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The Dollar, Interest Rates, and Stocks | IJS Speaks
The dollar has taken investors on a wild ride since the onset of the COVID-19 pandemic lockdowns in March 2020 when the index peaked around 103, to now where the index is trading around 104. The road from then to now, however, saw a near 30% rally from the lows of early 2021 to the highs of fall 2022. While all of 2023 and so far into 2024 the index has been confined to a narrow range, with one notable attempt to break-out last fall. The reasoning behind the movements in the dollar has evolved with the economic cycle, or at least where market participants perceive the economy to be on the economic cycle.
Interest rates, proxied by the US 10-year treasury for simplicity, have sustained a clearer trend than the one seen in the dollar. From the start of the pandemic to now interest rates have moved in one general direction, and that is up. We’ve seen three periods of consolidation so far where some investors began speculating that rates were peaking, just to see a further sell-off in bonds and interest rates drift higher. Much of 2022 was spent with stocks and bonds moving in the same direction, as the Fed commenced its monetary policy tightening cycle. The longstanding 60/40 portfolio model broke down, and the yield curve began to flatten and eventually invert.
Stocks, proxied by the S&P500 for simplicity, also sustained a clearer trend than the one seen in the dollar, with just two notable periods of retracement, which have both since been surpassed. Spring of 2020 at the onset of the pandemic, which was surpassed that summer, and most of 2022 while the Fed was well into its rate hiking cycle, which was eventually surpassed last month (January 2024). From a technical standpoint, stocks are breaking out of a continuation pattern, meaning that the market is attempting to do more of what it’s been doing. Now that we have an idea of where the price of stocks in general might be headed, let’s come up with a narrative keeping in mind that the simpler the better.
The lions share of US stock market returns where generated by 5 to 7 tech companies in the last couple of years, both on the way up and on the way down. They dragged down the market when the Fed was raising interest rates because their future cashflows were more heavily discounted as well as some of their dependency on capital markets. Then with the introduction of Artificial Intelligence (AI) software and its rapid proliferation, the tech companies at the forefront of this technological rollout are once again dragging markets higher. There are suddenly innumerable opportunities for subtle increases in productivity across the US economy and eventually the rest of the world, which suggests that businesses large, medium, and small can be efficient and profitable even with higher costs of capital are represented by general interest rate levels.
The forecast for interest rates has been a hotly contested topic since we started experiencing rapidly rising inflation around the globe because of the COVID related supply chain and labor market disruptions. The direction has been clear (higher rates), but the destination (what level), and duration (how long) has always been contended. My interpretation of the inverted yield curve is not necessarily forecasting an economic recession, but more so a financial market recession, which we have already experienced and are well on the way to recovery and by some estimations a new expansion. A normalizing of the yield curve signals a positive term structure and a growing economy, or at minimum expanding markets for risk assets like stocks and real estate.
Considering where unemployment levels currently are in the US, as well as the restructuring that is underway with global supply chains there is enough structural pressure to keep inflation hovering about the Fed’s target to stay the committee’s hand on cutting rates too much or too quickly. But if we are to expect...
Rising Rates, Growing Economy | IJS Speaks
The US 10-Year Treasury rolled over mid-summer 2020, and has been trending lower ever since. Meanwhile, most other markets that I follow, have spent considerable amounts of time in some level of flux, with no clear sense of direction with the price action. Gold and the Dollar have been standouts, as they have both had periods of high correlation (positive for gold vs negative for the dollar) with the US10YR. With its decisive move lower, the 10-year treasury is delivering on a promise by the Fed to fight inflation the best way they know how. The second part of the Fed's promise however, higher rates for longer, is still yet to be determined.
Orthodox macroeconomics suggests that monetary policy tightening as rapidly as it did, should have at minimum exposed deep fault lines in financial markets, and at most caused some kind of market calamity. We saw cracks this spring but no fault lines, when three poorly managed banks went out of business in rapid succession. Since then rates have moved higher at every point along the yield curve without much commotion. Some market participants suggest this means the Fed might actually accomplish what is now dubbed a 'no landing', wherein they can coax inflation back down to their target of 2% without causing a significant increase in unemployment. As romantic as that scenario sounds, it most likely has the lowest probability of occurring because it ignores the stochastic nature of disruptive market shocks.
