I often say that, in order to trade/invest in the direction of least resistance, we must understand the structural underpinnings of the markets.
Monetary policy is a huge part of that structure. In order to understand why the stock market has been so difficult to deal with thus far in 2015, we need to understand the dynamics at work in interest rates and the U.S. dollar.
At present, the widening interest rate differential between the United States and Europe is an important shift. While the ECB in Europe is busy doing more quantitative easing in hopes of spurring inflation toward its 2% target (and hopefully bumping along economic growth), the Fed is taking a more hawkish approach and “threatening” to increase rates later this year.
All of this news has caused a big rally in U.S. interest rates since early February and also further spiked the U.S. dollar, while the opposite is happening in Europe. This, in turn, has caused lots of v-shaped (and tent-shaped) reversals in asset classes for year-to-date with no real directional move, making for choppy movement.
U.S. Dollar
Click to EnlargeOn the first chart we see the PowerShares DB US Dollar Index (NYSEARCA:UUP) in blue, versus the SPDR Gold Trust (ETF) (NYSEARCA:GLD) in yellow and the United States Oil Fund LP (ETF) (NYSEARCA:USO) in red.
The big continuation rally in the U.S. dollar index, the inverse of which is a weakening EUR/USD, has pushed commodities like gold and oil lower, which is one reason why the rising dollar is a deflationary move.
The dollar is now very overbought through a multi-week/month lens and a mean-reversion lower could cause things like gold, oil and possibly even energy stocks to bounce.
Interest Rates
The second piece to the year-to-date market puzzle has been the reversal (lower) in bond prices in early February, which began about one week after the ECB announced its quantitative easing program.
Click to EnlargeOn the next chart we have the year-to-date moves in the iShares Barclays 20+ Yr Treas.Bond (ETF) (NYSEARCA:TLT) in red, the Utilities SPDR (ETF) (NYSEARCA:XLU) in orange, and the SPDR S&P 500 ETF Trust (NYSEARCA:SPY).
Note that, after the back-and-forth movement in January and February, both the TLT and the SPY are now essentially flat for the year while utilities stocks reversed sharply lower and down on the year.
In other words, we have a structural shift occurring in the dollar and potentially in interest rates, which means we must pay close attention or risk falling through the cracks.
Keep Watching Fed and ECB Meetings
The sad reality is that markets continue to limp from one Fed or ECB meeting to the next, and the next one of those meetings to watch will be the Fed meeting on March 18. On that day Janet Yellen will either need to confirm her hawkish threat or cave once again and push her interest rate hike further into the future.
So, on March 18 this multi-week rally in interest rates, which has been at the center of violent macro moves alongside the rising U.S. dollar, will either continue in a big way or completely fizzle out. In the latter case, we would likely also see the U.S. dollar move back down, which would provide a boost to stocks and commodities.
The market has been choppy and sloppy thus far in 2015, and interest rates and the U.S. dollar are likely to decide what happens next.
