Conflicting Signals

From the HRA Journal: Issue 310

It's not getting any less weird out there, that's for sure. We saw continued deterioration in several US economic metrics, but some stabilization elsewhere. There was enough "bad news is good news if it keeps bond yields low" vibe to maintain the SPX near its highs. That's impressive given how much traders could worry about if they had a mind to.

As this issue was being readied to send, there was word out of Beijing that China plans to play hardball at this week's US-China trade negotiations. Anyone who is shocked by this message has been listening to the wrong people about China. We'll see how the negotiation goes. Trump may cave for a quick win which Wall St would cynically applaud. I don't think traders will be nearly as happy if the talks actually blow up with no deal, however bad. Keep an eye on the news feeds about the talks as they could have a big impact.

Gold is still in a shallow correction that you'd think was much larger based on resource trader angst. The correction may go on for a while longer. We haven't seen the trend followers in the gold futures market adjust their long positions downwards much yet. That may have to happen before there's another strong upward move in bullion. Gold is trading against the USD again, and also against the SPX as a risk off asset. If a trade talk fail, repo market convulsion or worse economic metrics tank the SPX though, gold could just go higher again regardless.

Eric Coffin
October 5, 2019


Conflicting Signals

The US Fed meeting went much as I expected, though more hawkish than most of Wall St expected. Even so, markets reacted with reasonable calm to that and several other events in the past couple of weeks. I continue to be impressed by how stable equity markets are, really, given the mayhem in so many other areas.

The US 10-year yield chart below shows traders started backing off the "Fed Funds going to zero" meme even before the meeting, with yields seeing a top of 1.9% on the 10 year a week earlier. Yields have since dropped back to the 1.5% level, after a couple of weak economic readings and some political fireworks. The bond market seems calmer, though, even though there are new concerns about short term funding markets I'll touch on below.

The Fed gave traders part of what they wanted, a 25-basis point cut everyone knew was coming and that the market priced in. It didn't give them promises of much more though. There is a lot of dissention on the FOMC when it comes to further rate cuts. As I suspected several members expect no further cuts before yearend, and some expect no further cuts at all.

Fed Chair Powell was able to calm traders with comments about "changing policy as needed" but it was still surprising markets didn't take it worse. As it turns out, weak macro readings may help bond traders, and Wall St, get their wish in the form of another rate cut at month's end.

10-Year US Treasury Yield

Strangely (to me anyway) a "strong" payroll report was taken as bullish by Wall St. I would have thought traders would be unhappy that the odds of an October rate cut dropped by 20% after the payroll report. I found that a bit odd too. The increase in payrolls closely matched consensus, and revisions to prior months were better than expected.

Traders seemed dazzled by the fact the unemployment rate, an almost meaningless statistic, dropped by 0.1%. I found it odd that, again, Wall St ignored a much weaker YoY hourly wage increase (0% increase last month) and the implications that has for consumer spending going forward if it persists. Wall St, again, doesn't think its odd that unemployment rates drop and wages stagnate at the same time. Ok, then.

The bounce in the bond market and the falling yields that accompanied it would have helped Wall St. Rates were getting down to levels that freaked everyone out a month ago, but 1.5% on the 10 year must be "not too hot and not too cold".

A slight rise in some longer-term yields has flattened the yield curve, a bit, though most of it continues to be inverted. That inversion is getting long in the tooth, long enough to meet the requirements as a recession predictor.

Timing is uncertain but curve inversion as a recession indicator has a seven for seven track record with no false positives. You'd be hard pressed to find an economic indicator with a better track record than that, so don't just brush it off. Sudden curve steepening, caused by short term rates dropping fast, often immediately precedes a recession start. Check short term US yields (< 1 year) occasionally. If you see the bottom drop out, head for cover.

Most economic readings came in at or below consensus. Consumer readings continue to look better than corporate ones, though there were a couple of negative surprises like consumer confidence.

Corporate readings continue to show deterioration on the part of purchasing managers who want resolution to trade disputes. There's no doubt that the US will have to depend on the consumer to keep things on track until trade disputes get settled.

The biggest negative surprise since the Fed meeting was the ISM Manufacturing Index, which reported a very ugly reading of 47.8 for September. A reading below 50 implies contraction in the manufacturing sector, but not recession. We'd need to get below 45 for that.

Wall St bulls downplay manufacturing readings as it's only 10-12% of the US economy. That's true, though it impacts other sectors like transportation (doesn't take many 18 wheelers to move a Netflix movie) so the ultimate impact is larger.

That was followed by a stronger ISM services number, it's true, but that came in well below consensus. The services reading shows that larger portion of the US economy is still expanding, but it wasn't a great number. At 52.6. it's the weakest reading in over three years. Still "ok" but the large one month drop implies the weakness in manufacturing is indeed starting to bleed over to the rest of the economy.

You can put the blame for this squarely on trade wars, though the surging US Dollar didn't help. The "new export orders" portion of the ISM manufacturing survey looked considerably worse, which implies we may see another drop in that index next month.

Wall St wants the China-US trade war settled and now has something new to worry about: impeachment. It's impressive to watch the Pavlovian reaction to trade tweets by Trump. It's amazing that individual outbursts still have the impact they do. After scores of "we're close to a deal" tweets by Trump followed by, well, nothing, you can still count on an optimistic tweet to generate 10 SPX index points.

US and China trade negotiators meet again this week. Unfortunately, China's negotiators are already sending the message that they won't negotiate most of the issues that are important to Washington. It's obvious what's going on here. Beijing can see that Trump is weakened politically and desperate for a win.

