That was quick.
On Wednesday, the markets rallied sharply off the back of the Federal Reserve’s latest minutes.
On Thursday, they gave the lot back.
Why? And what’s next?
Why a stronger US dollar means tighter global monetary policy
Let’s just set the scene a little.
The US dollar has been shooting higher. There are some pretty basic reasons for that. The US is currently the least ugly looking developed economy. It’s also ending quantitative easing, and is apparently on the verge of raising interest rates.
All those things point to a stronger dollar. Europe and Japan remain frail and keener to loosen monetary policy than to tighten it. The UK is too prone to boom and bust. And China is slowing, which means less demand for the commodity currencies.
A stronger dollar has various effects. But the main one is that all else being equal, it means tighter global monetary policy. What do I mean by that?
The dollar is the world’s reserve currency. In other words, it’s the most widely used and most important currency in the world. Cheer or hiss that fact as you see fit – but it’s true. The world needs lots of dollars to do business. So if the dollar gets more expensive, so does doing business.
Put (very) simply, a stronger dollar is like a global interest rate hike.
So investors were cheered that various Fed members mentioned a stronger dollar as a worry in its latest minutes. That’s what sent the market higher on Wednesday. It was a typical bit of ‘buy-the-dips’ behaviour, and what everyone’s been conditioned to do over the past few years.
But it looks as though investors had time to reconsider on Thursday. And small wonder. The real question, as Josh Brown of the excellent Reformed Broker blog notes, is why markets rallied at all.
Now might be the time to stock up on bear market funds
Brown’s point is that everything that made the market advance strongly in 2013 is missing this year.
Investor fondness for stocks has now hit 2007-style peaks – there’s no one left to invest. Meanwhile, share buybacks are slowing. Earnings aren’t quite meeting over-enthusiastic expectations.
At the same time, quantitative easing (QE) is leaving the building – whatever the Fed says about the strength of the dollar, it’d take quite a bit of pain before it starts moving back towards more money-printing.
And to cap it all, the rest of the world seems to be sliding into recession. Now Europe’s ‘core’ economies – including Germany – are at risk of shrinking. Investors had been pinning their hopes on eurozone money-printing to pick up the slack from where the Fed is leaving off.
That may yet happen – I suspect it will. But so far, we’re stuck doing the same old eurozone hokey cokey – European Central Bank boss Mario Draghi sticks his neck out and the Germans tell him to pull it back in again.
The fact is, this bull market is old. It’s overdue a correction. The biggest question is – is this going to turn into something much nastier than a 20% slide? (As my colleague Tim Price certainly expects).
Clearly it’s impossible to predict the future. And the assumption has to be that the Fed would end up printing money again if markets slid further than they were comfortable with, and no one else was willing to start up the QE pump.
But with plenty of geopolitical upheaval to worry about too, now could be a good time to stock up on investment trusts that are positioned for bear markets, as Merryn noted yesterday.
A silver lining?
That said, there is one price has me particularly fascinated at the moment – the price of oil.
My own feeling is that oil has been defying gravity for a long time. US production has rocketed. Despite the upheaval in the Middle East (and if you can find me a prolonged time period in the last 50 years when you could have described the Middle East as ‘calm’, I’d like to see it), production there is picking up too.
Meanwhile, on the demand side, we’ve got feasible alternatives to fossil fuels taking off – and there’s now enough momentum to keep them going even if fossil fuel prices crater. China is slowing and its development is becoming less resource-intensive. Growth outside the US is sluggish. None of it screams ‘higher oil prices’.
But the strengthening dollar seems to have been the straw to break the camel’s back. The oil price has absolutely collapsed in a very short space of time over recent months. I’m no chartist, but I do like to keep an eye on some of the basic ‘technical indicators’ – if nothing else, you know a lot of other people are watching them too.
To keep a long story short, oil has just collapsed down through various ‘support’ levels – areas where you’d have expected it to at least have paused for breath.
For now, investors are fretting about the deflationary impact of a falling oil price. But in the longer run, a falling oil price is good for demand. For most of us, it’s like a tax cut or a pay rise.
Here’s what I’m getting at. If you go from spending £80 a month on petrol down to £60, say, what happens to that extra £20? You probably can’t say exactly what you spend it on, but I’m betting you don’t save it.
So for consumer-driven economies like the US and the UK, a falling oil price is ultimately inflationary. That brings its own challenges, of course – it’ll make it even harder for the Fed to justify keeping rates low if consumer demand picks up strongly. But unless you’re the president of Russia or a signed-up member of Opec, you’d have to be mad not to welcome a sliding oil price.
I’ve written more about the impact of the stronger US dollar – and what to do about it – in the latest issue of MoneyWeek magazine. You can get your first four issues free here.
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