Is this a bubble? We have just experienced the US equity market cruise through all-time highs as their inverse correlations, the risk off market, rallied significantly. Theoretically, inverse correlations move, well, the inverse of each other. When money flows out of equities, it flows into risk-off assets such as bonds and gold as per large institutional rebalancing. It is rare that money flows into stocks (risky assets) and bonds/gold (safe haven assets). That is exactly what is happening now, long story short, this is not sustainable and one will give. In the following article, we will go over the Fed and monetary policy, the global economic data, and Central Banks along with the trade talks and what we could expect from everything converging.
Below is a four-quadrant chart of the S&P 500 futures, 30-year bond futures, Dow Jones futures, and Gold futures. A 50/50 mix of the top risk off and risky futures assets. It’s evident that since the turn of the year, in 2019, all four of these assets have continued higher, we have focused the gains over the past month, from June 3rd to July 3rd, 2019.
The two equity indices, ES and YM are risk assets that have made substantial gains, 9.97% and 9.10% retrospectively. The S&P 500 just hit all-time highs at 3001.00 on the close and YM too made all-time highs at 26978.
On the other hand, risk off, or safe haven assets are assets that experience inflows of large capital when fear is baked into the market. Meaning, since equities have rallied, we would expect bonds and gold fall. However, as seen below in the same one month period, 30-year bonds rose 2.26% and gold, maybe the most surprising of all gained 8.31% and hit highs that haven’t been seen in 6 years. How long can this continue and what’s causing this optimism? One possibility is a switch to an expansionary monetary policy.
The Federal Reserve change in policy.
It was not long ago that the Federal Reserve, members, and chair alike were all on a rate hiking spree just months ago. That quickly changed once the proposed “Powell Put” was activated just before 2019 hit. On boxing day, December 26th we got the beginning of the rally right around the predicted Fed level, between 2300 and 2350. This level was announced as a potential level of Fed intervention where the Plunge Protection Team stepped in to bid the market higher.
Up until this point, the Fed had rate hikes planned throughout 2020, nearly once a quarter to prevent potential recession scares. Off the rebound of the Powell Put, equities then hit all-time highs, again in 2019, making a certain US President happy. Not too happy as he mentioned that if the Fed was doing its job, the ES should have been at 5000. This exposed the real nature of the Fed, as we knew was the case before. Their data dependence, as long as they served a president would be the market’s health.
The markets managed to drop in May, into early June off all-time highs as Powell’s job was under fire. This then activated the next proposed Powell Put around 2700, again propping the market to all-time highs. The bull run higher off those lows was accompanied by a shift in monetary policy by the Fed and a 95% chance of a 25-50 basis point cut in July. Powell just recently announced that he has not dismissed his expansionary stance even though he has expressed his concern for Fed data dependence and independence from the President. This helped the ES move into the 3000 level, for the first time ever.
The Fed’s influence does not end at the equity market influence. The move higher on this artificial inflation is not sustainable. Let volume be that indicator, on the whole move higher from 2700 and the second Powell Put, the volume has been dropping off and falling. There is no buying in this market, only jawboning from the Fed and Trump and trade talks. Money is flowing in equities, but not as much as is needed to sustain this upside.
The Fed has managed to prop Gold prices higher, the price struggled to break $1300. All of a sudden, we were trading at $1450, just after the Fed announcement, why is that? When monetary policy changes to a more expansionary stance, money is cheaper to borrow and the nation’s currency drops in demand. Causing the USD, or greenback to decrease in value. Gold and the USD have an extremely negative correlation which causes the gold market to rally on a very weak dollar and this upside in gold was well sustained by immense inflows on high volume. The volume to the upside in gold has increased as gold hit the $1450 area. While the rise in equities did not come with a rise in volume. Should gold maintain above $1400, we can see a fade in the equity market.
Bonds ripped as well off the expansionary news. The bond price reacts inversely to interest rates. Should interest rates fall, in this case a rate cut, then
In due time there will be an autocorrection in markets, but who will give?
