A Fine Line
Bond Market participants have a big decision to make here - to cross a line that has been almost 40 years in the making. Last week, that long term trend line halted the upward move in yields almost before they got going. The implications for financial markets are massively important.
U.S. 10 YR YIELDS : 1980 - Current
The question now is - will the FOMC push short term yields through that level? Is the dot plot forecast of a 3.75% funds rate next year a possibility? Will they invert the curve? Is a recession being inadvertently engineered by an overly tight FED?
Chairman Powell virtually said as much last week by musing: "we are a long way from neutral". However, just after making that statement and with a sharply dropping stock market, the chatter has quickly turned to the possibility of a FED pause.
I believe it will take multiple attempts over many years to sustainably push the rate environment into a new higher plateau through the major trend line. When anything comes from a long way to such a long-held trend, it takes a lot to get through it. I think the rate hiking cycle is closer to ending than anyone believes. The spectre of a growth slow-down of 2019 will allow the FED to back off the brakes.
The smaller downtrend line on the above graph corresponds to the current economic/financial cycle since 2008. The break of the shorter term downtrend in early 2017 is what people mean by 'a rising interest rate environment'. But there is a lot of work to do to reverse the larger secular trend.
More than anything else, the rise in rates is the reason we are correcting here. Rates have become a governor on the markets. Just ask the weakening housing and auto sectors if rising lending rates are biting yet. Those stocks, along with financials have been leading the weakness.
We have come a long way in the quest for a restoration of a 'normal' interest rate environment. Now the market is faced with the mother of all downtrend lines. Like the Caravan refugees who will shortly be at the U.S. border, it won't be an easy one to cross.
Stock markets are now trying to grapple with the dynamic of an head-strong FED pushing against an intractable 10 YR bond yield. Stocks are again being squeezed between that FED rock and the Bond Market hard place.
The current earnings season has been widely telegraphed and will ultimately be dismissed as 'old news'. It is unlikely to satisfy those who have been looking for a quick resumption of the bull market. As my long time friend and market historian Pat Taylor always said " what does the stock market have to do with the economy ... NOTHING!"
By that he meant economic news of the day is mainly composed of facts and figures that had already been discounted. When the reports of strong earnings are met with a sharp sell-off, such as Caterpillar and 3M earlier today, the power of the discounting mechanism is revealed.
And talk about 'sell on news', don't get me started on Pot stocks. The Canadian legalization event was predictably met with a speculative unwind of biblical proportions that has yet to run its course. This is what happens when rampant bullishness is thwarted by massive overvaluation.
So the bull market dynamic has shifted to focussing on 2019. And it doesn't like what it sees. Multiple compression is driving stocks to the point of breaking down. The narrative has switched. U.S. economic 'go it alone' policies - tariffs and sanctions, are being called into question. China matters. Emerging markets matter. Europe matters. How did U.S. investors get hoodwinked into believing they didn't
last month?
The market's wall of worry got a few new bricks this week with the Saudi- Kashoggi debacle. Market reaction to this geo-political mess is a classic example of the negative effect of uncertainty on valuation. Thankfully the Saudis haven't weaponized oil as they did in 1974. Just like China's massive holdings of U.S. Treasuries keeps them from selling, the Saudis have more to lose than to gain from doing something rash like reducing oil production and cratering global growth. They are more likely to hike production in an effort to repair their reputational damage thereby sucking up to Trump. Sell oil.
Unfortunately, we are blindly heading into these uncharted economic waters without a credible pilot at the helm.
Trump's policy grenades seem to be going off in his hands, if the market's reaction to them is any gauge. POTUS's random musing about tax cuts, - a blatant attempt to gain votes from a dwindling base, is not confidence inducing. Depicting Guatemalan 'Caravan' as cover for ISIS radicals ranks as desperation and misdirection. Abruptly withdrawing from the NPT nuclear treaty without any discussion is similarly destabilizing. And most importantly, using China as an election whipping boy isn't helpful to the bull case.
And now on stage:
THE OZARK MOUNTAIN DAREDEVILS
Yesterday's earnings release by a little known (outside of the U.S.), Bank OZK, was instructive. The bank, formerly named (improbably), Bank of the Ozarks, has been the poster boy for aggressive growth lending this cycle. The risk taking CEO George Gleason has been a Wall Street darling, engendering a 'walk on water' reverence from analysts. The bank's earnings miss, reflective of weakening credit quality in it's construction loan portfolio, is like the proverbial canary in the coal mine for the U.S. economy. The stock has been taken out to the cleaners. (See below)
Bank of OZK
The tide for lending is going out and we have found the first guy swimming naked. And he's really, really ugly.
This helps support the case for the FED to pause in the coming months and perhaps explains the hard bounce this morning in the homebuilding stocks and regional banks. (Tuesday at 11 - AGAIN!) The worsening picture for credit cyclicals has been something I have worried about for weeks now. It supports the case for lower rates, despite the FED's higher rate mantra. The market is speaking loud and clear that rates hikes are hurting. But the FED moves at its own pace and the December hike is long way away.
We have gotten to the point now where 'bad news is good news'. I'm getting more encouraged by the minute. As I have said, unless we bottom the banks , we can't bottom the market. And unless the FED cools it's jets, we can't bottom the banks.
Encouragingly, the possibility of a FED pause is slowly seeping into the market today , led by credit sensitives. If we can put in a positive close, we could be seeing the makings of market low. The garden variety correction I have been looking for is, so far, playing out pretty much as expected. Today looks very much like a successful re-test of the low.
So...
... when they're cryin' you should be buyin'
But slowly though.
Risk Model: 2/5 - Risk Off
The decline in the market is still being confirmed (with a lag) by the risk model.
The sentiment measure, AAII Bull/Bear ratio, is weak and below the 50 dma. Copper/Gold has held up despite the China sell-off. The RSI is in 'off' position but deeply oversold.
Watch the double top formation here in volatility. A reassuring FED is a mandatory prerequisite for the resumption of the bull market. The VXV Index would signal an improved risk appetite on a close below 17. We have a ways to go yet. Patience.
As for Oil, don't say I didn't warn you. Again - there is plenty of $70 oil !!! The $65 level looks like the bull's last line of defence. I'm still out. Alberta Natural Gas was temporarily priced at $0 this week in Canada due to the Enbridge outage. I don't know much, but I don't think that's bullish.