Yesterday we looked at the charts on oil and the U.S. 10 year yield. Both were looking poised to breakout of a technical downtrend. And both did so today.
Here’s an updated look at oil today.
And here’s a look at yields.
We talked yesterday about the improving prospects that we will get some policy execution on the Trumponomics front (i.e. fiscal stimulus), which would lift the economy and start driving some wage pressure and ultimately inflation (something unlimited global QE has been unable to do).
No surprise, the two most disconnected markets in recent months (oil and interest rates) have been the early movers in recent days, making up ground on the divergence that has developed with other asset classes.
Now, oil will be the big one to watch. Yields have a lot to do, right now, with where oil goes.
Though the central banks like to say they look at inflation excluding food and energy, they’re behavior doesn’t support it. Oil does indeed play a big role in the inflation outlook – because it plays a huge role in financial stability, the credit markets and the health of the banking system. Remember, in the oil price bust last year the Fed had to reverse course on its tightening plan and other major central banks coordinated to come to the rescue with easing measures to fend off the threat of cheap oil (which was quickly creating risk of another financial crisis as an entire shale industry was lining up for defaults, as were oil producing countries with heavy oil dependencies).
So, if oil can sustain above the $50 level, watch for the inflation chatter to begin picking up. And the rate hike chatter to begin picking up (not just with the Fed, but with the BOE and ECB). Higher oil prices will only increase this divergence in the chart below, making the interest rate market a strong candidate for a big move.
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Without a doubt, there was a significant shift in the outlook on central bank monetary policy this week. In fact, the events of the week may represent the official market acceptance of the “end of the easy money” era.
Draghi told us deflation is over and reflation is on. Yellen told us we should not expect another financial crisis in our lifetimes. Carney at the Bank of England told us removal of stimulus is likely to become necessary, and up for debate “in the coming months.” And even the Finance Minister in Japan joined in, saying Japan was recovery from deflation.
With that, in a world where “reflation” is underway, rates and commodities lead the way.
Here’s a look at the chart on the 10-year yield again. We looked at this on Tuesday. I said, the “Bottom May Be In For Oil and Yields.” That was the dead bottom. Rates bounced hard off of this line we’ve been watching …
This reflation theme confirmed by central banks has put a bid under commodities…
That’s especially important for oil, which had been trading down to very dangerous levels, the levels that begin threatening the solvency of oil producers.
That’s a 9% bounce for oil from the lows of last week!
This all looks like the beginning of another leg of recovery for commodities and rates (with the catalyst of this central bank guidance). Which likely means a lower dollar (as we discussed earlier this week). And a quieter broad stock market (until growth data begins to reflect a break out of the sub 2% GDP funk).
Have a great weekend.
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Yesterday we looked at the slide in yields (U.S. market interest rates — the 10-year Treasury yield). That continued today, in a relatively quiet market.
Let’s take a look at what may be driving it.
If you take a look at the chart below, you can see the moves in yields and gold have been tightly correlated since election night: gold down, yields up.
As markets began pricing in a wave of U.S. growth policies, in a world where negative interest rates were beginning to emerge, the benchmark market-interest-rate in the U.S. shot up and global interest rates followed. The German 10-year yield swung from negative territory back into positive territory. Even Japan, the leader of global negative interest rate policy early last year, had a big reversal back into positive territory.
And as growth prospects returned, people dumped gold. And as you can see in the chart above of the “inverted price of gold,” the rising line represents falling gold prices.
Interestingly, gold has been bouncing pretty aggressively since mid December. Why? To an extent, it’s pricing in some uncertainty surrounding Trump policies. And that would also explain the slow down and (somewhat) slide in U.S. yields. In fact, based on that chart above and the gold relationship, it looks like we could see yields back below 2.10%. That would mean a break of the technical support (the yellow line) in this next chart …
Another reason for higher gold, lower yields (i.e. higher bond prices), might be the capital flight in China. Where do you move money if you’re able to get it out in China? The dollar, U.S. Treasuries, U.S. stocks, Gold.
The data overnight showed the lowest levels reached in the countries $3 trillion currency reserve stash in 6 years. That, in large part, comes from the Chinese central banks use of reserves to slow the decline of their currency, the yuan. Of course a weakening yuan only inflames U.S. trade rhetoric.
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As we discussed on Friday, the dominant theme last week was the big run-up in global yields. This week, we have four central banks queued up to decide on rates/monetary policy.
With that, let’s take a look at the key economic measures that have been dictating the rate path or, rather, the emergency policy initiatives of the past seven years. Do the data still justify the policies?
