FOMC, US Dollar, S&P 500 Talking Points:
- We’re nearing the end of what’s been a significant week and month for both the US Dollar and US equities. The main push point is drive ahead of the Fed and that takes place next Wednesday at 2PM ET.
- The FOMC is expected to hike rates by 50 basis points but the bigger question likely pertains to the balance sheet and how they anticipate addressing that. The bank punted on that item in March and it helped to bring a strong risk-on rally in the second-half of last month.
- There’s more data: This morning brought PCE numbers which is the Fed’s preferred inflation gauge and despite a miss on the headline number, the employment cost components showed strong beats. And then next Friday, a couple of days after the Fed brings NFP for the month of April.
- The analysis contained in article relies on price action and chart formations. To learn more about price action or chart patterns, check out our DailyFX Education section.
The first month of Q2 is almost in the books and it’s been a busy one. It’s been a massive outing for both USD bulls and equity bears and the big item on the radar comes into the picture next week with the May FOMC rate decision.
And, really, this has been something markets have been looking to for some time as the rubber meets the road with the FOMC’s attempt to tackle inflation begins in earnest. The bank has shown a pattern of being incredibly careful with making new moves for fear of unsettling market participants so they avoided hiking in January, instead loading the picture for March but that was perhaps upset by the Russian invasion of Ukraine, to a degree.
So, when the bank met at that last rate decision they hiked by 25 basis points but they also ignored the elephant in the room – and that’s what they have planned for the $8 Trillion portfolio that’s amassed over the past 13 years. The fact that they avoided this topic helped stocks to rally in the second half of the month, reversing a large portion of what was previously a pretty threatening sell-off.
But, as the door opened into Q2 the focus shifted back to Fed policy and the fact that, eventually, they’re going to have to address the portfolio. And for bond market participants this is a very difficult to quantify risk and it gives very little reason for them to remain long bonds. Because the very act of lifting rates will push the tides on bond prices and bond portfolio managers will take a hit from the simple hiking of rates.
But – if you then add in an FOMC that’s actively drawing down their portfolio of fixed income holdings, well that puts more pressure on rates. And the bond portfolio manager now has an entirely new threat to contend with – and that’s the Fed, in essence, becoming net sellers of bonds.
So, is it any surprise that bond markets have been roiled as longs head for the exits? And this raises the scenario of an emergency in a crowded movie theater. If there is but one exit and only a few can get through at a time – are you going to wait around and hope for the best? The prospect of being stuck in line during a raging inferno can be enough to compel others to jump first, which then creates the panic without even really needing the fire to fuel the fear.
Given what’s happened in bond yields, its clear and perhaps increasingly so – that many aren’t going to wait around and hope. Below I look at the 10 year yield which is taking on tones of a parabola – and this is government borrowing costs for the United States.
US Treasuries – 10 Year Yield
That chart of Treasury Yields above is very similar to the chart of the US Dollar…
But there’s even an extra component added in when incorporating the USD and that’s one of counter-party risk. This is also an often overlooked aspect of FX markets.
Because currencies are the base of the financial system – the only way to value a currency – is with another currency. That’s why everything is in paired quotes, like EUR/USD or GBP/USD. Both of those quotes are quotes on the US Dollar – they just use a different counterpart as the base currency of the pair. Reading the quote is literally like saying ‘the value of one Euro, in terms of US Dollars is,’ or ‘the value of one British Pound, in US Dollar terms is.’
So, the fact that the USD is spiking isn’t necessarily just a rate move – it’s also the fact that this rate move is kind of happening in isolation – and that’s troubling because that can spread to even greater imbalance across macro markets. To be sure, we are seeing other Central Banks raise rates – but no major CB is as far behind the eight ball on the matter as the FOMC, who spent most of last year saying that inflation was transitory and likely to abate on its own.
But now that the Fed has to hurry up to try to catch up to and, hopefully, get in front of inflation, there’s a massive deviation amongst global currencies as the US Dollar is spiking on the back of rate hike potential and that’s created a near-historic move in the USD.
This month marks the largest jump in the US Dollar since October of 2008 – and that was the month in which the S&P 500 was down by more than -17%, at one point more than -29% as the financial collapse began to roil global markets.
This week also marked a fresh 19-year-high in the currency as prices pushed above the 2017 swing high, which was what I had discussed in the Q2 Trading Forecast that you can access from the below link.
US Dollar Monthly Price Chart
US Dollar – Where To From Here?
Markets are about anticipation and the move that we saw this week was very much driven by anticipation for what’s coming next week. But – the big question now is whether the Fed will actually deliver and whether the bank starts to set a plan forth to deal with the massive portfolio. Rate hikes, at least in my opinion, are a more manageable item, similar to what was seen in the last tightening cycle. The Fed can easily back off of a rate hike, or do an emergency cut, if need be. But, portfolio mechanics around an $8 Trillion portfolio and a market full of participants looking to save their own skin in a rising rate environment is far, far different, and very much more complicated to quantify.
Will they address it? Or will they punt? It’s the Fed so, more likely they’ll do a little of both, announcing a plan that doesn’t necessarily go into effect until June or July. Something that starts small but then winds up as time goes on. At least that’s what I’m expecting.
In the US Dollar, I remain bullish. Sure, this week was a massive jump and the currency moved deep overbought from a number of vantage points but, major market moves will often stay in extended overbought/oversold territory for some time.
Below, I’m looking at three possible support levels ahead of that FOMC rate decision next Wednesday.
US Dollar Hourly Price Chart
Chart prepared by James Stanley; USD, DXY on Tradingview
Stocks – S&P 500
My top trade for this quarter wasn’t the US Dollar – it was bearish US equities. Largely because of expectations around the FOMC and the fact that the one thing long equity has had in it’s back pocket from the past 13 years has been an accommodative Fed that simply can’t accommodate for much longer. And this is because of inflation and the fact that inflation has now become a political matter in the US. This can lead to significant change at upcoming mid-terms later this year or, perhaps even more worrying for the current executive branch – what might happen in the next general election in 2024.
So, it would seem that the current political party in power would like to stem inflation before that arrives, in hope of giving themselves the best chance at the polls, and stemming inflation may not be an operation for a few weeks or months – it may take years.
But, this also may come at the risk of the stock market and the massive gains that have accrued since the pandemic. But, if the Fed and the current executive branch has to choose one or the other – it seems that the decision has already been made and this could put even more pressure on to US equities.
To be sure, I’m not the only one tracking this and the sell-offs that engulfed US stocks at the start of the year have very much been driven by this premise. And, really, matters have only gotten worse with the Russian invasion of Ukraine which, on top of the humanitarian consequences, brings on the threat of even more inflation as the global supply chain is now seeing significant disruption.
While the Fed normally would’ve countered such a risk by even greater accommodation in the past, that potential doesn’t quite exist as it has given the trouble with inflation and the prospect of even more given the ongoing saga in Eastern Europe.
From the below weekly chart of the S&P 500, we can see prices in a descending triangle formation – which is often approached with the aim of bearish breakdowns. Support at 4100 as so far held the index with a swing point of 4138 being tested again this week. But – the fact that this support is showing a diminishing marginal impact suggests that bears are showing greater sway and, eventually, may be able to force a downside break.
The area around 3800 remains of interest for deeper support, as this plots very near the 38.2% Fibonacci retracement of the pandemic move and it’s also very close to the 20% marker from the highs that would denote entry into a ‘bear market.’
S&P 500 Weekly Price Chart
— Written by James Stanley, Senior Strategist for DailyFX.com
Contact and follow James on Twitter: @JStanleyFX