During August, the MacroTourist purposely tried to stay away from the screens. Over the years I have found that if I work during my vacation, I trade like crap, and in the meantime, ruin my time off. But this summer, even though I kept my positions to a minimum, I still found some time to read a little research and market blogs.
And the one thing that struck me was the near uniformity of the idea that a Fed rate hike would result in a stronger US dollar. It’s like everyone thinks the only determinant in foreign exchange movements is the change in relative interest rate differentials between countries. I wish trading FX were that simple.
There seems to be a huge fear a Fed rate raise will cause the US dollar to soar. I may not know much, but I know when everyone is scared of something happening, it is time to look the other way.
Especially when what everyone is afraid of does not even mesh with past experiences. Given the market’s level of worry regarding Fed rate hikes, it is logical to conclude the start of previous Fed rate hike cycles were the beginning of huge bull US dollar moves. Yet when you look back at the previous cycles, this is not the case.
Have a look at this great chart from JP Morgan’s David Kelly:
Although the 1998 tightening cycle did eventually result in a sustained US dollar bull move (but only after a small sell off), the other two cycles were the start of bear moves. A Fed that is raising rates is by no means a guarantee of a strong US dollar.
In fact, given the amount of fear out there, I would argue that the most likely outcome from a Fed rate hike is the exact opposite situation. If there was ever a chance for an “all baked in” situation, it is when the Fed finally raises rates.
The other interesting aspect about this whole rate rise scare is that most market participants assume the first hike will be the start of a tightening cycle. The Fed has never started a rate tightening campaign with inflation running below target. I had thought that given the anemic state of the US (and world) economy, the Fed would be hesitant to break this precedent. However it is increasing looking like the “zero was an emergency rate, and the emergency is long past” camp on the FOMC will extract a rate hike from the doves. But does this necessarily mean the start of a rate hiking campaign? What if this is a “one and done” rate hike? Let’s face it, apart from a somewhat tight labour market (but filled with conflicting signals with little wage growth), there is little reason for the Fed to be raising rates. This September the Fed could lift off zero and then stay low for a long time with no more hikes.
Although the initial reaction from a Fed rate hike might be a US dollar rise, within days I suspect the market will realize that any rate rise will be gradual (if at all), and will be selling US dollars.
Currently the market is convinced that higher US rates equals higher US dollar. Markets often go where they hurt the most investors, and nothing would be more hurtful than a rate rise that is accompanied by a US dollar sell off. No one is expecting it. And that is precisely why it is likely to happen…
Emerging Markets and copper
Following the 2008 credit crisis, copper and emerging markets equities seemed to be joined at the hip. From 2009 to 2013 they traded tick for tick. Then in 2014 copper started sinking. At the same time, the financial markets’ bid leaked into emerging markets equities and caused an “unsupported by the fundamentals” rally. This divergence lasted for all of 2014, and before this summer, was still fairly wide.
However this summer the financial markets’ bid finally filled in. Emerging markets equities were hit especially hard, and the EEM ETF lost more than 30%. The combination of global equity markets sinking combined with the atrocious performance of emerging markets’ currencies caused some real carnage. In doing so, the divergence between EEM and copper completely closed.
For the first time in a couple of years, you can buy emerging markets equities with little ‘good news’ priced in. I know everyone hates emerging markets and that China will implode to zero, but ask yourself what Baron Rothschild would be doing…
Thanks for reading,