by Jim Welsh
Micro Tides Monthly Report 03 October 2018
The trend is your friend as the old Wall Street adage suggests and for good reason. Bull markets usually run for four years or more and bear markets typically last 17 months on average. The primary driver behind bull and bear market trends is monetary policy. Injections of liquidity not only support economic activity but provide the fuel to power bull markets and low interest rates enable multiples to increase.
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Stock prices increase more than the percentage rise in corporate earnings during a bull market as investors are willing to pay more for each dollar of earnings allowing the P/E ratio to climb. Bear markets are the result of liquidity being withdrawn from the financial system which usually causes a recession, while higher interest rates lead to a compression in the price / earnings ratio and much lower stock prices.
When I first started learning about the stock market in the summer of 1978, I began to spend hours in the University of Wisconsin’s Milwaukee library, something I had rarely done while in college. I had the good fortune to find Norman Fosback’s book ‘Stock Market Logic’ with a subtitle of ‘A Sophisticated Approach to Profits on Wall Street’. Fosback used an IBM mainframe computer to evaluate dozens of indicators to calculate their effectiveness in forecasting the stock market in the next 6, 12, and 18 months. The indicators with the highest predictive value were all related to monetary policy, which led me to pore through the stacks finding and charting interest rates going back to 1966. I found prices for the Dow Jones Industrial Average and charted them above the federal funds rate, discount rate, and the 90-day Treasury bill rate.
Seeing the interplay between the DJIA and interest rates was illuminating. I learned why the stock market paid far less attention to corporate earnings than to changes in interest rates and changes in liquidity, as measured by changes in the amount of Free Reserves. This wonderful learning experience is why I have focused more on monetary policy than anything else. And yes I still have those hand drawn charts.
Psychology also plays an important role in this process as the wild swings in the price/earnings ratio over time highlight. Smoothing earnings over a 10 year period avoids the spikes in the P/E ratio that occur when earnings plummet during a deep recession. In 2009 the P/E ratio soared to 123, not because stock prices had gone up a lot, but because earnings collapsed. By using a 10 year average this type of misleading number is removed and this method has been made popular by Yale professor and Nobel Laureate Robert Shiller. Professor Shiller refers to this ratio as the Cyclically Adjusted Price Earnings Ratio (CAPE), or the more precise P/E10 Ratio. (Chart courtesy Doug Short, Advisor Perspectives)
Click on any chart below for large image.
Even with this smoothing the P/E 10 ratio has moved around quite a bit over the past 147 years. In 1982 investors were only willing to pay 6.6 times for each dollar of earnings but were excited to pay more than 44.2 times each dollar of earnings in 2000. The only way to explain these extremes is the madness of crowd psychology being influenced by the entrenched trend, current economic news, and the willingness to project the recent trend into the future.
The current CAPE ratio of 32.4 has only been exceeded in 1929 and at the end of the dot.com mania.
The regression analysis provided using data since 1881 illustrates how much the S&P 500 has risen above and below its trend. At the end of August the S&P 500 was 121% above its regression trend while the CAPE ratio was 64% above its trend. In the past 147 years the S&P 500 has returned to its regression trend no matter how far above or below it traveled.
The message from this chart is clear: sooner or later the S&P will decline to its regression trend.
I’ll let others debate whether this bull market began in March 2009 or in October 2011. Either way the current bull run is one of the most profitable and longest in history. After persisting for so long it certainly qualifies as being an entrenched trend. The economic news hasn’t been this good in more than a decade, which is clearly evident in Small Business Optimism and Consumer Confidence.
In September the Conference Board’s Index of Consumer Confidence jumped to 138.4 the highest since September 2000. Coincidently, in September 2000 the S&P 500 recorded a secondary peak less than 0.5% below its then record high in March 2000. The S&P 500 subsequently fell more than 36% in the next two years.