A more likely outcome has some subtlety to it. As promised by the Fed, rates on the front end of the yield curve will remain elevated, barring some sudden and rapid rise in unemployment. The middle and back end of the curve however, which are manipulated by market forces, will continue to drift higher as the bonds are sold off. US rates are currently sitting at or around 5% across the curve, and as long as inflation remains above the Fed's target and the US consumer has a job and access to credit, there is room for potentially more monetary policy tightening. The omnipresence of inflation in the hearts and minds of Fed members and market participants alike is currently being reflected in the bear steepening of the yield curve.
The evolving outlook for the term structure of US rates suggests that, short-term yields may remain elevated which in-turn means that medium and long-term yields will experience upward pressure as well. If the resilient consumer can keep borrowing despite rising interest rates and the change in the unemployment rate indeed remains subdued, then there is a scenario albeit with a low probability wherein the yield curve can eventually reflect a positive term premia. This for all intents and purposes will be the market manifestation of the ever elusive 'soft landing'. Enter a world where the economy adjusts to higher rates, the yield curve steepens, and the inverse relationship between stocks and bonds that make the 60/40 model portfolio work re-exerts itself.
Rectangle Chart Pattern: A Picture of Economic Uncertainty | IJS Speaks
The last 18 months have been a rollercoaster ride across financial markets, but in the grand scheme of things markets really haven't gone very far, and in most cases sideways ranges have emerged as a result of all the volatility. In the world of Technical Analysis, this type of price action creates a Rectangle Chart Pattern. This type of consolidation can occur at the end of a trending market, when buyers and sellers get to a point of indecision. Past the point of indecision, a breakout of the range in one direction or the other signifies a continuation of the previous trend, or a possible reversal.
The dollar rocketed higher while the Fed raised short-term rates by 75 bps for most of 2022 and into 2023. The dollar index reversed course as the Fed down-shifted from 75 bps rate hikes to 50 bps, which then consolidated into the lower-bound of the rectangle pattern. Now, as the narrative of a 'soft landing' for the US economy becomes more commonplace among some market participants, the dollar appears to be moving from the bottom of its rectangle towards the top. This repricing of the dollar reflects falling inflation in the US paired with a resilient labor market. The dollar can be expected to continue to rally, if inflation stalls-out before getting back to the Fed's 2% target and unemployment remains subdued. This leaves the door open for the Fed at any point to surprise markets with some type of policy tightening.
The market for Gold has been consolidating for the longest of all the markets I follow. The rectangle chart pattern starting forming in late 2020 for gold, and has been very well defined. Within the last 18 months, gold and the US 10 Year Treasury spent a considerable amount of time trading with a strong positive correlation, especially once the Fed embarked on the current rate hiking cycle. From its current level, gold can be expected trend lower as rates remain elevated and central banks keep downward pressure on inflation. In this environment, gold loses luster as an inflation hedge and as the opportunity cost of higher yields cumulate.
The US 10 Year Treasury market is at the point of breaking out of the rectangle chart pattern, but the trade setup suggests higher interest rates are on the horizon. The downtrend in price leading to the rectangle chart pattern was made up to two Bull Flag Patterns, so a breakdown of the rectangle could mean a return of downside momentum in fixed income markets. The strong positive correlation shared by Gold and the US10YR also suggest that the government bond market may experience selling pressure in the near-term, as Gold charts are also signaling selling pressure in the near-term.
The Oil market is always an interesting one to follow. A lot can be inferred from the price of oil about industrial activity globally, when adjusted for geopolitics. And if nothing else, the volatility can make your head spin. The market trended up from the lows of the COVID lockdowns when Russia and Saudi Arabia dumped oil on the market to bankrupt US shale producers, to the highs made post the Russian invasion of Ukraine. Then the market became concerned about the outlook for the Chinese economy and the Biden administration opened the taps on the US Strategic Petroleum Reserve so prices retraced. This setup the Rectangle Chart Pattern when the market started rebounding on news of Saudi and Russian production cuts and subsequent extensions of those cuts.
At current levels of consumer and industrial demand for energy, the production cuts planned by OPEC+ will continue to build a shortage into the near-term. Consumer spending in Europe is most likely the linchpin maintaining upward pressure on oil however. If Europe continues to slow, so will demand for Chinese exports and Chinese industrial demand for energy, which can take some steam out of the move higher in oil.
