Ignore ETF Knee-Jerk Reactions To Fed

December 23, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Corey Hoffstein, co-founder and chief investment strategist of Boston-based Newfound Research.

This month's Fed meeting ended with the beginning of the long-awaited rising rate environment. It has been nine years since the last rate increase in 2006, and in that time, the economy has gone through the worst crisis and then the longest bull market in recent history.

Even looking at previous interest rate hikes may not be indicative of how markets will react to this environment if markets are substantially different now.

However, the 025% increase in the target federal funds rate did not have a large impact on the markets when the news sunk in, especially not in the context of some of the recent volatile market moves we have witnessed.

Using intraday minute-by-minute data from Google, we can see that when the Fed announced the rate increase, the initial reaction in the market was a sharp decline in the SPDR S&P 500 (SPY | A-98); the long-term U.S. Treasurys fund, the iShares 20+ Year Treasury Bond (TLT | A-83); and the biggest gold ETF, the SPDR Gold (GLD | A-100).

Ignore ETF Knee-Jerk Reactions To Fed

For a larger view, please click on the image above.

Tide Quickly Changed

As the next half hour progressed, traders essentially leveled out SPY and GLD to their pre-announcement levels. TLT, on the other hand, increased by 1.23%, perhaps likely based on the Fed's reiteration of "gradual" interest rate increases.

If you believe this is a representation of an efficient market in U.S. Treasurys, this indicates the market had already priced in the small increase and had already priced in further increases into 2016.

When Fed Chairwoman Janet Yellen hosted a press conference from 2:30 p.m. to just past 3:30 p.m. ET, we again saw the markets react.

This time, GLD increased before retreating to near its previous level. SPY began to climb, and TLT declined, as we would expect it to when rates increased, or were anticipated to increase over the coming months.

Other ETF Reactions

Interest-rate-sensitive assets also exhibited strong initial reactions to the Fed announcement. The Utilities Select SPDR (XLU | A-87), the Vanguard REIT (VNQ | A-91) and mortgage REIT funds like the iShares Mortgage Real Estate Capped (REM | B-98) all generally declined at first and then climbed until the close of the market.

Ignore ETF Knee-Jerk Reactions To Fed

For a larger view, please click on the image above.

Rising rates generally hurt these asset classes unless the rise is accompanied by a strengthening economy.

Of course, if we combed through Yellen's statements, we could find what specific phrases or themes likely triggered these moves. There were assertions that the Fed thinks inflation is still too low and that room remains for job growth, and statements about continuing to monitor many indicators of financial health in the economy and reacting to them accordingly. There were also words like "confident," "smoothly" and "accommodative."

Knee-Jerk Action Unimportant

Regardless of the specific causes of these short-term moves, the long-term trends will likely be driven by a multitude of factors including credit spreads, oil prices and the strength of the U.S. dollar. These factors interact in a complex way that is often hard to predict, and in a way that goes beyond the statements of any single influential group like the Fed.

We can see that from September 2015 to the December meeting, the Fed's forecast interest rate at the end of 2016 has narrowed, but as it stated in its meeting, factors like inflation, job growth, GDP growth and the overall state of the economy will be the driving forces behind what monetary policy actually gets implemented. The economy is a giant feedback loop of smaller feedback loops.

Ignore ETF Knee-Jerk Reactions To Fed

For a larger view, please click on the image above.

News Overreaction

News will always be around, and with today's information economy, we are inundated with more and more "breaking news stories" that move the markets. How we react to them is up to us. The biases that are inherent to human nature often cause collective over-/underreactions, which is one of the plausible explanations for the existence of momentum in investing.

On one hand, events like rate increases are prime examples of times when large gains and losses can be made over a short period of time by picking a side and placing a bet.

But on the flip side, since markets are at least somewhat efficient, much of information is priced in as forecasts are refined leading up to the event. It is this gradual incorporation of information that momentum models seeks to capitalize on.

We may or may not see more rate increases over the next year, but, as with this first hike, we expect that much of the contribution to long-term market trends will happen in the periods in between Fed meetings.

At the time of writing, the author's firm owned SPY and TLT, but did not own XLU, VNQ or REM, but say they are in their investment universe. GLD is not in its investment universe. Newfound Research LLC is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. Founded in August 2008, Newfound offers a full suite of tactical ETF managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed-income and liquid alternative asset classes. For more information about Newfound Research LLC, call us at 617-531-9773, visit us at www.thinknewfound.com or email us at [email protected]. For a list of relevant disclosures, click here.

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