Saturday, March 15, 2014

China, Deflation & Lower Interest Rates

The Dow Jones industrial Average suffered it's first five day losing streak since May, 2012 and all the major indices took it "on the chin" as diplomatic wrangling over the Ukraine increased in volume as the trading week progressed and more bad news out of China lent impetus to the sell off.  The pinnacle of the week was Tuesday when the S&P attempted a renewed assault on all time highs only to be repulsed.  From there it was downhill as waning momentum culminated in Thursday's brutal yet methodical sell off.  Here's a five minute chart of the S&P showing Thursday and Friday's price action:

(click on chart for larger image) 

I've super imposed a five minute chart of the Japanese Yen to show the lockstep inverse correlation between the currency and US stocks.  The Yen has been very helpful in understanding the near term direction of stocks and Thursday was no different as stocks popped at the open only to turn down after the first ten minutes as the Yen surged at about 8:40AM.  It was all downhill from there.

All the major averages finished the week down 1.75% or more and gold was the big winner, ending the week up 3.11%.  Here's a daily chart of the S&P:

(click on chart for larger image)

We were told the reasons for the sell off on Thursday was events brewing in Russia as well as terrible economic news out of China which I documented in last week's commentary.  And while that these two issues were the catalysts that sparked the weakness this week it's never as simple than that.  So far as the crisis in the Ukraine goes, events are still very predictable mainly because, short of military intervention, there is nothing the West can do to stop Putin if he chooses to break up the Ukrainian republic.  Certainly, at this point, Putin has to be considering the enormous depreciation of the Russian ruble as money exits the country at a rapid clip and this situation, more than any other, may put the brakes on his imperialistic ambitions.  But when this is all said and done it will go down in the financial history books a a "splash in the pan".  The global economy has much bigger fish to worry about and it is China!

In the meantime, I'm looking for a bounce next week in stocks predicated on what I see as waning downside momentum in the indexes and Treasuries bumping into some resistance that could only be breached by another major negative news event.  In other words, both Russia and China have been priced into stocks at this point.  A proof of my thesis can be seen in small caps which also took a drubbing this week but had a surprisingly strong day on Friday before the weekend.  Here's a daily chart of the Russell 2000:

(click on chart for larger image)

I circled Friday's price action and while the candlestick doesn't give us much hope in the immediate term the fact that the Russell had an "up" day ahead of a weekend fraught with geopolitical risk told me two things:

1.  Investors clearly understand that events in Russia will have no long term financial reverberations to the global economy and
2. Investors were "bottom picking" in US stocks that have very little exposure to either global events or the global economy.  More importantly, investors were willing to expose themselves to further possible downside going into a weekend where news events were liable to dictate where equity markets could move on Monday.

Both points indicate to me that, in the short term, the bulk of the selling may be over.  

Certainly treasuries were giving us a similar signal in their own way.  Here's a daily chart of the iShares Barclays 20+ Yr Treasury Bond ETF (TLT).  TLT is a popular ETF traders use to place bets on the direction of long term bonds and interest rates (the long end of the yield curve):

(click on chart for larger image)

As you can see, TLT is at major resistance and has been turned away at this level twice before.  My hunch is that after it's incredible surge on Thursday it will at least hesitate here and probably be turned away in the short term.

For interest rates the line in the sand is 2.6% on the Ten Year Treasury yield.  A yield below this level would start to speak to much deeper problems in the global economy.  Here's a daily chart of the Ten Year yield:

(click on chart for larger image)

We traded as low as 2.61% intra day on Friday morning but bounced from there to close the week at 2.644%.

The bond market will continue to give us our clues on the direction of stocks as well as the health of the global economy.  The present level of interest rates are telling me that, Russia aside, all is not well with the global economy and even if the US economy is the "nicest house in a bad neighborhood" there are global headwinds which are creating a significant drag on our economy.

Gold is also sending the market strong messages that, in my opinion, don't have that much to do with geopolitical events or inflation (as some are surmising).  Here's a daily chart of the Gold spot price:

(click on chart for larger image)

The impressive surge gold has had is delineated on the chart and while it has bumped into Fibonacci resistance on Friday I expect it will cast this aside and continue to move to the major resistance I've marked on the chart ($1420 - $1430).

After three months of economic crosscurrents and trying to solve the riddle of gold in terms of inter market relationships, to answer that riddle with cliches about Russia or "inflation" are misguided in my opinion.  Gold is verifying the Treasury market's signal.  Simply, gold thrives in a low interest rate environment and its recent surge is predicting a lower interest regime going forward.  I know, how much lower can rates go?  I'm not willing to gander a guess but there is no justification for the "inflationista" argument that gold is responding to future inflationary pressures in the global economy.

Certainly, I'm sticking my neck out in presenting this thesis but let's look at the evidence that inflation is gaining ground in the global and US economy.  It is true that agricultural commodities have had quite a run up in recent weeks.  Here's a daily chart of the S&P Goldman Sachs Agricultural Commodity Index ($GKX) which penetrated a multi year down trend line in January and has been in a seemingly relentless bull market ever since:

(click on chart for larger image)

As we look at the reasons for the rally we see that the move in virtually all of these commodities are due to "one off" events, whether it was supply/demand issues due to weather events, geopolitical events in Russia (wheat), or the impact on livestock prices from higher feed prices.  And the chart of the Reuters/Jefferies Commodity Research Bureau Index ($CRB) bares out my thesis:

(click on chart for larger image)

The chart above is sporting a classic "island reversal" chart pattern.  If this pattern holds up (and I expect it will because it is very reliable) we will consolidate at the present level for the next week or so and then break lower.  Admittedly, penetrating the gap support I've marked on the chart is crucial to my thesis.  I've learned from past experiences never to be dogmatic when it comes to my opinions but I'm convicted about the correctness of this call.  I'll be providing further support for this thesis below.

