Fed to the Rescue ... Again

Market Moves 

Just when it seemed that U.S. stocks were heading for a third down day on Thursday after hitting new all-time highs early in the week, the Fed came to the rescue once again.

This time around, New York Fed President John Williams said in a speech that "it's better to take preventative measures than to wait for disaster to unfold." Essentially, Williams appeared to be advocating a swifter and more aggressive approach to cutting interest rates than what had previously been expected. Stock indexes had been falling deeper into the red on Thursday before Williams' speech but quickly reversed and moved higher on this new sign of enhanced Fed dovishness.

Incidentally, just a few hours prior to Williams' speech, the U.S. Philly Fed Manufacturing Index came out far better than expected, placing some doubt on the Fed's rationale for cutting interest rates. This particular data point is not the most critical of decision-influencers for the Fed. But when it's viewed in conjunction with other positive economic numbers like June's big jobs beat released earlier this month, the case for a rate cut based on slowing economic growth comes into question.

Nonetheless, words from a Fed President outweigh any speculation on economic data, and markets closed in the green for the first time since Monday. To give an idea as to just how much of an impact Williams' words had on investor expectations, below is a snapshot of the CME Group's FedWatch tool taken after the speech. For weeks, investors have been expecting a 100% probability of a rate cut at the end of July.

More importantly, though, prior to Williams' speech on Wednesday, there was a 65.7% expected chance of a 25-basis-point (BPS) rate cut and a 34.3% chance of a bigger 50 BPS cut. After Williams' speech on Thursday, the tables have definitely turned. Now, there's a whopping 69.0% expected probability of a full 50 BPS cut. And equity markets have reacted favorably as a result.

Chart showing target rate probabilities for the July Fed meeting

As might have been expected, the increased bets on potentially more aggressive Fed rate cuts prompted a further drop in bond yields and the U.S. dollar, and a surge in bond prices and gold.

Greenback Pullback

As for the U.S. dollar, the greenback fell sharply against its major counterparts on Thursday after the Fed president's dovish speech. The U.S. dollar index is a primary benchmark for the U.S. dollar, as it measures the value of the dollar against a basket of other major currencies, including the euro, Japanese yen, British pound, Canadian dollar, Swedish krona, and Swiss franc.

Generally speaking, currencies have a positive correlation with interest rates. When all other factors are kept constant, money flows toward currencies that are higher yielding and away from currencies that are lower yielding. This is the basis for the currency carry trade.

In this case, as shown on the dollar index chart, new expectations of lower interest rates in the U.S. have prompted a dive for the dollar. Overall, the dollar index is still in a longer-term uptrend, but its upside momentum has been put to the test of late, especially as the Fed has become more staunchly dovish.

On Thursday, the increased dovishness from John Williams prompted the index to fall tentatively below its key 200-day moving average once again. If the dovish Fed environment is maintained or intensifies in the run up to the next FOMC meeting at the end of the month, the dollar could continue to tumble. The next major downside support target in this case is around the 96.00-area lows.

Chart showing the performance of the U.S. Dollar Index

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Bonds on the Rebound

Bond yields like the benchmark 10-year U.S. Treasury yield tend to fall when the Fed is expected to maintain low interest rates or cut interest rates. So yields fell on Thursday when the New York Fed President telegraphed lower rates. And bond yields and prices are inversely correlated – when yields fall, bond prices generally rise.

This is precisely what we're seeing on the chart of the iShares 20+ Year Treasury Bond ETF (TLT). In fact, we've seen a sharp rebound within the past week off the key 50-day moving average. We discussed the potential for such a rebound last week, and it appears that the rebound has indeed happened. If the dovish expectations continue to prevail up to the FOMC decision at the end of the month, TLT could see a resumption of the uptrend with a potential breakout to new multi-year highs above the $134.29 high.

Chart showing the performance of the iShares 20+ Year Treasury Bond ETF (TLT)

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The Bottom Line

These days, more than ever, when the Fed talks investors listen. At this point, expectations of lower interest rates from the Fed have pretty much reached a fever pitch. But how much more can the Fed boost the market on expectations alone? Going forward, although lower interest rates may indeed help keep the market on its feet, it will likely take much more than that to prompt progressively higher record highs in the major stock indexes.

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