Saturday, July 6, 2013

A recovery without a reflation trade

All the major indexes finished the week significantly higher on the tail of a seemingly strong monthly employment report that beat expectations with healthy upward revisions to the May and April numbers.  Most of the job creation, however, was in part time work and in the hospitality and food service industries.  Sounds a bit seasonal to me ...

Friday's rally was also the result of playing "catch up" with the rest of the globe after the brief hiatus of July 4th.  On Thursday, the ECB (European Central Bank) signaled continued monetary accommodation with the strongest language that Mario Draghi has used since his "whatever it takes" statement in 2012.  Draghi had to do some serious "jawboning" as his hand is being forced.  A strong positive correlation between US and global interest rates emerged after the Bernanke news conference on 6/19 as global yields followed US yields higher.  Europe can ill afford higher interest rates at this time as they can be likened to a drowning man trying to keep his head above water.

Technically, the charts of the major indexes are speaking to a resumption of the rally as significant resistance has been breached in a number of indexes.  Small caps have also resumed leadership in the advance which is a bullish short to intermediate term indicator.

Most importantly, Friday's price action in stocks and treasuries strongly suggests that the market is ready to take off the "training wheels" its been riding with since the onset of the Fed's unprecedented QE policy.

Before I get too far into the commentary I want to address a call I made earlier in the week here ( ).  While I did say that the call I made might be early I still made it and it does appear at this time that my call was incorrect. 

I'd like to qualify my position.  First of all, lumping the precious metals with industrial commodities was a mistake.  It's not that there couldn't be a positive correlation but the environment at this time does not lend itself to such a correlation.  For instance, Gold and industrial metals can and will weaken in a disinflationary or deflationary environment but in a situation where interest rates are rising in a disinflationary environment Gold and Copper cannot be positively correlated.  Rising interest rates normally are predictive of expanding economic activity in the early stages of an economic cycle and would be good for industrial metals.  Rising interest rates are the bane of precious metals unless those interest rates are skyrocketing (ie. 1979).

Secondly, the "pop" we saw in industrial commodities last week coincident with bottoming Euro zone economic data was not necessarily a wrong call at the time if Europe is actually bottoming.  But the situation in China is worsening and this has been a drag on the entire commodity complex.

I'll be addressing this state of affairs below in my analysis but regular readers know I've been identifying this "disconnect" in global financial markets and we're seeing "a tale of two economies", that being the US economy and the rest of the global economy.  Or, are we seeing a tale of the US financial markets and the rest of the global economy?  And how can long term interest rates be rising if industrial metals are still treading water?

But first, let's look at our markets. I'm going to start with the Russell 2000 small cap index:

(click on chart for larger image)
On Friday the Russell broke thru a resistance line drawn from the May 22nd intra day high of 1008.23 and closed the day at an all time high of 1005.39, closing above the key 1,000 level for the first time ever!

SPY (S&P 500 SPDRs)  also penetrated a resistance gap I identified here on a 60 minute
chart ( ):

(click on chart for larger image)
The S&P  daily chart also managed to close above its 50 day moving average which had been resistance for the better part the past two weeks.  It's presently butting up against a downtrend resistance line from the May 22nd intra day high of 1687.18:

(click on chart for larger image)
And the following chart is the reason for my comment above about "training wheels":
(click on chart for larger image)
This is a daily chart of the yield of the Ten Year Treasury Note which is the benchmark for mortgage rates in this country.  I circled Friday's action and as can be readily seen, the yield on the Ten Year surged over 21 basis points on the day and has surged 107.6 basis points from it's May 1st low. 
Regular readers of my commentary will know I had recently identified a new correlation to determine stock market direction using the yield on the Ten Year:
Ten Year Note yield up - stocks down
Ten Year Note yield down - stocks up
The market sent a signal on Friday that this correlation ended on Friday as both stocks and interest rates surged together.  Moreover, the market sent another very clear message along with that price action.  It is shrugging off the fear that "tapering" by the Fed is going to send these markets into a tailspin.
This is important, folks.  The Treasury and stock market are telling us that a healthy economic recovery is taking hold in this country and that the recovery can handle the higher interest rates that are bound to occur as the Fed takes its suppressing hand off the long end of the yield curve.  How high interest rates can go is open to conjecture.
The US Dollar is also exploding and here's a daily chart of $USD:
(click on chart for larger image)
I'll be addressing the Dollar extensively in my analysis.
With the exception of oil which is rallying due to political (really economic) turmoil in Egypt which could threaten the shutdown of the Suez Canal, the commodity complex largely retraced the gains it made the week before.  Here's an update on Copper as of Friday's close:
(click on chart for larger image)
 The street continues to blame the commodity weakness on a stronger Dollar which may be a technically satisfying answer but the question has to be asked, why is the Dollar strengthening?  I'll be attempting to answer this question in my analysis.
 I addressed the change in the inter market relationship between the Dollar and equities most recently here ( ) and I do believe that in a normal economic cycle a stronger currency is indicative of a stronger economy and subsequently stronger equity markets.
The saying over the past year that we are "the nicest house in the global slum" is also an accurate statement and the reason why our currency is strengthening.  We saw the Euro take a nosedive on Thursday with more follow thru on Friday because of the ongoing economic weakness in the Euro zone which forced Draghi to manage market expectations by talking interest rates lower. That sparked a rally in European bourses and a sell off in the Euro.
So, as identified in previous commentaries, the classic inter market relationship between the Dollar and stocks is finally returning after a thirteen plus year interruption!
However, in a strengthening economy, upward pricing pressures also come to bare on commodities due to greater demand.  This is a natural and expected consequence of business cycle expansion.  In the market it is called "the reflation trade".  But where is the reflation trade?
Anyone who reads my commentaries regularly knows I've been defending a deflation thesis for the past three years and other than the temporary lapse of judgment I had earlier in the week I've been consistent in that defense.  While economic fundamentals are incrementally progressing in this country we are certainly not going "gangbusters".  Friday's employment report fueled momentum to a rally that was already taking place in Europe because of ECB actions on Thursday as the S&P e-minis were already up more than 12 points at the time the employment report was released.  But that employment report, other than "the hours worked" statistic, masked underlying weakness in full time job growth.
As an aside, it was amusing to watch Bill Griffeth and Kayla Tausche of CNBC query business leaders on Friday afternoon on the reasons why so many part time jobs were being created to the exclusion of full time jobs.  As many times as they asked about the ramifications of Obamacare legislation on full time employment they were turned away.  Heck, the guy on the street knows that Obamacare is a major impediment to small business hiring in the country!  Why won't business leaders admit it on national TV?  The answer to that question is outside the scope of this commentary.  :-)
I've identified the problems in China in past commentaries and Emerging Markets are also struggling.  Here's a daily chart of the iShares MSCI Emerging Markets ETF (EEM):
(click on chart for larger image)
I've pointed to Friday's price action.  The bounce off the June 24th lows met stiff resistance at the 38.2% Fibonacci retracement level and turned lower.
What's more problematic for Emerging Markets is that their bond markets are selling off and emerging market bonds positive correlation with the US Treasury market is sending their interest rates to prohibitive levels in an anemic (at best) global economy.  Here's a daily chart of the iShares JP Morgan USD Emerging Markets Bond Fund (EMB):
(click on chart for larger image)
It too bounced on June 24th but was subsequently turned away at the 50% Fibonacci retracement level. 
Higher interest rates in these exporting countries will strangle economic activity at a time when they have become accustomed to extreme central bank accommodation. 
As a footnote, the patterns on the two charts above mimic the patterns on almost all industrial commodities!

In the meantime, while recent European economic data seems to point to a basing out of the recession there, commodities continue to point to continuing deflationary pressures in the global economy.
Where does this all leave us this week?
1. As stated above, Friday's price action in both stocks and Treasuries was obvious and glaring.  It is a strong indication that the "junkie" may have shaken off his tapering withdrawals started on 6/19.  Moreover, in a normal economic environment, higher yields and higher stock prices are positively correlated in the early stages of an economic recovery.
2. Dollar strength, while indicative of US economic relative strength, also speaks to a weak or weakening global economy.  The "flight to safety" trade as we have come to predominately know it in the past four years may be waning but is taking on a different meaning as the rest of the planet remains mired in sub par or in economic contraction. 
3. Rising interest rates in an environment where commodity prices cannot gain traction is a danger signal that the classic economic cycle has been severely skewed by central bank intervention. 
4. If the present positive correlation between US yields and global yields persists, it inevitably spells trouble not only in those exporting countries where economic growth will break down and inevitably that cancer will come to our shores.
Finally, it must be remembered that the central bank interventions that I personally believe were very necessary following the GFC (Great Financial Crisis) are part of a great experiment.  The Fed, BoJ and to a lesser extent, ECB, have, by default, taken responsibility to reflate the global economy.  The distortions that have been created by that artificial attempt at reflation largely make any theoretical projections on the global financial picture based on a normal business cycle meaningless.  Central banks may ultimately succeed in their great experiment but the malformations identified in the points I made above will have to be addressed and corrected.  And frankly, only the market place will correct those malformations.
With all that said, I'm not necessarily bearish on the future.  The US consumer certainly has the propensity and maybe the ability(?) to assist in reigniting global growth but we will need Europe's consumption to pull us out.  The rest of the exporting globe is being held captive to these two economically developed entities.  So, in many ways it gets back to Europe.  The longer they wallow in recession/depression, the more serious becomes the economic plight of exporting countries.  And with time, the mammoth deflationary forces that central banks have attempted to paper over will continue reasserting themselves on the planet and then we will have much more serious problems. 
 In the short term, look for more upside next week in stocks unless things get really out of hand in Egypt.  We get a spate of economic data out of Europe on CPI/PPI and industrial production.   
In this country, I'll be watching the CPI (Consumer Price index) and PPI (Producer Price index) numbers on Friday as an indication on the direction of the disinflationary environment we find ourselves in this country. 
The fact that stocks and interest rates rose together on Friday is a significant short to intermediate term positive development and with stock indexes broaching some stiff short term resistance areas we are set to see new all time highs very soon. 

Have a great week!