The equity market, proxied by the SP500 rocketed higher from the lows ...
Chart Patterns Paint a Clearer Picture | IJS Speaks
There is this Cup-and-Handle formation that is evolving on a 3-month chart of the Dollar Index, and I think the chart is presenting at the beginning of the handle portion of the chart pattern. I’ve been watching and trend-trading the dollar index against a basket of currencies, because I believe the forex markets have the most immediate link to the macroeconomy, and we are certainly living in interesting macroeconomic times. Cup-and-Handle chart patterns tend to signal a continuation of a trend in the direction of the breakout, so I zoomed out to a 1-year chart and saw what I initially thought was a ‘kinda weird’ Double Bottom formation, had the potential to form a ‘not-so weird’ (inverted) Head-and-Shoulders if the Cup-and-Handle played out. Technical Analysis talk aside, all three of the aforementioned chart patterns told me the same thing; the dollar was queuing up for a move higher.
The Cup-and-Handle overlays best with the current narrative in financial markets. The dollar first started trending higher as the debt ceiling negotiations began intensifying and the date estimated by the Treasury when America would run out of cash to pay its bills approached without an agreement. Before that point the dollar was trending sideways for about a month, which came after about a month of trending lower. The short-term peak in the dollar occurred around the time an agreement was reached between Democrats and Republicans about the US debt. This is when the pattern caught my attention, as the price on the index started rolling over into the beginning of the handle.
The next macro event on the economic calendar is the June Fed meeting (13th-14th) which will conclude with the Fed deciding to either raise interest rates or hold them at current levels until their next meeting in July. The market consensus appears to be that the Fed will hold rates steady at its next meeting and maybe even at its subsequent one, which is in-line with what Fed officials have been saying. Then the two go their separate ways. The Fed has and continues to say that rates are meant to stay higher for longer, and market participants are suggesting that rate cuts can begin as early as the fourth quarter of this year. Financial markets are also implying that because the Fed should be cutting rates by years end, the dollar has peaked and should be weakening as higher foreign rates begin to look more attractive.
The inevitable divergence of views between the Fed and market participants completes the handle in the formation. The capitulation of market participants will later drive the breakout of the pattern, which on the longer timeframe would lineup with the breakout of the (inverted) Head-and-Shoulders as well.
Let me explain. Markets agree with the Fed that rates remain unchanged at the June meeting, which to the Fed means rates remain unchanged at the June meeting and nothing more. To market participants, however, it means rates have peaked and after a short pause they are coming down, so the dollar sells off. When we get to the next meeting if there is still no rate change because monetary policy operates with long and variable lags, markets will infer that we’re even closer to a rate cut especially if the economic data worsen, so the dollar may tend to trade sideways. Finally capitulation can/may occur when later in the year the Fed surprises markets with a rate increase despite further deterioration in the economic environment simply because inflation will have remained sticky above their target of 2%. Short dollar positions would have to cover losses, and some will even reverse course, all of which will push the dollar higher.
Then there’s the issue of the Fed further tightening monetary policy while economic activity slows, while labor hoarding and consumer credit keeps a floor under inflation. Economic weakness at home and abroad could move the needle on market sentiment towards one that embraces...
What Happens If... | IJS Speaks
We get to the Treasury’s X-date and no compromise has been made on raising the US debt limit, or in other words the anarchists get their way. The most direct impact would be felt in the bond market as investors would be in a bit of a panic, rushing to move money out of fixed income. In this type of environment, cash and liquidity will be at a premium and risk will be sold across the board to cover losses on bonds and other credit instruments. Falling bond prices will push up market interest rates, which will in turn put downward pressure on stocks. An unlikely scenario worth considering is the historically inverse relationship between stocks and bonds that underpin the 60/40 portfolio model holding through the market disruption, whereby a sharp sell-off in the fixed income space results in a rally in stocks as a function of portfolios being pre-priced and re-balanced. More likely, the run-up in both stock and bond yields from falling prices could also mean precious metals become less attractive as they do not have a carry yield, and investors do not get paid to wait. There’s also a reduction in demand from an inflation hedging standpoint as rising rates signal less credit creation, which means less upward pressure on inflation from consumption and investment spending.
