The Living Daylights
Out of the Bond Pit
In a week where markets started rocked by an over-inflated Italian crisis, interrupted by the closing of the NAFTA deal and excited by strong ADP and ISM, they finished rolling with an under-inflated NFP Report. In a bid to make our newsletters increasingly topical in the short and medium term, just like the market, we have shifted our focus back to the bond market away from Italy for now. As in 1987, it is all about Bond Hits and The Living Daylights (1987)
We had originally planned to explain why Italy could well provide a near term recovery in the euro and a catch up in the European stocks. But, notwithstanding any other topical distraction, Italy will be our subject next week not least because it fits neatly in with the current driver: the bond market. Following this week’s break up in yields and the market’s now almost obsession with bond market drivers, today’s newsletter highlights why this yield shift and in particular a weak NFP provides opportunity to rejoin the blowout in stocks, and fade some but not all USD pairs.
USDJPY and Oil have been moving (leading and lagging) in line with yields for weeks.
The break higher in US yields (attributed to the best ISM since 1997) and to a lesser extent other bond markets, resurrected two conflicting fears:
Firstly, the spectre of inflationary growth that has underpinned the stock uptrend and recent USD rally. This led the Fed Chair Jerome Powell this week to say the Fed may continue hiking rates past the neutral rate.
Secondly the consequent threat an excessive rise in yields could ironically pose to inflationary growth has been seen by some as a licence to kill the stock uptrend. Goldman Sachs interestingly warned around the February selloff that if yields rise by more than two standard deviations in a three month period, the three month stock-bond return correlation tended to flip positive or, more simply, stocks begin to selloff with bonds. The quantum of solace if you like. But they were right as the further rise in yields into February’s NFP triggered the sharp stock sell off.
Simply then, a rise in yield has and can be interpreted as either a spur or threat to stocks and the USD. ThIs conflict of opinion and indeed sentiment is important in both a current and historic sense particularly if we understand that both these views are correct—in succession. The overriding takeaway, or a view to a kill, from today’s newsletter is that the bond move, just like 1987, is driving a blowout in stocks and yields that will ultimately but later cause its reversal once it has gone too far.
COMPARISON WITH JANUARY – SKYFALL?
Many are citing the current break higher in yields as analogous to the break in January that prompted both USD to rally and the sharp 10%+ reversal in stocks on February. They are right to a certain extent.
Certainly the narrative is similar to January. Yet stocks didn’t reverse until 14 days after the break. And the Dollar only began its eight month 10% uptrend later and doesn’t compare well to the current mature uptrend that appears to be forming a consolidation top.
So, just a question of time until a stock market and USD top and then die another day? Well those who sold indices on the yield break following Trump’s election will have to wait until the full extent of a crash to break even. The market could shift dramatically in the interim—certainly if 1987 is our guide. The January break and reversal in our opinion is a dress rehearsal then for a later further yield and stock break and reversal along the lines of 1987.
COMPARISON WITH 1987 – YOU ONLY LIVE TWICE
As we have pointed out many times previously the bond market is the key driver behind a 1987 style inflationary growth stock uptrend that reversed because bond yields rose too far too quickly.
The current interaction with the 200-month moving average is interesting to say the least with respect to the stock market top and crash of 1987. But yield movements alone cannot and do not fully account for what is happening now to stocks and other markets. It is the interaction of asset classes and instruments that is important.
In contrast then, the price action of the last week provided a golden opportunity to rejoin the stock uptrend in near term and fade some currencies only against the fragmented correcting USD. But only if we timed it right. It requires a golden eye and a gold finger in a divergent correlation break down market which follows the bond market one day but not necessarily the next.The markets may have appeared to be following January-February 2018 last week.
Our hunch then that NFP would provide a fakeout break down and opportunity to buy stocks and EURUSD has proved valid so far. But it’s the next few days and weeks that will confirm whether the blowout and USD divergence will continue into November—or until the vast majority cite the bond for why tomorrow never dies.
“Why is it that people who can’t take advice always insist on giving it?” (Casino Royale). This may seem like a Casino Royale but we remain convinced we are heading for extremes higher before lower. The Bond 25 production will start in December when we think the living daylights will be shaken out of the markets in a thunderball.
Our reason? Never say never again. History is repeating itself.
“Sometimes the old ways are the best.” (Skyfall). But it is clear, to us at least, that stocks and yields will only die another day. Until they are shaken not stirred or each quantum of solace starts to fall, like it was this week, we will continue to monitor the key bond-stock relationship—for your eyes only.
Here’s to beating THE LIVING DAYLIGHTS out of this market. Did I mention the year that movie was released?
My name’s, Matts, Ed Matts