As expected if the Fed decided to halt rate hikes and take a more dovish stance, the dollar would weaken and the equity, bond, and commodity markets would rally. However, we must take a step back and look at the big picture as to whether this rally is based on solid economic fundamentals (strong earnings and growth) or is this more of a Fed driven rally?
Recent Fed History
Ever since the Fed moved from a Dovish tone to a Hawkish tone and pulled the trigger on their first rate hike in December, while Europe and Japan have become more Dovish, the dollar rallied and became strong. This created disinflationary pressure, sent commodities lower, and consumers feel the real effect with lower gas prices.
Heading into 2016 the Fed was expected to remain Hawkish and set expectations for 4 more rate hikes, some expected perhaps more. The market reacted, we saw an exit from the bond market (bonds fall, yields rise) as investors wanted to get in front of the rate hikes. Equity markets sold off as the cost of margins would rise, and disinflationary pressure would curb business growth. What further elevated concern, that fueled more selling in the equity markets, was the concerning economic data from China’s growth and their export/imports, same-store sales weakening, and weak top-line revenue warnings.
courtesy of wikipedia
The expectations of a rate-hike flip-flopped faster than a politician running in the Presidential election. The certainty of a March rate hike quickly faded. However, what created more confusion, that only injected more volatility into the market was one of the big three government data points, the Labor Report. It came out far stronger than expected, which the media turned into a cheerleading session that our economy is strong. What was happening, earnings and other economic data both abroad and domestic was showing signs of a recession, yet the big government headline numbers were showing robust economic growth. Was the Fed going to raise rates or not?
If you have been following the Market Preview, you know what camp I have been in. The big three government headline data is window dressing at best and through machinations, seasonal adjustments, and model changes is not really reflective of the actual economic landscape, but hell – it makes for good headlines and certainly sells optimism. The Fed isn’t oblivious to this, certainly they will site the big government headline data as justification and proof their policies are working. Yet, the reality is they can’t really raise rates, stop buying bond, stop buying mortgage back securities, and shrink the money supply – because if they did, they know this Fed led (not private sector) recovery would quickly send the economy in to a recession. Please don’t misconstrue my observation for anything other than that. I am not debating the Fed should or should not intervene, but rather pointing out that we have been and continue to be heavily dependent on the Fed interventionism, which is the core driver of the market.
From FOMC statement:
“The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.”
We saw the dollar index drop like a rock right after the Fed announcement on Wednesday afternoon, that help drive the equity, bond, and commodity markets higher. The dollar continued to decline yesterday and that further helped push markets higher.
The question we need to consider is how much of the equity rally is based on the recent strong earnings and fundamental expectations vs. how much is from the Fed changing course into a more Dovish tone and not raising rates, which weaken the dollar.
Notice the Dollar Index rallied after the ECB announcement lowering rates and increasing their QE, but then sold off when President Draghi made a Hawkish comment on March 10th. Then notice the dollar drop in the afternoon when the Fed announced they would not raise rates and made a Dovish comment.
The big commodity companies are getting a boost from the weaker dollar, driving up commodity prices. We saw Alcoa rocket 8% and Devon blast off over 10%. However, many of these companies have announced profit warnings, more lay-offs, and lower earnings guidance. Caterpillar announced profit warning over 30% for the first quarter, but it too rallied 4% after the Fed announcement (Note: CAT is a big exporter, a weaker dollar could help boost exports).
But here is the conundrum, if expectations remain high (which they are), that the Fed will be back to raising rates in June and become Hawkish, how long will this rally last? When will the dollar find a bottom and begin to rebound? Should we expect more earnings warning, if the Fed is going to start raising rates? Is this to be a short-lived rally? Ironically and unfortunately, it all comes down to the Fed and not real economics or fundamental data. Again, it is all about the Fed and whether they will or will not raise rates.
I suspect we are in for more volatility. The recent rally out of the 1st quarter lows is certainly giving everyone a sigh of relief, thank you Fed! However, I am not sure if we should buy into this as a long-term trend. June is 3 months away and the market is going to try to second guess the Fed’s next move. We will hear a parade of Fed governors and presidents lecture, interview, or write articles about what they think, believe, guidance, silly “dot-plot”, etc. The media and economists will also weigh in with their worthless 2 cents. We will of course see more strong government headline data, that continues to reflect a strong recovery. However, that will be in direct conflict with top-line revenues, export/imports, same-store sales, and private sector data that continues to show stagnation or declines. All of this will only add more uncertainty, which will translate to more volatility – until we have ANOTHER FOMC meeting.
There is another twist in this tale, the election. The Fed Chair, Vice-Chair, and all current sitting governors have been appointed by President Obama. They are all Keynesians, lean Dovish, and some (including our Chair) lean towards socialism (based on their academic papers). They certainly do not support a Republican agenda or have a Hawkish bone in their body. As President Reagan once said, “Dance with the one that brung ya!” Meaning, they will most likely continue to lean Dovish, to keep the market aloft as we head into November – supporting the Democrats that appointed them as governors.
No Rate Hike in June!
Putting it all together; weaker China, Western central banks lowering rates (NEGATIVE – NIRP) and increasing their stimulus, stagnant to weak top-line numbers, real economic data showing weaker growth at best, an inherently Dovish Keynesian Fed, and an election year – I seriously doubt we will see the Fed become Hawkish and I doubt we will see any rate hikes prior to November election.
Support & Resistance
INDU 17,200 – 17,800
We blasted above the 17,200 resistance area, which was the support level at the end of 2015. The news is out, the Fed didn’t raise rates and sounded more Dovish. So we could see some additional moves higher, but I think we could stall a little at 17,800 as the market catches a breath after the heavy volatile 1st quarter.
While the Dow Jones has managed to get back to break-even for the year, the tech heavy index is having some difficulty getting back there. I think a jump to 4500 is certainly in the cards, Apple has their big show that can bring volatility to this index (up or down). I would look at 4300 as support.
SPX 2000 – 2080
Much like the Dow Jones, the S&P500 has made it back to break-even for the year. However, I think while we have room to move higher – we may get into a consolidation zone up here as we take our breath to review what has happened, what the Fed has done, what the Fed plans to do in June, and what is going on in China and the real economy.
RUT 1060 – 1100
The broader index manages to make it back up into a consolidation range, unfortunately it is not showing the kind of strength that we are seeing in the narrower over-weight indices. We have yet to get back above 1100 and to break-even on the year. Watch the close today, volume, and see if we face resistance at 1100. I continue to watch the Russell as the guide for general order flow in the equity markets.
It has been a wild ride in the 1st quarter and while we have recovered for the most part, I am not sure if this wild ride is over. Fed has certainly given us a couple of months of breathing room and has flip-flopped back to Dovish. However, as we close in on June and if government headline data remains strong, the market will expect a rate hike again and we may see the “risk off” trade (equity and bond sell off).
The good leading indicators are:
- Russell (RUT) – for general market order flow in the equity markets.
- Dollar (DXY) – for strength / weakness. Strong dollar indicates expectations of Fed rate hike.
- Bond Yield (TNX) – 10-year yield will reflect Fed rate hike expectation. If we see yields move up, then the bond market is expecting a Fed rate hike.
I also want to point out the VIX is now in the 14 range and broke into the 13 range yesterday. We are in orange alert area, where the market is getting a little too complacent in this rally – as if nothing is going to happen. It’s getting to euphoric levels – that concerns me. Below 15, it is getting cheap. Below 14 you need to buy some. Below 13 you need to buy extra. Below 12 – time to back-up the truck.