The Week Ahead: Don't Trust Any Signs of a Rally

This week’s action in financial markets and the chatter surrounding it will be focused on one thing only: the Federal Reserve Bank. The Fed has made it pretty clear that they intend to raise rates at their meeting this week, ending a long period of speculation as to the timing of a rate hike. Much of the trading over the last few months has been about positioning for that decision. Most observers are focusing on stocks, but, as is often the case, stocks are really following what is happening in the three Cs, currencies, credit, and commodities.

In currencies the relative strength of the dollar has been the story. Starting in the middle of October the dollar index climbed sharply from levels that, in an historical sense were already elevated, reaching the 11 level that represents an all time high just a couple of weeks ago.

That, in turn, pushed commodity prices lower, exacerbating losses that had already occurred due to worries about global demand and, in many cases, increased supply. That increase in production was generally planned and began last year, when commodity prices were high and is, in a theoretical sense, a wonderful example of simple supply and demand in action. Prices were high, at least in part due to easy monetary policy around the globe, which prompted more production, which increased supply, which forced prices down. Somewhere, Adam Smith is watching events with a smile on his face.

The fact that many small commodity producers, and oil companies in particular, borrowed money to finance expansion projects that made perfect sense with oil at $100 but now look like huge liabilities has had an effect on the high yield market. Junk bonds have come under enormous pressure, led by the commodities sector. With the benefit of 20/20 hindsight, that was somewhat inevitable as that market had become overbought as investors had chased yield that was hard to come by when interest rates were at record lows...which brings us back to the Fed. Ah, the beauty of the financial system!

On that basis, if no other, a move away from a zero interest rate policy this month makes perfect sense. It may even be a little late, but better late than never. What interests me as a trader and investor, however, is what is happening now that the well-telegraphed policy change is imminent. We have seen the dollar begin to back off of those highs.

1 Year Dollar Index. Source: Market

1 Year Dollar Index. Source: Market

This move was kickstarted by disappointment at the extent of measures announced by the ECB to further ease monetary policy there, but it should be noted that the dollar has also lost ground in the last couple of weeks against the yen and the pound. In other words, there is some general dollar weakness, not just euro strength.

All of that suggests that, in the forex market at least, there is an element of “buy the rumor, sell the fact” to the current movement, but equity investors should still exercise caution this week. Oil is still leading stocks and, no matter what happens to the dollar, there is still oversupply in the industry, with the threat of Iran re-entering the global market early next year still on traders’ minds.

There is also a danger that the Fed will not meet current expectations. Those expectations are now focused not on whether or not there will be a rate hike, but on what language regarding the future will accompany it. There seems to be a feeling that the Fed could indicate that this is a “one-off” move with no timetable outlined to even consider further hikes.

If that is the case, then “buy the fact” will certainly be the case. If we look at what FOMC members have actually said, however, it is more likely that the committee expresses a desire to raise rates further, dependent of course on the data. Even without a clear timetable outlined, that may be enough to prompt another major selloff.

So, with the continued overhang of oil and the fact that the market seems to have convinced itself that the news this week will be other than what the Fed has so far indicated it seems that all of the risk is to the downside. In that environment it makes far more sense for investors to hold off this week.

If oil does bounce and the Fed does back off from a hike, or even just indicate that this is a one-off, then stocks may rise somewhat. If, on the other hand, oil turns lower again and the Fed sticks to what they have said to date, both of which look more likely than the opposite, the volatility that we have seen in the last few weeks will be just the beginning.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Martin Tillier

Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.

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