Negative Interest Rates & Their Impact On Financial Asset Prices

In an unexpected move very early this past Friday morning (Jan 29th), the Bank of Japan announced that it will cut the rate on current accounts that commercial banks hold with the BoJ to minus 0.1%, adding that it will push this rate even lower if necessary. With this move to a negative interest rate policy (NIRP), the Bank of Japan now joins a half dozen central banks in major countries across Europe with interest rates also below zero. 

When I was a fresh young student at the University of Chicago Graduate School of Business 40 years ago, interest rates below zero were thought to be theoretically impossible. However, here we are in the real world and clearly the impossible is now becoming commonplace. In recent Q&A's following scripted speeches, Federal Reserve Chairman Yellen and influential NY Federal Reserve President William Dudley both said that a negative interest rate policy here in the United States was possible if financial conditions deteriorate enough to warrant such action.

San Francisco Federal Reserve Bank President John Williams told reporters this past Friday that he now sees slightly slower growth, slightly higher unemployment, and about a tenth of a percent lower inflation this year than he had expected in December, when the Fed raised rates for the first time in nearly a decade. The Federal Reserve probably needs to keep U.S. interest rates lower for longer given headwinds from weak global economic growth, a stronger dollar and an unexpectedly sustained drop in oil prices, according to Williams."Standard monetary policy strategy says a little less inflation, maybe a little less growth ... argue for just a smidgen slower process of normalizing rates," Williams said. "We got a little stronger dollar, some mixed data on the economy, some weakness in (fourth-quarter U.S. GDP growth), all of those coming together kind of tell me that we probably need a little bit more monetary accommodation this year than I was thinking in the middle of December." 

All the "ducks" are starting to quack now! The hawkish views that were so "unanimous" following the Fed's interest rate hike in December have quickly receded to the point where almost no one expects more than a single interest rate hike from the Fed for the remainder of 2016, and voices can already be heard around the water coolers on Wall Street that the Fed might actually have to cut rates before year-end. And a 4th round of QE may also be a possibility now!

What does this mean for investors?

For U.S. equity prices, probably flat to higher over the rest of this year. Corporate earnings disappointments coincident with an economy on the verge of (or already in) recession will negatively impact share prices which will tend to offset any potential easing of monetary policy by the Federal Reserve.

For U.S. bond prices, Treasuries will probably represent a reasonable flight-to-safety option, and Treasuries will have scarcity value if talk of another round of QE escalates. Corporate bonds will be plagued by the stigma of  potential bankruptcies in the energy sector, but overall the better credits should do well.

For foreign exchange traders, the U.S. Dollar has been "king of the hill" for almost five years now. After bottoming out in May 2011, the U.S. Dollar Index is up 37% since then. When the BoJ "shocked" the financial markets this past Friday with a negative interest rate policy, the U.S. Dollar Index jumped about 1%. My own feeling is that Fed governors and other Fed presidents like Williams this past Friday will join in a united chorus of dovish speeches over the very near term which will knock down the U.S. Dollar in foreign exchange dealings over the next several quarters. And if QE4 is actually announced by the Fed, then the U.S. Dollar could plunge! 

What's left?

Oh yes, GOLD, precious metals, and related mining shares. I believe that the 4 1/2-year bear market in gold, silver, and related investments is over! Gold prices are already up 5.48% in 2016 (despite a stronger U.S. Dollar!), which far eclipses almost every other investment in terms of performance. The S&P 500 Index is down 5.07% so far this year, and most other major U.S. stock indexes are down even more. Among sector indexes, the NYSE Biotech Index is actually down 24.00% and the KBW Bank Index is down 12.62% year-to-date so far in 2016!

In the interest of full disclosure, my current allocation to precious metals mining shares is approximately 40% in the accounts I manage. This relatively high sector allocation is up from zero % to start the year.

If a picture is worth a 1,000 words, please take a look at the latest monthly chart of the Philadelphia Gold/Silver Stock Index (symbol XAU) which shows a monthly chart buy signal just triggered by my computer trading system for the first time in 18 years (since January 1998). A monthly chart buy signal was also triggered in the Major Gold Miners ETF (symbol GDX) this month (among other buy signals in gold and silver related mining shares).

Philadelphia Gold/Silver Stock Index (XAU) Monthly Chart with Computer-generated Buy & Sell Signals

Major Gold Miners ETF (symbol GDX) Monthly Chart with Computer-generated Buy & Sell Signals

Will The Federal Reserve "Blink" At Its Next FOMC Meeting?

