Mae West Never Traded Currencies

With apologies to Mae West, too much of a good thing isn’t necessarily so wonderful. That may work in the arena she was clearly referencing, but…

The European Central Bank’s surprise decisions to both keep interest lower for longer and extend fresh loans to the region’s banking system roiled markets today, so let’s run through the impact these steps had:

#1. Lower-for-longer ECB rate policy pushed the euro to solid 1-year lows versus the dollar. The old low was $1.121 back on November 11th. As of this afternoon, the euro was trading for $1.118, down 1.1% on the day.

#2. Thanks to weakening in other dollar pairs, the DXY index is now sitting close to 1-year highs. The levels today: 97.68 versus a 12-month high of 97.71.

#3. That European banks need more help from the ECB pushed the MSCI European Financials index down 2.6% in dollar terms, with further selling after the regional close. That augurs poorly for tomorrow’s European equity trading.

#4. This action dragged down US Financials as well. Large caps were hit (down 1.0%, worse than the S&P) and even US small cap Financials saw pressure (down 1.0% as well, and worse than the Russell 2000).

#5. Offsetting the decline in US equities was a strong rally in long-dated Treasuries. They followed the lead set by German 10-year bunds, which now sport their lowest yields since October 2016 (6 basis points). Ten year Treasuries now yield 2.64%, among their lowest payouts of the last year.

This linkage between currency/rate markets and equities forces an uncomfortable question: what is the US Federal Reserve going to do in the wake of the ECB decision? Do they follow along to both limit the damage from a slower Eurozone economy and curtail the dollar’s rise? Fed Funds Futures were wrestling with that question today:

  • While still small, the odds of a 25 bp rate cut in June more than doubled to 7.8% from 3.3% yesterday.
  • Odds that the Fed cuts rates by the end of the year jumped from 5.8% yesterday to 17.3% this afternoon.
  • Looking out to January 2020, futures now give basically one-in-four chances that Fed Funds will be lower than they are today.

As for what this means for portfolio positioning just now, our thoughts:

  • We continue to favor US stocks over international equities. Europe is an underweight for us, and we’ve had that position for over a year. While Emerging Markets hold some promise if a US-China trade deal comes together (55% of EM is greater China), a dollar rally is rarely good for this asset class. At best, we’re neutral on EM.
  • At the risk of extrapolating too much from one day’s market activity, today’s ECB decision feels like the sort of road-to-Damascus experience that changes investor perceptions. This year was always going to be a foot race between optimism over US-China trade and negative sentiment on corporate earnings. A stronger dollar, not the Eurozone economy, is the real problem with the latter. The bears are catching up to the bulls, and quickly.
  • With only 16 trading days left in the quarter and “earnings warning season” set to begin, the best-case scenario for US stocks is to hold current levels through March 31st. As Jessica has noted in several reports, the S&P had an outsized February even after a very strong January. History says we never give up all the gains for Q1 after a +6.0% January, so there’s no precedent for a real market swoon just now. Not to say it can’t happen, but we’re betting against it.

Summing up with one final point: lower global interest rates put a cap on Treasuries, and that is the hidden positive for US stocks in today’s market action. Corporate earnings will take a further hit (expectations have been coming down even before today) from a stronger dollar. A lower discount rate is the primary counterweight to that inevitability.

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