The NFIB Small Business Optimism Index soared to record 108.8 in August, topping the July 1983 high water mark of 108.0, and the highest in the survey’s 45-year history. Sixty-two percent of small business owners now plan to create new jobs, also a 45-year high in August. Ironically, the S&P 500 topped in October 1983 and then bottomed in July 1984 after falling -13.4%.
With the S&P 500 posting a new record high in September, economic growth so healthy, and such record optimism and confidence, it is only natural for investors to expect the good times to keep rolling. No surprise then that a recent poll found only 12% of those surveyed mentioning economic issues as being the most important problem. That’s lower than the 13% in 1999 near the end of the long 1990’s economic expansion and the 16% in 2007 just before the roof caved in.
These extreme sentiment data points have tended to occur within 12 months or less of the end of the good times. The glowing headlines are making the majority of investors complacent since they expect the trend of good news to continue. There’s a line from a Grateful Dead song entitled ‘Uncle John’s Band’ that seems appropriate. “Cause when life looks like easy street, there is danger at your door.” While danger may not be at our door in the next few months, it may be around the corner.
There are a number of tailwinds that have benefited the U.S. stock market for years and specifically in 2018 that will fade in 2019 and headwinds that have emerged in 2018 that are likely to strengthen in 2019. These shifts have the potential to negatively tip the scales toward a less favorable environment for U.S. equities sometime in 2019.
The most significant tailwind for equities for years has been central bank Quantitative Easing programs that pushed trillions of dollars of liquidity into the global financial system. Although the Federal Reserve suspended its QE program in 2014, the European Central Bank (ECB) and the Bank of Japan (BOJ) increased their QE programs. Even after the Federal Reserve began shrinking its balance sheet in October 2017, the QE programs by the ECB and BOJ vastly exceeded the Fed’s cutbacks so the global central bank balance sheet kept expanding. Importantly the year-over-year rate of change in the expansion of the central bank balance sheet slowed materially in 2018 and, with the exception of the U.S., has had a pronounced impact on global financial markets.
The strength of the S&P 500 compared to global equity markets which will be addressed later. In October the Federal Reserve is increasing the runoff of its balance from $40 billion a month to $50 billion, and the ECB is lowering its purchases from $30 billion to $15 billion and is expected to stop its purchases altogether in January 2019. Although the BOJ has made no formal announcement it has progressively lowered its monthly so far in 2018. The figures for the BOJ during Q3 and Q4 are my estimates and reflect a lessening in the rate of reduction in reported BOJ purchases in Q1 and Q2.
The table shows that for the first time since 2008 the global central bank balance sheet will decline in absolute terms by the end of 2018. The year-over-year rate of change in the expansion of the central bank balance sheet will become progressively more negative in 2019.
For years the rising tide of central bank Quantitative Easing lifted all boats. In 2018 the tide began to recede and the loss of added liquidity has become readily apparent in global equity markets and the U.S. and International bond markets. As the table below highlights, the spread between the U.S. stock market so far in 2018 and other equity markets is unusually wide.
The Vanguard World is positive since it includes the U.S., while the World – U.S. does not. Returns in the U.S bond market have been negative across the board. It is noteworthy that the High Yield and Junk bonds have materially outperformed investment grade corporate bonds. This reflects investors’ confidence in the U.S. economy and willingness to reach for yield despite the additional risk. Emerging Market bonds have performed poorly, especially local currency EM bonds due to the strength in the Dollar since April. Diversification has not worked in 2018.
The corporate tax cut has enabled the U.S stock market to outperform the rest of world since it boosted earnings substantially, and the reduction in personal taxes put more spending money in workers pockets which lifted GDP to 4.2% in Q2. By comparison the U.S. looks far better than the rest of the world which has been slowing since early 2018. The growth impulse from the tax cuts are expected to wane in 2019, so the strong tailwind provided in 2018 will blow with progressively less intensity by the end of 2019, and be negative in 2020 according to the Commerce Department.
According to the Bureau of Economic Analysis (BEA), companies repatriated $305.6 billion in the first quarter and undoubtedly more in the second quarter. (Note: The spike in 2005 was after the Homeland Investment Act.) Through June 30 companies have spent more on stock buybacks than on capital expenditures (investments) by a wide margin.