At its December 2015 FOMC meeting, the U.S. Federal Reserve raised interest rates for the first time in almost a decade. While this first hike was only 25 basis points, post-meeting comments from FOMC voting members suggested that eight more 1/4-point hikes would be forthcoming over the next two years.

The U.S. stock market, as measured by the S&P 500 Index, fell sharply in the first three weeks of this new year. If we start with the closing year-end 2015 level of 2043.29 and then compare it to the January 20th intra-day low of 1812.29, the decline was 11.3%. And if we measure the January 20th intra-day low against the May 21st, 2015 all-time high in the S&P 500, then the decline was 15.1%. I don't think it's a stretch to conclude that at least some of investor concerns this year so far have been related to the actual and apparent expected tightening of monetary policy by the Federal Reserve. Don't fight the Fed? Isn't that the best investor advice ever written in the shortest possible words?!! Of course, maybe the collapse in crude oil prices had something to do with the collapse in U.S. stock prices, or lower economic growth in China, or the warm December weather, or the cold January weather. Pick your poison? Maybe it's Donald Trump's fault? You're fired!

I don't think it really matters why U.S. stock prices caved from January 4th through the morning of Wednesday,  January 20th. What matters is where do we go from here? My computer trading system indicates that U.S. stock prices are going higher from here. The rebound from Wednesday's intra-day lows has been meaningful, and I don't think this rebound is a "dead cat bounce". However, right now my own long positions only include energy, commodities, steel, and precious metals stocks. I recently read that over the last six years the best strategy has been to buy the general market (SPX) one week before each FOMC meeting and sell one week after each FOMC meeting. I was stunned by the results in this report. The "buy & hold" portfolio earned about 12% annually while the FOMC "two week" holding period strategy yielded more than double the buy & hold result. I think it's interesting that the U.S. stock market bottomed on Wednesday, January 20th, one week prior to the FOMC meeting this coming week. My best forecast here is that U.S. stock prices will be higher at least through the end of this month and maybe even for a couple of days in early February (consistent with the FOMC trading strategy of buying one week before each meeting and selling one week after each meeting)..

In my last blog dated Sunday, January 17th, I predicted that crude oil prices would bottom out early this past week and that prices would not stay below $30 a barrel for very long. For now, this looks like a pretty decent call. Of course, when prices were collapsing early Wednesday, my energy positions were testing my patience to the limit. However, the rebound in energy prices late Wednesday, Thursday, and Friday was nothing short of spectacular! One of my energy stocks, SM Energy (SM), actually rebounded 60% from Wednesday's intra-day low to Friday's intra-day high! My simple view here is that WTI Crude Oil prices will probably not trade significantly below $30/barrel for the remainder of 2016. $40/ barrel is a reasonable forecast for the current rebound over the near term (120 days), but I suspect prices will overshoot on the upside at one point in 2016. 

While Gold and Silver are among the few winning positions so far in 2016, with gains of 3.4% and 1.4% respectfully so far in January, most of the precious metals mining shares have been poor performers. While I am not sure why gold/silver mining shares have been weak (except ABX & AEM), It's not hard to imagine that the specter of four interest rate hikes this year from the U.S. Federal Reserve and the resulting positive impact of higher U.S. interest rates on the U.S. Dollar may have investors in the precious metals arena just a little bit nervous (understatement!). But what if the Fed backs down this coming Wednesday from its hawkish stance as signaled following its last meeting in December 2015? What will happen to gold and silver prices when investors realize that the U.S. Federal Reserve is NOT going to raise interest rates in 2016, and it may even lower them! And if U.S. economic results continue to disappoint, could the Federal Reserve actually initiate another round of "quantitative easing" (QE4)? For gold and silver prices to rally sharply, all that has to happen is for the FOMC to decide this coming week that maybe four rate hikes this year are off the table for now. While the Fed probably won't announce this action definitively, it probably will convey a much more dovish monetary stance, and gold, silver, and related investments will then surge sharply higher!

Bottom line:

1. The U.S. Dollar looks vulnerable to a major correction

2. Gold and Silver prices look ready to breakout on the upside

3. Gold and Silver mining shares look historically cheap right now

U.S. Dollar Index Daily Chart with Computer-generated Buy & Sell Signals

U.S. Dollar Index Weekly Chart with Computer-generated Buy & Sell Signals

Barrick Gold (ABX) Daily Chart with Computer-generated Buy & Sell Signals

Major Gold Miners Index (GDX) Daily Chart with Computer-generated Buy & Sell Signals

Russell 2000 Index Daily Chart (RUT) with Computer-generated Buy & Sell Signals

Russell 2000 Index Monthly Chart with Computer-generated Buy & Sell Signals