Category: Fixed Income

Treasury, municipal and corporate bonds

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China sizzle turns to fizzle

China’s announcement of economic stimulus and hints at an even larger “bazooka” ahead caused a sizzling rally on the Shanghai exchange, with the CSI 300 leaping 20% in the last week of September.

Shanghai Shenzhen CSI 300 Index

Hong Kong’s Hang Seng Index displays an even steeper rally.

Hang Seng Index

However, a failure to follow through this week with sufficient detail of the stimulus package caused the rally to fizzle, with a sharp correction on both indices. Today, the Hang Seng is testing support at 20500.

China Stimulus

Crude Oil

Brent crude reversed sharply as prospects faded for a demand recovery in China.

Brent Crude

Treasury Markets

Ten-year Treasury yields stalled and will likely re-test new support at 4.0%.

10-Year Treasury Yield

According to the theory of interest developed by Swedish economist Knut Wicksell, the equilibrium or natural rate of interest—at which inflationary and deflationary pressures are in balance—is when the cost of borrowing is higher than the average return on new investment. This means that the 10-year Treasury yield–the risk-free rate–should be roughly equal to nominal GDP growth, approximating the return on new investment. The chart below shows that the 10-year Treasury yield, at 4.0%, is significantly lower than nominal GDP growth of 5.7% for the 12 months ended in Q2.

Wicksell Analysis: Nominal GDP Growth & 10-Year Treasury Yield

With the economy showing little sign of slowing, the likely outcome is either higher long-term interest rates or a build-up of long-term inflationary pressure.

Stocks

The S&P 500 gained almost 1.0% on Tuesday, with a shallow retracement and rising Trend Index troughs signaling buying pressure.

S&P 500

Nvidia led the advance of mega-cap stocks, breaking above its August high, while all seven advanced yesterday.

Top 7 Technology Stocks

The equal-weighted index lagged as large caps failed to match mega-cap gains.

S&P 500 Equal-Weighted Index

Financial Markets

Bitcoin continues to test the upper border of its trend channel. A breakout would be a bullish sign for financial market liquidity.

Bitcoin (BTC)

Dollar & Gold

The Dollar Index is expected to retrace to test new support at 102. Respect would confirm an advance to 104.

Dollar Index

Gold is headed for a test of support at $2,600 per ounce, but respect will likely confirm a re-test of $2,700.

Spot Gold

Silver is testing support at $30 per ounce, with respect again likely to signal a re-test of resistance at $32.

Spot Silver

Metals

Copper retreated in response to China’s disappointing stimulus. Expect a correction to test support at $9,250 per tonne.

Copper

Iron ore also reflects disappointment, retreating to $106.30 per tonne.

Iron Ore

Conclusion

A disappointing lack of detail on China’s newly announced stimulus led to a retreat in Chinese stocks and global crude oil, copper, and iron ore.

Ten-year Treasury yields are expected to retrace to test support at 4.0%. While yields are likely to remain low as the Fed cuts interest rates, the long-term equilibrium rate is expected to be higher—between 5% and 6%.

Respect of support at 5650 on the S&P 500 confirms our year-end target of 6000, but the advance is exceedingly narrow and precarious.

Gold is headed testing support at $2,600 per ounce, but respect is likely and would signal a re-test of $2,700.

Acknowledgments

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Harley Bassman | The MOVE Index

The MOVE Index has jumped to the fore as the best measure of financial market volatility. While the VIX measures volatility in equity markets, the equivalent MOVE Index measures volatility in the far larger bond market which as a better track record as a leading indicator of the economy. Here are some quotes from MOVE creator Harley Bassman that explain how the MOVE works:

The MOVE and the VIX are very similar in that they basically measure short dated one month volatility. The key thing is that these indices are mostly coincident indicators as opposed to forward looking, because they tend to track realized volatility……

When you have a very steep [yield] curve, so a two year of, call it two, and a 10 year of four, that creates a forward rate that’s much higher than today.

When we get that, the steeper the curve or the more inverted, the bigger the distance between today’s interest rates and tomorrow’s interest rate. Time only goes one way. So the future becomes the present, which means that forward rate got to come to the spot, today’s price, or today’s spot price has to go up to the future price. The bigger the distance, the bigger the spread, the more movement there has to be, and therefore the more uncertainty you have; and the price of uncertainty is implied volatility. (ICE.com)

MOVE Index

As the creator of this Index, let me say that both 50 and 150 are the “wrong number”. A level near 50 can only occur when the FED actively constrains risk, while a level near 150 occurs when the FED has lost control. The MOVE at 150 infers interest rate changes of about 9.5bps per day, a volatility that is unsustainable if only because human beings cannot tolerate such stress for long periods of time. (ConvexityMavens.com)

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The bond market revolt

The rise in Treasury yields accelerated over the past week, with 10-year Treasuries closing at 1.54% on Thursday and 10-year TIPS at -0.60.

