You may have noticed the Central Banker’s policies and the market’s expectations of those policies appear to be the only game in town for the markets these days. I have no doubt that the market would have corrected more deeply if the Fed made a strong statement that they were on track for a June rate hike. But they did not. They opened the door wide open to delaying the hike by pointing out the weak economy and low inflation rate. The market’s interpretation was clear: the Fed is likely to delay hiking until at least September.
Most of the market’s movement this week occurred at the opening and closing of the market and within one hour of the Fed Chair speaking on Wednesday and show the shift in expectations.
We should not be too surprised. The Fed’s initial unemployment target was 6.5% and as the reports approached this target in 2014, they lowered the target. And since we are approaching their new target, they again lowered the target to 5.1% this week.
What are we to make of this moving target? One point -of -view is that the Fed’s threat of raising rates is a way to keep a lid on the markets. The Fed also believes that as we approach full employment, wage inflation should pick up and will approach their 2% target. Of course they do not want to overshoot. But today inflation is low and looks to fall further as oil prices impact prices. This gives the Fed cover for delaying rate hikes.
I do believe the Fed would like to raise rates sooner than later, but they now face two current problems: a decelerating economy and a surging dollar. I think the Fed’s immediate concern was to slow the surging dollar down against other currencies. Going forward, a surging dollar has more tightening effects on the economy than a small rise in interest rates alone. By adjusting market expectations on the timing of rate hikes the perception of divergence in monetary policy narrows enough to force the crowded long side trade of the dollar to correct and slow the headwind to the US economy and market down in the short run.
The consensus remains that the economy and corporate earnings will once again return to strong growth in the latter half of 2015 and delaying a rate hike will allow the supporting data to come in. The consensus tends to be over-optimistic toward the end of bull markets and market cycles, so only time will tell if the consensus is correct this time. The economy is still facing the global headwinds of a stronger dollar at home and abroad, and a rapidly decelerating Chinese economy that has been one of the main drivers of global growth. The energy sector should remain very weak in the US, and remember it was the energy sector that created much of the job growth in the US since the last recession. What will be the new driver of the US economy? You can not export healthcare and consumption.
But these are fundamental concerns and the markets have been more reactive to monetary policies and especially the divergence of policy in the US from the rest of the world. This week, the divergence was interpreted as weaker than what the markets had already priced in. So some back tracking is in order for the one-sided currency trade. In the chart above we see the EURO recovering from its over-sold position. The I fund captured the currency shift along with the equity returns.
Last week I pointed out that the last nine corrections hit the 108-day moving average and if the correction’s bottom was in, it was the smallest correction on a percentage basis of the last ten. Well the market is in rally mode, so it did not hit the moving average and was indeed the smallest correction. This could be interpreted as bullish, and based on the Fed Chair’s backpedaling there is support is support for this all other factors aside.
The rally this week was not sharp like the previous rallies. For each two steps forward it took one step back. With the Fed’s speech out of the way, I expect to see the S&P 500 (TSP C fund) continue in the upward trending price channel. With the dollar surge stalled, the TSP I fund can capture all of the European indexes growth in the short term plus any correction in the dollar. The S fund remains the best relative bet for the US equity funds and the F fund gets a reprieve from rising rates for a little while longer.
But much of the current rally is priced into the TSP funds and I prefer lower risk entry points if one has funds out of the market. We may or may not get a low risk entry point prior to the beginning of the next round in (the only game in town): global monetary policy. But nonetheless I’ll be watching for a correction toward the lower side of the current price channel.
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