Fundstrat: Divergence Stats Suggest Dollar Weakening After Fed Tightening

After shocking traders with his lack of enthusiasm for quantitative easing – and seeing the euro rise in value, shocking European central bankers – ECB head Mario Draghi reversed course and pledged to “do whatever it takes,” saying the size and endurance of his quantitative easing muscle would not be limited by man or markets. For institutional research firm Fundstrat Global Advisors the divergence between the ECB easing and the Fed tightening has interesting statistical correlations and leads to a specific play in the crowded U.S. dollar trade and beaten down oil.

ECB / Fed divergence has statistical tendencies

A key economic point of quantitative easing is that it typically devalues the local sovereign currency, thus making a nation’s exports cheaper on a relative basis. As the ECB is coaxing the euro lower the Fed, in tightening interest rates for the first time in nine years, is partial causation for a rise in the value of the U.S. dollar. But Fundstrat, going against the grain, says the end of the dollar long trade is in sight and  could occur after the Fed tightens.

To a degree, this represents buy the rumor sell the news, particularly if the Fed plans to stay pat for a considerable period after tightening.

Fundstrat, for its part, considers the past performance statistics and notes that in the particular type of divergence that is occurring between the ECB and Fed might actually be positive for stocks and is likely to lift oil.

Fundstrat: Watch for dollar reversal after Fed announcement

Since 1971, Fundstrat observed, 45 percent of Fed hikes started while ECB eased, lasting 17 months. In fact, countering common herd thought on the matter, during the last 11 Fed tightening cycles, 5 started while the ECB was easing. “This is counter to those who said today’s policy divergence is unprecedented,” the report pointed out, but that is not to say this time isn’t unique. What is odd about easing this time is the historically low interest rates across the Eurozone, near or below zero in short maturities. The lowest previous starting point for easing was in 2004 leading up the 2008 crash when rates were near 1 percent.

Although a situation where the Fed tightens and the ECB eases interest rates would lead an analyst to believe that the dollar would strengthen and the euro would fall in value, the statistics don’t bear this out with a high correlation percentage. In divergences, despite Fed tightening vs ECB easing, the U.S. dollar has only weakened 60 percent of the time and typically when it does fall the six month median drop is 6.6 percent, with a range running from 3.6 percent on the low side to 9.9 percent.

Considering the run-up to the divergence as fodder, the force of trend on a historical basis should be considered. What does this mean? Since mid-2014, when the U.S. dollar was trading near $80 from June 30 2014 to a high just over $100 on March 11, 2015, the market has moved over 25 percent in nine months. Separate trend analysis indicates such a strong move could be subject to mean reversion, further bolstering the Fundstrat thesis. The fundamental backdrop supporting this thesis is that efficient markets are typically not this maladjusted over a short period of time, particularly given that not much has changed on a fundamental basis.

Don’t fear the divergence

A divergence in and of itself should not be feared, the report pointed out. Opposed to many analysts who seem to think the Fed going one way and the ECB going another is a signal to sell U.S. stocks, Fundstrat takes the contrarian point of view.

Based on its statistical analysis, the S&P 500 performs well when Fed diverges, gaining 80 percent of the time six months after the divergence. “Interestingly, equities tend to be soft in the first month—falling a median 2 percent (declining 80 percent of the time), which we believe reflects market uncertainty around the first move.”