rise in volatility etc. In our view, all these variables have a single, simple cause: the Fed is preparing the banking system for liftoff and diverging from the reflationary policies of other major central banks. With this basic pattern in hand, asset allocation becomes a matter of understanding which sectors outperform and which sectors underperform in this world of divergent monetary policies. It’s still all about the Fed.