This is the first time since 2014 so it is apparent where much of the repatriated money has been deployed. US public companies announced a whopping $436.6 billion worth of stock buybacks in the second quarter, according to research firm Trim Tabs. Not only is that most ever, it nearly doubles the previous record of $242.1 billion, which was set during the first three months of 2018.
For the first time ever U.S. companies will likely buy back more than $1 trillion of stock in a single year in 2018, according to Goldman Sachs. The largest multi-national companies have repatriated the most money (think Apple, Cisco Systems) and are the biggest buyers of stock. Since these large companies have a disproportionate weighting in the S&P 500, the top 10 stocks have contributed more than half of the year to date gains (right scale on chart) in the S&P 500 (left scale on chart). That compares to about 30% of the gain in 2017 and less than 30% in 2016. Stock buybacks are not likely to be sustained at the $1 trillion pace in 2019, but they will remain a significant prop under the market since they are concentrated in the stocks that have the largest capitalization.
When the majority of hedge funds were short the Dollar in February, I thought the Dollar was poised for a strong rally as I reiterated in the March Macro Tides:
“Once the top in the Euro is confirmed, the Dollar chart suggests a rally to near 95.00 is possible in coming months. This would represent an increase of almost 8.0% from its low at 88.25. A Dollar rally of this magnitude could prove a headwind for U.S. stocks, some commodities, and Emerging Markets.”
The Dollar exceeded 95.00 by mid June and Emerging Market stocks and bonds sold off.
There were a number of reasons why a Dollar rally was expected and one of them was the repatriation of overseas profits as discussed in the January Macro Tides: “Goldman Sachs and Bank of America Merrill Lynch estimate that 20% to 40% of the cash held overseas is in non Dollar assets. In order to bring non Dollar assets home, companies would first liquidate the investment, sell the currency they are denominated, and then purchase the Dollar with the proceeds. Potentially several hundred billions of other currencies could be sold and an equal amount of Dollars purchased, which could result in declines in some currencies and a rally in the Dollar.”
There is a lagged affect between changes in the value in the Dollar and the volume of exports. The sharp increase in the Dollar since March has just begun to weigh on exports which grew strongly after the Dollar’s peak in January 2017 and subsequent 15% decline into February 2018.
The Dollar rallied in a 5 wave pattern off the February low which suggests that after the current pullback is complete the Dollar will rally again and exceed its August high of 96.92. The next rally is likely to be driven more by weakness in the Euro than economic fundamentals in the U.S. If this next Dollar rally develops, it will put further downward pressure on U.S. exports and lower GDP growth in 2019.
As expected the rally in the Dollar has pressured Emerging Market currencies, bond prices, and equities. Since its high in April, the JP Morgan Emerging Market Currency Index has fallen by more than 12%, while Turkey’s Lira has plummeted by 60% and the Indian Rupee has plumbed a record low after falling by more than 13% against the Dollar in 2018. The sizable decline in EM currencies is pushing up inflation, especially for those countries that import goods denominated in Dollars like oil and the majority of commodities.
India is the world’s third largest importer of oil and relies on oil imports for 80% of its oil consumption. Its economy and central bank is dealing with the double whammy of a weak currency and the 23% increase in oil prices in 2018. When adjusted for the decline in the Rupee and rise in oil, India is paying 40% more for oil than when 2018 began.
India is not the only country dealing with this duel problem. Turkey, South Africa, Indonesia, and the Philippines also import most of their oil. On September 28 the central bank of Indonesia raised its policy rate for the fifth time since May citing the increase in its trade deficit to more than $1 billion due to oil imports. Referencing the increase in inflation the Philippine central bank raised its policy rate on September 28. Should oil prices climb further and the Dollar exceed it August high, these weak EM countries will become weaker and potentially pull more countries with a current account deficit into this negative vortex.