The implications for commodity markets would be similar to those of other risky asset classes. If US demand for fuel is seen as waning, the price of oil will have justification to accelerate its slide lower, which probably incites more production cuts from OPEC+. The asset class whose forecast is the most opaque is crypto, as the market reaction in the space will largely depend on how volatile the moves are among the other risky assets. For example, if the broader market sell-off is orderly the crypto space could indeed act as a safe-haven for alternative liquidity. If, however, the market sell-off is violent and abrupt, the crypto space will experience the proverbial baby being thrown out with the bath water, as investors flock to liquidity in the form of fiat currency. Most likely candidates will be the Swiss Franc, Japanese Yen, and the US Dollar which all typically hold the haven status in times of great market uncertainty.
The run-up to the ‘X-date’ will be filled with market volatility with a bias to the downside. With the level of uncertainty surrounding the risk of the US government not making debt payments, investors will rightfully shift holdings away from market risk and toward liquidity. As the adage goes, “America always does the right thing, after doing everything else.” If history informs expectations, then the failure to pass the TARP legislation on the first vote comes to mind. Political lines were drawn, and the interest of the American public became an afterthought. It wasn’t until financial markets responded with a massive sell-off that Congress saw the light and voted to authorize the bailouts. With this as prologue, it’s easy to see why investors are shifting to overweight cash. The expectation is that an adverse market reaction to Congress making wrong decision at first, would present opportunities to acquire premium assets at discount prices, shortly before the right decision is subsequently made and assets again reprice to reflect the new reality.
Safety and Liquidity Still Matter | IJS Speaks
Since the lows of last October (2022), financial markets have rebounded higher in-line with the post COIVD re-opening of the Chinese economy and a simultaneous mild winter in Europe. At home, we have also experienced an exceptionally resilient labor market in the face of tightening monetary policy and subsequently credit conditions. Measures of inflation in the US economy are trending lower from their post-COVID peaks of around 10%, which is great news, but being above 4% is still nowhere near the Fed's target of 2% so its safe to expect more policy tightening from the central bank. The market reaction to more of the same from the Fed might be a little different going forward as expectations fall in-line with the economic reality the world faces. As inflation has been falling in the US over the past couple of fiscal quarters, so has the dollar as market participants anticipated an eventual pivot in monetary policy back towards accommodation and easy money.
The coming couple of fiscal quarters will probably see the impacts of rising interest rates finally hit the labor market in a meaningful way. Thus far the recent memories of labor shortages during the post-COVID re-opening in the US, means employers are more likely to cut hours versus cutting headcount. The apparent labor hoarding has been supporting wages, which paired with falling inflation means consumers have been experiencing real increases in their income, albeit from depressed levels. Stocks markets have latched-on to this idea and are reflecting a world where economic activity slows just enough to bring inflation down, but not enough that lots of people lose their job as a result of the slowdown. Classic case of wishful thinking.
The labor market tends to be a lagging indicator of economic activity, and so by the time businesses en-masse decide that its not worth holding onto a full staff and labor supply overshoots labor demand, interest rates would have been too high for too long and the damage would have already been done. As the summer months approach, market participants will have to adjust their expectations for economic activity in the back half of the year. Consider two scenarios: 1) The rate of change of the drop in inflation slows and the Fed keeps ratcheting up interest rates until economic activity grinds to a halt, and we get an acceleration in unemployment and inflation finally drops back down to the Fed target with a recession. 2) The long and variable lag in monetary policy is realized and market participants conclude the Fed has already gone too far as the rate of change of the drop in inflation accelerates taking it below the Fed target and creating an event sharper jump in unemployment, resulting in a recession. We are dealing with an issue of what flavor of recession will (not can) the Fed create. The difference being short and deep where there is a sudden drop in inflation and economic activity which the Fed can quickly address with interest rate cuts. Versus long and shallow where there is a grind lower in economic activity and inflation, to which the Fed's response will be hesitation to accommodate as they will fear a resurgence of inflation which would put them in the opposite of liquidity trap, where addressing one problem exacerbates another. In either scenario, the US consumer goes on the defensive and corporate earnings are directly affected negatively.