10-Year TIPS & Treasury Yields

A sharp fall in daily new COVID-19 cases has fueled optimism about a rapid re-opening of the US economy.

USA: Daily New COVID-19 Cases

As well as fears of higher inflation.

10-Year Breakeven Inflation Rate

What the sell-off means

Investors are selling Treasuries at a faster rate than the Fed (and banks) are buying, out of fear of accelerating capital losses. Fixed coupons have been badly affected, with iShares 20Year+ Treasury Bond ETF (TLT) showing a loss of 13% over the past 6 months. But even inflation-protected bonds have lost value in anticipation of higher real interest rates, with PIMCO’s 15 Year+ TIPS Bond ETF (LTPZ) falling more than 6%.

20 Year+ Treasury Bond ETF (TLT) & 15 Year+ TIPS Bond ETF

The Fed response

The Fed is likely to respond by weighting purchases towards longer maturities. The 10-year Treasury yield has already started to anticipate this, falling to 1.39% by Friday’s close.

10-Year Treasury Yields

Source: CNBC

The result is a 16 bps fall in the real 10-year yield, to -0.76% on Friday (1.39-2.15).

Conclusion

Fed purchases are expected to suppress long-term Treasury yields over the next few months, with inflation breakeven rates continuing their upward trend, while real yields remain negative.

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Gold, low interest rates and volatile currencies

Gold is in a primary up-trend, after ranging sideways for several years, fueled by low interest rates and volatile currency markets.

The chart below highlights the inverse relationship between gold and 10-year Treasury yields. When LT interest rates fall, the gold price surges.

Spot Gold in USD compared to Real 10-Year Treasury Yields

At present, 10-year Treasury yields are close to record lows, testing long-term support at 1.50%.

10-Year Treasury Yields

Yields in Germany and Japan are much lower, having crossed below zero, and the opportunity cost of holding physical assets such as Gold is at record lows.

Negative Bond Yields in Germany & Japan

Volatility in currency markets is another factor driving demand for Gold.

China’s Yuan is testing support at 13.95 US cents. Breach is likely, especially if US-China trade talks break down again, and would signal continuation of the primary down-trend. A weak Yuan fuels Chinese demand for Gold.

CNYUSD

The Dollar Index continues to edge higher, boosted by the current trade turmoil. A strong Dollar is likely to weaken demand for Gold but Trend Index peaks below zero warn of selling pressure.

Dollar Index

Gold is testing support at $1495/ounce. Breach would warn of a correction, while breakout above the descending trendline would indicate another advance.

Spot Gold in USD

Silver is similarly testing support. Breach of $17.50/ounce would warn of a correction.

Spot Silver in USD

The All Ordinaries Gold Index is trending lower. Breach of 7200 would warn of another decline, with a short-term target of 6500, while recovery above 8000 would suggest another advance.

All Ordinaries Gold Index

Patience is required. Gold is in a long-term up-trend, with a target of the 2012 high at $1800/ounce. A correction would offer an attractive entry point.

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S&P 500: Donald Trump and the next recession

Treasury yields continue to fall, with the 10-Year testing long-term lows at 1.50%. A sign that investors are growing increasingly risk averse.

10-Year Treasury Yields

Crude oil prices remain weak; a bearish signal for the global economy. Breach of support at $50/$51 per barrel would warn of a decline to $40.

Nymex Light Crude

Volatility (21-Day) above 1.0% on the S&P 500 is flashing an amber warning. Breakout above 2940 is likely and would signal another test of 3000. But expect stubborn resistance at our 3000 target level.

S&P 500 Volatility

Bearish divergence (13-Trend Index) on the Nasdaq 100 warns of secondary selling pressure. Breach of 7400 would warn of a test of primary support at 7000.

Nasdaq 100

Robert Shiller maintains that Donald Trump is unlikely to survive a recession:

“So far, with his flashy lifestyle, the US president has been a resounding inspiration to many consumers and investors. But his personal narrative is unlikely to survive an economic downturn….the end of confidence in Trump’s narrative is likely to be associated with a recession.

During a recession, people pull back and reassess their views. Consumers spend less, avoiding purchases that can be postponed: a new car, home renovations, and expensive vacations. Businesses spend less on new factories and equipment, and put off hiring. They don’t have to explain their ultimate reasons for doing this. Their gut feelings and emotions can be enough.”

