A Dollar Breakout Could Lead To Equity Market Carnage
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Stocks finished the day lower, following hotter-than-expected PPI data and some commentary from Jay Powell that caused traders to pare back bets on December and January rate cuts. The market now sees the next rate cut not coming until March.
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All of the talk from the Fed speakers the last few days seems to center around them going slower and being able to take their time when heading to the neutral rate. The neutral rate, of course, is just a fantasy number that is talked about, but no one has a clue where it is. Based on the price action of risk assets, one would think that policy is easy. However, according to Powell, the policy is restrictive because the unemployment rate has risen and the labor market has loosened.
So, let’s say the Fed Funds neutral rate is around 3 to 3.5%. This probably means that the 10-year rate and yields still have much further to climb from current levels. If the 10-year rate gets to 300 bps higher than Fed Funds, it will have to rise to at least 6%.
Assuming inflation breakeven stays at 2 to 2.5%, the 10-year real yield will be 3.5 to 4%. Whether they stay anchored, of course, is another story. To say that the 2-year inflation swap is on the cusp of making a big move may be an understatement at this point. But, a breakout could be of epic proportions, and more importantly, it carries much meaning behind it.
For now, the path higher in the 10-year period appears to be on track.
In the meantime, the dollar index continues to soar. It was chillin’ most of today, but once Powell started speaking and rate cuts were dialed back, the dollar took off. Just look at the move in the 5-year euro/USD basis swap spread. The funding cost for dollars appears to be rising at a breakneck pace.
So, for now, the dollar also finds itself incredibly well positioned to break out above the 107.25 level. If the dollar breaks out here the amount of pain it is about to inflect on the equity market will be rather stunning.
So we wait.
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Charts used with the permission of Bloomberg Finance L.P. This report contains independent commentary for informational and educational purposes only. Michael Kramer is a member and investment ...
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