It's too early to tell how markets will react to impeachment drama. So far, the reaction is muted. Markets have very short information feedback loops. Impeachment, if it even gets that far, is not a short process. Best case scenario, it will take months. That's too long for Wall St to obsess about anything.

Wall St realizes that impeachment will require a two thirds majority vote by a majority GOP Senate. What are the odds of that? Unless an impeachment inquiry finds something that sways most of the US public, I don't see the Senate ever voting Trump out.

An impeachment investigation may have at least one silver lining for the market. Based on the comments about this week's negotiations it seems Beijing thinks the odds of a near term trade deal are much higher. The bad news is that China is out playing Washington.

I think if there is a trade deal it will be a lousy one for the US. The question is whether Wall St goes along with the PR spin and applauds a trade deal that's not good for the US. I don't think its possible to be too cynical when it comes to Wall St, so I'm going to answer "yes" to that question. The illusion might wear off quickly though, if the deal really is a poor one.

The foreign policy setbacks for Washington didn't stop with China. Just before the issue was closed off, North Korea announced it was pulling out of negotiations with the US over nuclear disarmament. That shouldn't impact the markets too much. I don't think there's anyone outside the White House who didn't think Trump was being played by Kim all along.

Politics aside, traders had other things on their minds. There's been a lot of attention on the repo market lately. This short-term lending market experienced huge volatility for a couple of weeks before calming down again. No one's sure what caused the problem but capital injections by the Fed, which will continue for at least a few more weeks eased short term liquidity issues for now. Should we worry? No and yes.

There were some technical factors like corporate tax installments and quarter end withdrawals that drained cash from the banking system. Most repo lenders are banks or others with excess reserves on deposit. Post Financial Crisis changes in bank reserve requirements mean banks can't lend a large part of these reserves.

Excess reserves have been shrinking since the Fed started reducing its own balance sheet by selling some of its bond holdings. Doing that moves cash from the market dealers to the Fed, in exchange for the debt they buy. On top of that, the US Treasury is issuing huge amounts of debt right now.

I think all the above combined to create short-term cash shortages. The large amount of excess reserves banks have held since the Financial Crisis (which I don't think are a bad idea) meant thee have been few Fed market operations needed to grease the wheels since 2009. Before that however, it was common for the Fed to set up lending facilities to keep the overnight repo rate in line with the Fed Funds Rate.

I don't think we should be freaking out about the repo market. We should keep an eye on it though. When things started to go off the rails in 2008, it showed up first in repo, money market and LIBOR.

I have a distinct memory of being out at a dinner in late 2008 when the guy next to me got a call from London (it was a late dinner) telling him the LIBOR market had gone "no bid". None of is at the table thought that was even possible.

We all got the shivers from that phone message but there was much worse news to come. That was one of the first signals that things were going very wrong in the world's financial markets. I don't think the current repo market issues are analogous, but with all the market weirdness going on, we need to be alert for dislocations that can spin out of control.

One beneficiary of the ISM miss was the gold market, and none too soon. Gold was in the midst of a correction when it got a $40 boost from the weak ISM and SPX. Its settled back after the nonfarm payroll report but is still hanging on at about $1500.

It was only a few months ago that a $1500 gold price would have had resource traders jumping for joy. But the markets are all about "what have you done for me lately?" $1500 is now a disappointment, at least based on the way the sector is currently trading.

It's too early to tell if the move back above $1500 will be enough to kickstart the larger uptrend again. It doesn't feel like it. Chart traders wanted a deeper pull back and futures speculators are still very bullish. I'd be more comfortable if more of them had closed out long positions during the dip. The $US has been strong and gold' gone back to trading against, rather than with it. Gold's also been trading against the SPX. Wall St has been stalwart, but that could change if US-China trade talks flame out this week.

Whether it does or not, I don't think it changes the longer-term bullish story for gold. Bullion has seen its correlation to the USD go negative again, just as the Dollar was surging. Higher US interest rates and growth rates are driving the Dollar strength.

The chart above, from Jim Bianco, shows the US is "winning" the short-term yield contest. US Treasury yields are what passes for the world's risk-free rate, so it's quite unusual for everyone else's short-term rate to exceed it. This normally happens when other economies are in recession or on their way there. It looks like that is what's happening again. Historically, when we've seen this pattern of relative rates, the US follows other countries into a slowdown.

The US has been an island of relative stability up to now. But with manufacturing, agriculture and energy all getting hit at the same time, the risks of a slowdown broadening are increasing. The consumer has been a pillar of strength so far, but the ongoing political circus, especially if it is accompanied by slower job and/or wage growth, will start to take a toll. Keep in mind that measures like consumer confidence tend to peak right at the end of economic expansions. By the time you see sentiment surveys like that fall hard, a recession is already underway.

The updated recession probability chart, above, looks worse than the last version I published a couple of months ago. It's now at levels that have virtually always been followed by recessions. While its structured to give probability of recessions within 12 months, its now at levels usually seen immediately before a recession starts.

The Fed changing course and getting back to rate cutting could keep pushing things back though it will run out of ammo soon. And it may not be enough if the trade and political issues don't get settled. And don't forget what I said earlier in this piece about yield curve steepening. If we suddenly see short term rates dive, either by Fed action or treasury market buying, its time to look for the lifeboats.

There are plenty of reasons for gold to move higher once its correction ends, be that two days or a few weeks from now. Staying positioned in strong gold exploration stories will continue to be the play for HRA unless I see some fundamental shift in the market for the better. Stay alert and be safe out there.

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