I would go further and argue that Trump’s management style is likely to cause a recession.

Some of the aims the President is attempting, like addressing China’s unfair trade practices, are vitally important to long-term US interests and he should be given credit for tackling them. But his constant hyperbole, erratic behavior, with a constant mix of bouquets and brickbats, and on-again-off-again tactics, has elevated global uncertainty. Consumers are likely to increase savings and cut back on expenditure, while corporations may cut back on hiring and new investment, which could tip the economy into recession.

GDP growth contracted to 2.3% in the second quarter, while growth in hours worked contracted to 0.92% for the year ended July 2019, pointing to further falls in GDP growth for the third quarter.

Real GDP and Hours Worked

August employment figures are due for release next week and will either confirm or allay our fears.

We maintain our bearish outlook and have reduced equity exposure for international stocks to 40% of portfolio value.

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Gold: Every cloud has a Silver lining

Long-term interest rates are declining after more dovish speeches from the Fed, with 10-year Treasury yields re-testing support at 2.0%. The opportunity cost of holding gold is low.

10-Year Treasury Yields

The Dollar Index is likely to weaken, testing primary support at 95. A weakening Dollar boosts demand for Gold.

Dollar Index

A big gain in Silver this week is likely to be followed by a similar move in Gold. The two precious metals tend to move in unison. Breakout above $16.00/ounce signals an advance to $17.50.

Spot Silver in USD

Gold is consolidating above short-term support at $1400 after a strong advance, indicating buying pressure. Another advance is likely, with a medium-term target of $1500/ounce.

Spot Gold in USD

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Gold buying pressure

Long-term interest rates close to zero after inflation, with 10-year Treasury yields testing support at 2.0%, means that the opportunity cost of holding gold is minimal.

10-Year Treasury Yields

A weakening Dollar Index is expected to test primary support at 95, further boosting demand for Gold.

Dollar Index

Gold found short-term support at $1400 after a strong advance, indicating buying pressure. Respect of support at $1350/$1400 would offer a medium-term target of $1500/ounce.

Spot Gold in USD

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Gold lifted by rising Treasuries and falling Dollar

10-Year Treasury yields are testing LT support at 2.00% after falling 120 basis points (bps) since late last year.

10-Year Treasury Yield

Rising global uncertainty has caused a massive outflow from equity funds into bonds.

The Dollar Index penetrated its rising trendline, warning of a correction to test 95.

Dollar Index

Demand for Gold is boosted by lower bond yields and a lower Dollar. Spot Gold breakout above resistance at $1350 would signal a fresh advance, offering a medium-term target of $1500/ounce (short-term: $1400).

Spot Gold in USD

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Gold retreats as the Dollar strengthens

China’s Yuan fell sharply against the Dollar on imposition of tariffs by the US. Expect a test of primary support.

Chinese Yuan/US Dollar

The Dollar index strengthened. Follow-through above 98 would signal a fresh advance. The long-term target is 100.

Dollar Index

10-Year Treasury yields are testing support at 2.40%. Breach would offer a target of 2.20%. Rate hikes are a distant memory.

10-Year Treasury Yield

Gold continues to test medium-term support at $1280/ounce. The tall shadow on this week’s candle warns of selling pressure; as does the Trend Index peak at zero. Breach of support would signal a test of primary support.

Spot Gold in USD

Silver continues to fall, heading for a test of primary support at $14. Declining Trend Index peaks indicate selling pressure.

Spot Silver in USD

Gold is likely to follow.

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Silver leads Gold lower but safe haven demand rising

Silver has broken support at $15/ounce, warning of a test of primary support at $14. Declining Trend Index peaks indicate selling pressure.

Spot Silver in USD

Gold continues to test medium-term support at $1280/ounce. Precious metals tend to move together and Gold is expected to follow Silver in a test of primary support ($1180 for Gold).

Spot Gold in USD

The Dollar index, however, retreated below its new support level at 97.50. Penetration of the rising trendline would warn of a correction.

Dollar Index

China’s Yuan fell sharply against the Dollar as trade talks encountered major turbulence. The outlook for a trade deal now looks poor.

Chinese Yuan/US Dollar

10-Year Treasury yields are also falling as the prospect of further Fed rate hikes dims. Trend Index peaks below zero warn of strong demand for Treasuries (downward pressure on yields).

10-Year Treasury Yield

Failure to ink a trade deal is likely to boost demand for safe haven assets like the Dollar, Yen, Gold and US Treasuries. Capital flight from China may accelerate.

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