How to Stop a (Non) Inflationary Bubble
How Rate Rises are Driving all Markets
This week saw Fed raise rates to a ten year high of 2.25%.
It was widely expected. In isolation it is easy both to over and under-estimate the significance of this event and price movements throughout the week. US 10-year yields spent their first week entirely over 3% for over seven years. SPX finished and posted its best Q2 since 2013 adding 7.3% during the summer. The Nikkei also made a new 27-year high after a summer of JPY weakness, and Italian bond yields hit five-year highs, on a populist free-spending budget. Ground breaking markets possibly, but they reacted in the same way they almost always do after a US rate hike.
But these short term price movements or a further 25bp rise shed little light on what is really happening and in particular to the interaction of different markets that will drive the next three to 12 months.
Fed tightening holds the key not just to the US economy, stocks, yield and Dollar but, as the vanguard of the global economy and cycle, it is significant to other economies and the interaction of other markets. In today’s newsletter we seek to explain the importance and impact of this hike from a FITS (fundamental, intermarket technical and sentiment) perspective.
The Fed is raising rates in a bid to move an easy (75bps below neutral) to restrictive monetary policy (as reflected by the removal of the word ‘accommodative’) . The reason is that data continues to suggests that spending, earnings, economic growth will continue to rise faster than capacity and therefore risking inflation that will ultimately undermine them. This potential overheating and policy response has a varied and disproportionate effect within and outside the US.
The most important impact domestically and on US indices generally is the effect rising interest rates has on the interrelationship between stock prices and earnings. Continued hikes will ultimately stop the growing divergence between expectations and actual corporate profits that clearly underpin any stock uptrend.
The overheating and current over-anticipation of future profits is clearly benefiting revenue growth stocks in the technology sector (NDX) but the response of rising rates helps financials and partly explains our view of a DJIA catch up in a monetary driven market if an where trade issues abate. But the overheating and scale of response is not yet happening to the same extent elsewhere and leads to increasing divergence between various economies and reflective instruments. The Dollar’s rally and DAX underperformance can be attributed to this divergence.
The same situation prevailed in 1929 and 1987 for 12 months after an inflationary tax cut before the famous stock market crashes. (Incidentally suggesting an October-November stock market top and December- January Crash) The divergence also helped underscore the international tension that led to the similar trade wars of that period that further exaggerated the correlation break down between tariff beneficiaries and victims. To the point when, two days before the 1987 crash….
Words that panicked the market not just because it was a further deterioration in international relations but marked an end to a decline in real interest rates.
It also threatened to destroy an already fragmented market structure. If one took the analogy possibly to an extreme, waiting for such an escalation to hit stock market or Dollar bids could make one trigger happy in a world of Donald Trump tweets. But monitoring the interaction of interest rate driven markets at the same time, will hopefully help timing.
Two years ago we projected the break down in market correlations as a necessary and sufficient condition for the final blowout in stocks and yields before a crash in both stocks and the Dollar. A lack of breadth that is caused by the fundamentals no longer driving all markets and exaggerated by the uneven impact of rate rises. Possibly great insight but believing the market will be all over the place doesn’t necessarily help trade it.
Knowing that correlations appear to break down in the same time frame but actually continue with lags does sometimes help. The Nikkei’s 24 hour lead of DAX this week tipped the post hike expansion. The gyrations in Oil help explain why USDJPY appears to be leading USDCAD in a yield driven play to the upside. But trying to use the clearest of the three US indices we follow closely (NDX, SPX, DJIA) to trade the others is fraught with difficulty due to extreme day by day rotation.
Knowing that a general mistrust in current valuations will lead then to money flowing in and out of instruments at in the short term may help conceptually devise a similar trading strategy.
But it doesn’t necessarily help pick which instruments at which time nor the maturity of the general trend. With one major exception one of our major projections is that after SPX and DJIA finish their current blowout and have marked out the first leg lower, the subsequent upside correction and selling opportunity takes NDX to an all time and final new high. Given that the eventual stock market fall out will hit NDX and FANGs most, and last highlights the importance of still buying tech dips in the interim and leveraging the final technical divergence.
Technical sequencing holds the key to the break down in intermarket before they come back together in a crash.
John Murphy’s excellent book Intermarket Analysis is an accurate description of the interaction between asset classes in the run up to the 1987 stock market top and crash and also what is happening now.
But it is a technical account that firstly glosses over some of the reasons and possible exceptions or variations that may help or hinder now. And secondly it did not explain some of the interrelationships between members of the asset classes that we believe could be instrumental.
We have already covered the DAX-SPX spread that reflects trade war tensions and DAX’s attempt to catch up into a crash..
Given the extreme rotation between US indices alone there are clues how spreads and notable stocks should perform over the coming works and will be covered in part in next week’s technical aspects of bubbles.
USDJPY remains the key currency pair in that it reflects risk appetite/aversion, rate rises and yield (or inflation differentials). In 1987 and now it led both the USD and stocks higher in time if not distance, and turned first until it joined all other markets in a crash. In this respect the link to US 10 year yields is important.
Since it is the relationship between corporate earnings and stock prices that will ultimately turn the market due to the impact of interest rate rises and their effect on inflation, the key chart in our opinion to riding a bull market into a top and crash is the SPX/US10Y (US 10-year yields)
There are also clues in the currency markets that reflect a break down in correction from an interest rate driven stock market blowout into risk aversion. We have previously highlighted how in 1987 USDJPY led and is leading the Dollar in the blowout USD rally that actually preceded the stock market. So too now USDJPY remains the key currency pair in that it reflects risk appetite/aversion, rate rises and yield (or inflation differentials). In 1987 and now it led both the USD and stocks higher in time if not distance and turned first until it joined all other markets in a crash. In this respect the link to US 10 year yields is important. Although sideways price action in yields allows a recovery in the USDJPY/US10Y spread it is the later break down to a further new low that marks the top in the stock market. Clues also come from other non USD pairs. CADJPY should remain stable until a further new low also highlights an imminent crash.
Although this has done pretty much everything it needed to satisfy the stock market uptrend, the simple fact the SPX/US10Y top so far has not coincided with a top in the stock market suggests the spread and therefore stocks has further to go.
Sentiment and how it impacts positions is possibly the answer to everything. If we could nail sentiment accurately then there is arguably no need for fundamental, technical or intermarket analysis. Moreover sentiment analysis of intermarket relationships at this juncture is almost pointless in two respects. Firstly, correlation break down is so extreme that an accurate reading of the market’s view today of how interest rates are driving stocks, dollar, yields or commodities could be made redundant tomorrow by a Trump or Xi tariff announcement. And yet secondly as markets come back together in the very last stages of the stock bullmarket so sentiment refocuses on the key instrument: stocks and yields and the need to be long—and wrong.
Here’s to making the very best.
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