Forget the Fed, Look At The Dollar

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Forget the Fed, Look At The Dollar

We want to cover two related “Data” topics today: the release of the Federal Open Market Committee meeting from April 30th/May 1st and recent moves in the dollar.

#1: The market isn’t buying what the Fed is selling.

  • Today’s minutes can best be summarized in one sentence from the release: “In light of global economic and financial developments and muted inflation pressures, members concurred that the Committee could be patient as it determined what future adjustments to the target range for the federal funds rate may be appropriate to support those outcomes.”
  • Fed Funds Futures think “patient” will only last 161 days, until the October FOMC meeting. They give the chance of a rate cut essentially 50-50 odds here. Yesterday, the odds were a little better in favor of the Fed’s patience running through October 30th (the exact day of the FOMC meeting) at 54%. Now, despite today’s minutes, the odds have shifted to 49%.
  • Push out to the end of 2019, and Futures are even less convinced the Fed’s patience can last that long. They put 68% odds on a Fed rate cut by then.
  • 2-year Treasury yields aren’t taking the Fed’s bait either, ending today at 2.23% – the 6th lowest close of the last year.
  • Source: https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

Bottom line: capital markets are clearly not pricing financial assets based on Federal Reserve pronouncements. Rather, they are skating to where they think the puck is going (the old Wayne Gretzky line). Whether that’s because markets see more risk than the Fed from US-China trade uncertainty or just late-cycle worries, this disconnect is remarkable.

#2: The stealth rally in the dollar is about to break prior highs on a trade-weighted basis, something the most common measure of dollar strength is missing.

  • The DXY Dollar index, heavily weighted to the euro (58%), yen (14%) and pound (12%) trades at 98.1. This is 18% off its 2001 high of 119. So despite the dollar’s rally in 2019, not all that worrisome…
  • But the Fed’s trade-weighted dollar index is much more representative of the currency’s strength in real-world terms, with a 19% weight to the euro, 16% to the Chinese yuan, 14% to the Canadian dollar and 13% to the Mexican peso. Moreover, these weights change over time as trade flows vary.
  • By this measure, the dollar is just 1% away from its 2002 all-time high. The current index reading is 128.6; the old high was 129.8.
  • Source: https://fred.stlouisfed.org/series/TWEXB

Bottom line: A strong dollar is both a markets head- and tailwind. On the plus side, it is deflationary since imported goods are cheaper (at least those not subject to tariffs). This helps keep interest rates low. On the negative side, it hurts the bottom line of companies with significant offshore revenues. In terms of S&P sectors, Technology (58% non-US revenues) and Materials (55%) are the most exposed.

Summing up: markets prices are always a tug of war between countervailing fundamental forces. Interest rate expectations are clearly tugging US equities higher even if the Fed is doing their best to dampen hopes for a rate cut. Dollar strength hasn’t been as much a bearish talking point, but that should change if the greenback’s rally continues.