The dollar has had a small rebound off its 3 year low and many are wondering if this is a good sign to buy into the greenback strength. Many of the indicators point to a higher Dollar, stronger economic growth, Higher interest rates in the US, and (so far) low inflation. Looking at a one month chart of the dollar index to the price of the 10 year treasury, you can see that the movement of the dollar to other currencies was in high correlation to the price of US bonds. Because yields move inverse to bonds, it could be assumed that lower bond prices (and higher yields) make the dollar become an attractive place to put money relative to other currencies. This trend should be watched to see if investors are using this as a short term trading catalyst or if the introduction of equity risk increased the relationship between bonds and the dollar.
Looking over a longer term trend there is a story to be told. The movements between the dollar and the yields in the past have been in sync (as you can see by the opposite movements in the chart) until the last 6 months where yields have dropped and the dollar followed suit. The cause of this could be a combination of many things, such as inflation expectations getting revised higher, or the political gridlock we have seen over the tax cuts and budget bill. It is certainly an adjustment to the expectations of that yields will not be lower for longer like we have seen in the past. Where is the 'proper' level to bring yields back to an attractive level that investors are bullish on holding dollar debt? Shorter term the answer looks like now, longer term we have to watch, inflation, the fed, and politics to determine what will make the US debt market investable again for large foreign buyers.
US CPI came in higher than expected at 2.1% year over year. Core inflation came in at 1.8% vs the 1.7% est., this caused futures to sell off in the US. Since last month when the markets sold off after wage growth came in higher, the markets have been closely watching for signs of inflation that could cause another adjustment in interest rates.
Longer term this will matter as adjustments are made to the valuations of equities to be able to compete with higher bond yields as well as higher borrowing costs for companies. This squeeze on companies could keep the US equity markets at a flat level for the year, with higher volatility as a new fact of life.
This week started with more selling around the globe. The US futures look like they are going to take on more losses today. It is a good time to start to panic and wonder if there is more to this than a simple consolidation. The strength of the individual investor is that they have time and it should be used. So lets looks over a few shorter term theories that could be the start of a larger trend that would require action.
Consolidation: Markets have had a spectacular 2017 with December and January of this year seeing nearly in-stoppable gains each day the market was open. Markets were past due for a correction and this has occurred all at once. Despite the news coverage these losses takes the market back to the beginning of December of last year. Too many people running for the door could overshoot the selloff and we will eventually find a balance and start the focus back on the data.
Bond Yields/dollar: The equity market notices the bond markets were starting to price in more inflation and higher rates in the future. A declining dollar also stoked the fears of more inflation in the US as the economy progresses. With the Equity market not accounting for as much of a rate increase from higher inflation and a stronger economy it would makes sense there would have to be a value adjustment to reflect the future that is seen in bond market yields.
Total collapse: The end is truly here and losses are mounting everywhere (look at the VIX). Listen to the news 20 hours a day to get the best understanding of how bad it really it. Constant negative reinforcement will provide the insight needed to make sure you hold on till the lowest possible moment to sell.
Paying attention is important and knowing when to sell can help pare losses, but the key is to understand why the market is behaving the way it is and determining then if portions of your assets are ripe for selling. Times like this, when the VIX is this high, almost all assets are being sold off, which is more a time to start to look for key assets to buy as the market continues to panic. Emotionally counterintuitive, but in time a more desirable play in the long run.
This week will be one to keep an eye on the bond market. This morning in Europe the PMI numbers came in better than expected for Europe and less than expected for the UK. This had a negative effect on both currencies and didn't help in reversing the downward trend that we saw at the end of last week. For the rest of the week there will be more economic health indicators coming out for Europe and the US but the main events will be central banks talking.
Today Draghi, the head of the ECB, will be speaking. With the strong growth in the Euro zone it will be important to see if there are any changes in his outlook for the asset purchasing program or when rates will need to start an upward rise. Any concerns about inflation will be another point the markets will be looking at. On Thursday the BOE will have an interest rate decision. Many are expecting no change in the interest rate but the central bank's outlook for inflation is going to be important.
Financial conditions between the UK and Europe will play into the Brexit talks as businesses pare back expansions in the uncertainty of a deal. When looking at how market are perceiving the news coming out of the two countries and the progress of a deal, look at the spreads between inflation prone countries in the Euro zone, like Germany and the UK. In Germany the inflation threat is pushing rates up all across the yield curve while in the UK many are skeptical that Inflation will be as big of a threat in the post Brexit world.