Janet's Kool-Aid Stand

From the November 10, 2015 HRA Journal: Issue 242

It’s all good.  Just ask Janet Yellen or any hawkish Federal Reserve board member.  Indeed, there have been some better readings on the US economy lately but things are far from outstanding. 

Plenty of equity traders suddenly expect new highs on the major markets any day now.  The bond market is pricing in 70%+ probability of a December rate hike.  This time around markets are not jittery because the Fed has assured us offshore problems won’t touch the US.  Let’s hope they are more right about that than they were four short months ago.

As noted in the editorial if this new narrative holds we’re back to the situation we were in early in the year in the metals markets.  Hoping the Fed just gets it over with so traders can stop obsessing over and shorting because of a potential rate hike.  As strong as the Dollar has been I remain a skeptic about the 120 USD Index predictions that are now common.  If that comes to pass it will obliterate the US manufacturing sector.  The equity rally is already a pretty narrow one.  More sectors generating negative earnings growth might be too much to bear.

One thing to look ahead to is tax loss selling season.  After that we may actually see inflation start to turn up as lower energy and material prices are fully reflected in year over year comparisons.  That could make real rates more negative again which would support metals prices. 


Major markets have continued to rally. All is forgiven and forgotten after the August Scare.  Best of all, well known economic prognosticator Janet Yellen assures us that everything is awesome.  What could possibly go wrong?

The rally and the “new” reasons for the rally are not good news for gold and most other metals—though they would ultimately help some base metals if the optimists are right this time. 

Sentiment in the gold market turned extremely negative very quickly and we are in the midst of a test of the $1180-1190 level. It’s too early to say whether that level will hold but its clear most traders don’t expect it to. 

An important aspect of the gold market has always been the “anti-Dollar” trade. Look at the USD chart below and it’s clear why gold’s bullish followers suddenly vaporized.  The combination of a hawkish sounding (they really mean it!) Fed talking about a December rate hike and a very strong October payroll report has the USD surging.  There are plenty of chartists around calling 120 targets on the USD Index.  I remain skeptical about that level of strength for reasons noted later in this editorial but a breakout is clearly in play.

We’re most of the way through earnings season.  For all the hoopla, this hasn’t been an outstanding one even outside the energy and materials space.  Lots of misses on the revenue side and it still looks like earnings will come in down three or four percent quarter-over-quarter.  Even that result took quite a bit of accounting magic to pull off.

The current rally is all about central bank speak. Comforting words from several central bankers have traders fully into “risk on” mode once again. 

Note that I consciously chose the term “words” not “deeds”.  I think the US Fed is the most serious.  The Fed board clearly took the message of the market seriously after the September meeting.  Yellen and Co have decided the price of waiting until 2016 is a complete loss of credibility.  I agree with that. 

The Fed has telegraphed this minor rate hike far too much to back down now.  With the strong payroll report we’d have to see some really awful economic metrics before the next meeting to forestall a hike. 

The Fed now feels potential market fallout from a small rate increase is smaller than the potential fallout from traders losing faith in central bankers.  That should have been obvious before the September meeting but it apparently took a shellacking from traders to get across.

Traders aren’t happy there is a probable rate hike in December. They’re happy about the reasons given to justify it.  The latest Fed rate decision removed all the negative language about offshore problems and their potential to impact the US.  It’s more than a bit strange all of that is suddenly not a problem.  While it’s easy to be cynical about central bankers its clear traders still hold them in higher esteem than they claim to.  No one questioned the sudden about face.

The damage done to commodities and gold wasn’t just based on the Fed.  It was the combination of the Fed all but promising a rate increase in December and promises of easing from other central banks. 

China’s central bank cut both interest rates and the bank reserve ratio again. Trade figures released since then were weak.  The Shanghai exchange is enjoying an impressive rally of its own, in part because traders assume we’ll see more and broader stimulus.

The Bank of Japan made no new promises but just about everyone expects an expansion of their QE program.  Japan’s Q3 GDP reading should be out shortly after this issue.   Based on a slew of weak economic readings there is a good chance that reading will be negative.   That means Japan has probably entered its umpteenth recession in the last decade or so.   QE doesn’t really seem to be working that well for the Bank of Japan but traders are convinced it will double down.

The final piece of the puzzle came from the ECB.  Mario Draghi didn't actually DO anything at the last ECB meeting but he promised to do lots.   Disappointing, though not terrible, readings from the core countries and continued lack of inflation has the central bank on edge.  Draghi promised an extended and expanded QE program and perhaps more if the inflation picture doesn’t improve by December.

