The value of the U.S. dollar has been dropping all month as traders have been preparing for the Federal Open Market Committee (FOMC) to cut interest rates a couple times during the second half of 2019, but the decline has accelerated this past week.
The U.S. Dollar Index – which compares the value of the U.S. dollar (USD) to a basket of currencies, including the euro (EUR), British pound (GBP), Japanese yen (JPY), and Swiss franc (CHF) – had been consolidating in an upward-trending wedge for a year. That all ended this week when the index broke down through uptrending support.
Typically, when a country's central bank starts moving toward a more accommodative monetary policy, the value of that country's currency will start to weaken compared to other currencies. That appears to be what is happening here.
While the value of the USD is still strong compared to where it was before its blistering rise in late 2014 and early 2015, this pullback could be good for some large multi-national companies that generate a lot of revenue overseas. When the value of the USD is stronger, companies get less bang for their buck from profits generated overseas because the conversion rate works against them when they repatriate the money back to the United States. Conversely, when the value of the USD is weaker, companies get more out of their foreign-generated profits because the conversion rate works in their favor.
For instance, if a company generates €1 million in profits in Europe when the EUR/USD exchange rate is 1.25 (like it was in early 2018), the company can claim $1.25 million in profits when it repatriates the money because €1 is equal to $1.25. However, if a company generates €1 million in profits in Europe when the EUR/USD exchange rate is 1.10 (like it was in May), the company can only claim $1.10 million in profits when it repatriates the money because €1 is only equal to $1.10.
Watch for companies that generate a lot of revenue overseas – like eBay Inc. (EBAY), McDonald's Corporation (MCD), and Mondelez International, Inc. (MDLZ) – to benefit if the USD continues to decline.
S&P 500 vs. Russell 2000
The S&P 500 accelerated its pullback from its recent all-time high as two members of the FOMC disappointed traders with their comments on monetary policy today.
The disappointment started when James Bullard, president of the Federal Reserve Bank of St. Louis, surprised Wall Street by downplaying the potential that the FOMC will cut the Federal Funds rate by 50 basis points (0.50%) at its July meeting – an idea that had been picking up steam. Traders had priced in a 42.6% chance of a 50-basis-point cut in July as of yesterday, according to the CME FedWatch Tool. As of today, traders have pulled those odds back to 35.4%.
Not to be outdone, Fed Chair Jerome Powell threw his own wet blanket on the interest-rate speculation by saying, "we are mindful that monetary policy should not overreact to any individual data point or short-term swing in sentiment." While this statement certainly doesn't rule out the potential for future rate cuts, it was enough to trigger a raft of profit taking today.
Traders were already concerned about escalating tensions between the United States and Iran and that President Trump's meeting with President Xi Jinping at the G-20 Summit won't resolve the trade war between the two countries. Now take away the exuberant hope that the FOMC was going to ride in and save the day with aggressive rate cuts, and you've got the potential for Wall Street to continue selling.
Risk Indicators – TNX
After a momentary bounce last Friday, the 10-year Treasury yield (TNX) has once again taken a turn to the downside. For the first time since Nov. 8, 2016, the TNX has closed below 2%. This is further confirmation that traders are anticipating not only an extended period of low interest rates but also the potential of an economic slowdown and a decline in the stock market.
Traders tend to buy Treasuries – which pushes Treasury prices higher and Treasury yields lower – when they anticipate that the FOMC is going to cut rates and when they anticipate that stock prices could come under pressure. It's virtually a foregone conclusion at this point that the FOMC is going to be cutting interest rates during the next six months. The only question is by how much.
What we don't know is what is going to happen to the U.S. economy and the S&P 500 during that same time frame. It's hard to complain about the index hitting new all-time highs, but traders are still nervous about a potential pullback. Watch for the TNX to remain low for the foreseeable future.
Bottom Line – Profit Taking
With the uncertainty still swirling around Wall Street, I wouldn't be surprised to see more profit taking as we approach the Independence Day holiday. However, it's important to remember that profit taking doesn't have to mean a new bearish pullback. I'm anticipating more consolidation.
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