The combination of a weaker currency and higher inflation has forced a growing number of Emerging Market central banks to increase interest rates. The number of EM central banks that are tightening policy is the highest since 2011, which will slow EM growth in 2019. The longer the slow motion train wreck in EM currencies persists the risk of contagion rises. The countries that have a current account deficit are more vulnerable since they depend on the kindness of strangers to fund their trade deficit.
This is one of the reasons why some of the weakest currencies in 2018 have been Argentina, Turkey, Indonesia, India, and South Africa. Since they have less money to intervene, the risk of a run on a central bank that is attempting to stabilize its currency is higher for those countries whose Reserves as a percent of GDP is low (vertical scale on chart above).
The situation is so bad in Argentina that the IMF pledged a $50 billion aid package in June. When this record aid program didn’t arrest the decline in the Argentine Peso, the IMF increased it to $57.4 billion through 2021 on September 26. It is the largest loan to a single country in the IMF’s history. Interest rates have soared to 60%, inflation is approaching 40%, and Argentina is headed for a deep recession.
EM bond yields have increased in response to rate hikes by the Federal Reserve, weaker currencies, and higher inflation, which is why EM bonds denominated in the local currency are down -13.6% in 2018. In the next 15 months more than $700 billion of Dollar denominated loans and bonds will need to be refinanced. Even if all goes well, emerging market companies will be paying higher interest rates on their debt which will squeeze profit margins.
Companies that generate all or most of their revenue in their local currency, but have Dollar denominated debt to repay, the squeeze on cash flow could become troublesome. If a country’s currency is down 10% versus the Dollar, a company will have to allocate 10% more of their cash flow to service its debt in 2019 and beyond. Firms in Turkey that use oil are paying almost 100% more, while Indian companies are paying 40% more and 35% more for Indonesian firms. This will contribute to slower growth in a number of EM countries whose currency has fallen and have a high proportion of Dollar denominated debt.
Any additional strength in the Dollar will only make a difficult situation worse and increase the risk of a broader rout in EM currencies, EM bonds, and equities. On a valuation basis Emerging Markets looks cheap especially when compared to the U.S. The forward Price/Earnings ratio for the U.S. is 17.0 and only 10.9 for EM, which implies that EM is selling at a 35% discount to the U.S. The 29% discount to Developed Market equities in general is not much more than the historical 22% discount.
EM growth is not likely to improve in 2019 and the Federal Reserve is planning on increasing the federal funds rate once more in 2018 and 3 times in 2019. There is a definite risk that EM could be a value trap in coming months, even though it is cheaper than an expensive U.S. market. Technically, the Emerging Market ETF EEM is in a well defined downtrend, with lower highs and lower lows.
The black horizontal trend line at $38.00 provided support in 2013, 2014, 2015, and resistance in late 2016. The breakout above $45.00 in late 2017 was reversed when EEM broke decisively below $45.00 in June. In coming months EEM has the potential to test $38.00 which suggests patience.
In the August Macro Tides I discussed how synchronized global growth in 2017 had given way to a synchronized slowing of growth in 2018:
“The volume of shipping by air or by container ship is a reflection of global growth. Since peaking at a high level in the second half of 2017, the 3 month rate of change in air freight traffic and container traffic slowed significantly through May. Although they are still well above the lows in late 2015 and early 2016, the rate of deceleration can’t be ignored.”
The weakness noted through May continued through July as the updated chart illustrates. Merchandise trade in the G20 largest countries contracted on a quarterly basis for the first time since the first quarter of 2016. That weakness occurred as the decline in oil prices reached its crescendo and weighed on global growth.
Oxford Economics Coincident Indicator of world trade estimates that trade growth is currently a little under 3.0% from a year ago. Oxford’s Leading indicator suggests that the growth in world trade will slow to around 1.0% by year end. The uncertainty created by the implementation of tariffs and the threat of more to come has clearly dampened company’s willingness to pursue international sales until there is more clarity. This overhang of uncertainty will remain until new trade agreements are achieved, which could curb growth in world trade in 2019.