First up tonight is Australia. The RBA was among the last to slash rates when the global economic crisis was unraveling. They cut from 7.25% down to a floor of just 3% (while other key central banks were slashing down to zero). And because China was quick to jump on the depressed commodities market in 2009, gobbling up cheap commodities, commodities bounced back aggressively. And the outlook on the commodity-centric Australian economy bounced back too. Australia actually avoided official recession even at the depths of the global economic crisis. With that, the RBA was quick to reverse the rate cuts, heading back up to 4.75%. But the world soon realized that emerging market economies could survive in a vacuum. They (including China) relied on consumers from the developed world, which were sucking wind for the foreseeable future.
The RBA had to, again, slash rates to respond to another downward spiral in commodities market, and a plummet in their economy. Rates are now at just 1.5% – well below their initial cuts in the early stages of the crisis.
But the Australian economy is now growing at 3.3% annualized. The best growth in four years. But inflation remains very low at 1.7%. Doesn’t sound bad, right? The August data was running fairly close to these numbers, and the RBA CUT rates in August – maybe another misstep.
The Bank of Japan is tonight. Remember, last month the BOJ, in a surprising move, announced they would peg the 10 year yield at zero percent. That has been the driving force behind the swing in global market interest rates. At one point this summer $12 trillion worth of negative yielding government bonds. The negative yield pool has been shrinking since. Japan has possibly become the catalyst to finally turn the global bond market. But pegging the rate at zero should also serve as an anchor for global bond yields (restricting the extent of the rise in yields). That should, importantly, keep U.S. consumer rates in check (mortgages, auto loans, credit card rates, etc.). Also, importantly, the BOJ’s policy move is beginning to put downward pressure on the yen again, which the BOJ needs much lower — and upward pressure on Japanese stocks, which the BOJ needs much higher.
With that, the Fed is next on the agenda for the week. The Fed has been laying the groundwork for a December rate hike (number two in their hiking campaign). As we know, the unemployment rate is well into the Fed’s approval zone (around 5%). Plus, we’ve just gotten a GDP number of 2.9% annualized (long run average is just above 3%). But the Fed’s favorite inflation gauge is still running below 2% (its target) — but not much (it’s 1.7%). Janet Yellen has all but told us that they will make another small move in December. But she’s told us that she wants to let the economy run hot — so we shouldn’t expect a brisk pace of hikes next year, even if data continues to improve.
Finally, the Bank of England comes Thursday. They cut rates and launched another round of QE in August, in response to economic softness/threat following the Brexit vote. There were rumors over the weekend that Mark Carney, the head of the BOE, was being pushed out of office. But that was quelled today with news that he has re-upped to stay on through 2019. The UK economy showed better than expected growth in the third quarter, at 2.3%. And inflation data earlier in the month came in hotter than expected, though still low. But inflation expectations have jumped to 2.5%. With rates at ¼ point and QE in process, and data going the right direction, the bottom in monetary policy is probably in.
So the world was clearly facing deflationary threats early in the year, which wasn’t helped by the crashing price of oil. But the central banks this week, given the data picture, should be telling us that the ship is turning. And with that, we should see more hawkish leaning views on the outlook for global central bank policies and the global rate environment.
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Remember, up to mid 2015, there were reasons to be optimistic about the outlook for the global economic recovery. The U.S. economy was improving. With the job market hitting targets, the Fed was preparing the world for the first rate hike, to begin moving away from emergency policies. The BOJ was keeping its promises of going full bore into an aggressive easing program which had driven the yen much lower, and stocks much higher, which was beginning to reflect in the economic data. And the European Central Bank had finally started an aggressive easing program to deal with deflationary malaise in the European economy. Better data plus continued aggressive global stimulus was reason to believe better times ahead.
But then came a jolt to markets by the Chinese making an about face on their currency (from strengthening to weakening). That created question marks about the health of China. Were things there worse than people think? And is China beginning to respond with a mass currency devaluation? That shook markets and confidence. And then we had the oil price bust early this year. That threatened mass industry defaults, and a spread to the global financial system. That shook markets and confidence. And, of course, we’ve had the surprising vote from the UK to leave the European Union (Brexit). That shook markets and confidence.
In this environment, stocks (especially U.S. stocks) are a key barometer of confidence. And it becomes self-reinforcing. When confidence shakes, stocks go lower. When stocks go lower, confidence wanes more. Weak confidence starts reflecting in weaker economic data. Weaker economic data pushes stocks lower. And the circle continues.
