foxex: Dollar's Strength is the Market's Weakness

Chart Advisor | Focus on the Price

Wednesday, May 01, 2019

1. FOMC is worried about lack of inflation

2. Dollar is a 'headwind' to watch

3. Small caps still stuck near resistance

Major Moves

The Federal Reserve Open Market Committee (FOMC) met today and left their main interest rate target unchanged. As usual, what the FOMC statement said is more important than the decision about the short-term interest rate which was already priced into the market.

The FOMC noted that growth measures have improved slightly but that inflation remains below the Fed's target rate of 2%. It may sound strange that the Fed wants inflation, but most economists are much more worried about the negative effects of very low inflation (disinflation) or deflation.

Very low inflation numbers have been tough for the market because that tends to be correlated with low growth or expectations for slower growth in the future. Usually, if the economy is growing quickly, wages will rise and demand will drive up commodity prices; neither of those are happening now.

This seeming contradiction between low inflation and growth has been a tricky problem for economist and investors. The economy is growing and simultaneously sending signals through inflation that future growth may be weak. This is one of the reasons that investors are pricing in a rising probability for a rate cut later this year.

As you can see in the following chart from the CME Group (CME), the futures market is pricing in a 35.4% chance that the target rate will be 2.00-2.25% in October, rather than the current level of 2.25-2.50%. If you total all the probabilities in the chart, you will find that investors are pricing in a 44.2% chance of a rate cut by October.

Although it has been a long time since the Fed has lowered the target interest rate without a recession, it was fairly common practice in the 1980's and 1990's. In that sense, I wouldn't suggest there is anything worrisome about a rate cut, but it also isn't something that happens when growth is accelerating.

S&P 500

An interesting phenomenon I have pointed out before in previous Chart Advisor issues is what happens to the S&P 500 just after the FOMC releases its statements. For the last 10-years, over 70% of the time, whatever the market does during the first 20-30 minutes following the report (prices rise or fall,) will be reversed by the end of the session. Today is a good example of this phenomenon.

As you can see in the following chart of the S&P 500 using 5-minute candles, the initial reaction to the FOMC was positive and prices rose towards the session's highs. Approximately 25 minutes after the announcement, the S&P 500 reversed and erased those initial gains.

I am not sure I can fully explain this pattern but knowing when there may be excess volatility during the day can help traders avoid risky entries. Because the overall performance of the market on FOMC days isn't very predictive for where prices will be in a week or a month, there doesn't seem to be a disadvantage to waiting for volatility to calm down before deciding about adding or removing risk from your portfolio.

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Risk Indicators - Dollar "headwinds"

After a brief respite this week, the US dollar reacted to the Fed's announcement by bouncing off support and heading higher again. The move in the dollar is likely a reaction to the FOMC's comments about the slow pace of inflation. The dollar is an attractive source for yields from international investors as other markets languish and low inflation makes it an even more attractive store-of-value for investors.

The dollar's strength is a problem for the market because it makes imports cheaper and exports more expensive and therefore less attractive. It also means that profits earned by US multinational firms are converted back at a less favorable exchange rate, that drags on earnings.

Coca-Cola's (KO) management team pointed this issue out in their earnings call last week, but it didn't get much press because the rest of their report was good enough to boost the stock. However, KO's management reported that despite strong sales and earnings growth, free cash flow was down 1% due to "currency headwinds."

This is a problem that investors must continue to watch as its effect will be worse next quarter if the dollar doesn't start to retreat.

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Bottom Line - Resistance is still an issue

From a technical perspective, the S&P 500 (large caps) and Russell 2000 (small caps) remain stagnant at or just above their prior highs. A better than expected earnings season is helping to boost prices, however, a strong dollar and a slow outlook for inflation should continue to create an environment where investors pile into stocks with stable growth trends and avoid others that have been struggling.

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