Until the deterioration in trade talks is reversed and real progress is certified, the view that the U.S. economy can somehow be immune to what’s happening in Emerging Markets, lower U.S. export growth, and the slowing in the global economy seems optimistic. It is encouraging that a trade deal with Mexico and Canada has been reached, although Congress must pass it for it to take effect. With the Democrats likely to become the majority party in the House, the passage of the trade pact with Mexico and Canada is not a sure thing.
The elephant in the trade room is China. The U.S. has already imposed a 25% tariff on $50 billion of Chinese imports and a 10% tariff on $200 billion of additional imports from China that will be increased to 25% on January 1, 2019. President Trump has pledged to impose a 10% to 25% tariff on the remaining $200 billion in imports not covered also on January 1, 2019. China has responded with tariffs on $110 billion of the $135 billion of U.S. exports to China.
Oxford Economics has estimated the cumulative economic drag on GDP for the U.S., China, Hong Kong, Eurozone, and Japan through 2020 from a full blown trade war. Oxford’s estimate assumes the U.S. does not increase its tariffs to 25%. If the U.S. increases its tariff from 10% to 25% on $400 billion of Chinese imports, the negative drag on growth would be larger.
Oxford thinks U.S. GDP would be 0.9% smaller by the end of 2020, while China’s economy would be 1.3% smaller. The Eurozone and Japan would not be as affected as much as the U.S, China, or Hong Kong but would suffer collateral damage. The largest drag occurs in 2019 where 0.6% of the cumulative hit of 0.9% is absorbed in the U.S. and 0.7% of the 1.3% headwind clips China.
The slowdown in global trade to date has been, for the most part, from the effects of uncertainty. Imagine what the impact will be if the real deal shows up in 2019 and the knock on affects and loss of confidence from a full blown trade war ripple through the global economy.
China’s economy is the second largest in the world, so any fallout from a trade war will not only affect China, but global growth and Emerging Markets. It is important to note that China has been and will continue to deal with domestics issues that have resulted in a gradual ongoing decline in economic growth. Since peaking at 10.61% in 2010, China’s GDP has slowed materially and with an amazing lack of volatility.
Clearly, China cooks it economic books. China has ‘projected’ GDP growth of 6.5% in 2018 and no doubt it will be achieved. According to IMF estimates, growth in the next 4 years is expected to trend lower, so China is not likely to provide any upside to global GDP growth in coming years.
For the first time in 20 years, China reported a current account deficit of $28.3 billion in the first half of 2018. China runs a huge trade surplus with the U.S. but a deficit with the rest of the world.
For years China boosted domestic GDP through building huge cities with no inhabitants, large airports, and basic infrastructure. For the first time since the European sovereign debt crisis rattled the global economy in 2011, year-over-year infrastructure investment is negative.
Some of this slowdown is due to a crackdown on the Shadow Banking system by Chinese bank regulators. As a percent of GDP the Shadow Banking system has been shrinking, while total bank loans as a percent of GDP have been increasing since 2016. The much needed reform of the wild-west Shadow Banking system is a positive for the future stability of the Chinese financial system but has slowed the economy. To offset this drag, the PBOC has cut bank’s reserve ratio 3 times and China has urged local governments to issue municipal bonds to fund the growth of residential development. The increase in residential building is now the second highest in more than a decade.
From a global perspective, the good news is that ‘excess private debt’ has fallen from 6.4% of global GDP in 2007 to 5.2% in 2016, according to the latest figures available from the Bank of International Settlements. The bad news is that the composition has changed radically. In 2007 the vast majority of excess private debt was concentrated in the U.S. and Eurozone. In 2016 the bulk of excess private debt is in China, with the second greatest concentration in other EM. The biggest risk during the next meaningful slowdown in global growth will come from China and EM. What happens in China will not stay in China.