With this said, for much of the year, there has been speculation of another recession coming. The interest rate market had been pricing in a deflation forever story, with $12 trillion worth of global government bonds in negative yield territory at one point this past summer.
And despite the fact that the intensity of the macro concerns has abated, the fall back in the interest rate market was still sending a very cautionary signal to markets. That caution signal looks like it’s lifting. U.S. 10 year yields look like a run back above 2% is coming soon. And most importantly, the yield on German 10 year bunds (another key global benchmark interest rate) has been on a tear, exiting negative yield territory this week and running up to levels not seen since the day of the Brexit vote.
This move higher in rates, from record low levels, should be good for confidence, good for the economic outlook, and therefore good for stocks (as it removes the another cautionary cloud over sentiment).
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Last week we talked about the set up for a move in global bond yields. And we discussed the case for why the bond market may have had it very wrong (i.e. rates have been too low, pricing in way too pessimistic a view on the current environment).
Well, today rates have finally started to remind people of how quickly things can change. The U.S. 10 year yield finally broke above the tough 1.80% level and is now trading 1.85%. German yields have now swung from negative territory just three days ago, to POSITIVE 19 basis points at the highs today. Importantly, German yields are now ABOVE pre-Brexit levels.
Still, we’re approaching a second Fed rate hike and U.S. yields are almost 1/2 point lower than where they traded just following the Fed’s first hike in December of last year. As for German rates (another key benchmark for world markets), we found with the Fed in its three iterations of QE, that QE made market rates go UP not down, as people began pricing in a better outlook. That’s yet to happen in Germany. The 10 year yield was closer to 40 basis points when they formally kicked off QE – still above current levels.
But remember this chart we looked at last week.
In the white box, you can see the screaming run-up in yields last year. The rates markets had a massive position squeeze which sent ten–year German bond yields from 5 basis points (near zero) to 106 basis points in less than two months — a 20x move. U.S. ten–year yields (the purple line in the chart below) moved from 1.72% to 2.49% almost in lock–step.
This time around, as we discussed last week, let’s hope a rise in rates is orderly and not messy. Another sharp rise in market rates like we had last year would destabilize global markets (including the very important U.S. housing market).
But the buffer this time around should be the Bank of Japan. Remember, the Bank of Japan, just last month announced they would peg the Japanese 10 year yield at zero. Even with the divergent monetary policies in Europe and Japan relative to the U.S. (central bank rate paths going in opposite directions), the spread between U.S. rates and European and Japanese rates should stay tame. That means that Japan’s new policy of keeping their 10 year yield at zero will/should prevent a run away U.S. interest rate market – at least until there is a big upgrade in the expectation in U.S. growth. On that note, we get a U.S. GDP reading tomorrow.
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Global markets continue to swing around today. Remember, the past couple of days we’ve looked at the three most important markets in the world right now: U.S., German and Japanese 10-year government bonds.
In recent days, German and Japanese debt have swung back into positive territory. That’s a huge signal for markets, and it’s sustaining today – with German 10-year yields now at +8 basis points, and Japanese yields hanging around the zero line, after six months in negative territory.
Stocks are on the slide again, though. And the volatility index for stocks is surging again. Those two observations alone would have you thinking risk is elevated and perhaps a “calling uncle” stage is upon us and/or coming down the pike, especially if it’s a bubbly bond market. If that’s the case, gold should be screaming. It’s not. Gold is down today, steadily falling over the past five days.
So if you have a penchant for understanding and diagnosing every tick in the markets, as the media does, you will likely be a little confused by the inter-market relationships of the past few days.
That’s been the prevailing message from the Delivering Alpha conference today in New York: Confusion. Delivering Alpha is another high profile, big investor/best ideas conference. There are several conferences throughout the year now that the media covers heavily. And it’s been a platform for big investors to talk their books and, sometimes, get some meaningful follow on support for their positions.
Interestingly, one of the panelist today, Bill Miller, thinks we’ll see continued higher stocks, but lower bonds (i.e. higher yields/rates). Miller is a legendary fund manager. He beat the market 15 consecutive years, from the 90s into the early 2000s.
Miller’s view fits nicely with the themes we talk about here in my daily notes. Still, people are having a hard time understanding the disconnect between this theme and the historical relationship between stocks and bonds.
Let’s talk about why …
Historically, when rates go up, stocks go down — and vice versa. There is an inverse correlation.
This see-saw of capital flow from stocks to bonds tends to happen, in normal times, when stocks are hot and the economy is hot and the Fed responds with a rate hiking cycle. The rate path cools the economy, which puts pressure on stocks. That’s a signal to sell. And rising rates creates a more attractive risk-adjusted return for investors, so money moves out of stocks and into bonds.
