Curve Ball

Baseball's minor league rosters are full of guys who can hit fastballs out of the park yet have no clue what to do with a curveball. Only the best hitters are talented enough to handle the big league curve. That keeps them in the majors long after the flash-in-the-pan free swingers are sent packing to triple-A. This week, we will see which stocks can handle the suddenly dipping yield 'curve' that has been thrown by the Fed.

The announcement by the Federal Reserve that accommodation in monetary policy would be eventually winding down, was, by most opinions, fully expected. What was not expected was the bond market's reaction to it. A sudden sharp rise in the 2 yr bond yield, combined with a puzzling drop in longer-dated bond yields created a curve from 2's to 30's that was suddenly much flatter (chart below). You would think news of the impending end of the QE era would translate to higher yields in longer-dated issues. But the reaction to the news was met by drops in commodity prices and inflation break-evens. A weakening stock market reinforced the mixed message. That, combined with a technical 'risk-off' bid to lower volatility assets, created an anchored longer end, hence the dramatic curve flattening.

U.S. and U.K. Yield Curves: 2y/30y Differential

Fans of this blog will recall that, despite what you hear from talking heads, stock prices are not always a reflection of what is going on in the economy, especially in the short run. Stocks are a monetary phenomenon. And when important inflection points in monetary policy occur, they trump the effects felt by growth expectations, earnings, and dividends. Hence the mini-correction we saw last week.

Notably, the previous winning trade, 'value', became an underperforming segment, and key 'growth' stock plays such as Apple and Microsoft came through the sell-off unscathed. Banks and copper stocks were particularly punished. But the economy is likely to remain strong, notwithstanding this small change in tone from the Fed, so the words 'knee-jerk reaction' comes to mind. I'm starting to warm to the cyclical/value trade after the recent check-back.

Value vs Growth ETF Relative Price

Yesterday's bounce was broad enough to include the Energy, Financial, and Materials, as well as a further advance by the quality growth mega-caps. The message of the market seemed to be "We see what you're doing Mr. Powell, and we can handle it". His fastballs, in the form of dovish commentary around the transitory nature of inflation, are missing now the plate. Seems everyone was sitting on the curveball, in the form of the tapering announcement, and are now trying to take it out of the park. Time to get the bat off your shoulder.

My message has been clear lately, this is a market of stocks, not a stock market. The gyrations that we are seeing have created a series of short-term rotations of leadership. I previously flagged that people should be watching the 2 year and not just the 10 year for their cue to a corrective phase for stocks. The spike in yields was sharp but contained to the front end which is now 'pricing in' a rate hike coming in 2023. That is hardly a reason to go full-on bearish.

Although the market seems 'over its skiis' in terms of valuation, the strong earnings back-fill is helping maintain that imbalance for now. I would only be worried if we had seen a dysfunctional bond market led by higher long-term yields. The equity risk premium, thanks to the strong results now being reported and messaged, has risen noticeably, cushioning the blow.

This market, with positive estimate revision and surprise factors still intact, is a buy. The 'sell in June and wait for a swoon' game plan now needs to be re-thought. The Bitcoin collapse (back to the Dogehouse!) reflects a bit of froth being blown off the top of the more speculative segments - a healthy sign that was overdue. Some are saying it's just part of being a crypto player and have said to stay the course. But asking the bulls, like Mike Novogratz, what he thinks of Bitcoin is like asking Trump what he thinks about the election. I also believe we are seeing the unwinding of 'meme' based investing fad as the Robinhood crowd is now getting fleeced on their Bitcoin longs. The short squeeze play now only works for real baseball players.

But this market still has plenty of guys who can hit the curveball. Take a swing here and buy the dip.

Risk Model: 1/5 - Risk Off

The audible yawn in response to the Fed hawkish turn emanating from the volatility markets is constructive. The model's signal line is still falling and the recent market action was insufficient motivation to even challenge the 100 dma. I do anticipate this lower volatility environment to persist for a while longer, albeit in a bottoming phase. A quiet, choppy period of 'wait and see' markets could easily lead to a more challenging volatility regime come late summer.

3 Month VIX

Copper has broken its trend against gold, signaling a slowdown in the re-opening momentum. This morning's news of lower existing home sales reflects the effect on demand from the sudden drop in affordability. It doesn't take much change in lending rates to cool off the artificially overstimulated credit cyclical components of the economy. The road to a higher long-term 10 yr rate above 2% suddenly appears to have lengthened, but still is intact.

Copper/Gold Ratio