The bond market is certainly facing an interesting conundrum. We saw 10-year yields rally into the New Year, as the news of the Taper spooked the markets. However, since the New Year, the yields have come down to 2.7%. We have seen some volatility in recent days heading into Yellen’s first FOMC meeting. She stayed a steady course, but the FOMC Fed Statement certainly became more Dovish. Right now the market is reacting on action, not words. Her Q&A session only added more uncertainty and confusion, which injected more volatility into the equity and bond markets. So has anything really changed going forward?
On Friday I wrote about a possible break-out rally in the equity markets. We had a good run so far, but have faced significant short-term injections of volatility. We have had geopolitical instability which has sent ripples through the oil/gas markets and spilled over into the equity markets, primarily the Ukraine situation, which I believe, is still a factor. Then we had our first FOMC meeting with our new Fed Chair, Janet Yellen. The Fed Statement, which was far more Dovish, was met with a rookie gaff Q&A session, which sent the markets into an intra-day drop. However, has anything really changed in the big picture?
Nothing has changed!
I would argue that nothing material has really changed since last year, yet the sheeple still believe there is change, sheeple are easily fooled.. We have a very accommodative Fed. While they have Tapered at each meeting they are officially injecting $55 billion a month and if you look at the monetary expansionism (part of that was rumored to off-set Russia’s trades in treasuries) we saw the biggest expansion in almost a year (over $100 billion by the Fed in February). So how much is the “official” QE rate really a factor? I am sure we will see continued back-door funding and asset purchases. Additionally, we have a zero short-term rate, which the Fed will keep for a very long time.
Courtesy of Rebane’s Ruminations
As I pointed out on Friday, this QE (asset purchase, zero rates, bond buying, MBS buying) very accommodative measure (“extraordinary measures”) doesn’t look to stop anytime soon. That means that the bond market should remain elevated as the Fed continues to prop it up, thus keeping rates very low. What does that mean for investors, it means that treasuries still pay negative REAL returns (less than the rate of inflation)? It also means that treasuries are also short-term risk, if not held to maturity. So the only real place to invest is the equity market.
16,500 is a big area for the Dow Jones. The 16,400 level has shown some resistance, but if we look at both the liquidity and volume, it is has been a little light and thin. Perhaps traders didn’t want to take a big position with the FOMC meeting last week. There is certainly SOME resistance in this range, but with nowhere else to go and also expansion on the margin side; I can’t see why the market would sell off significantly just yet. Where would the money go, into bonds or cash? Both are not very good investments in the current Fed monetary policy environment.
So as we look across the broader indices, I see a pivotal point in which we could get another solid leg-up. This would be helped fueled by some short-covering, as we have seen some increase in short-interest. The big issue is we can’t fight the Fed policy, regardless of how wrong we believe it to be. As long as equities offer both growth and yield potential, where cash and bonds offer nothing, then we have unfortunately little choice.
However, it remains a pivotal point with risk to the down side for some of the exact same reasons why it has potential to the upside. We have massive expansion on the margin side. While it continues to expand, it is becoming rather massive. We know that credit (debt) expansion can’t continue forever without some contraction and settlements. With the NYSE above $450 billion and hitting new highs every day, it is just a massive representative in how much debt is in the equity markets.
Additionally, we have some risk in the oil markets, primarily with the escalated situation in the Ukraine. While oil is priced in dollars (for the most part) – petrodollars- that have been the principal reason that it has maintain strength as a global currency, that status is weakening and each year it is being chipped away at. Primarily as the emerging markets consumption and purchases of oil continue in non-US dollars.
Fulcrum of Faith!
It’s all about faith and I wonder how much MORE faith can the Fed continue to push down to lift the market? We had faith waver during the crisis when Bear Stearns failed, the dollar broke (money markets negative overnight), and the dollar window closed for just a weekend, shows how fast things can unravel. Most of us didn’t notice, but if it were not for extraordinary last minute measures that weekend, we could have seen the dollar fail. Probably unlike any time in history the dollar was at risk of failing.
Could that happen again? Certainly it could, since trade and exchange is entirely based on faith. It would only take a large nation like China, Brazil, or even Mexico to stop accepting US dollars. Perhaps it would be OPEC repricing international oil trade out of dollars and into a mix-basket currency or new currency. These situations may seem like “tinfoil” hat scenarios and the probability low, but it never the less is a real possibility.
What would trigger such a scenario is the loss of faith and concern, much like we saw that weekend with Bear Stearns. What fuels that concern is the expansionism of the Fed’s balance sheet, national debt, and zero interest rates. The Fed actively taking a position to devalue the dollar and try to create inflation is what heightens those concerns. The recent dovish tone of the FOMC Fed statement, that went as far as stating, “inflation persistently below its 2 percent objective could pose risks to economic performance” certainly created some attention from China and other large creditor nations. They read it clearly that the Fed will continue to try to create inflation (weakening the dollar). That is a direct threat to trade, but more importantly increases the risk in holding dollars and treasuries, which currently lose REAL rates of return against even the current amount of “modest” inflation, if one uses the government’s current CPI model. Yet, take a glance at the pre-1990s CPI model and inflation already looks too high, 5% or the pre-1980s model and we are closer to 9%. If bond traders, international leasing business, and international lending firms are looking at REAL inflation, not the current CPI models, you can bet that China and other large treasury holders are as well.
Blowing up a balloon.
So as we come full circle you see we are in this pivotal situation. The market is hovering in a range at all-time highs. Fed monetary policy on one hand is pushing the equity markets higher, but their policies are also bringing forth concern about the US dollar as a reserve currency, debt, and inflation.
It’s analogous to that inhale moment as you take a breath to further blow-up that balloon. It’s a pause and you wonder, is that enough air or should I blow again and make this balloon a little bigger. The Fed is going to blow again and continue to inflate (pun intended) this balloon (treasury/dollar bubble). The question is do we take a reprieve at this pivotal point and let a little air out of do we blow more air in and go higher?
Support & Resistance
INDU 16,000 – 16,500
We look like we want to move higher, at least to 16,500 before we take any reprieve, however at the same time this is a pivotal point in which we could retrace and pull back to 16,000. I would remain cautious.
NDX 3650 – 3750
The NDX is holding up in an upper range since mid-February. However, it looks like a good drop to 3450 is in the cards. I would expect volatility.
SPX 1840 – 1880
If we can push up and trough 1880 we could be in for that break-out rally. However, if we have strong resistance and not enough optimism, expect a pull back to 1840. VIX is hovering in that 14-15 range, telling me that even the option’s premium is uncertain whether to price in a rally or a pull back.
RUT 1180 – 1210
A strong rally to 1210 and a break-out or a pull back down to 1180? I am not certain, I think the next move will be whether the market has faith and optimism or if concern again rears its head. Fundamentally speaking the market should probably pull back, but who is monitoring fundamentals, it’s all about the Fed.
I believe that Fed is holding their “Aces” to play in late Summer and into the mid-terms. They don’t want to seem to accommodative early in the year, thus exhausting the “oomph” in their measures. The bonds are still unattractive, sending any possible capital into the equity markets.
I suspect we could be in for a little reprieve, a dead-cat type bounce after the recent decline and rally. The only reason is that we are so far over-leveraged at this point, compared to historical norms. However, I don’t expect that we see a full on correction yet, but I do believe that one is coming in the near future.