For most of this spring, I’ve been telling clients that I’ve been in “wait and see” mode. The US dollar, bonds and stocks have all been rallying this year, and while that can happen in the short-term, the dynamics of the market say that can’t last in the long run. Basically, 1 of the 3 is “wrong.”
If the US dollar continues higher, bonds are right and stocks are wrong as a higher dollar slows the economy through weaker exports and FX losses on foreign sales (most companies in the S&P 500 are global companies).
If the US dollar is able to weaken from here, then stocks can be “right” and we could see another wave of economic reflation which would support commodities, emerging markets and stocks in general. We would likely see bonds weaken in this environment.
For the past 6 weeks, the dollar index (DXY) has been toying with a breakout but backed off right at the end of May. Last week’s big bounce was a classic “reflation trade” as the dollar dropped a good bit and nearly everything else rallied. However, I need to see the dollar continue to press lower before I can buy in that the global central banks are successfully creating another wave higher as they did in 2016. While the DXY has been flirting with a breakout, a lot of currencies not in the DXY basket, like EM currencies, have been making new lows against the dollar – another reason why I still think the dollar overall continues higher.
The US dollar is probably the most important thing to track right now. The direction it moves will basically determine the majority of portfolio positioning. A higher dollar means overweight bonds and US over international.
US Dollar Index (left: weekly; right: daily)
The bond market has been disagreeing with stocks in a big way all year which is why I still think stocks are “wrong” in the short-term and likely to move lower in the second half of the year. Yields have dropped dramatically across the board and rates markets are now pricing in 2-3 cuts by the Fed – a dramatic shift over the last 6 months! I’ve been expecting cuts since last fall but the more interesting thing is why. The Fed Funds Rate has persistently remained above the Interest on Excess Reserves (IOER) Rate since March. I’m not going to get into the details of these but simply put, this should not happen. It says there are larger liquidity issues within the plumbing of the banking/credit system and the Fed will need to cut to loosen policy just to regain control. The Fed actually cut IOER in early May by 5 bp in the hopes a small “technical adjustment” would fix the problem but it hasn’t. To me, this is one of the bigger issues to keep an eye on. The Treasury yield curve is now inverted from the 3-month out to the 10-year.
By my preferred metric, I think the Fed needs to cut 3 times just to get policy back to a neutral position where they’re not restricting economic growth. Australia and India just cut rates. If the Fed does too, it will probably be the start of the next global easing cycle.
“Corporate” Yield Curve – Inverted by 0.75%
Stocks have posted a strong rally over the last week but the larger momentum structure underneath this market remains broken. The rally to new highs last September and again in April both created negative divergences on weaker momentum. Below is the updated version of a chart I posted last fall. If June’s rally can continue then it’s possible a lot of this can be negated but given the macro picture of the dollar (higher), bonds, oil and copper (all lower), I remain suspicious. Breadth and liquidity measures remain positive so this is supporting stocks and credit for the time being, but May did a good bit of damage and might be the start of a rollover. If breadth starts to deteriorate again or momentum turns negative, the December lows are easily in play.
S&P 500 – Monthly
Forward looking indicators say the economy is already set to decelerate on a year-over-year basis for the rest of this year and likely into Q1 of 2020. This is already baked in from the increases in the dollar and rates over the last year and a half, and this isn’t including additional tariffs or breakdowns in trade talks. It’s rare for stocks to rally in a slowing environment. Historically, they either hold steady/consolidate or drop so I’m not expecting a run away rally this summer or fall.
I also think the bond market (2’s through 30’s) has very quickly priced in the expected rate cuts and will likely pause for most of the summer – even if we do get a Fed rate cut in July. I took some profits in long-term bonds last week but will look to re-add during any pullbacks this summer. I like to track bonds by watching the rate of change in yields. It typically marks pretty good intermediate term points where to buy and sell (remember, bond prices move in the opposite direction as yields; yields down = bonds up)
10-year Treasury Yields
Without major change in fiscal policy, I absolutely still think yields are moving lower over the intermediate to long term. The bigger concern right now is how central banks handle the next recession. The US is the only country that came anywhere close to normalizing rates and we only made it to a Fed Funds Rate target range of 2.25% – 2.50%. On average the Fed has cut rates around 5% during past recessions. If things slow hard, we’re going to very quickly return to 0% and then what? Are we going to -2.5% I sure hope not and I think the Fed understands the issues that negative rates have created overseas. This is likely why they’ve been dropping other ideas in speeches lately like expanding QE and Yield Curve Control. But that’s a topic for a future post. We’ll see how this year plays out first.
Thanks for following!
-Nick