foxex: Fed Relieves Pressure from the US Dollar

Chart Advisor | Investopedia

Focus on the Price

By John Jagerson, CFA, CMT

Wednesday, January 30, 2019

1. The FOMC Announcement

2. Emerging Market Continue to Breakout

3. A Falling Dollar Should Help Manufacturers

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Major Moves

Today is another Fed day when the Federal Reserve Open Market Committee (FOMC) announces whether the overnight target rate will be raised, left flat, or reduced. Today's decision to leave the overnight rate flat isn't much of a surprise. The Fed said it would be "patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate," for full employment and inflation targets.

I thought the most important statement from the Fed is that it's prepared to make adjustments in its plans for balance sheet normalization. Like any other bank, the Fed has a balance sheet that reflects its liabilities and assets. Since the launch of quantitative easing in 2008, the Fed has been buying US treasury bonds (and other fixed income instruments,) which are reflected on the asset side of its balance sheet (see the following chart). If the Fed starts selling the trillions of dollars in bonds that it owns, it could drive the price of bonds lower.

Investors care about the potential for the Fed selling bonds, and "normalizing" its balance sheet because falling bond prices will result in higher longer-term interest rates. Many investors worry that rising long-term interest rates would slow the US economy because the cost of capital will rise, although historical evidence does not show a good correlation between those two factors.

Emerging Markets

Regardless of whether everyone agrees about the impact of higher long-term interest rates, the dovish tone in the Fed's announcement today is seen as a positive for US and emerging markets stocks. Lower interest rates in the US is positive for emerging market economies because it should push the value of the US dollar down which keeps the pressure off of domestic emerging market currencies.

As I have pointed out over the last month in the Chart Advisor newsletter, emerging markets (especially China) are already showing an increased likelihood for outperformance over the next six months. As you can see in the following chart, the iShares Emerging Market ETF (EEM) has mirrored the performance of the Hang Seng index and confirmed its own double bottom breakout today. In my experience, a Fibonacci retracement—anchored at the high of the double bottom and the most recent low—can be used to provide a reliable target at the 161.8% retracement level of the pattern. Without the headwind of a rising dollar, it should be much easier for emerging stocks to reach their prior highs from last July.

Should You Invest In Emerging Markets?

Amazon Needs Another Positive earnings Report

Risk Indicators - USD

The risk posed by a rising dollar is not just an issue for emerging markets. I have been very concerned that the bullish dollar of 2018 would wind up crushing the US industrial sector. If the dollar is rising against most other currencies, that means US exports from US manufacturers are less competitive internationally. In this respect, I see two positive developments today. First, the Fed did a lot to put traders at ease about rising interest rates in the short term, which should push the value of the dollar lower.

Second, Boeing's (BA) earnings report this morning provided a lot of good news for manufacturers concerned about slowing in China and other emerging markets. Boeing exceeded estimates for topline and bottom-line performance and reached a new all-time sales record of over $100 billion. If industrial firms are not in as dire a situation as investors had feared prior to earnings, and the dollar starts to fall, industrials and other multinational firms could be seriously undervalued.

You can see this relationship that I have discussed between the value of the US dollar (candlesticks) and industrial stocks (blue line represented by SPDR Manufacturing and Industrial ETF XLI) in the following chart. The inverse relationship is imperfect, but historically, a rise in the US dollar like the one we experienced in 2018 is usually accompanied by devaluation in industrial stocks and economic uncertainty. Something very similar to this occurred in 2014 just prior to the "earnings recession" of 2015.

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Bottom line:

This earnings season continues to look better than expected, but I am still waiting to see how consumer stocks look once the bulk of those reports are released early next month before completely sounding the "all clear". In the meantime, I will use upcoming Chart Advisor newsletters to take a closer look at oil stocks and utilities as the situation in Venezuela progresses and the so-called "Polar Vortex" increases demand for energy and commodities throughout the Midwest. There could be some interesting opportunities in those two stock categories for risk-tolerant investors in the short-term.

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