Fed Relieves Pressure From the US Dollar

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 that 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 U.S. 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 U.S. economy because the cost of capital will rise, although historical evidence does not show a good correlation between those two factors.

Total assets of all Federal Reserve banks
Board of Governors of the Federal Reserve System

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 U.S. and emerging markets stocks. Lower interest rates in the U.S. are positive for emerging market economies because they should push the value of the U.S. dollar down, which keeps the pressure off of domestic emerging market currencies.

As I have pointed out over the past 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.

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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 U.S. industrial sector. If the dollar is rising against most other currencies, that means exports from U.S. 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, the earnings report from The Boeing Company (BA) this morning provided a lot of good news for manufacturers concerned about slowing in China and other emerging markets. Boeing exceeded estimates for top- 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 U.S. dollar (candlesticks) and industrial stocks (blue line represented by the SPDR Manufacturing and Industrial ETF, XLI) in the following chart. The inverse relationship is imperfect, but historically, a rise in the U.S. 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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The 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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