Can the Fed Help the Dow and Dollar Rally? by Jes Black
Currency traders have had to keep one eye on Wall Street lately, as the gyrations in US asset markets remain the best proxy for dollar sentiment. Wednesday's Fed decision is going to make waves in the stock and bond markets and should hold sway over the buck. History shows the dollar usually gains from lower rates. But if the Dow and dollar rally in anticipation that the Fed will ease next week, it’s a recipe for “buy the rumor, sell the fact” because any further cut would be ineffectual without improving economic fundamentals in place. Therefore, the bigger question is whether or not this rally is for real, because if its not, traders are likely to mimic the dour mood on Main Street and begin selling the dollar again.
The dollar slipped on today’s rise in jobless claims and below forecast 3.1% gain in Q3 GDP. Immediate focus remains on the jobs report and ISM survey tomorrow, but the main event is next Wednesday’s Federal Reserve monetary policy meeting. Currently, futures are pricing in an 85% chance of a 25-basis point cut, from the 40-year low of 1.75%. Traders feel pretty confident in a cut because the economic data is so poor. But the market is likely to be disappointed since the Fed lowered rates eleven times last year and one more is not going to help.
In fact, while rate cuts are normally seen as benefiting stocks, the "Don't fight the Fed" mantra has not produced anything but a bear market rally in this downturn. Greenspan's impotence is most telling in the recent consumer confidence surveys that have plunged to 9-year lows. Although this same survey was used as justification for a "V-shaped" recovery during the October 2001-March 2002 rally, some have already written off the Conference board's massive decline. But the University of Michigan's index showed identical weakness and is now sitting on trendline support of a 20-year bullish channel. A fall from here would not only mark new multi-year lows, it would also imply that consumer confidence has reversed from a 20-year bull run, a significant psychological development which would likely be a further drag on the economy. Moreover, the employment component of these surveys points to a deterioration in jobs availability while the falling expectations figure could be a drag on spending in 2003. It may be one of the mildest recessions on record, but it will get ugly if consumers reign in their purchases - even a little bit.
This environment puts the Fed is in an uncomfortable lose-lose situation where a rate cut won't help the main drag on growth which is new capital investment by businesses, while inaction will be met by ire. If a manager has not already decided to invest, another 25 bp isn't going to change his mind. On the other hand, if Greenspan and Co. does not cut rates, it may push Wall Street into another nasty selloff. In a further complication, if the Fed uses a cut now and the economy doesn't turn around it will be regarded as wasted ammunition if another terrorist attack or war in Iraq threatens to derail the national psyche.
The greatest risk to the market is not the Fed’s decision on rates, but the constant deterioration of economic fundamentals, which will weigh on earnings growth and force prices down until a more normal P/E ratio is reached. This fundamental norm remains the biggest nemesis to market bulls and by most technical indicators the rally from October's 5-year lows is already showing signs it won't last.
Anatomy of a Rally
The rally from October’s 5-year low of 768 in the S&P flies in the face of this month’s dire data releases which all point to a stalling recovery. Some might like to say stocks are climbing a “wall of worry,” but investor bullishness indicators have already surpassed that of the August highs, exposing this bear market rally for what it is. One major difference is the likelihood that bond prices peaked in October when the 10-year note fell from 116.10 to 111.75. This high is not likely to be revisited and the profit taking in that market has allowed for portfolio adjustment into stocks from bonds. While this sets the stage for an eventual strong rally in US stocks, it doesn’t necessarily have to happen now.
Each of the three major rebounds over the past two years have occurred when the market was heavily oversold on a weekly basis and ripe for a corrective squeeze. The latest rally is no different. In addition there is little basis to call this THE bottom considering volume, breadth and the advance/decline ratio have all been below historical norms for a bottom. The only hope that this is THE bottom is hope itself.
In the September 24 article A Few Bad Days Away From a Crash, we warned that the “S&P had formed a clear Head and Shoulders pattern and that failure to hold its neckline around 950 would be an ominous sign.” That outlook still holds as current prices have risen to a high of 907, well below resistance at 924, a previous high and the 38.2% of the 1177-768 decline. Resistance is seen at 924, followed by the August high of 965. Only a sustained move above 965 would give credibility to this rebound.
While the market may try to test key resistance around 924-965, the steady decline in volume means momentum is fading fast and bulls are less prominent than short covering bears. Stochastics, Relative Strength (RSI) and the Moving Average Convergence Divergence (MACD) on a daily chart are at exactly the same point when the S&P was trading at its August highs. In addition, MACD is now about to cross over, meaning a further rise in prices would likely create a “negative divergence” which traders use to signal a top. This indicates that once short covering ceases to drive the market higher the bears will go back to the shorts.
That makes the market ripe for a selloff once price action runs out of steam. And with the current stream of negative economic data, sentiment is likely to turn on a dime as traders will have plenty of "fundamental" reasons to sell this rally.
Dow, Deflation and the Dollar
Residual optimism from the 1990s lingers on Wall Street and the stabilization around July’s lows has kept the dollar in a steady range as trader ponder whether or not the market has bottomed. While the Dow/Dollar connection may appear overly simple with all that is happening in Europe and Japan, the fact is that stabilization in US stocks is crucial to preventing another fall in the dollar because so much is still riding on the hope of a US economic recovery.
This became most evident during the sharp decline from March 2002 that erased 400+ points in the S&P, or about 35%. At the peak, USD/JPY had risen over 15% from its September 2001 lows as traders positioned themselves for a strong “V-shaped” recovery. When this did not materialize, profits were taken and shorts re-entered. The July and October lows around 770 in the S&P reached this year are now being compared to the bear market bottoms of the 1970s and 1930s, setting the stage for further disappointment if that comparison proves to be premature.
Moreover, the roaring 1990s were financed in large part by foreign capital which means the US economy is still heavily dependent on keeping foreign investors satisfied. While the $1.8 bn daily dose of foreign capital continues to be financed in large part by the bond market, falling share prices could easily provoke a similar retreat in dollar demand like that seen in the March-July downturn as foreign investors keep money at home and currency traders jump on the weak dollar trend.
Current account deficit risks are well known, but another risk to falling share prices is the depressing effect it would have on the American psyche and by extension much needed price inflation. There is already anecdotal evidence that the last bastion of consumption – teenage girls – is waning. Retail is suffering, and if curtailed consumption depresses the US service sector like it has manufacturing, further disinflation could push the real burden of US consumer debt (already higher than it was in the 1930s) to new highs, forcing a cutback in spending and risking a downward spiral in prices and demand – the dreaded deflation scenario.
With the Fed funds rate and GDP deflator at 40 year lows, stabilization in US stock prices is needed to prevent the undesirable deflation scenario from taking place. Stabilization would also support the dollar, which is why currency traders still have to keep one eye on Wall Street. But another rate cut by the Fed may not prevent a retest of this October’s lows. A break below this key double bottom support would undermine confidence in the US recovery, raise questions about the Fed’s effectiveness and drag the dollar below current levels.
-Oct 31, 2002
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