The latest Federal Reserve statement and press conference certainly gave investors all they wanted to hear when it comes to the central bank’s “flexibility,” which was a major issue in the fourth-quarter selloff in the stock market.
“Patiently awaiting greater clarity,” as Fed Chairman Jerome Powell put it last week, is very different than the “autopilot” gaffe he delivered Dec. 19, sending down the Dow DJIA, -0.10% S&P 500 SPX, -0.27% and Nasdaq COMP, -0.42% Perhaps Powell has learned that as chairman, it’s not just what you say but how you say it that moves the markets. Still, it has to be acknowledged that the numerous Twitter attacks from the president may have goaded the Fed chairman into taking a firmer stand, which regrettably backfired in the stock market.
This U-turn from the Fed and the cessation of Twitter attacks on the Fed chairman, combined with the pending trade deal with China, is what drove the S&P 500 to have the best January since 1987. My thesis remains that there will be a trade deal with China by the March 1 deadline and, if enough progress is made, it is possible that the final deal will be made at a somewhat later date without tariffs on Chinese goods going from 10% to 25% on March 1.
I believe that the announcement of a trade deal with China will serve as a catalyst for the U.S. stock market to make further progress and retest its all-time highs. U.S. stocks have already erased more than two-thirds of their fourth-quarter losses (see chart). Such a trade deal will also be a positive for the U.S. dollar as China is the biggest driver of the trade deficit and the goal is to completely eliminate the bilateral imbalance in trade estimated to be over $400 billion in 2018 in the next five to six years.
Furthermore, I don’t believe that anyone is looking for economic re-acceleration in the United States in the second half of 2019, but when President George W. Bush passed his tax cuts in 2003, there was a surge in economic activity, a breather of sorts, followed by another surge. Is it possible that the economy will take a breather in the first half of 2019 and then re-accelerate in the second half? It sure is, but such a notion has not been embraced by a majority of investors. If that happens, the S&P 500 should trade above 3,000 points by year-end.
Implications for the dollar
I see a lot of positioning for an end to the U.S. dollar rally, given the outlook for a more patient Fed, but I believe that such positioning is premature. If indeed there is a second-half re-acceleration in the U.S. economy, Fed rate hikes would resume. But it’s not only the Fed rate hikes driving the dollar. The Fed balance sheet unwinding has continued, and it does not show any indication of stopping or decelerating (see chart).
On the other hand, the European Central Bank (ECB) stopped expanding its balance sheet in December 2018. There was talk of “normalization” starting in 2019, which I do not believe will happen this year. With the Fed continuing to unwind its balance sheet and the ECB not unwinding, given a weakening Eurozone economy and the Damocles sword of Brexit, it is possible for the U.S. dollar rally to resume. The euro has certainly rebounded after the end of ECB balance-sheet expansion, but since it is highly unlikely the ECB will shrink its balance sheet in 2019, this rebound is highly suspect. Due to the euro’s disproportionate 57.6% weight in the U.S. Dollar Index DXY, +0.30% I think the thesis that the U.S. dollar has topped out is misguided (see chart).
Another reason why the euro rebounded somewhat is that the interest-rate differentials (as measured by 10-year bonds) shrank somewhat. On a closing basis, the high in 10-year Treasury yields hit in October 2018 was 3.23%, and that same rate was 2.68% last week. The recent highs in 10-year German bund yields was 0.56% in October 2018. The bunds closed last week at 0.17%, trading intra-week at 0.10%.
Since October the Treasury/bund spread has dropped from 267 to 251 basis points at last count. That’s not much shrinkage, but there is some narrowing in this interest-rate differential. Since there is a record supply of Treasuries in 2019, due to the Trump tax cuts, it would not be inconceivable for the Treasury-bund spread to expand again, particularly if the Fed’s balance sheet runoff rate does not decelerate (see chart).
Any foray into business or economic forecasting starts with three basic scenarios: best-case, base-case and worst-case. The base-case scenario, in my view, even with a Brexit deal, is that Europe will continue to stagnate, and the U.S. economy will do well in 2019.
That would make a rebound in the U.S. dollar highly likely.
Ivan Martchev is an investment strategist with institutional money manager Navellier and Associates. The opinions expressed are his own.