I have concerns in the currency market that I believe will be pivotal to understanding the direction of all asset classes later this year and into 2015. However, I am going to delay an explanation of those matters as it's not pertinent to the short and intermediate term direction of financial markets. But I'd like my readers to see a weekly chart of the Euro:

(click on chart for larger image)

Euro zone leaders have been bemoaning the strength of the Euro in the face of the continued malaise the EU economy has been facing for years.  Right now the Euro is fighting through a resistance zone I have not highlighted on the chart.  If the currency can penetrate the 140 -142 level in coming months it will validate a grand thesis I've been considering that will have vast implications in the FOREX (foreign exchange market) and global economy.  Stay tuned ...

In a week where events in the Ukraine and Crimea took center stage, the real challenge facing the global economy was from China, which took a subordinate position to those issues.  

There are many charts I can display that substantiate the radical slowdown in the Chinese economy over the past few months and I've already highlighted in past commentaries the dangers in their corporate debt market that are only exacerbating that slowdown.  In many ways, what is going on in China ties in with the grand thesis I spoke about above in addressing the Euro currency.

As China takes the next steps to truly move their economy and country into the mainstream of the global financial system the growing pains are becoming self evident.  The questions remains whether their leadership has the necessary finesse to effectuate those changes without plunging their economy into recession.  So far the verdict is out as their banking system is taking a hit.  Here's a ratio chart of the Global X China Financials (CHIX) to the Shanghai Composite Index ($SSEC).  The chart is used to measure the strength of their banking system to the total economy as measured by stock performance:

(click on chart for larger image)

We've broken Fibonacci support but have stabilized in the last week.  If we look at the Shanghai Composite we can see that it too, has stabilized above crucial support at the 2000 level but the situation is tenuous at best:

(click on chart for larger image)

For anyone who wishes to see some charts detailing the serious breakdown in the Chinese economy I refer you to an excellent post by

As we get past the noise emanating from the Ukraine, the China problem and Fed tapering will once again move to the fore of the market's attention and hold it captive for the remainder of the year.


The weather and now geopolitical events have taken the market's attention away from the issues which will be major drivers going forward.  While it is true that China got some press relating to their slowdown I don't believe the street has come to grips with the possible implications a radical China slowdown would engender.  The latest developments surrounding corporate debt defaults in that country could have a frightening outcome as investors flee that market now that moral hazard has been addressed.  More likely, however, the result would be a progressive dry up of liquidity in that market which would only exacerbate an already rapid economic slowdown.

We have our own problems in this country as inflationary pressures continue to wane.  The Producer Price Index (PPI) for February came in on Friday below expectations once again, to which the street decided on a "glass half full" approach, mainly applauding "tame" inflationary pressures.  But in a world awash in fiat currency and deflationary forces clearly having a stranglehold on vast sectors or the global economy, applauding waning inflation as "tame" is tantamount to burying one's head in the sand.  The China slowdown is going to have a huge impact on these deflationary forces.

Here's the latest chart of the iShares Barclays TIPS ETF (TIP) - iShares Barclays Seven to Ten Yr Bond ETF (IEF).  The chart measures investors inflationary expectations.  TIPS are Treasury Inflation Protection Securities tied to the CRB Index (highlighted above).  As inflation expectations rise or fall investors will move in and out of TIPS and regular Treasuries that have no inflation protection.

(click on chart for larger image) 

The ratio chart clearly shows that inflation expectations have been waning since 2011 while the S&P 500 (black line on the chart) continues to move higher.  If inflation is a necessary by product of greater economic growth and velocity (and it is) why the divergence between the ratio and the S&P?  This is not a new story and the answer is simple: the Fed has made it so.  And this week we have another FOMC meeting which will finally take the market's focus off the Ukraine (good) and China (not good).  

The chart above validates the thesis I've presented above pertaining to the bond market, gold and commodities.  While I expect a short term bounce this week in equities for the reasons mentioned above, the China story will continue to haunt us and will eventually slow growth in this country to the extent that it has to impact US stocks.  How much will it do so?  Much will depend on the Fed's "generosity".  They are not going to change direction regarding the tapering of asset purchases at this time and I expect no new revelations from their meeting on Tuesday and Wednesday that will do anything but soothe markets.  But if the economic drag that I think the China slowdown will spawn comes to fruition, more Fed stimulus may be needed later this year to bolster equity markets.

While growth will still be tepid this year our economy is the strongest economy on the planet but to largely explain this bull market in terms of P/E ratios and balance sheet fundamentals misses the point of the divergence on the chart I posted above.  I'm not predicting a bear market in stocks but the divergences above must be reconciled at some point.  And I think the China slowdown may be the catalyst for this reconciliation.

In the meantime, I think we will see lower interest rates in the coming months for the reasons I've specified above but look for a short term bounce in stocks this coming week.

Have a great week!