This week provided some good insight into the markets and what happens when market’s expectation shift. A quick look at the relative performance of the five TSP funds shows the equity funds all performing relatively the same. But we need to take a deeper look at some key differences in the I fund which is invested outside the US. And why did the F fund turn south at the beginning of February and why did it not turn up this time when the equity funds started their correction. All these events are related to the same shift in expectations.
The shift in expectations that occurred this week was based on when the market believes the Fed will start raising interest rates. Half the analyst believed the weaken economic data would cause the Fed to push back raising rates from June until September. When the jobs report came in above estimates, this tilted the expectation back to June. Since raising rates represents divergence in monetary policy from the rest of the world, it gives this rate hike more importance.
The ECB also announced they were launching QE next week, a week earlier than planned. Twenty one countries have lowered their interest rates since the beginning of the year and United States’ monetary policy is moving in the opposite direction. While the rest of the world appears to be engaged in a currency war to devalue or protect their currencies, both the US economy and monetary policy support a stronger dollar and the dollar has been rallying relative to other currencies since July.
This week the dollar jumped higher due to the same shift in expectations and broke to a new recent high against the EURO. Money was front-running the ECB QE the last month as funds flowed into Europe and may have stalled the dollar’s rally until recently. The international stock markets making up the I fund have outperformed the US markets since the announcement of European QE, but once you subtract out the effects of the rising dollar the I fund has not been able to capitalize on the move.
In the chart above, the three European countries listed make up 30% of the I fund exposure. They started outperforming the S&P 500 after the ECB announced their QE program. The Swiss broke their peg to the Euro prior to the announcement and we can see the effect of a rapid currency adjustment on their stock market in dollar terms. We also see at the bottom of the chart that the dollar has rallied 19% against the EURO since July. The dollar has rallied against all the currencies representing the I fund and this has pulled the I fund’s return down. When the EURO leveled off in February, the I fund moved higher. Once the dollar rally was back underway, the I fund turned down relative to the international stock markets it tracks.
On February 2nd, interest rates in the US bottomed out. The 2% decline in the F fund in this time period equates to a 0.4% rise in the yield of the I fund’s securities. The rising US interest rates trumped any shift of funds from equities into fixed income. The bond market has been in a bull market since the 1980’s with only short corrections and now we are bouncing off historic low rates. Uncertainty is building in the market over what happens when the Fed begins to raise rates after pegging them to zero for so long. Add in diverging monetary policies and the global effects of a strong dollar and uncertainty begins to enter the picture.
Trillions of dollars have been loaned out in emerging markets and around the world. As the dollar rallies and commodities prices tumble the risk of default increases since much of the world’s recent growth was on the back of the commodity boom. As the global financial system becomes more unstable, money flows into the safety of the US sending the dollar higher and a negative feedback cycle begins.
The key take-away from this week, is the markets are not being driven by economic fundamentals. They are driven by a monetary policy that was focused on inflating financial assets to repair the bank’s balance sheets with the excuse of a trickle down effect to the real economy. A slow economic recovery allowed the Fed to maintain ultra-easy monetary policy for an extended time. Today the market is more concerned about the ending of this easy money policy than on expectations of the real economy. Expect increased volatility going forward.
Once the markets adjust to the change in expectations about when the Fed will raise rates, interest rates can reverse and fall again due to the longer term effects of the ECB QE on global interest rates. There is still the possibility of the Fed “surprising” the market by pushing back raising interest rates to September due to a weakening economic outlook but this would also signal a weakening economy and the market might wake up to fundamentals.