Yield Curve Ball

The boys of summer will soon begin plying their trade at ballparks across North America, creating a much-needed diversion for investors from the dismal economy. Baseball is a lot like investing. Big league hitters will be faced with the choice to swing or 'take' the pitch, primarily based on intuition. They often rely on the past history of the pitcher's tendencies, waiting for the right time to swing.

The biggest threat to a hitter is the dreaded 'big league curve ball'. It is the most dangerous weapon in a pitcher's arsenal. There are hundreds of guys who can hit a fastball, but you get to the 'show' by being able to handle the curve.

The financial markets' reaction to the sudden yield curve inversion last week has many parallels to hitting a baseball. Is the sell-off on Friday justified? I'm not so sure. If we are in uncharted waters from a monetary policy standpoint, does that not allow for a bit of "this time it's different" thinking when it comes to yield curve analysis?

Corroborating evidence from Global economic data is now being inspected for evidence to support arguments on both sides. On that front, the data are mixed.

Globally, PMIs are weakening and trailing numbers like housing have been bad. But that is stale data and subject to sentiment swings. The markets are looking over that valley after the best start to a year in a decade. Weakness in housing is reflective of affordability due to asset inflation, not employment or income growth. PMI data, being a survey of intentions, is subject to behavioral swings from the many headline risks that abound.

Credit Spreads, the premium for risky debt, is a time-honoured metric for risk takers to use for guidance. On the face on it, the evidence is bullish. Recent action in credit markets (see High Yield ETF price, below) is not indicative of financial stress. Hence many commentators are calling for investors to ignore the curve inversion. They see the lack of corroborating weakness in credit as a reason to disregard the yield curve indicator.

The pivot points circled in the chart correspond to inflection points in economic expectations. The first one corresponded with a recovery in oil prices in 2016, leading to a shoring-up of credit quality in the oil patch. The more recent December bottom was coincident with FED pivot to the "patient" policy regime.

But what if the non-confirmation of Stocks and High Yield performance is a function of the global quest for yield? Have credit markets lost their reaction function to economic downturns?

We know that, unlike past economic cycles bond fund inflows have consistently surpassed those of stock funds. Despite being ten years into an economic expansion, investors are sanguine about inflation risks. They are also clinging to a more conservative asset mix resulting from the financial crisis, pushing more cash into the bond market.

We also know that the unconventional monetary policies, especially of the ECB, have created a $10 Trillion of negative yielding assets globally. There is simply no alternative to higher yielding paper, no matter what traditional credit analysis would dictate. It gives me cause to be suspicious that credit markets can help divine economic conditions. I want to wait for a bit more confirmation.

The Tuesday at 11 turnaround (a bit early) is upon us this morning. The Bulls are seizing the day. They contend global economies are likely to bottom from a combination of Chinese reflation policies and a U.S. - China trade deal. The wall-of-worry concerns about Trade, Brexit, and profit warnings have all been dismissed, at least for today.

It's important to understand why the curve inverts, and not just that it has.

I'm going to listen to this week's FED-speak about future rate intentions for clues. I believe they are taking their cue from markets. It is the market that inverted the curve last week, not the FED! In past cycles, the FED continued to tighten after the first inversion. There is no chance of that, given the weak global picture and Chair Powells's new 'patience' policy.

Inter-market action from the commodities are also a helpful gauge. The copper/gold ratio has dipped to the 'risk-off ' 50 day moving average. It looks like a buying opportunity for risk assets, if it bounces here.

Oil is similarly unfazed by the 'doom signal' signal from bonds, as it continues its rally from the Q4 2018 low.

Taken as a whole, the message of the markets is becoming clear. This yield curve inversion is mostly technical in nature. It looks like Aberrant supply and demand dynamics have created a phony inversion. More importantly, it is only inverted at the front end. The Treasury inversion that really would scare me is the 2 YR - 10 YR part of the curve. The chart below shows a major non-confirmation by 2s-10s, with the curve actually steepening this week. Unless the longer dated part of the curve confirms the near term, the signal is suspect.

So investors, like a patient hitter, are keeping their bats on their shoulders, waiting for a fat pitch. They aren't swinging at curve balls.

Risk Model: 5/5 - Risk On

It doesn't get any better than this! With a slowdown in price momentum (RSI below 60) the risk model is in full-on happy mode.

Although investor risk aversion is evident in asset allocations and huge bond fund inflows, the AAII sentiment on the outlook for stocks is still positive.

Volatility spiked a bit this week and my trade last week to buy some insurance (I use $TVIX as a liquid play) worked beautifully.

Although the markets have run ahead of the positive narrative surrounding the FED and China reflation, the types of stocks that have performed best are actually in the more defensive sectors like Utilities and Growth.

A move into cyclicals is still in the offing and that's where the opportunities lie. Emerging markets have held up well, and the commodities are weathering the storm nicely. Glass half full time!