Where Is The Stock Market Going: Watch The Fed And The U.S. Dollar

by: John M. Mason

Summary

The foreign exchange market has been very sensitive to what the officials at the Federal Reserve seem to be doing.

As Fed actions have lowered the real rate of interest, the value of the US dollar has fallen in foreign exchange markets.

But, as the real rate of interest has fallen, asset values, especially in stock market prices, have risen providing opportunities for investors to gain.

The Federal Reserve indicates that it is not going to raise interest rates and the value of the US dollar goes down.

The Federal Reserve suggests that it will be raising interest rates this year and the value of the US dollar goes up.

This has roughly been the pattern over the past year-and-a-half.

The foreign exchange market seems to be taking these Federal Reserve moves…or, lack of moves…as an indication that it is going to keep real interest rates low, so as to not derail the economic recovery and labor market improvement.

With the latest Fed refusal to raise its short-term policy rate, the yield on the 10-year US Treasury Inflation Protected securities, a proxy for the real rate of interest, has dropped below 0.150 percent, closing last Thursday and Friday around 0.135 percent.

At the end of December 2015, soon after the Federal Reserve raised its short-term policy rate, the yield on the 10-year TIPS was around 0.860 percent.

One can also notice that the yield on the 5-year TIPS dropped into negative territory at the end of February 2016 and has been below zero for most of the time since. At the end of last week, the 5-year TIPS closed to yield below a -0.310 percent.

At the end of December 2015, the yield on the 5-year TIPS was around + 0.520 percent.

Thus, the Fed's actions and lack of action have seriously impacted the market expectations.

Furthermore, the changes in the real rate of interest have an impact on asset prices, in particular on stock prices.

As the real rate of interest has fallen in the United States, stock prices have risen.

The S&P 500 stock index closed at a low for the year on February 11 ending the day at 1,829.

On Friday, April 1, the S&P 500 closed at 2,073, a rise of more than 13 percent since that February 11 close.

Robert Shiller's Cyclically Adjusted Price Earnings ratio (NYSEARCA:CAPE) is now back up to 26.24 from coming in at 24.09 in February this year. This is still below the near-term peak of 27.00 reached in February 2015, but it is moving into that neighborhood.

In other words, asset prices appear to be responding to the recent drop in the real rate of interest.

But, in more general terms, the recent behavior of stock market prices is consistent with the performance of the stock market for much of the economic recovery since the end of the Great Recession. That is, investors are following the advice that they should not "bet" against the Fed.

This rule has worked well for investors over the past six and three-quarter years, so why should they change their behavior now?

The advice here, then, is watch the value of the US dollar in the foreign exchange market, because it is very sensitive to what the Federal Reserve is doing. And, if the value of the US dollar is moving down… invest in the stock market.

If the value of the US dollar is moving up… then, get out of the stock market.

This is a very short-term viewpoint. This does not take into account how the longer-term, game-playing in the foreign exchange market might work out. Here one needs to consider whether there is some kind of currency war going on in the world or are country's conspiring to keep the market's more stable.

How you view this will be determined by your investment strategy.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.