Monday, March 28, 2016

The Dollar and Shifting Expectations

What a difference even a short trading week can make because while Friday’s strong GDP report may have been released to an empty room, it was the perfect way to end a week that saw a major shift in the market’s expectations regarding the Fed and its rate hike plans.  St. Louis Fed President James Bullard joined the chorus of non-voting presidents who obviously read our last posting and are now calling for the FOMC to recognize the improving economic outlook and even consider doing something once thought unthinkable by professional Fed watchers; hiking rates at April’s FOMC gathering despite the lack of a pre-arranged press conference.  As ludicrous as that may sound to people who spend 24/7 trying to predict the Fed, the CME FedWatch Tool shows traders are now forecasting a 12% chance that they hike in April and according to Marketwatch article on March 23rd they were only forecasting 7% in mid-March.

We can already hear you saying “big whoop” but for wary Fed watchers (which should be everyone in this bull market) will note that Bullard’s comments have already started a major adjustment in some parts of the market.  Given how much this rally has depended on hopes of keeping monetary policy nice and easy, we’d be surprised if investors weren’t watching every tick of the PowerShares DB US Dollar Index Bullish Fund (UUP) which continues to find strong support at the $24.60 level and racked up a strong 1.2% gain for the week.  The strengthening dollar might be just one reason why the S&P 500 closed down for the first time after racking up five straight weeks of gains, but more on that later.  Meanwhile, a weak dollar has been the lynchpin behind most of this rally’s biggest winners so if the dollar has been finding its feet then all those unhedged international equity and gold mining funds we’ve talked so much about were the big losers with the Market Vectors Gold Miners Fund (GDX) down almost 5.6% while the iShares MSCI EMU Index was down 2.37% compared to a 2% loss for the broader MSCI EAFE and a mere .87% draw down for the iShares MSCI Japan Fund (EWJ.)

Bringing up the rear performance-wise were those EM and Latin American equity funds with the iShares Latin America 40 ETF (ILF) down 3.3% for the week while the iShares MSCI Brazil Capped ETF (EWZ) was off 4.18% although mostly on political and economic issues with its hedged counterpart, DBBR, down 4.04%.  Normally, with a strengthening dollar and serious losses after a strong run-up you’d expect to see ILF and EWZ headlining a list of “biggest behavioral losers” on our ETFG Quant Movers Report but instead you’ll find both funds and seven other EM or commodity dependent economies on our Behavioral Top 25 list with EWZ still the top ranked behavioral scorer while ILF currently sites at #16.  While ILF’s behavioral score did shift lower over the last four trade days, EWZ’s score continues to skyrocket thanks to high short interest and incredibly high implied volatility which is something it has in common with nearly every other country or EM fund on that list.

Breaking down the “Why,” both the iShares MSCI Australia ETF (EWA) and the iShares MSCI All Peru Capped ETF (EPU) reported positive in-flows and given their less-than-stellar returns last week it’s probably safe to assume that traders are gearing up for more gains by Uncle Buck and thus more pain for the short dollar crowd.  We’ve talked before about using the Behavioral List as a contrarian indicator but in the current situation with the Fed it’s hard to tell who’s playing with fire this time and like everything else in this market, it all depends on what shakes out with the next FOMC gathering in April.  Doubting the Fed’s willpower when it comes to hiking rates has been a pretty sound strategy over the last few years but if April’s meeting comes and goes without a hike or even substantial change in the released statement, those going long the dollar could suddenly find themselves on the wrong side of the trade.  Then again, if the economy stays strong then time is likely on the side of the dollar bulls and whether rates rise now or later is only going to be relevant to the very nimble trader although some are already looking for the exits for other reasons.

Our chartist friends will be quick to point out that with Thursday’s close, the S&P 500 has now formed a lovely descending channel and that if the rally is going to live on, the market needs to close above 2040 this week.  The only problem with that is that although we haven’t approached last fall’s levels, most sectors are trading close to (or above) their October highs, so a strong close above these levels to break out of the channel might be a bridge too far for investors who were glad to make back some losses and move on.  The obvious losers who are in the still in the red include financials, energy, consumer discretionary and health care names which represent a fairly significant chunk of the market.  The catalyst for a move one way or another will be a series of speeches by Fed officials this week including Janet Yellen on Tuesday, so be prepared for more shifts in the road ahead.

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