The Fed didn’t say much of anything new on Wednesday. There were some minor revisions to their outlook but the most important comment was that “The Committee continues to see the downside risks to the economic outlook for the economy and the labor market as having diminished since the fall.” That sounds good for stocks, but it also increases the potential for the Fed to begin tapering its asset purchases sooner than traders would have anticipated.
Unfortunately, the Fed really didn’t expand much further on that topic at all. They may taper sooner than expected or they might not. The slightly improved outlook seems to indicate that a short-term cut in bond purchases is more likely, but that may have already been priced into the market since May 22 when Chairman Bernanke commented to Congress about pulling back on asset purchases. We believe that it hasn’t been fully priced in yet so there is probably a little more downside in stocks in the short term.
The Initial Reaction
FOMC statements are usually followed by some fairly dramatic swings back and forth in the major asset classes. Today has been no exception to that general rule, and the volatility is unlikely to calm down very much until we get the full reaction to the report from Asia in the overnight market. However, there were some interesting reactions outside the stock market that were more consistent and therefore potentially more reliable to be used in our initial forecast.
Click to EnlargeIn the chart below, you can see the initial reaction to the FOMC report in gold, the Mexican Peso (MXN) and the Brazilian Real (BRL). In all three cases, the assets are losing value versus the dollar. In fact, very few assets were able to stand up to a stronger dollar just after the announcement, which is actually a little weirder than you might think at first glance.
Usually, when the dollar appreciates in value, Treasury bonds will as well. However, the initial reaction to the FOMC report was accompanied by everything losing to the dollar — including bonds. Rather than adding to our confusion, this provides some clarification of our expectations for a taper.
Emerging markets are heavily invested in U.S. Treasuries. If expectations that the Fed will taper in the short term are rising, then those assets will lose value without the buying pressure provided by the FOMC. That will weaken international currencies, which will drive the value of the dollar up on a relative basis. If emerging market economies start selling Treasuries to stem their losses, the decline in bonds could accelerate, which would feed back into emerging market asset losses again.
How Will This Affect Stocks?
This is a hard question to answer because it is clear that the market has already priced in some declines in emerging market economies already. For example, the Vanguard Emerging Markets ETF (VWO) is already down 10% since the beginning of the year — more than 80% of that decline has happened in the last month. Could emerging markets fall further? Yes, emerging markets just completed a head-and-shoulders bearish reversal pattern that is only 50% of the way to its normal target. You can see that in the next chart.
Click to Enlarge The decline in emerging stocks is important because it can put more downside pressure on U.S. and European equities as well. In particular, commodity stocks are very sensitive to this kind of market disruption. The financial, tech and retail groups may help support the S&P 500 in the short term, but a decline in commodity prices will eventually win.
The Fed was clear that they don’t anticipate inflation to be an issue in the short term, so that won’t help commodity prices either. Chinese economic data remains fairly negative (and fraudulent) and “Abenomics” in Japan (no, not an emerging market, but they are acting like one) has been fading fast over the last month, which eliminates two more big economic players from supporting emerging markets and commodities in the short term.
InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.