Investors should expect the markets to move after the Federal Reserve’s monetary policy decision on Wednesday. Particularly important will be the action in artificial intelligence and commodities.

Before the decision, the market was hoping for a pause. By the time this article is posted, we will know whether the consensus was right or wrong. My focus is on how to trade the market after the Fed’s move.

If the Fed raises rates, it will most likely be by 25 basis points. That would take the key rate to the 5.5%-5.75% area which would provide a hefty deal of competition to the inherent risk of owning stocks. This could unleash pent up selling in stocks. As I describe below, professional investors are already taking advantage of the currently high rates by increasing their exposure to cash.

Ahead of the decision, investors were in selling mode. The S&P 500 Index (SPX) broke below its 50-day moving average and seemed headed for a test of the 4350-4400 price area. A post decision reversal above 4500 would be a bullish sign.

The U.S. Ten Year Note yield (TNX) was flirting with a long-term breakout above its years’ long resistance yield of 4.37%.

A break above that key yield would likely be negative for stocks. On the other hand a move below 4.3% would likely spur buying in stocks.

The Big Picture

The Fed is important. But what’s most important to investors is how the market reacts to Fed decisions. Moreover, it’s equally important to put the market’s response in the context of the biggest macro influence of the moment: the ongoing reversal of globalization.

In essence, what’s driving corporate boardroom decisions these days is the process of reducing operations in China and the cost of moving them to friendlier climates such as Vietnam, Eastern Europe, Latin America, and even the U.S.

This process is unfolding in two ways: negative money flows out of China, and inflation.

Currency markets are often seen as arcane trading vehicles for big money types. I find them useful in keeping tabs of where money is moving and what it may mean for other investments.

In general, a rising currency is a sign that money is moving into a country, at least partially due to its economic conditions being seen as favorable. Higher interest rates can also attract foreign capital.

In the case of the U.S. and China, both factors are applicable.

You can appreciate big trends in international money flows by looking at the U.S. Dollar Index (USD). Despite its recent pullback, the dollar remains in a well-established long term uptrend against most currencies.

This is a sign that money that used to be active around the world, especially in China is now active in the U.S. And the higher U.S. interest rates rise or remain at elevated levels, especially when the U.S. economy remains more robust than others in the world, the more attractive the U.S. dollar will be for investors.

In addition, the capital flight from China (CNYUSD) into the dollar has recently accelerated, as is clearly illustrated in the price chart of the Chinese Yuan below. The capital flight out of China has been worsened by the steady decline in China’s property sector, accompanied by rising unemployment, and a rather tepid response by the Chinese central bank via a minimalist approach to lowering interest rates.

The take home message is that the current inflation is a result of the reversal of globalization. That’s because as companies move money out of China to build factories and infrastructure elsewhere, they are faced with post-COVID materials and labor scarcities, which in turn raise prices. To maneuver global operations, companies buy dollars, thus the rise in the dollar.

According to recent figures, the amount of capital flowing out of China is the worst it has been since 2015. As much as $49 billion left the country in the month of August alone, according to Chinese government data.

If capital flows out of China continue, the odds of inflation easing are well below average, barring an all-out global recession. This is because decades of investment in factories in China was so large that it can’t be undone rapidly.

And as I pointed out in my July 2023 article, investors who focus on sectors where supplies are tight and demand is stable or high will outperform those who ignore this important economic tenet.

Commodities and Cash Rule the Roost.

The big winners recently have been commodities. You can see the bullish chart pattern of the Invesco DB Commodity Index Tracking Fund (DBC), an exchange-traded fund (ETF) that’s heavily weighted toward energy (25.4%) and surprisingly holds nearly 40% cash now, divided between U.S. Treasury bills (13.3%) and short-term money market instruments (27%).

DBC is currently overbought, with a Relative Strength Index (RSI) above 70, but is not showing signs that its fall is imminent, although a consolidation period would be healthy. The overriding theme here is that Saudi Arabia and Russia aren’t likely to back down from their recent oil production cuts.

DBC’s sister ETF, the Invesco DB Agriculture Fund (DBA), has done even better. It currently holds 22% short term, high yielding money market fund assets while nearly 8% of its capital is in U.S. Treasury bills. That adds up to 30% cash. Its largest agricultural commodity holdings are cocoa futures (7.8%), live cattle futures (6.8%), coffee futures (5%) and corn futures (4.4%).

The big bets here are that winter demand for hot chocolate will be profitable in the wake of decreased supplies and that steak prices aren’t going down anytime soon.

As with DBC, this ETF is proof that the scarcity trade is ongoing.

The losing trades of the moment involve those sectors where Wall Street’s marketing machine has been most active in the last few months, especially AI. A perfect example is the Global X Robotics & Artificial Intelligence ETF (BOTZ), which is testing the long-term support of its 200-day moving average after rolling over in July.

The currently bearish case for AI is clearly illustrated by the steady downtrend which has carried this ETF to its current price point. Especially poignant is the cluster of Volume by Price bars (VBP, bars left side of the chart) through which prices have cut through to get where they are.

VBP bars illustrate where money is concentrated. The larger the bar, the more money that is moving in an instrument. When VBP bars cluster such as what we see in BOTZ, it’s a sign that large sums of money are trading hands. Thus, when prices rise above, or fall below large clusters of VBP bars, it’s a sign that big decisions are being made by investors.

In this case, it’s clear that money is moving out of AI. You can’t drive apps and you can’t eat servers.

In contrast, the price chart for DBC shows its price sliced through an equally impressive cluster of VBP bars on the way up. That’s a sign of bullish conviction. Moreover, that cluster of VBP bars in DBC can be a source of price support.

You can also see that the VBP bars in DBA are much smaller than those for DBC and BOTZ. That’s a sign that DBA may be more vulnerable to selling that DBC. That should not be surprising given that DBA’s holdings, by nature, are seasonally influenced.

Bottom Line

The Federal Reserve and other central banks are trying to quell inflationary pressures over which they have little control. That’s because this inflation, which was clearly fanned by record levels of monetary easing during the pandemic, is a structural phenomenon related to the reversal of globalization.

The flight of money from China to the U.S. dollar is emblematic of the times as companies move their operations from China to friendlier lands and need dollars to fund their moves.

The combination of factors has created a scarcity of goods which has been worsened by labor shortages. The upshot is rising prices and structural inflation because production can’t keep up with demand as production capacity and labor access have been reduced by circumstances.

Commodity investors have reaped huge profits in the last few months. The quiet winner has been cash, whose attractiveness is highlighted by the huge cash holdings of commodity-based ETFs.

When the Fed makes its latest intentions known, markets will move. If commodities and other winning sectors continue to move higher, the market is likely betting that the Fed is wrong and that inflation is likely to accelerate. On the other hand, if current losers such as AI stocks rebound credibly, it’s plausible that the Fed may be done, at least for a while.