December 18, 2018

Last week, the dollar hit a fresh 52-week high of 97.70 on the US Dollar Index. For all intents and purposes, my annual prediction that the dollar would be up in 2018 has worked out well. Emerging market currencies have been much weaker than developed market currencies, so the old US Dollar Index tells only half the story (for more, see December 18, 2017 Marketwatch article “Ivan Martchev’s 2018 predictions: Gold will sink, and the dollar will rally”). Gold is also down so far in 2018, although not as much as I had expected. That would make the accuracy of my annual predictions 4 out of 5, or 80%.

One way to differentiate between the US Dollar Index and the JP Morgan Emerging market currency index is to think that the first rise measures the strength of the US dollar, while the large decline measures the weakness of emerging market currencies. The former measures the exchanges value of the dollar against major developed market currencies only, while the latter concentrates on emerging markets.

While the US Dollar Index has been perky in 2018, the picture in the JP Morgan Emerging markets currency index has been abysmal, with the index hitting an all-time low in 2018. It is fair to say that 2018 has been a lot worse for emerging markets currencies than for developed markets currencies.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The extreme cases from the G-20 are those of Turkey and Argentina, where years of rampant dollar borrowing finally caught up with the local currencies and they both were under severe pressure last summer. In the case of Argentina, the IMF got involved yet again. In the case of Turkey, it looks like there are enough forex reserves to cover external debt payments and the current account deficit recieved help from the price of crude oil, which fell like a rock in October and November. In the case of Argentina, it does not appear that the forex reserves are enough to maintain the exchange rate, but we have the IMF actively intervening. It doesn’t appear that the worst is over for many emerging markets currencies.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Conventional wisdom says that if the Fed stops tightening, the dollar would top out, like it did in 2001, when it was obvious that we had entered a recession in the U.S. and that the Fed had begun to reduce the Fed funds rate. Still, the tops in the dollar have tended to come after the Fed has embarked on rate cutting cycles and arguably we have not yet put an end to the present quantitative tightening cycle.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

This Fed tightening cycle is very different, as it is comprised of hiking the Fed funds rate and unwinding the central bank balance sheet. As the pace of quantitative tightening began to accelerate in 2018, the stock market begins to flip like a fish out of water. This is because quantitative tightening sucks electronic cash (in the form of excess reserves) out of the financial system via repurchase agreements. All primary dealers that are counterparties to such repurchase agreements are major players in the stock market. As the suction rate of such repo activity has accelerated, so has risen the volatility of stocks.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

It is hard to say when the runoff rate of the Federal Reserve balance sheet will slow down, as it is so far been ramped up to a level of $600 billion a year, or $50 billion per month. It is that balance sheet runoff rate that also affects the exchange value of the dollar and not just the Fed funds rate.

Big Week for the Fed

This week, the Fed is expected to deliver another Fed funds rate hike to get the target rate to 2.5%. There is speculation that the Fed would soften its language, given the volatility in the stock market and the softening of some economic indicators. If one looks at the December 2019 Fed funds futures – which forecast the Fed funds rate at 100 minus ZQZ19 for settlement in December 2019 – the Fed funds rate is forecasted to be 2.595% based on a ZQZ19 price of 97.405 at the close on Friday.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The forecasts of the Fed fund futures markets have taken off the table 40 basis points worth of rate hikes since late October as the stock market has weakened. Since the stock market is one of the leading indicators of the economy, this is only natural.

Still, it is a mistake to focus on the Fed funds rate only as the runoff rate of the balance sheet is just as important, if not more important, in this Fed tightening cycle. I am not aware of any financial instruments that can be used to forecast the Fed balance sheet runoff rate the same way the Feds funds and euro-dollar futures are used to forecast the Fed funds rate.

The situation is so unusual that in theory the Fed could cut the Fed funds rate and increase the balance sheet runoff rate and that still could end up being a tightening move. I am not saying they would do that, but I am suggesting that it is a mistake to focus only on the Fed funds rate, particularly in the present tightening cycle.

Still, I think any material softening of the language of the FOMC statement this week would be cheered by the stock market the same way dialing back the hawkish Fed rhetoric did on November 28.

About The Author

Ivan Martchev
INVESTMENT STRATEGIST

Ivan Martchev is an investment strategist with Navellier.  Previously, Ivan served as editorial director at InvestorPlace Media. Ivan was editor of Louis Rukeyser’s Mutual Funds and associate editor of Personal Finance. Ivan is also co-author of The Silk Road to Riches (Financial Times Press). The book provided analysis of geopolitical issues and investment strategy in natural resources and emerging markets with an emphasis on Asia. The book also correctly predicted the collapse in the U.S. real estate market, the rise of precious metals, and the resulting increased investor interest in emerging markets. Ivan’s commentaries have been published by MSNBC, The Motley Fool, MarketWatch, and others. *All content of “Global Mail” represents the opinion of Ivan Martchev*

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