The S&P 500 will continue to rebound after the post-FOMC rally but forex market risk trades like AUD/USD will underperform as the market adjusts to the zero-growth reality in the United States.
The FOMC decision set off a wild round of trading. In less than two hours, the S&P 500 traded in a 117 point range. Eventually stocks closed at the daily highs and pulled risk trades along for the ride.
Here are some highlights of the FOMC decision:
- The Fed committed to keeping rates low until “at least through mid-2013”
- Three FOMC members dissented to ‘mid-2013’ saying they preferred to keep the vague commitment to low rates “for an extended period.”
- The Fed said growth so far this year “has been considerably slower” than expected. They noted a deterioration in the labor market. There is no longer any mention of “the recovery”. They also noted that temporary factors like the tragedy in Japan account for only some of the recent weakness.
- Previously, the Fed said it expected the recovery “to pick up” in the coming quarters. It now expects “a somewhat slower” place of recovery. They compounded the downgrade by saying that downside risks have increased.
- The outlook for inflation was downgraded.
- The Committee discussed the range of policy tools available to promote a stronger economic recovery… and “is prepared to employ these tools”
The final point was key because it helps explain the rebound in risk assets. It sounds like the Fed has several ideas on how to boost the economy, if need be. The thinking is that after Jackson Hall something will be implemented. This was the course of action with QE2.
To us, a larger factor was the relative value of stocks compared to bonds. After the FOMC, ten-year Treasury yields touched a record low of 2.03%. Dividends on 22 of the 30 stocks in the Dow yield more than 10 years and the average yield is 3.26%. The market tried to bully the Fed into QE3. The Fed didn’t bite (yet at least) so the market took a second look at where it could stash its money and decided risk assets were still a good bet.
That’s the takeaway for the immediate term, but what about the next 4-6 months?
We believe the market is in the process of pricing in a long period of near-zero growth in the US — something akin to the Lost Decade in Japan.
The US government is tapped out and spending cuts will continue no matter the economic state. This will be a headwind to growth, cutting about 0.5% per year from GDP.
The Fed is tapped out as well. There is nothing the Fed can do to lending rates that will stimulate growth. Borrowing rates are next-to-nil and we they don’t have a mandate or the power to get the economy moving.
This scenario may sound negative for stocks but it’s not as bad as it sounds. 1) Companies with solid (A+) ratings can borrow at extremely low rates. 2) The worldwide economy is growing, booming in some places. Multinationals are making a larger and larger portion of their revenues abroad.
In the forex market, this doesn’t translate into the ‘risk trade’. Slower US growth will hurt commodities more than corporate profits so commodity currencies will underperform. CAD is especially vulnerable because a) rate hikes are priced in. b) Canada is highly integrated with the US. c) raw commodity exports are a large part of the Canadian economy. d) Canadian house prices are overvalued.
The first thing to break down will be the carry trade. This has already begun and will continue as AUD/USD falls to 90-cents. The Canadian dollar will be the next to decline. Traders will increasingly look to emerging market currencies.