Speaking before a World Economic Forum event in the city of Tianjin on September 19, Premier Li Keqiang did not directly mention the trade conflict but he said that devaluation would do “more harm than good“, and that talk of Beijing deliberately weakening its currency was “groundless.” He said:
“One-way depreciation of the Yuan brings more harm than benefits for China. China will never go down the road of relying on Yuan depreciation to stimulate exports.”
It should be noted that Premier Li Keqiang’s comments occurred after the Yuan had lost about 9 percent of its value versus the Dollar since mid-April. Call me a cynic, but when I hear a politician use the word ‘never’ my radar pings. There is a good chance that Li Keqiang’s use of the word never was in actuality a veiled threat to the Trump administration that China would be more than willing to use a devaluation of the Yuan to offset the impact of additional tariffs.
A 10% depreciation of the Yuan would not only minimize U.S. tariffs, but increase China’s export competitiveness with the rest of the world. The Yuan bottomed in January 2017 just as the Dollar index was topping versus many currencies. As the Dollar Index was falling 15.0% from January 2017 until February 2018, the Chinese Yuan appreciated 10.3% versus the Dollar. It wasn’t a coincidence that the Yuan recorded a low in mid August 2018 at 0.14498 (Dollar higher vs. Yuan 6.955) that was less than 1% above the January 2017 low at 0.14397 (Dollar lower vs. Yuan 6.890).
The Trump administration has vowed to increase tariffs from 10% to 25% on the second tranche of Chinese imports at the end of 2018 and apply the same rate on an additional $257 billion of imports. If negotiations fail to make any substantive progress, and China’s economy slows due to the higher tariffs, the Chinese may use devaluation to retaliate. This would be signaled if the Yuan falls below 0.14397, or the Dollar rises above 6.955 and definitively if the Dollar rises above 7.0.
Should China devalue its currency, EM currencies would experience another wave of selling and global financial markets may swoon, as they did in August 2015 after the Yuan was devalued. The Chinese have surely noticed how much President Trump likes to brag about the U.S. stock market making new all time highs. What better way to get Trump’s attention that precipitating a decline in the S&P 500 of 10% or more.
Federal Reserve
In the section entitled Corporate Debt, This Cycles’ Excess in the September Macro Tides I noted:
“In every extended economic cycle excesses build up that are usually recognized in hindsight as the excesses are unwound, create instability, and negatively impact the economy.”
I described a number of excesses that have built up in the corporate bond market, including the record amount of low quality investment grade corporate bonds, the record amount of covenant lite loans, and the record level of corporate debt to GDP.
Lael Brainerd is a member of the FOMC and in a September 12 speech she noted that financial excesses were already apparent in the corporate bond market, leveraged loan market, and stated that the valuation of the equity market was ‘elevated’. Brainerd also echoed Powell’s comments in saying that overheating sometimes shows up in markets before more conventional inflation measures:
“The past few times unemployment fell to levels as low as those projected over the next year, signs of overheating showed up in financial-sector imbalances rather than in accelerating inflation. The Federal Reserve’s assessment suggests that financial vulnerabilities are building, which might be expected after a long period of economic expansion and very low interest rates.”
In particular, she said corporate debt is rising and is susceptible to downgrades if conditions should change. She also noted that leveraged lending is rising as underwriting standards ease and said stock market valuations are “elevated.”
In Chairman Powell’s press conference after the FOMC meeting on September 26, he emphasized the uncertainty surrounding the appropriate neutral rate, future productivity growth, and impact of trade tariffs on inflation and economic growth. Given the high level of uncertainty, FOMC members are likely to become more circumspect about monetary policy in speeches and interviews, even though this might increase the level of uncertainty and volatility in the financial markets. However, the Fed may not view that as a bad thing, since the last two recessions were not preceded by a bout of cyclical inflation, but excesses in valuations in the financial markets as noted recently by Chair Powell and Lael Brainerd.
Although the Federal Reserve has been increasing the cost of money with its increases in the federal funds rate, it has not taken any step to lower the availability of liquidity, according to the Federal Reserve of Chicago’s National Financial Conditions Index.
