That poor can gets kicked again
Last week, Janet blinked first – and reverted to her usual dove impersonation. But as I mentioned last time, whatever the Fed does or doesn’t do, it is powerless in the face of the deflationary forces sweeping the globe.
Not to be left out of the can kicking theme, Japan has put off a planned sales tax increase and has kept its QE programme alive.
And Draghi continues to keep his finger on the BUY button and is sweeping up corporate bonds now because he has run out of decent sovereign bonds to enrich the front-runners. It is a game of guess which corporate bond is on his shopping list for hedge fund trading desks. Actually, I do not believe they need to guess – for pretty obvious reasons.
Yet one more clue that the next deflationary wave approaches is the behaviour of the Chinese currency which is being deliberately weakened by the authorities in the race to the bottom. They have pledged to return the yuan gradually to a free-floating currency from the dirty peg to the dollar it seems to be at present.
This is a chart of the offshore dollar/yuan which is traded mostly in Hong Kong. but follows closely the onshore currency:
Because China has become the manufacturer to the world, a weakening yuan translates into downward price pressure on importers – and is why the trend of US import prices remains down. And with very fierce retail price competition in the West due to an oversupply of goods, company earnings are also under pressure and are actually falling.
In my last blogpost I showed a chart of the PPI of the three main trading blocs, USA, EZ and Japan. It showed a clear downward trend in negative territory in all three – and a continued weakness in the yuan will only exacerbate this trend. As S&P company earnings continue to decline, as they are, this will place irresistible pressure on stock markets, which are priced for continued Fed ‘stimulus’.
Back to the above chart and note that the yuan was strengthening in the January – May period while it was weakening between November – January. Here is a chart of the Dow in those two periods
Is this a coincidence? I don’t think so, given the deflationary forces at work.
But interest rates still hold the key
The Fed is caught in a bind. At times, it says it wants to start raising the Fed Funds rate (such as last December with a promise of four rises this year) and several members still do. At other times, it is clearly under pressure to lower them even further to ‘stimulate’ the economy and raise inflation. Their waffling is a sure sign they know they are losing control (if they even had any in the first place).
But with gold/silver and also crude oil in strong rally mode this year, is this signalling that inflation will pick up in the months ahead and drive bond yields higher? Last week, the T-Bonds (which are the most sensitive to inflation expectations) spiked into new high ground with yields reaching new lows. This is working against the message from commodities.
So my question is this: have Treasury yields bottomed and now start to obey the lesson from gold/silver? There is no doubt the T-Bonds have been over-loved and overbought for a long time. Here is the weekly T-Bond price chart
From the low twelve months ago, the rally is in a clear five up with wave 5 perhaps topping last week on a big momentum divergence (similar to that which preceded the April – June 2015 collapse).
But hedge funds to not believe a reversal is at hand. Here is latest COT data on the 10-yr T-Note (the most closely-watched bond)
Hedgies substantially increased their long bets over shorts (as did the small trader), but the item of interest for me is the swing to the short side of the commercials (smart money). Of course, many commercials will be hedging their bond inventories to lock in profits, but selling is selling and when/if the market heads south, you can be sure many more will be inclined to copy the early birds.
Also, latest DSI sentiment reading shows the bulls at well over 90% and at a point where previous tops have been made. This is no time to panic buy Treasuries!
Many have called this a Bond Bubble, which applies just as much to corporate bonds. US companies have been falling over themselves to issue low coupon bonds in order to buy their own shares, to maintain dividends in the face of falling profits, and merger activity (which notoriously removes value in moat cases). As it stands, the ratio of cash balances of the S&P 500 to corporate debt stands at or near an all-time low.
There is little cushion to prop up a share collapse when it starts. And that is when the deflationary fun will begin as corporate bond prices collapse with companies unable to maintain coupon payments.
Finally, here is HYG the Junk Bond Index that I have shown before
With the general positive sentiment and the recovery in the crude oil market, junk bonds have been gobbled up by yield-hungry investors in recent months. But this market is poised for another decline leg with the rally displaying a large momentum divergence. A break below the 82 level will spell curtains for junk. Soon, all bond yields will start to collapse when the can runs our of road, which it will.
Could it be that the Brexit vote this week is the catalyst? We shall soon find out.
I had the T-Bond market as one of my Trades of the Year, but was premature in the first half. I sense that it is starting to come into its own now.