The Fed continues to preach data dependency and is slowly beginning to admit there is no reason to cut as of yet. We feel that Powell does not want to scare markets off highs by announcing that himself. However, should enough voting members express this we may see the slip? Back into the 2900 level. Even further, imagine this as a worst case scenario, rates are 1.00% or lower and the S&P 500 is around 3100. Then markets starting crashing, risk off is skyrocketing so more money gets flooded into gold and bonds. The market drops down into 2000, with more room to go down to 1550 for a 50% crash and there are barely any rates to cut from the 1.00%. Next thing we know, the US turns into the ECB and Japan with a Central Bank rate of 0.00% and a 20-30 year expansionary policy and struggling to recover the economy. Again worst case scenario. The 10-year bull cycle will end once the S&P 500 is under 2300.
The US economic data is the center of the Fed’s decision, or it should be. The global economic data should also dictate how monetary policy is approached, in this portion we will focus on the US economic data and if it justifies a rate cut. Where is the US economic data headed and does it make sense to take expansionary action? There is a plethora of data the Fed looks at when deciding to hike or cut. We will focus on inflation/CPI, GDP, employment numbers, and home numbers. Below is a more full list of the Fed’s rate indicators.
The cut would be more likely if there is a slowing in the growth trend, in GDP and employment growth. Inflation expectations are also a large focal point for the Fed. Along with a consumer, side slow in growth.
Over the past year, inflation has been slowing and CPI slowed in May (1.8%) YoY from prior months 1.9% with the June numbers yet to be released. If inflation data continues to be muted, this may be a strong case for the Fed to cut rates.
There is a substantial slowing in the GDP growth expected in the current quarter from April to June, not yet released. The Atlanta Fed has an annualized increase at 1.4%, while other institutions have it pegged at 1.1%, compared to the first quarter growth of 3.1%.
It’s no surprise that employment figures have been a bit iffy, especially in the non-farm front in the US. In 2018, average monthly jobs added were 223,000, in 2019, that number has dropped to 164,000 on a monthly average. With the May number coming out at 75,000, significantly low and the June number expected at 164,000. Each of the past three months has been revised lower as well. March revised lower from 189,000 to 153,000 and April down from 263,000 to 224,000. The unemployment rate remained significantly low in May at 3.6%. Average hourly earnings missed from March, April, and May. The June numbers have just come out as a HUGE beat, 224,000 versus the 162,000 expected. Causing markets to drop from all-time highs, now about 20 points. So why was this a bear, because this is a hugely important Fed number for potential rate cuts. The market anticipates a decline in rate cut chance because of good economic numbers. About a week ago there was a 100% chance of a cut in July, now only 91%, let’s face it, the cut is priced in.
Looking at housing numbers, there is an overall increase in building permits over the past three months from March, April, and May (1288, 1290, 1294) respectively in thousands. There was also an increase in existing homes sales, 5210, 5210, 5340 respectively in thousands. And a general increase in housing starts, 1199, 1281, 1269 (slight decrease in the last month)
Overall there are major economic data points that are struggling to growth and the slowed growth can be considered grounds for a rate cut in coming months as there are a proposed 2 rate cuts (now) in 2019. The Fed and it’s voting members will have to look at all the figures carefully, their growth potential and how they relate to the market and current political conditions to make a decision as the S&P 500 is a pivot economic indicator or so we thought. The trade talks with Xi and Trump and even Europe may have artificially inflated recent stock prices. The futures may be more dangerous for the market than it seems.
Even if the Fed does not decide to cut rates, the Trade talks have done more than enough to move equities higher. The optimism that stems from trade talks with no real document backing either president is concerning for the long term market growth. A lot of stocks are in overbought territory, however as equities have reached all-time highs, not many stocks are at their all-time highs which means a fall from greatness as more money floods into risk-off assets.
