Yesterday, I wrote that the most influential thing this week would not be what anybody says or tweets about trade, it would be the data afforded by two reports on pricing, CPI and PPI, that are due out today and tomorrow. The reason for that assertion was simple enough: The biggest driver of stock prices right now is interest rates, or more accurately interest rate expectations, and the Fed has said many times that they will make changes based on hard data and nothing else.
If CPI and PPI show prices to be rising slower that the Fed’s 2% inflation target, a cut looks very possible. If you expect that to happen though, the question remains -- how should you play it?
Before we get there, let’s just assess the possibility of a cut. The pressure has been building for just that, with a lot of people saying that rates have risen too far, too fast. Not least among them is President Trump, and that, as a Wall Street Journal piece yesterday put it “complicates rate calls.”
To be somewhat blunter, if the data even hint at weaker prices, conventional wisdom is that the only reason Jay Powell and his committee would have for not raising rates would be the desire to avoid looking like they were giving in to political pressure.
The FOMC members, however, are aware that that is the perception, so while they don’t want to be seen as “obeying” the President, they presumably don’t want to look petulant either. The answer is to act based solely on the data, and anything in the range of the expected would justify a reversal of December’s hike on that basis.
Positioning for a cut, and possibly a small series of them, therefore makes sense.
Still, it is not a certainty, so the ideal pick to play the possibility would be something that has a chance of making money even if no rate cut comes.
The answer may lie in a commodity play.
In October of last year, when it could be argued high interest rates became a problem, commodities in general started to collapse. The chart below is for the commodity index tracking ETF, DBC, which lost over twenty percent in the fourth quarter of last year. Stocks fell then too, but unlike the major stock indices, DBC has remained depressed.
That gives more room to the upside than most stock plays, which is a plus, but there is another reason that DBC or something similar may be the best way to play the prospect of a rate cut. Even if that cut doesn’t come, the Fed will be looking for some way to avoid prices falling and a deflationary environment taking hold; the best indicators of the overall price environment are commodity prices.
In other words, there is a good chance that whatever the Fed says or does next week, it will be specifically designed to push commodities higher. Central banks are neither infallible nor omnipotent, but twenty years in the interbank forex market taught me that it is always best to work on the assumption that what the Fed wants to happen will happen.
In general, when targeting a specific move, I would rather look for individual stocks than an ETF. The broad nature of the funds often means that returns are limited, but in this case, it is hard to find a specific stock to use. The sudden drop and the extended period of low prices have left commodity-dependent companies struggling.
In many cases, cuts have been made that will make a rapid turnaround difficult even if prices do begin to recover. That may limit the potential of individual stocks but will only help commodity prices in the long run, as it could lead to short supply as demand also recovers.
So, with a logical place for a stop-loss just below the end of year low of $14.32 and a good chance of an exaggerated bounce if rates are cut, DBC looks like the best, risk-managed way to play the possibility of a rate cut next week.