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Despite the Fed raising interest rates since December 2015, U.S. financial conditions are the easiest since 2014.
One of the key drivers of the easing of U.S. financial conditions this year, is the weak U.S. dollar (USD). The FOMC met again this week and the results reinforced the Fed’s recent dovish overtones. On this news, the dollar sold off and equites moved higher.
The dollar rallied sharply post-election, as the Trump agenda was very pro-growth and many investors believed that the Fed would need to respond aggressively (i.e. raise interest rates) to counter balance the massive fiscal stimulus that was coming. We all know how this has turned out. Fiscal stimulus is still a pipe dream, dysfunction still rules in Washington, D.C. and at the same time, European growth has positively surprised.
A recent BofA Merrill Lynch global fund manager survey captured portfolio manager “tail risk” concerns. From June to July, global investors had become uneasy that the Fed and or the ECB would push a “normalization” agenda and make a significant policy mistake. See the graphic below.
In the past couple of weeks, the Fed and ECB have indicated a desire to “slow play” policy normalization. This was music to the ears of the stock market and the Goldilocks moment for stocks continued as the market moved to new highs.
For all of 2017, the stock market has been pushed higher, while the dollar has been pushed lower, by diminishing Fed rate hike expectations.
In the current environment, I believe the USD is the key macro variable to watch regarding the direction of the stock market. I believe the USD and the U.S. stock market “trade”, are more or less one and the same.
The reason this relationship is important right now is in the chart below.
The UUP (PowerShares DB USD Bullish ETF) which I am using as a proxy for the USD, is now down more than 9% and is nearing a 1.5 sigma move on a 7-month rate of change basis. This is approaching the limits of a “normal” move over this time frame.
JP Morgan is also highlighting that the current level of USD positioning has reached the “shortest” level since 2013 and equals a 2 sigma move.
With institutional dollar positioning and the 7-month price change on the dollar nearing extremes, odds favor a reversal.
We have already seen a strong euro negatively impacting European equities.
For U.S. investors, a strong euro has been “hiding” weak European equity prices for the past few months. It has just been a modest correction at this point, but I believe this is a direct result of the strong euro.
Technology stocks have been the darlings all year but institutional investors appear to be taking money off the table, while retail investors are the ones likely stepping in and pushing these stocks higher. See graphic below.
Technology stocks took a tumble Thursday afternoon with no apparent catalyst, bringing a level of intraday volatility that we are no longer accustomed to, as institutional support wanes.
Financial markets are tightly woven and interconnected in ways that are often difficult to comprehend. With systematic financial stress currently plumbing the depths of its recent range, the likely direction of financial stress is higher.
What I believe is likely to occur over the next few weeks is an unwind of the weak dollar trade, which then bleeds over into other areas of the financial markets. Technology stocks have been one of the biggest beneficiaries of a weak dollar and will sell off in response. This will then trigger a broader equity pullback. I’m not expecting gloom and doom, just your everyday, “garden variety” consolidation, pullback, etc.
A modest bull market correction is not a sell signal, but I would look at the current environment as an opportunity to rebalance portfolios and take some risk off the table.