Dollar devaluation to continue - just a matter of timing
Updated
January we saw a steady grind higher in US equities until this week. This week felt very much like a repeat of last month, but the sell-off this time was bigger and faster. The market commentators are already speculating that this could be the start of a major correction in equities. The driving force? A rapid fall in long-term US treasury bond prices.
Bond prices suffer when inflation expectations start to materialise. Bonds pay a fixed rate of return and their face value remains fixed, which means inflation eats away at their value two-fold. By contrast, equities should benefit from inflation.
So why are equitiy prices also falling? Prices have been screaming higher ever since the Corona pandemic recovery measures were announced. This is due to record amounts of stimulus announced to try and keep interest rates low (therefore high bond prices) and encourage the economy to stay liquid. Low interest rates force investors to try and find other places to get a decent return and this fueled the equities markets. In essense, the value of equities has become relative to other assets, a function of the market as opposed to the equities actually being perceived as more valuable fundementally.
So we may have reached a potential tipping point, where bond markets are no longer convinced that the FED will be able to keep interest rates low without also triggering meaningful inflation. Since equities have become more dependent on bond prices than fundementals, we could see that inflation fears cause equity prices to fall, defying the logic that many have been touting as a reason to drive equity prices higher.
All this being said, there are lots of deflationary pressures ongoing at the moment and we won't know if inflation has really arrived for years yet. It is the new Brexit topic of financial markets and there will continue to be a strong case for both infaltion and deflation, but more importantly the timing of any real inflation. As the market tries to make it's mind up on this, there are likely to be some fairly aggresive movements in both directions. One thing that looks more certain, increased volatility could be around for a while.
The dollar has benefitted this week as nervous asset sellers move into dollar cash. Ironically, given the inflation fears that are driving the sell-off this has boosted the dollar and created a bout of short term deflation.
I see two outcomes from here, both bearish for the dollar on different timescales:
1) Inflation fears prevail, the bond sell-off continues. This would put further upwards pressure on the dollar, but then subside as assets are reallocated into inflation hedged investments such as commodities. This should then lead to a long term continuation of the dollar devaluation.
2) Inflation fears subside, and cash is redeloyed back into the bonds. This will create an immediate downside pressure on the dollar.
I favour the second option, and propse this tight stop trade for the coming week. If the stop gets hit, I would consider re-entering long later in the week.
Bond prices suffer when inflation expectations start to materialise. Bonds pay a fixed rate of return and their face value remains fixed, which means inflation eats away at their value two-fold. By contrast, equities should benefit from inflation.
So why are equitiy prices also falling? Prices have been screaming higher ever since the Corona pandemic recovery measures were announced. This is due to record amounts of stimulus announced to try and keep interest rates low (therefore high bond prices) and encourage the economy to stay liquid. Low interest rates force investors to try and find other places to get a decent return and this fueled the equities markets. In essense, the value of equities has become relative to other assets, a function of the market as opposed to the equities actually being perceived as more valuable fundementally.
So we may have reached a potential tipping point, where bond markets are no longer convinced that the FED will be able to keep interest rates low without also triggering meaningful inflation. Since equities have become more dependent on bond prices than fundementals, we could see that inflation fears cause equity prices to fall, defying the logic that many have been touting as a reason to drive equity prices higher.
All this being said, there are lots of deflationary pressures ongoing at the moment and we won't know if inflation has really arrived for years yet. It is the new Brexit topic of financial markets and there will continue to be a strong case for both infaltion and deflation, but more importantly the timing of any real inflation. As the market tries to make it's mind up on this, there are likely to be some fairly aggresive movements in both directions. One thing that looks more certain, increased volatility could be around for a while.
The dollar has benefitted this week as nervous asset sellers move into dollar cash. Ironically, given the inflation fears that are driving the sell-off this has boosted the dollar and created a bout of short term deflation.
I see two outcomes from here, both bearish for the dollar on different timescales:
1) Inflation fears prevail, the bond sell-off continues. This would put further upwards pressure on the dollar, but then subside as assets are reallocated into inflation hedged investments such as commodities. This should then lead to a long term continuation of the dollar devaluation.
2) Inflation fears subside, and cash is redeloyed back into the bonds. This will create an immediate downside pressure on the dollar.
I favour the second option, and propse this tight stop trade for the coming week. If the stop gets hit, I would consider re-entering long later in the week.
Trade closed: stop reached
Look to re-enter long trade later in the week
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