Will the market rally last?

Markets around the world are rallying after their wobbles over Christmas. And as is usual these days, it’s all down to one thing. John Stepek explains.

190111-markets

A quick note before we get started this morning. Earlier this week, I mentioned that we were doing another event you can now buy your tickets online.

On the evening of 12 February, I'll be sitting down with value investor and MoneyWeek regular Tim Price, and Iain Barnes of challenger wealth manager Netwealth, to discuss the threats and opportunities we all see ahead for investors this year. The event is in central London.

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You can get all the details and buy your tickets here. Just to warn you the last event sold out quickly so if you want to make sure you get a ticket, please do book as soon as you can.

And now, back to this morning's topic what's going on with markets so far this year?

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Whatever the fundamentals, markets are rallying hard

There's still plenty of caution on markets. But there's no question that they've turned around since their bout of Christmas Eve panic.

Every market tells the same story. The S&P 500 rose for the fifth session in a row yesterday that makes for a gain of 9% over that period. European markets have rallied during that time too. Our own FTSE 100 is nudging closer to getting back above the 7,000 mark.

Then there's the oil price. Brent crude rose for the ninth session in a row yesterday. That's equal to its longest winning streak ever, according to the FT. The benchmark has now risen by more than 14% since the start of this year.

Why the burst of optimism? Forget the flow of news. This has got very little to do with US-China trade talks. And it has very little to do with the US government shutdown. As for oil, it's not really got much to do with any supply or demand imbalances.

It's all about central banks, as usual.

The Federal Reserve has backed down somewhat from the very punchy stance it took in autumn last year. Jerome Powell was much more conciliatory towards markets in recent speeches, hinting that he admired Janet Yellen's ability to change course quickly in 2016, when markets were gripped by a similar panic to the one we saw in December.

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We then had a set of Fed meeting minutes that also suggested the Fed is a lot more hesitant about raising rates any further than the mood music had previously indicated.

Why does this matter? Because markets have spent the last ten years gradually getting used to the idea that whatever happens, the Fed will always have their backs.

When that idea was threatened when the "central bank put" was going to be taken away markets panicked.

The hope now is that Powell "gets it". He understands what the deal is between markets and the central bank, and he's going to be a good little central banker from now on.

The weakening US dollar is good for markets

Now, the Fed hasn't actually done anything yet. It is still reducing its balance sheet (ie, it is still enacting quantitative tightening). And while there might not be any more interest rate rises any time soon, the market had already been sceptical about that prospect anyway.

But what the Fed's newfound attitude has done is to help send the US dollar lower. And right now, if anything can give us a steer on whether this rally will last, it's the strength of the American currency.

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I've said this lots of times before, but I keep repeating it because it's important if you want to get a good idea of how tight global monetary policy is, you just need to look at the dollar.

The dollar is the most important currency in the world. Everyone needs it. So if it gets more expensive, that means money gets tighter around the world. Of course, it's more complicated than that, but as a rule of thumb it works pretty well.

For example, the weakening dollar means that we get a stronger Chinese yuan. That's good news because a Chinese devaluation is one thing that markets really are nervous about (a slump in the Chinese currency would be very deflationary for the global economy, and deflation is still the big bogeyman as far as investors are concerned right now).

A weaker dollar and a rising oil price is also inflationary, at least in the short term (the oil price is a little more complicated, in that higher petrol prices hit disposable income for consumers and therefore arguably act as a tax but a rising oil price certainly makes it harder for companies to keep prices down).

Overall, what markets want to see right now is inflationary pressure, economic strength, combined with a supportive Fed.

So what lies ahead? Keep an eye on the US dollar (we do this every Saturday in Money Morning, along with lots of other charts).

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But in terms of what could impact this, I think we're looking at two main things. One is the strength of US economic data. And two is the way in which the Fed reacts to this.

The market basically wants the Fed to always be "dovish", relative to economic conditions. If the economy looks as though it is growing strongly, then the market will give the Fed a bit more leeway. If the economy looks wobbly, markets will immediately expect the Fed to react in some way I suspect by promising to adjust the pace of QT.

In other words, investors want the Fed to stay "behind the curve". That mentality won't change until they view inflation as being a greater risk than deflation (and even then it might not change).

The big question and I don't think we have the answer to this yet is whether or not the Fed will play along. Hints from Powell that he will indeed follow in the footsteps of Yellen, Ben Bernanke and Alan Greenspan, are what has driven this latest rally.

My gut feeling is that he'll be called upon to back this up with action at some point in the near future. And when that happens, I reckon he will capitulate, possibly using the government shutdown as the ideal excuse to extend Fed support for the US economy.

But we'll see. That's what to watch.

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