A reduction in liquidity is far more detrimental to economic growth than the gradual allocation of credit based on its cost. Clearly, there are potential home buyers that can’t afford to buy a home since mortgage rates have increased the monthly payment beyond their reach.
The lagged effect of higher interest rates will progressively impact more consumers and corporate borrowers. This is another reason why economic growth is likely to slow in 2019 as the 2.0% increase in the federal funds rate since December 2015 becomes a stronger head wind.
U.S Stocks
As the table above earlier illustrated, U.S. stocks are about the only asset that has gained in value so far in 2018. The corporate tax cut boosted corporate earnings significantly which allowed the U.S. market to be repriced at a higher valuation. Economic growth in the U.S. has accelerated in 2018, while growth everywhere else has decelerated. This has led equity strategists to favor U.S. stocks over international markets by a wide margin. According to the Bank of America Merrill Lynch’s Global Fund Manager Survey in September, positioning in U.S. equities is very high relative to the average weighting since 2001. Global managers are as overweight the U.S. as they are underweight EM equities.
This reinforces the view that a buying opportunity in EM equities is developing. As discussed previously, there are clouds over hanging EM that are likely to remain for awhile, so it’s just a question of timing. It is also interesting to note that the uncertainty about trade is leading global managers to overweight cash as well.
The U.S. stock market is overvalued, as the first chart above clearly indicates, and there are a number of reasons why growth will slow as 2019 unfolds. Being long the U.S. is a crowded trade. Although the U.S. market is likely to hold up for the remainder of 2018, the risk of a 20% decline or greater beginning in the first half of 2019 as the economy slows seems reasonable. Goldman Sachs Risk Indicator is up to 75% and the highest since 2008, so a bear market may very well be around the corner.
Treasury Bonds
The U.S. economy is humming along and the FOMC reiterated that it plans to raise rates in December and three more times in 2019. This represents no change from the prior meeting and the post meeting statement was virtually identical when compared to the August post meeting statement.
Since peaking in mid May Treasury yields have been chopping sideways in a range knowing what the Federal Reserve was planning to do with the federal funds rate. On October 3 the 10-year and 30-year Treasury yield broke out above the mid May high based on the technical chart pattern rather than economic or monetary policy. This break out may represent a buying opportunity based on positioning in the Treasury bond futures market and a short term positive RSI momentum divergence.
The 10-year Treasury yield soared to 3.179% on October 3, which is well above the May high of 3.115%. The RSI has so far registered a lower RSI (green line) which is a short term positive divergence and could set up a trading low as long as it is maintained.
The positioning in 10-year Treasury futures shows Large Speculators holding a far larger short position now than in March 2017, after which the 10-year Treasury subsequently fell from 2.62% to 2.03% in September 2017. If the 10-year Treasury yield closes below the May high of 3.115% soon, it would increase the odds of a false break out.
The pattern in the 30-year Treasury yield is similar and also sports a positive RSI divergence (green line). To negate the break out, the 30-year Treasury yield would need to close below the May peak of 3.247% soon.
Unless the break outs in the 10-year and 30-year Treasury yields are reversed, the weekly charts suggest that yields could surge in coming months. The 10-year Treasury yield could rise to 3.60% to 3.75% (Weekly chart below left – red horizontal line). An increase of this magnitude would lift 30-year mortgage rates to near 5.50%, which would further weaken an already weak housing market. Existing home sales have fallen in 4 of the past 5 months and are 1.5% lower than in August 2017. The 30-year Treasury yield could climb to 3.80% to 3.95% (red horizontal line) in coming months.
Gold – Major Bottom Forming
The positioning in Gold is extreme and sentiment is outright bearish. Looking out over the next 6 to 12 months and longer, Gold is likely forming a major bottom as this process extends in time. Gold is likely to trade above $1300 before the end of 2018 and above $1400 sometime in 2019.
The only question is how much additional pain there will be in the short term. Gold could fall to $1123 which is the December 2016 low, although the odds of that are small given how constructive positioning and sentiment already are.