Traders have gone all in on the “it’s all good” narrative suddenly emanating from the Fed.  Combined with good earnings from a few of the companies that account for most of the rally (think Amazon and Alphabet) has the S&P back to the top of its range and only a couple of percent off its record high.

The combination of strong dollar and faith in central banking has hit commodities again.   Expectation that virtually every central bank outside the US will increase stimulus added to the assumption that US growth may be quickening again has lit a fire under the USD.  How far will this trend go?

The charts above show the S&P and Value Line indices we’ve been tracking.  Like the last couple of times we looked at these to indexes together a considerable divergence remains.  It looks better than it did a month ago but relatively weak XVG shows the rally is still a narrow one.   This could still resolve in the favor of the S&P if the rally broadens.  It may do that if we see new S&P highs but the narrowness of the rally means it’s still prone to failure. 

The US will report retail sales for October a few days after this issue goes out.  A good gain in retail sales, say 0.4% or better, could be the final boost needed for new highs.  Conversely, a weak reading would call the growth rate for Q4 into question again.

Another red flag for equities is the stubborn refusal of bond traders to get fully on board.  The very long term chart below displays the Dow Jones average against Aaa bond yields.  There have only been a handful of times (about one per decade) when both equities and bonds sold off significantly together.  The most recent occurrence was last month.  Because bonds (at least government and highly rated corporates) are considered safe havens you tend to see yields drop as traders shift money into their perceived safety when the stock market is falling.  The reason why this doesn't happen occasionally isn’t well understood but the assumption is that bond traders are seeing increasing risk in corporate debt.

Bond traders have a good track record for seeing risks early.  That is borne out by the fact the DJIA dropped 10% or more within six months in every instance when the DJIA and bond indices saw large simultaneous selloffs.

This time could be different.  There’s very little “normal” about the cycle we’re in.  That said, it’s important to remember how central share buybacks and leveraged takeover transactions have been during the post 2009 rally.  They have provided a substantial percentage of the buying volume across the major markets.

Almost all that buying is debt funded.  The bond market’s willingness to let companies leverage their balance sheets provides much of the fuel for this bull market.  Equity traders can’t shrug off bond traders and expect to see the rally continue unless a new source of buying appears.

Near term prices for most metals will be tied to the USD.  With central bank divergence expected traders have gotten very bullish on the USD and I have seen several analysts targeting the 115-120 level.  Perhaps, but there are reasons to think things won’t go that far.

Short term the USD is very overbought which should lead to some easing.  Medium term, the high targets assume not only a Fed rate increase but significant easing by other central  banks, the ECB in particular (the Euro makes up more than 50% of the dollar index weighting). 

Draghi has certainly made promises, but so far they are only that.  Interest rates are already zero (or less) across the continent.  Draghi is hoping to bring down the Euro to help reverse deflationary forces. His dovish call and the Fed’s newfound backbone has already moved the Euro from $1.15 to $1.07 in a couple of weeks. 

A 115 to 120 level for the USD index implies a Euro well below parity, as low as 90 cents.  That’s possible but not likely unless the EU economy really falls apart.  Germany has put up some weak manufacturing numbers (like everywhere else) but there have been more positive than negative surprises in EU data.  Draghi and more hawkish ECB board members could well decide the Fed has done their work for them and stand pat.

At a more general level, a USD index above 110 means huge pain for the US manufacturing sector and more emerging market dislocations.  We could see a repeat of the issues that generated the August Scare.  The latest trade report from China was quite weak and the biggest negative surprise was exports.  The world biggest exporter reporting lower sales for the fourth month in a row says something.  The Fed needs to be proactive but I could see currency traders reversing the USD bullish move well below the levels targeted.

With a rate increase on the table we’ll just have to see how things play out.  I’m skeptical we see levels for the USD being targeted and wouldn’t underestimate the dangers to the market from renewed weakness in manufacturing and refusal (so far) of the bond market to play along.  Equity traders are overwhelmingly bullish again which should add a cautious note by itself.

Gold is already back near its July lows.  It won’t take much to push it lower.  Unless we see move higher of at least $40-50 (to start) assume lower lows are in play.   We’re back to the pre-July scenario of hoping the Fed just gets it over with. We may need that rate increase to put a bottom in on bullion.  In the meantime we are seeing more supply response from base metals, copper and zinc particularly.  That could breathe a bit of life into those sectors.

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