Watch the Greenback

US stocks didn’t do much overnight. The Dow fell a bit, while the S&P 500 increased a bit. It seems that investors are treading water, awaiting news from the Federal Reserve, which will conclude a two day meeting and reveal their decision on interest rates tomorrow, our time.

The expectation is that rates will remain on hold for now. But the focus (as always) will be on what the Fed says.

Inflation pressures are building in the US economy. Oil prices are at the highest level in years, as are many other commodity prices. Recent measures show inflation running around 2%, which is the Fed’s inflation target, and the highest it’s been in years.

So the expectation is that the Fed will continue with its path of rate hikes. They have previously indicated they expect to increase rates four times this year. They increased once in March, and will probably do so in June, September and December.

That’s the market’s expectation, anyway. With the Federal Funds rate target currently at 1.5–1.75%, three more rate hikes this year would bring the target to 2.25–2.5%.

Assuming inflation remains around 2%, that means the real interest rate (which is the nominal rate minus the inflation rate) will go from -0.5% to -0.25% to +0.25% to +0.5%.

That’s still a very accommodative monetary policy, even after three more rate hikes. But the question is, what will the economy and stock market make of it?

It’s well known that the economic expansion (which has been underway, fitfully, since 2009) is now long in the tooth, from a historical perspective. And now you’ve got the Fed raising rates at an increasing pace, which will facilitate a cyclical slowdown. 

It’s always the way. Fed tightening precedes most post-Second World War recessions. It’s just the way the cycle turns.

What is the Stock Market starting to see now?

Is this what the stock market is starting to see now? I mean, we’re in the midst of one of the best bunch of earnings reports in years from US corporates and the market can’t seem to make any headway.

Apple reported after the market closed in the US overnight. Of course, the results beat analyst expectations. But did it beat the market’s expectations? You’ll have to wait and see what the share price reaction is tomorrow and in subsequent days.

And what’s with the rally in the US dollar? Is this keeping a lid on the stocks market too? There are many different reasons behind a currency’s moves. You could argue a bullish or a bearish case.

I don’t profess to know the reasons behind the recent rally in the greenback. But I do know that it bottomed just before US stock markets topped out in late January (meaning dollar weakness is good for stocks).

And in the past few weeks, the greenback has really surged. As you can see in the chart below, in the past few days it broke back up through resistance, which sat just below 92 points on the index.

US Dollar INdex DXY (WI) 02-05-18

Source: Optuma

[Click to open new window]

Is this the foreign exchange market simply making a rapid adjustment for a more hawkish than expected Fed? Or does it mean the Fed’s planned rate hikes will lead to a cyclical slowdown and a more pronounced move to a ‘risk off’ environment?

Let me put that in plain English: Is the US dollar expecting the start of a bear market in the US stock market? Let me join the dots…

Higher real rates could lead to lower credit creation and therefore lower economic growth. This will flow through to slower earnings growth and potentially declining earnings into 2019.

The market will price this in before you see it in the headlines, though.

The other, more benign explanation is that the dollar is simply rallying after a prolonged bought of weakness. Maybe there is really ‘nothing to see here’. Certainly, from a very short term perspective, the rally is overdone and profit taking will result in the next few days.

And looking at the chart, I would argue that the US dollar is still in a decent downtrend. The breaching of resistance in the past few days weakens the downtrend slightly. But what generally happens after a strong rally is that prices come back to test the lows. If they hold and the dollar rallies again, it will increase the odds that the downtrend is over.

If that happens while US stocks continue to struggle and look weak in the face of strong earnings, then a more prolonged bear market could indeed be upon us.

Regards,

Greg Canavan,
Editor, Crisis & Opportunity


Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing. He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’. That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors. And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis. Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Money Morning here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:


Leave a Reply

Your email address will not be published. Required fields are marked *

Money Morning Australia