Stormy Weather, Steady Stocks
The passing of Hurricane Harvey and the imminent landfall of Irma failed to rock the boat for equities, which remain near all-time highs despite puts and takes amid industries being impacted by severe weather events. More remarkable than trade posturing in home improvement and insurance stocks is the observation that benchmark interest rates and the dollar continue to slide. The trade-weighted dollar is now at two-and-a-half year lows amid better growth in Europe and a significant rebound in emerging market equities. And while a strong bid in Treasuries is explainable in part by rising geopolitical risk premiums, the implications of continued subdued rates of underlying inflation and currency differentials promise ongoing ramifications for interest rates both here and abroad.
Dollar Weakness Extends
The Fed’s next central bank meeting won’t take place until the week after next, but traders are already shifting their bets about the timing of additional interest rate hikes. While we don’t expect any action on rates at the September 20 meeting, we do expect Yellen & Co. to signal the beginning of a process to start reinvesting less than 100 percent of U.S. government and agency-backed bonds maturing. The reduction in reinvestment rates is unlikely to rock the bond market, but continued sub par inflation leads some to argue that our central bank should take its foot off the rate hiking pedal. In fact, the Federal Funds futures market is now discounting less than a one-in-three chance of the Fed raising rates again this year. The increasing probability that short-term interest rates remain unchanged into 2018 is the latest factor weighing on the dollar.
What Lies Ahead
Unlike in the U.S., European central bankers have yet to begin unwinding monetary stimulus, but with the European Central Bank’s €60 billion per month quantitative easing (QE) program about to lapse at year-end, investors are wondering what comes next. As expected, the ECB left the zero-interest rate policy unchanged at its meeting earlier this week, but central bank chief Mario Draghi suggested that investors would have to wait until the central bank’s next gathering at the end of October for guidance about the future of QE.
A key factor weighing on the central bank’s decision about a presumed tapering of its bond buying is the same lack of inflation puzzling U.S. policy makers. In turn, notable strength in the euro is threatening to reduce the price of imports and move the inflation rate further from policymakers’ objective, while also reducing the competitiveness of European exports. After having weathered years of sub par economic growth, European policymakers are understandably cautious about prematurely removing monetary stimulus. Amid ongoing policy uncertainty, currency markets responded by pushing the euro past the $1.20 mark this week.
With global economic growth extending to the emerging markets in 2017, we continue to believe that the removal of monetary stimulus here and abroad is happening for the right reasons, and that the timing and cadence of additional rate hikes will remain subject to the tenor of incoming economic data. Importantly, we observe that weakness in the dollar is playing an increasingly significant role in the earnings revival that U.S. multi-national companies are enjoying this year, an earnings revival that has keyed equity returns year-to-date.
Takeaways for the Week:
- Stocks remain well bid despite rising geopolitical tension and severe weather events in the southern U.S.
- Investors continue to ponder what lies ahead for monetary policy both here and abroad