The US stock market continues to push higher. It’s trading near all-time highs, as earnings season approaches. And while profit results are expected to be positive, the stock market may think otherwise. The US Federal Reserve’s meeting could shift market expectations tonight. There’s been a big change in mentality since June.
Remember, the Fed raised interest rates for the third time since December 2016 last month. It was on track to lift rates higher later in the year. The Fed also said it would start reducing its bond holdings before year’s end.
Today, the rosy feeling has gone. There are no policy changes expected for the rest of the year.
Last week, Fed chair Janet Yellen said interest rates are close to a ‘neutral’ level. That means they might not move much higher. Of course, that won’t stop financial markets from hanging on Yellen’s every word.
Lloyds Bank announced in a statement: ‘With no policy change expected in July, the focus for markets will be on whether the Fed sends any new signals about its intentions for the rest of the year.’
According to the CME FedWatch Tool, which analyses the probability of the Fed moving rates, there is less than a 50% chance that rates will rise higher this year.
In recent weeks, the majority of Fed members have made cautious comments. That’s a big divergence from last month, when they were suggesting one more rate rise this year. In my view, if the stock market starts to pull back, the Fed could easily backflip on raising rates higher at any moment. That could trigger a 10–15% stock market correction.
Don’t forget about the Chinese
CNBC reported yesterday:
‘“We believe that the announcement that comes out will be rather benign; it will be what the market is anticipating,” Chad Morganlander, portfolio manager at Washington Crossing Advisors, said Monday on CNBC’s “Trading Nation.”
‘“I think ‘don’t fear the Fed’ is true for the next several months, but keep in mind that the Fed will be raising rates, overall, over the next 18 months,” he said.
‘Morganlander expects three further interest rate hikes, by 0.25 percent each, as well as the beginning of a balance sheet reduction. This could all elevate volatility as well as “financial stress,” he said, and investors should be “balanced” in their investment strategy, particularly when it comes to investing in bonds.
‘And equity investors ought to keep in mind that valuations are somewhat stretched, so a cautious approach would be best over the next six months, he added.’
Chad Morganlander makes a lot of sense. But there’s something he has overlooked — China.
In September 2015, the Fed was deeply worried about China. A collapse in Chinese stocks, coupled with a surprise yuan devaluation and shrinking foreign exchange reserves, taunted financial markets. Janet Yellen couldn’t sleep at night. She kept delaying the first interest rate rise in more than a decade.
That concern has gone away for now. But there’s a wall of Chinese debt about to mature. That could change things for the Fed.
China’s US dollar-denominated bonds are the biggest risk. According to the Bank for International Settlements (BIS), the debt total stands at over half a trillion dollars! Chinese entities have issued 20 times more debt since 2008.
The number has doubled over the past two years.
China’s issuance of dollar-denominated bonds is out of control. It has issued more than a third of the emerging market total. That’s up from a quarter two years ago. The number stood at less than 5% in December 2008.
Here’s the catch…
A fifth of China’s dollar bonds mature within a year, according to BIS data. More than half are due to be refinanced in the next five years. If the Fed keeps raising interest rates, the debt will need to be rolled over at higher costs. That could impact China’s already struggling economy.
Admittedly, Chinese companies can also refinance their debt in yuan. But that would likely weaken the yuan, which has other repercussions in itself. It would cost Chinese companies more to repay the US-denominated debt. That could trigger major defaults across the country.
It’s no wonder the Chinese want to keep their currency artificially high.
The US Fed seems oblivious to this looming issue. It hasn’t publicly flagged China’s debt as a major risk in their policy discussions…yet. If that happens, it could spook the stock market, causing it to fall. That could see the Fed backflip on its bullish tone. And we could easily see another 10–15% correction.
Take a look at the Dow Jones weekly chart:
Source: Tradingview.com; Resource Speculator
[Click to enlarge]
The Dow Jones remains bullish at the moment. It’s been in an uptrend for over 18 months without a 10–15% correction. That’s unusual for markets. A weekly closing below 21,169 points — the February high — should signal a correction. That should see the Dow Jones close convincingly below technical support, as shown by the pink line.
Now, there is some support around the 21,000-point area. You can see that by looking at the blue support line. A monthly closing below that level should confirm the correction.
In that case, with the trend being your friend, I’d still be buying stocks today. But, keep your eyes focused on the numbers. If China’s economy keeps deteriorating and Yellen looks to shift policy gears, we may see an overdue 10–15% correction soon. If that happens, look to buy as much as you can of your favourite stocks.
Editor, Markets & Money