Jitters

From the HRA Journal: Issue 294

Yes, this issue is late, as have been a few others in the past few months. Please note my comments in the Update section introduction on page five where I detail my plan to address that issue.

We've got a more nervous market suddenly, which has been putting a bid under the gold price. Its too early to say how this will pan out, but the movement in yields we've seen in the past few weeks looks more and more like a major secular story, not a blip. Wall St is still, sort of, relaxed, but we shouldn't be. I don't think traders there can handle much more rate uncertainly and I think they are going to get it. Things could be choppy on Wall St for a while and the odds of a larger correction are high.

I don't love fear buying as a reason for gold to go up, but I'll take it. Several juniors are trading better than the big board stocks as more traders come to expect another leg up in gold prices. I think the jury is still out on that, but I do like the odds.

Base metals have hung in, as I suggested they might in the last issue. Barring a real economic slowdown I expect more positive action from base metals. I will discuss the favourable market structure for most base metals in the next issue. We did get some good news from a few names and the results are starting to flow more quickly again so there should be more on the way soon.

Eric Coffin
October 19, 2018


October is living up to its uneasy reputation in the equity markets. We just went through the worst two weeks on Wall St since February. In the greater scheme of things, a 6% pullback isn't that big a deal. Even so, its important to understand what caused it and whether its just a blip or the early stages of something more serious.

The chart below is an updated version of one you've seen from me many times, but its important. There is a constant interplay between equity and debt markets. Investors views on bonds versus stocks dominate money flows between the two markets.

Wall St. continues to be a very bullish place, but many are getting concerned about how markets will act under higher bond yields. After ten years of suppressed interest rates, everyone knows those near zero rates were a major underpinning for the stock market.

Earnings have been good too, but not good enough in many sectors to explain the elevated prices of so many stocks. Cheap money was a major, some would argue THE major, reasons the market kept elevating.

No one knew for sure what level of bond yields would start spooking traders, though many suspected they didn't need to go much higher.

We got our answer this month, or part of it. The 10-year yield climbed to 3.25% and the market was not pleased. There is nothing magical about the 3.25% level. It was traders reacting to the combination of high valuations, concerns that trade wars, etc., might start impacting earnings AND the yield increase that drove things.

Markets can certainly increase at the same time as bond yields. They do it all the time. But we need sufficient economic and earnings growth to overcome yield increases for it to work.

Some flight to safety buying in the bond market knocked yields back, but only slightly. You can see the dip at the end of the one-year chart above. That calmed traders slightly but it may only be a temporary respite.

The bigger question is whether we have finally turned the corner and left the low yield environment behind. That's where the chart below comes in.

The chart below is also ten year yields in US Treasuries, but this one spans 37 years, with monthly bars. That's all the way back to when Paul Volcker wrestled inflation to the ground by pushing the Fed Funds Rate to 20%.

The drop in yields shown in this chart is a major, historic, secular trend. Keeping in mind that bond prices move in the opposite direction to yields, you're looking at one of the longest and strongest bull markets in history. And, make no mistake, that bull market has been a major underpinning for equities, real estate and just about any other risk asset you can name, notwithstanding a couple of stock market crashes along the way.

The "end of the Great Bond Bull Market" has been called before by some very high profile investors and commentators. Equity and bond market bulls have made light of some of these calls because there hasn't been a big inflation move yet. It increasingly looks like those bond bears did, in fact, call the bottom on yields, they just haven't moved that far yet.

The chart above shows yields have now risen to meet the descending 200-month moving average. This comes after a double bottom that was four years in the making.

10-year yields have never broken above the 200-month moving average since the bond bull market began 37 years ago. It's hard to overstate the potential significance of this move. This looks like a secular change, not a cyclical one.

Assuming yields break through the 200-mma and hold their gains, which seems inevitable, the markets could become a very different place going forward. I would expect it to be a more volatile and choppy market. Stocks and bonds may play off against each other more forcefully than they have in the past 30+ years. And, a constant support for the market that most Wall St traders have never been without will be gone.

