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3 Ways To Play A "Fed Trade" That Works Every Time

Published 10/15/2017, 01:54 AM
Updated 07/09/2023, 06:31 AM
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The next Federal Open Market Committee (FOMC) meeting is slated for Nov. 1.

Traders give Team Yellen a 98.5% probability that the Federal Reserve is going to raise rates in November and an 86.7% probability that it'll raise rates in December.

Are you and your money ready?

I hope so.

There are huge profits at stake, and now's a perfect time to "trade the Fed" using a play that's worked 100% of the time ahead of interest rates since 1990.

It all comes down to financials, and specifically, buying banks.

According to Kensho, a three-and-a-half-year-old startup that uses artificial intelligence to parse big data related to real-world events, buying financials two months before a rate hike has generated an average return of 10.74% every single time since 1990.

Granted, there have been only four December rate hikes over that time frame, so you need to take that research with a grain of salt. But don't let that stop you when it comes to pursuing profits.

My research shows that year-end rate hikes are typically part of a much broader financial setup that includes everything from window dressing to performance-enhancing trades that portfolio managers use to position hundreds of millions (or even billions) of dollars for the following calendar year.

Key moves include shedding losers, deferring income, harvesting winners, and more – all of which should sound familiar considering we've talked about doing the same things in years past.

This time around, though, there's a little more incentive.

You see, raising rates towards the end of this year is really a vote of confidence in upcoming economic conditions rather than just a rate hike, like most investors think.

That's what makes today's trade so attractive and potentially very profitable.

Remember, we're talking about an opportunity that's worked 100% of the time, according to Kensho's research. The probability of success drops to only 62% for rate hikes at other times of the year, in case you're wondering.

In other words, the calendar – not the Fed – is giving you an edge.

Here's how I break the situation down.

A Fractured Fed That Doesn't Know How Money Works

Team Yellen continues to struggle with the "control" it supposedly exerts.

The latest minutes from September show members openly debating whether or not low wages and price pressure are more of a long-term problem than a short-term market risk. That tells me they have no idea what it really is, let alone how to "fix it." Not that they ever did, but that's a story for another time.

The key is that they're going to try anyway as long as the "medium-term economic outlook remains unchanged," according to the official account of what transpired at the last meeting. That's like trying to bake a cake when you don't understand the ingredients – and about as futile.

Unbelievably, the minutes also show that the majority of Fed officials, including Ms. Yellen herself, still believe higher inflation is just around the corner, so they're not ready to "recalibrate" the models used to make policy decisions.

Makes me want to beat my head against a wall!

The Fed does not understand how real money works, let alone why its models are broken – a point I've made frequently since the global financial crisis began. I see this latest statement as proof positive that that's still the case.

Inflation is not caused by tight labor markets and higher salaries, like Team Yellen and her band of merry economic misfits think. Rather, it is caused by excess money in the system.

What most investors and many professional economists are missing is very simple.

The Fed can control liquidity, but it cannot control credit, which is constantly expanding. That's what's really holding inflationary pressure down in the monetary system.

People accuse the Fed of playing with imaginary money all the time, but in this instance, it's the banking system that's creating it out of thin air. Every loan application, every credit card offer, every derivative contract… those are all backed by nothing except the financial condition of the institution making the offer.

Yellen and her team cannot model what's happening, so they pretend the relationship between foreign exchange rates, loans, derivatives, bond markets, and traders does not exist – and do their meddling anyway.

Traders, on the other hand, do understand the linkage I've just described – and very well. They have to because they have trillions of dollars of real money on the line every day, not just broken academic models.

Now for the fun part.

You can make this trade any number of ways depending on your risk tolerance and trading objectives.

  1. If you like to trade stocks, I think buying the best bank you can get your hands on makes sense as determined by its return on common equity, or "ROCE" for short. To me, that's a choice like Phoenix-based Western Alliance Bancorporation (NYSE:WAL), which has reported an average ROCE of 14.92% for the past four quarters.
  2. If you'd rather spread your money around via an exchange-traded fund, a choice like iShares US Financials (NYSE:IYF) makes sense. Just understand that some of the upside will be limited by weaker banks with lower return on shareholder equity that are included in the fund.
  3. If you'd like to play along more aggressively, consider a choice of call options or options-related spreads on JPMorgan Chase & Co (NYSE:JPM), which will likely grow loans and key business lines aggressively as Yellen's Fed raises rates. I think the JPM Jan. 19, 2018, $97.50 call (JPM180119C00097500) is worth a closer look.

As always, remember that we're talking about a "trading" opportunity here, not investing, as is usually the case.

So you're going to want to do two things if you want to follow along: (1) limit the amount of capital you put at risk to only the money you can afford to lose if things don't go as expected, and (2) remember that past results never guarantee future results.

I suggest you implement a trailing stop to capture profits and minimize losses if the markets have other ideas.

Over the years, I've suggested 25% below your purchase price as a good place to begin, but there's nothing wrong with running a much tighter 5% trailing stop if you don't have that kind of risk appetite.

In closing, I hope you've enjoyed today's column.

We don't get the chance to talk about the nuts and bolts of a trade like this as often as I'd like, so it's always fun when we do.

Especially when it comes to a fluid situation that's got this kind of profit potential.

Don't Miss: This Strategy Could Unlock Life-Changing Wealth

With gridlock in D.C. and rising geopolitical tensions, many are concerned about a market downturn that could set them back years.

But here’s the thing – none of that matters. Because I’ve identified a pattern that takes a lot of the guesswork out of finding those lucrative opportunities.

This pattern is a way to see that a stock is rising with near 100% certainty. When it appears, the stock is going up in price – fast.

I’m talking nine gains in one week… 30 triple-digit gains this year… and 46 triple-digit winners in the last 12 months.

The post Three Ways to Play a "Fed Trade" That Works Every Time appeared first on Total Wealth.

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