While traders have been ready for the Federal Open Market Committee (FOMC) to lower interest rates a few times during the second half of 2019, the value of the U.S. dollar has been declining all month. However, the decrease has intensified this past week.
The U.S. Dollar Index has been consolidating in an upward-trending wedge for a year. It measures the value of the U.S. dollar (USD) against a basket of currencies, including the euro (EUR), British pound (GBP), Japanese yen (JPY), and Swiss franc (CHF). All of that came to an end this week as the index fell below resistance from the rise.
The value of a nation’s currency often begins to decline in relation to other currencies when its central bank begins to shift toward a more flexible monetary policy. That seems to be what is going on in this situation.
This reversal may be advantageous for certain huge multinational corporations that make a significant portion of their income abroad, even if the value of the USD is still robust compared to where it was before to its meteoric climb in late 2014 and early 2015. Companies make less money from profits made abroad when the USD is stronger because the conversion rate makes it more expensive for them to bring the money home to the United States. On the other hand, businesses benefit more from their earnings made abroad when the USD value is lower since the conversion rate is in their favor.
As an example, if a corporation makes €1 million in profits in Europe at a EUR/USD exchange rate of 1.25 (as it did in the beginning of 2018), the company may claim €1 million in earnings ($1.25 million) when it repatriates the money. However, a corporation may only declare $1.10 million in earnings when it repatriates the money if it makes €1 million in profits in Europe at a EUR/USD exchange rate of 1.10 (as it did in May). This is because €1 is only worth $1.10.
Be on the lookout for firms like McDonald’s Corporation (MCD), Mondelez International, Inc. (MDLZ), and eBay Inc. (EBAY) who have significant international revenue to profit from a further decrease in the USD.
S&P 500 vs. Russell 2000
Two FOMC members’ disappointing remarks on monetary policy today caused the S&P 500 to retreat further from its most recent record high.
The FOMC had been expected to decrease the Federal Funds rate by 50 basis points (0.50%) at its meeting in July, but James Bullard, president of the Federal Reserve Bank of St. Louis, shocked Wall Street by downplaying the possibility. According to the CME FedWatch Tool, traders had priced in a 42.6% possibility of a 50-basis-point decrease in July as of yesterday. Traders have lowered those odds to 35.4% as of right now.
We are conscious that monetary policy should not overreact to any given data point or short-term movement in mood, Fed Chair Jerome Powell said in response to the interest-rate speculation. Although this comment doesn’t necessarily exclude the possibility of further rate reduction, it was sufficient to cause a wave of profit taking today.
Traders were already alarmed by the rising hostilities between the United States and Iran and the prospect that President Trump and President Xi Jinping’s meeting at the G-20 Summit would not end the trade spat between the two nations. If you take away the fervent expectation that the FOMC would intervene and rescue the day with drastic rate cuts, Wall Street may resume its selling.
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Risk Indicators – TNX
The 10-year Treasury yield (TNX), which briefly recovered last Friday, has once again started to decline. The TNX closed lower than 2% for the first time since November 8, 2016. This is another evidence that traders are preparing for a time of low interest rates that might last for a while as well as the possibility of an economic slowdown and a collapse in the stock market.
When traders believe that the FOMC will reduce rates and when they believe that stock prices may decline, they tend to purchase Treasury securities, driving up Treasury prices and lowering Treasury yields. At this point, it seems all but certain that the FOMC will lower interest rates during the course of the next six months. The only remaining question is how much.
What we don’t know is what will happen to the S&P 500 and the American economy over that time period. Although the index has reached fresh all-time highs, traders are nonetheless concerned about a possible drop. For the near future, keep an eye out for the TNX to stay low.
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Bottom Line – Profit Taking
As we get closer to the Fourth of July vacation, I wouldn’t be shocked to see more profit taking given the ongoing volatility on Wall Street. Profit-taking, however, might not always result in a fresh negative slump. More consolidation is what I’m expecting.
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