Trump and Xi have recently agreed to come back to the table and lean towards their nations best interests in the proposed trade deal. The tariffs that were proposed will not be dismissed, however, Trump did not hit China with the remaining tariffs on $300 billion worth of goods as Trump and Xi met during the G20. There is still a lot of uncertainty around the wording of the trade deal and if both parties would agree to the deal. However the jawboning throughout the talks have pressed equity markets in the US higher. A trade deal going through would undoubtedly rally the market and if rate cuts would go through with a trade deal we’ll hit new highs, which could spell disaster in the medium to long term for the economy and markets.
This whole Trump/Xi negotiation seems like a solid game of cat and mouse as the G20 meeting is very similar to the one in December 2018, Buenos Aires when the two met again. What’s the same? The nations are in great relations, and a deal is coming right up. There is still a 10% difference in the US and China trade that has to be settled. Not hitting the remaining $300 billion of Chinese imports to the US with tariffs is exactly what happened in 2018, that time it was not raising tariffs on $200 billion dollars of goods. What happened? A large market correction on the back on rate hikes. Is Trump just buying time before his election in 2020? With markets at all-time highs, he has a strong case for the election, however, no ones really thinking of the long term and economic health, what would happen then when everyone realizes how overbought everything is and how artificially hit it is and artificially low rates are? Is the US just waiting for China’s total capitulation of the tech issues that sparked this debate in an attempt to launch a full out economic war for their own gain?
China has an ace up its sleeve, the natural devaluation of the Yuan-Renminbi currency as the global economy slows, the devaluation would offset tariffs. They have done this before but it was a forced devaluation if they allow natural devaluation they will have a strong hand to play. Simultaneously if they sell off or stop purchasing US Treasuries, of which they have $1.3 trillion in US assets could increase long term US rates and the value of the greenback which increases the slowing of global growth. China has already begun to hold back on purchasing further US assets this year and last. What does a rise in long term rates and the value of the greenback lead to? A huge stock sell-off, and that would anger Trump drastically since he’s pinned the US economy to the market’s strength.
Below is a chart of the S&P 500 futures market that outlines the last G20 summit and the repercussions, also aided by rate hikes. This time around based on fundamentals and technicals we could see a stern ramp higher to fresh all-time highs that have already been catalyzed. Based on a double market positive, we could see the S&P 500 into the 3120 area on a Fibonacci Extension level. Which may be long term troublesome.
China isn’t the only nation that is under US tariff fire in this trade war. Trump recently expressed his concerns with Europe in their “currency manipulation game and pumping money into their system in order to compete with the USA”. Should the Euro continue to weaken, due to dovish ECB monetary policy and continued expansion, Trump could very well slap tariffs on Europe. Mario Draghi recently announced the ECB has no clear indication of hiking rates in the near future. How can this affect the US and its economy? Well, Trump may pressure the Fed to cut rates to a more aggressive tone to balance out the devaluation of foreign currencies in relation to the dollar which would help the equity market rally as well… Artificially.
The SPY/GLD indicator
The ratio between the SPY and Gold is very interesting, especially how it has behaved recently. The SPY/GLD cross-correlation is supposed to hit new highs and trend in higher highs and higher lows should the equity market be considered a true bull. Which was the case, from August 2011 to September 2018, however that is no longer the case? Leading us to believe that the equity market has been artificially inflated. The reason we watch the correlation is that equities, in the SPY are fear assets while gold typically the inverse a politically-neutral monetary commodity is supposed to show signs of weakness in a bull market as we mentioned before. Seen below.
As seen below, the SPY prints all-time highs while the ratio stopped printing highs, and broke bull structure, discontinuing its higher highs and higher lows. Officially breaking the 7-year actual bull cycle in the equity market. Don’t take this is as the single indicator to start selling all the equities you can name, just consider it.
Where does that leave us with all of this analysis? The unprecedented all-time highs in the equity market may not seem that strong based on the underbelly of everything else going on. The Fed is about to switch to an expansionary monetary policy stance which will leave little room to save the economy and markets from a recession should that be the case. While global economic data and US economic data may be worrisome as growth slows. All of the asset classes rising simultaneously is unsustainable too, fear and greed assets are both getting inflows of capital which ends in a crash from either or. It’s too early to say, but there will be auto-regulation in one asset class or the other.
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