December 19, 2016
Here are four simple rules that can often explain economic conditions:
Rule one: when the economy is strong the Fed will tend to raise rates, conversely when the economy is weak the Fed will tend to lower rates.
Rule two: when the economy is strong and jobs are being created, consumers will spend money because they are comfortable in the belief that they will not be fired. Conversely when the economy is weak consumers cut back for fear that their job or pay might be cut.
Rule three: when a country is raising its rates, its currency is typically strong.
Rule four: when an economy is strong, stocks go up in price and bonds go down in price as yields are rising.
These four simple rules explained everything that happened in the market last week. The biggest news was the Fed’s Open Market committee decision to raise short term rates by 25 basis points, marking only the second increase since the financial crisis of 2009. In addition, the Fed indicated that it expects to raise US interest rates three more times in 2017. I love a Fed that gives you their playbook well in advance.
Following the Fed’s announcement the US dollar continued its rally and reached a 14-year high versus a basket of other key currencies. Currency movements are obviously key drivers of competiveness across the globe. Some countries have manipulated their currencies in the past in order to make their products more competitive. Per our simple rule we know that when a country is raising interest rates, its currency tends to be strong. With three rate increases expected in 2017, the dollar probably stays strong near term.
Since the Presidential election, the yield on the 10-year US treasury note has moved over 1% higher, reaching as high as 2.639% at one point last week. Global bond investors have seen an estimated $1.45 trillion decline of market value as yields have risen. Market pundits are starting to say that the bond market bubble is beginning to burst. One thing is certain: when a market experiences a $1.45 trillion negative move some people are experiencing some financial pain. One area suffering pain this week was the emerging markets. Many small countries have debt tied to US interest rates and to the US dollar. The combination of a strong dollar and rising US rates will not be good for some of these smaller emerging markets in the short term. It was also reported that investors had taken $17 billion in money out of the emerging markets.
In spite of all this, the US equity markets flirted with all time highs as the Dow Jones Industrial Average danced around the 20,000 level. Most all of the week’s events were consistent with the four simple rules outlined above. If the economy and job growth continues to improve, we can probably expect more of the same.