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Why Emerging Markets Could Soar and How Investors Can Play It

Emerging market stocks could be the big winners thanks to a dovish Federal Reserve.
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Listening to Fed Chair Powell's testimony on Capitol Hill, one gets the sense that the Fed is not going to raise interest rates anytime soon. After seven 25 basis-point increases over the past two years, Powell implied that the Fed's key rate is no longer accommodative. "This is a good time to be patient and watch and wait and see how the situation evolves," he said.

Who will be the big winners thanks to the Fed's softer stance? It could be emerging market stocks.

Higher interest rates attract capital, and when this happens on a global scale, the underlying currency tends to strengthen. The opposite is also true; now that the Fed has adjusted course, traders who went long U.S. dollars in anticipation of higher interest rates are selling.

Technically, the greenback is completing a bearish "ABCD" pattern that should take the U.S. Dollar Index ($DXY) down to 95.75. Could the dollar move even lower? According to the chart, there is no real support until we reach the area just above 95.

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Source: TradeStation

One side effect of the weaker dollar is higher commodities prices. If the dollar falls in value, you'll need more dollars to purchase a barrel of oil, or an ounce of gold. That's why emerging market countries -- particularly ones that are significant exporters of commodities -- could be an interesting play here.

For example, Brazil is a major exporter of iron ore, crude oil, and soybeans. If those goods begin to fetch higher prices, Brazilian companies that deal in those commodities will see an increase in capital flows. Many emerging market countries, such as Mexico and Chile, are substantial commodities exporters.

Perhaps the best way to play this potential rise in commodities prices involves the iShares MSCI Emerging Market ETF EEM. Looking to the weekly chart, this ETF appears to have recently bottomed.

EEM also received a rare weekly buy signal from its MACD (moving average convergence divergence) indicator (shaded yellow). In recent years, two similar signals (A, B) resulted in substantial gains.

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Source: TradeStation

What would make this trade even better? What if the Fed took a slightly more relaxed attitude toward inflation?

Earlier this week, a Wall Street Journal article suggested that the Fed is rethinking its policy of targeting inflation at a rate of 2%, and might be willing to tolerate up to 2.5% inflation.

Powell clarified his thoughts on this matter during this week's testimony. "We're trying to think of ways to make that 2% target highly credible, so that inflation averages around 2%, rather than only averaging 2% in good times and then averaging way less in bad times."

Sounds to me like 2% inflation is no longer considered a ceiling, but rather an average. That's great news for stocks in general, but even better news for stocks that focus on emerging markets and commodities.

At the time of publication Ponsi was long EEM.