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As expected, the Fed’s ‘extended’ easy money meant trends ‘extended’ as well, as even govvies rallied in the face of an extension of the up trend in equities. And as far as the govvies go, this has happened before, and there is even more reason to allow that they can rally along with equities this time. This has been part classic govvies ‘hostage to fortune’ rally (i.e. anticipation of equities stalling out into a downside correction) and part yield curve comfort now that the FOMC and Mr. Bernanke have signaled no risk of a rate hike for at least four months.
While that doesn’t make the govvies a bull market, it allows for near-term buoyancy. But it comes with a lot of risk. In a nutshell, we see attempts to monetize the annualized yield spread between Federal Funds and the 10-year T-note as a fool’s game. Accepting a 75 basis point nominal profit per quarter for holding longer dated govvies is pretty reckless. That’s on two fronts. In the first instance, the major bullish cycle in govvies which proved so tenacious and more robust than most people might’ve imagined across many years has very likely reversed into a major bearish part of the cycle.
Those owning the ‘flattening’ trade (i.e. long the long-end on short-money borrowing) are risking that the primary trend might hit them at any time; even if there is zero chance for a Fed rate hike. Let’s face it, if any strong equities activity should foment near term weakness in govvies, an immediate loss of quite a bit more than potential earnings on the trade for a full quarter could occur at any time.
That said, there is nothing wrong with owning a bear market for a limited potential, as long as that is also for a limited amount of time. Yet, any profits in this case are more likely to be related to the equities and govvies returning to more classical counter-trend activity from their recent mutual rally. And there are good reasons that is likely to occur fairly soon; either for better or worse in each asset class.
The psychology behind these sporadic govvies ‘hostage to fortune’ rallies is worth reviewing. Rather than simply an academic exercise, as in previous seasonal phases this may also be critical to near-term trend analysis. This is due to the divergent focus of the govvies and the equities. Except under the worst of economic conditions, earnings season is a classically buoyant time for equities. Previous quarterly corporate performance may be a ‘rearview mirror’ indication, but typically better than expected figures still have the power to drive the equities.
The extra benefit in this quarter is the upbeat guidance based upon better overall economic expectations by corporate executives, reinforced by successive previous quarters’ outperformance. That shows up in higher corporate borrowings from banks, even though consumer borrowing for things like mortgages remains very weak. Of course, that latter bit flies in the face of the upbeat corporate expectations.
As such, equities are rallying on anticipation as much as the sheer positive previous results. Govvies on the other hand are more focused on real world implications of underlying economic data trends. US housing is in a definitive double dip that already includes new lows in quite a few markets, employment is still spotty to weak (witness last week’s Initial Jobless Claims and today’s ADP figures), and energy and commodity prices are weighing heavily on consumers’ future ability to engage in expansive discretionary spending.
They are also raising input and transportation costs for most businesses. Hence, there is some rational foundation for govvies to suspect equities will have more headwinds than previous. The question ultimately becomes which of these divergent expectations dominates as earnings season comes to an end? As that is going to occur into the middle of this month, it will become more important to assess current economic data and market responses once again. Any further weakness in the data on top of today’s weakish developed country Services PMI’s will be more important, both as an extension of recent soft figures, and the factor which might finally cause the equities to stall and reverse.
In spite of the commodity boom and weak US dollar being good for some of the very large multinationals (glaringly obvious in DJIA upside leadership), there is a point of diminishing returns. That is all part of the moderately perverse perspective on why the govvies have been able to counterintuitively rally along with commodities: the prospect that all those higher input costs will slow rather than spur the developed economies. If the Fed’s easy money policy were occurring into a robust employment situation with rising wages, a case could be made for demand-pull inflation. But in the current weak jobs and wages context, it is more likely companies will run into price resistance that significantly crimps profit margins.
Extended Market Implications (as of 09:30 CDT Wednesday)
As noted in our recent regular market analyses, even the initial impact of the Bin Laden news only took the June S&P 500 future up to its next (and fairly critical) resistance in the 1,365-70 area on Monday. And while it has now fallen back fairly significantly from that major resistance range, it had run up so quickly that the drop so far is only a correction. As noted last week, on anticipation of the friendly Fed, the June S&P 500 future signaled an UP Break on its push above the top end of 1327-34. Only a Close back below that area (and ultimately that means a weekly Close) would signal the sort of failure that might lead to a larger correction; or possibly the beginning of a return to a much more bearish phase.
That works hand in glove with the fact that upside leader June T-note future has pushed not only back through resistance at 120-08/-16 and is now trading above 121-08/-16. Yet it is still only up approximately 1/4 point on the day in spite of equities further slippage. It would seem that any escape from the more prominent 122-00 area resistance will likely require that more significant failure in the equities discussed above.
As to the other markets, it is most interesting that commodities are weakening along with equities; seeming to point to an overall economic weakening mentality. While here as well is likely takes the further equities failure to reinforce the current weakness, current signs are telling. June Crude Oil is finally back below lower support (at the recently overrun topping action) in the 111.04-110.30 range. That might be worth the drop back to the 106-105 area. June Gold future which ran up so quickly in its attempt to overrun the 1,550-60 area resistance on Monday is right back down to the top of the critical 1,520-30 Negated resistance knocked out so easily last week.
And of particular note, nothing seems to help the US Dollar Index, as it fades back below the most recent test of the interim .7325-00 area. Of course, that remains a minor way station after it had already dropped below the .7417 major November 2009 low. Not a major surprise that finalization of the Portuguese bailout has elevated the euro nearer to important resistances at EUR/USD 1.5000 and 1.5147 (its major November 2009 high) while weighing on the German Bund.
Thanks for your interest.