The Reserve Bank of Australia [RBA] released the minutes from its monetary policy decision meeting earlier this month. The minutes contain some great detail on the RBA's assessment of global financial conditions. Of particular interest to me was the RBA's observations on the Federal Reserve's recent discussion of policy normalization and the market's subsequent reactions (emphasis mine).
Members opened their discussion with the observation that the main driver of financial markets over the past month had been the reappraisal by the markets of the future path of monetary policy in the United States. Following its policy meeting in June, the Federal Reserve had reiterated that it would not consider raising the federal funds rate as long as the unemployment rate remained above 6½ per cent and inflation expectations were well behaved. However, the Fed had added that if its forecast for the economy came to pass, it would expect to begin scaling back its rate of bond purchases later this year, and to end bond purchases completely in mid 2014. While there was little new in this statement, financial markets subsequently brought forward their expectation of the first increase in the federal funds rate to early 2015 from the end of that year.
The RBA went on to describe the cascading fallout from the market's revised assessment on interest rates: higher bond yields across the globe and a sell-off in international stock markets that hit emerging markets particularly hard. The minutes affirmed the RBA's belief that the Australian dollar remains too high even after the recent sell-off. Yet, in contrary form, the Australian dollar strengthened off the bottom after the release of these minutes. Per the strategy mentioned in a previous post, I used this relief rally as an opportunity to initiate a fresh fade of the Australian dollar.
The S&P 500 (SPY) has now fully recovered from this sell-off with new all-time closing highs, seemingly affirming the fact that the Fed said nothing new about the direction and conditions for monetary policy. The U.S. stock market stands tall in its interest rate resilience. The recovery from the interest rate blues has been uneven and perhaps speaks volumes on where the vulnerabilities exist if rates manage to continue climbing.
- Interest rates (TLT) have cooled off a bit but have reversed little of the increases since mid to late May. Monday's 2.57% rate on the 10-year Treasury is still well above the 2.03% from May 22nd. The rate got as high as 2.73% on July 5th. Again, this setup suggests that the U.S. stock market has already gotten over its fear of rates at these levels.
- Homebuilders (ITB) have failed to recover their losses and in fact are mostly severely lagging the S&P 500 in this recovery from the latest sell-off (for example, see "Jim Cramer's 'Housing Worries' Come From An Overly-Optimistic Outlook"). Despite the market's apparent fear that higher rates will clip the nascent recovery in housing, the National Association of Home Builders [NAHB] reported 7 1/2 year highs in builder sentiment for July. The gains in sentiment (confidence) were broad-based and significant. We can see this confidence in builders like Lennar (LEN), which essentially said in its last earnings call that it is immune to higher rates (see "Lennar Declares Itself Immune From Higher Interest Rates").
- The U.S. dollar index (UUP) has experienced a roller coaster ride since May 22nd. At first, the bond tapering talk was interpreted as a negative for the dollar and it sank along with the stock market. The index literally did a 180-degree turn and led the S&P 500 higher until last week's reminder from Bernanke that the Fed has not said anything new sent the dollar gapping down. Suffice to say that trying to interpret the dollar's short-term moves right now is probably a kind of path to insanity. I am expecting the dollar to remain within its same range from the last 18 months. The chart below shows this range is still roughly defined by the dollar's levels at the time of QE2 and QE3.
- The Australian stock market (EWA) has rallied 7% off its recent lows, but it is still well off its May and 2013 high. Unlike Japan's current experience, the Australian stock market has not benefited from the strong devaluation of the local currency. This minimal benefit to-date is likely one reason the RBA insists the Australian dollar is still too high.
- Emerging markets as represented in the iShares MSCI Emerging Markets Index Fund (EEM) have recovered 7.8% from the recent low printed on June 24th but has only recovered about half its losses from the recent sell-off. EEM's ability to rally has been led by Taiwanese stocks. The iShares MSCI Taiwan Index Fund ETF (EWT) has managed to recover all its losses from May 22nd, but it has not yet printed a new 52-week high. I remain bearish on EEM and prefer fading rallies as I stated in a previous post. I am building a fresh position of puts on the backs of the current bounce. The chart below shows EEM is trading at a resistance level that marked the last leg of the previous sell-off.
Only time will tell the full significance of the ability of any given stock, ETF, or sector to recover from interest rate blues. Of the group mentioned above, only the S&P 500 was strong going into the interest rate blues. It is very possible that as the fears fade into the background, trends and patterns simply resume their previous course; the S&P 500 grinding higher, homebuilders are going nowhere, Australian stock market and currency are steadily grinding lower, and emerging markets sinking.
Perhaps the most interesting opportunities will appear in commodity-related stocks. As a group, commodities reached a peak in 2011 and declined at varying speeds ever since. Higher interest rates will be yet one more negative for the group. Yet, with some commodity plays reaching 2009 levels and worse, the time has come to more closely examine trades and investments here (I have already started). In coming pieces, I will do a long overdue refresh on 2011′s "Commodity Crash Playbook."
The performance of the S&P 500 (red) has sharply diverged from the 10-Year Treasury yield (blue)
Source: St. Louis Federal Reserve
Weekly view shows the general trading range for the U.S. dollar index for the last 18 months
The Australian stock market traded in negative territory during the sell-off
The Australian dollar has plunged for almost three straight months versus the U.S. dollar
The 2013 downtrend in EEM remains well intact
Taiwanese stocks have out-performed the general EEM ETF
Be careful out there!