The world economy can survive higher rates. It's done it plenty of times before. There is currently no reason to expect a violent move in rates, though there could be periods of heavy selling in the bond market if the move through the 200-mma triggers technical sell signals.

With the cost of capital continuing to move higher, it will be tougher and tougher to justify borrowing for share buy backs capital investments. Buy backs have been another major tailwind for large cap stocks. If rates keep moving higher, its also going to play havoc with government budgets across the G20.

The markets got a bit of a save when US CPI readings, again, came in on the low side. This seemed to be the driver for a bullish reversal in the gold market. Gold bulls haven't bee pleased to see bullion trading down to the $1180s but, the truth is, gold held up quite well so far in the face of rising yields.

The CPI "miss" was followed by more weak data in the form of the US Retail Sales number for September that came in significantly below consensus. September month over month retail sales reported 0.1% growth in core retail sales, rather than the 0.4% expected, and with the August number also revised lower. That said, the "Control Group" retail sales growth was better at 0.4%. That is the number used in calculations of GDP growth, so it wasn't all bad news.

The retail sales number helped gold have another green day in the market, completely lifting the price out of the trough its occupied since early August. That was particularly significant as weaker economic readings in the past few days have not done much to bring bond yields down.

Gold and bond yields moving together is a fairly unusual event. Some of the buying in the gold market might be traders assuming weaker inflation and sales numbers mean the US Fed is less likely to raise rates. That doesn't jibe with the rise in market yields, though.

I don't think it jibes with reality either. I would still put the odds of the US Fed raising rates in December at close to 100%. Continued or greater weakening in US economic readings might slow the Fed down, but it will take really negative numbers to do it.

The tightening cycle, so far, is more about normalizing rates so the Fed has ammunition for the next downturn than anything else. If equities dropped enough to start impacting consumption, and it would take a bear market for that, we might see the Fed reverse course. I certainly wouldn't count on them doing it just because the S&P is a few percent off its highs.

So why isn't the gold price getting killed (more)? Real rates are rising, bond yields appear to be breaking out of a multi-decade downtrend. Shouldn't gold be falling harder, not bouncing?

I think a big part of the change, so far at least, is a shift to a higher risk environment. Maybe the recent drop on Wall St turns out to be just another downward blip that doesn't amount to anything. Perhaps, but you sense that traders are not so sure this time. I think few literally expect a crash, but a secular change in yields will definitely lift the risk level on Wall St.

In addition to rate risk, there are a host of other things that are weighing on traders, like the potential for a debt blow up in Italy and a trade war with China that shows no signs of cooling, whether Brexit gets settled and upcoming mid-term elections in the US. There's no shortage of things to worry about if you're determined to.

And even if none of the above bothers you, there's the fact that the Wall St bull market is so long in the tooth. Assuming a higher level of turbulence going forward seems like common sense. I don't think many believe we're in the last inning of the game right now but pretty much everyone agrees it's the late innings.

Forward looking surveys that try to spot recessions before they arrive are still fairly benign, but not as positive as they were even a couple of months ago. A recession in 6-12 months is still unlikely, but several proprietary surveys are putting the odds at 25-35% now, rather than the <10% likelihood of recession estimated during the summer.

A growing hesitancy about future growth rates in the US, further clouded by the trade war with China, is probably giving the gold price an assist as well.

Even though there as been an important move up in market yields, we haven't seen that move fully feed through to the US Dollar. Currency cross rates are largely determined by a combination of the relative levels of real interest rates and perceived relative future growth rates between two currency blocks.

Real rates continue to rise in the US which should lift the USD further. The fact the USD can't seem to break out above the level it was trading at when 10-year yields were below 3% makes me think the market may be downgrading its estimates of future US growth, at least unofficially.

What gold bounce we've had then, is a combination of fear and short covering. I don't like fear as a reason for price moves; it's too fickle. It will work as a reason if Wall St starts dropping again, though.

A currency realignment still looks like our best bet for a sustained rally in gold prices from here. I think only a small percentage of the huge short position in gold has been covered. There is still fuel for a large rally if gold can claw its way $10-20 higher.

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