Wednesday’s market drop wasn’t all that surprising, but it is somewhat uncharacteristic. Going into the latter half of December, typically the markets tend to outperform. With the Fed easing rates and the US economy reportedly in good health, equities should have been on a solid footing. So, what does this mean for the currency markets?
Of course, the most proximal catalyst was the “hawkish cut” by the Fed, and the unexpected rejection of a stop-gap federal funding bill added to worries. But the Dow Jones Industrial Average had been trending lower for 10 consecutive days, a first since 1978. Additionally, there was the unexpected rejection of a stop-gap federal funding measure leaving the US government just two days away from a shutdown. Could there be something more to the drop than just a momentary market reaction?
Notable Moves in the Markets
The sudden strengthening in the dollar left the EURUSD lower, and USDJPY higher. The latter was further compounded by the BOJ holding rates unchanged, followed by comments from Governor Kazuo Ueda that seemed to imply that the rate hike wouldn’t happen until March. The VIX, the premier measure of volatility, jumped to its highest since early August. That was the sudden drop (and subsequent recovery) in the wake of disappointing US labor data.
As far as the impact on currencies, the move was a strong risk-off, with dollar yields moving higher. Major pairs were affected, but emerging market currencies were punished. If US markets were to regain their risk appetite going into the holidays, then a reversal of the dollar strength would be expected, benefitting the currency pairs that fell.
Not So Risky After All
The interesting thing about the slump in the DJIA over the last couple of weeks is that the other indices, particularly the Nasdaq, continued higher. The descent before Wednesday in the Dow was steady, but relatively small each day (contrary to the 1978 crash). The DJIA has a much larger weighting of defensive industrials, while the Nasdaq has more growth tech stocks. Therefore, it was consistent with a rotation away from defensive towards growth, which would be in line with investors thinking that the market is generally trending higher.
While the lack of agreement on funding the federal government got a lot of headlines, it’s not by itself a major mover for the markets. After all, businesses keep functioning. What is more relevant is the difficulty that Trump might have in getting his agenda implemented, given the disagreements even among Republicans. That might mean the impact of tariffs and other measures might be delayed.
So, Buy the Dip?
If the market was reacting to the Fed’s rate decision, then a rebound would be expected. What the market didn’t like was Fed Chair Jerome Powell essentially slamming the door on an upcoming rate hike. The dot-plot matrix showed only two rate cuts next year, instead of the three that the market expected. The basis was for higher inflation, driven by economic growth, which in the long run would be good for risk appetite. As a result, for example, gold lost despite the risk-off move.
On the other hand, US indices remain at historically high valuations. Typically, that is funded by low interest rates. If rates remain high, the market might be open for a larger correction. That can be particularly pronounced in a period of low liquidity, which is typical around the holidays. If that were to happen, the dollar could gain substantially through the rest of the year.