The recent price action in stocks could be a sign that the equities market is changing. U.S. stocks moved higher, almost in a straight line for two years after an 11.5 percent correction in the S&P 500 that found a bottom at 1,810.10 in February 2016. The index reached a high of 2,872.87 on January 22, 2017, an increase of 58.7 percent in just twenty-four months.
In Europe, the Eurex DAX, or index of 30 major German companies on the Frankfurt Exchange rose from lows of 8690.50 to highs of 13,596 over the same period.
With just over a 56 percent gain during the same period, the index of European stocks kept pace with the S&P on a percentage basis. At the same time, the euro-dollar exchange rate moved from the $1.12 level during the second week of February 2016 to its current rate of around $1.24. During the final week of January and first sessions of February, stocks began a correction that became ugly on Monday, February 5.
The U.S. dollar has been declining in value against the euro since the start of 2017 despite a widening short-term interest rate differential between the two currencies. The Fed has characterized U.S. economic growth as “solid” while the ECB continues to point to “moderate” growth in Europe. The U.S. signaled the end to its program of quantitative easing in 2014 and began to hike the short-term Fed Funds rate from zero percent in December 2015. Since then, the U.S. central bank has increased the rate a total of five times with the latest coming in December 2017 bringing it to 1.25 percent. However, the ECB has yet to pull the trigger and increase their short-term rate that remains at the negative forty basis point level.
One of the most influential factors when it comes to the value of the dollar versus the euro is the differential in interest rates. However, the current relationship has ignored the widening gap over the past year, and the euro has posted gains against the dollar. In hindsight, it was the shift in monetary policy in the U.S. from accommodation to tightening that lifted the value of the dollar from May 2014 to the start of 2017. The euro versus dollar relationship moved almost to parity. It is likely that the market’s current perception is that the ECB will pivot towards tightening credit sooner, rather than later. The euro has been climbing against the dollar over recent months.
The correction in stocks is a sign that higher interest rates will cause the flow of capital from equities into fixed income securities over coming weeks and months. Volatility is picking up across markets in all asset classes, and when corrections occur they often impact the markets that have moved the most. The European stock indices, like the DAX, could be waiting for the ECB to shift its monetary policy course. The latest price volatility could be a sign that this will occur soon. Investing in stocks has created optimal returns over the past two years, but at this point, trading may be the best way to take advantage of equity markets in the coming months.