But in this world, when the Fed is moving off of the zero line for rates, with the hope of being able to escape emergency policies and slowly normalize rates, they aren’t doing it with the intent of cooling off a hot economy (as would be the motive in normal times). They’re doing it and praying that they don’t cool off or destabilize a sluggishly growing economy. They’re hoping that a slow “normalization” in rates can actually provide some positive influence on the economy, by 1) sending a message to consumers and businesses that the economy is strong enough and robust enough to end emergency level policy. And by 2) restoring some degree of proper function in the financial system via a risk-free yield. Better economic outlook is good for stocks. And historically, when rates are lower than normal (under the long term average of 3% on the Fed Funds rate), P/E multiples run north of 20 – which gives plenty of room for multiple expansion on expected earnings (i.e. supports the bullish stocks case).
That’s why I think stocks go higher and rates go higher in the U.S. I assume that’s why Bill Miller (the legendary fund manager) thinks so too. It all assumes the ECB and the BOJ do their part – carrying the QE torch, which translates to, standing ready to act against any shocks that could derail the global economy.
But even if the Fed is able to carry on with a higher rate path, they continue to walk that fine line, as we discussed yesterday, of managing a slow crawl higher in key benchmark market rates (like the 10-year yield). An abrupt move higher in market rates would undo a lot of economic progress by killing the housing market recovery and resetting consumer loans higher (killing consumer spending and activity).
We headed into the weekend with a market that was spooked by a sharp run up in global yields. On Friday, we looked at the three most important markets in the world at this very moment: U.S. yields, German yields and Japanese yields.
On the latter two, both German and Japanese yields had been deeply in negative yield territory. And the perception of negative rates going deeper (a deflation forever message), had been an anchor, holding down U.S. market rates.
But in just three days, the tide turned. On Friday, German yields closed above the zero line for the first time since June 23rd. Guess what day that was?
Brexit.
And Japanese 10-year yields had traveled as low as 33 basis points. And in a little more than a month, it has all swung back sharply. As of today, yields on Japanese 10-year government debt are back in positive territory – huge news.
So why did stocks rally back sharply today, as much as 2.6% off of the lows of this morning – even as yields continued to tick higher? Why did volatility slide lower (the VIX, as many people like to refer to as, the “fear” index)?
Here’s why.
First, the ugly state of the government bond market, with nearly 12 trillion dollars in negative yield territory as of just last week, served as a warning signal on the global economy. As I’ve discussed before, over the history of Fed QE, when the Fed telegraphed QE, rates went lower. But when they began the actual execution of QE (buying bonds), rates went higher, not lower (contrary to popular expectations). Because the market began pricing in a better economic outlook, given the Fed’s actions.
With that in mind, the ECB and the BOJ have been in full bore QE execution mode, but rates have continued to leak lower.
That sends a confusing, if not cautionary, signal to markets, which is adding to the feedback loop (markets signaling uncertainty = more investor uncertainty = markets signaling uncertainty).
Now, with government bond yields ticking higher, and key Japanese and German debt benchmarks leaving negative yield territory, it should be a boost for sentiment toward the global economic outlook. Thus, we get a sharp bounce back in stocks today, and a less fearful market message.
Keep in mind, even after the move in rates on Friday, we’re still sitting at 1.66% in the U.S. 10-year. Before the Fed pulled the trigger on its first rate hike, in the post-crisis period, the U.S. 10-year was trading around 2.25%. As of last week, it was trading closer to 1.50%. That’s 75 basis points lower, very near record lows, AFTER the Fed’s first attempt to start normalizing rates. Don’t worry, rates are still very, very low.
Still, the biggest risk to the stability of the bond market is, positioning: The bond market is extremely long. If the rate picture swung dramatically and quickly higher, the mere positioning alone (as the longs all ran for the exit door) would exacerbate the spike. That would pump up mortgage rates, and all consumer interest rates, which would grind the economy to a halt and likely destabilize the housing market again. And, of course, the Fed would be stuck with another crisis, and little ammunition.
As Bernanke said last month, the Fed has done damage to their own cause by so aggressively telegraphing a tighter interest rate environment. In that instance, he was referring to the demand destruction caused by the fear of higher rates and a slower economy. But as we discussed above, the Fed also has risk that their hawkish messaging can run market rates up and create the same damage.
Bottom line: The Fed is walking a fine line, which is precisely why they continue to sway on their course, leaning one way, and then having to reverse and shift their weight the other way.
