Jay’s Got Your Back

From the HRA Journal: Issue 311

FOMO is back on Wall St, so are positive liquidity flows. Nothing else seems to matter much, as traders know Powell is going to give them the rate cut they want this week. The announcement will take some careful scripting, traders will be saying "what have you done for me lately?" about five minutes after the announcement. I really don't think the FOMC is in the mood to promise or imply more rate cuts, but they'll try not to be too obvious about that.

All that sunny positivity on Wall St hasn't been helping the gold price. It's very much a risk on market, and that doesn't drive traders to want more bullion. Gold's not trading terribly, but it does look like it's going to drop through support so we could have choppy seas for another few weeks. Bullion does tend to do better towards year-end, so there's that.

Part of the optimism on Wall St is expectation of at least a mini China -US trade deal, which it looks like we'll get. That seems to be helping base metal sentiment, at little. I think we need to see China's growth rate accelerate for that to stick, though supply issues should support most of the base metals as well.

I'll be sending off an invite to the next Metals Investor Forum on November 15th and 16 shortly. Some good companies and the usual great services. Note the change of venue for the next MIF only, due to an ongoing strike at the Georgia.

Eric Coffin
October 25, 2019

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Jay’s Got Your Back

The chart below sends as clear a signal about the next US Federal Reserve meeting as you're likely to get. The market is pricing in a 90%+ probability of a rate cut later this week.

In theory, the FOMC could surprise everyone by not cutting but the chances of that happening are close to zero. If Powell and Company were even thinking about that they would be hedging their bets in public speeches, and they're not. "Surprising" markets by not cutting when a cut is priced in this completely would be a very, very bad idea.

You'd be forgiven for wondering why Wall St is so intent on the next rate cut and, honestly, why they even think the market needs one. The SPX is at all-time highs. Anyone taking a cursory look at the charts for any major US market index won't see a situation that looks like it needs saving. So why the focus on cuts?

Mainly, it's because the markets, thanks to loose Fed policy, are doing better than the underlying economy. The US has been slowing for a couple of quarters now. Most of the deceleration has been on the corporate side. Some of this is the trade war, some of its declining margins and profits that have made the C Suite more cautious.

The next chart compares the SPX to US corporate profits since 1970. The two measures don't always match up but do tend to revert to some sort of equivalence over time. There are two instances of extreme divergence in the chart, where the market got way ahead of earnings. The first was the late 1990's internet bubble when profitless companies were attracting huge valuations. The second period is now.

Like the late 1990s, corporate profits are impressively flat. They have gone basically nowhere for the last five years. There are lots of paths the market index and profit lines can follow to come back together, but I think we'll see the SPX moving down more than we'll see the profit line moving up.

There's little reason to think we'll suddenly see an explosion in corporate profits. Margins have been getting squeezed and it's expected that this quarter will show a year over year decline in S&P500 net profits. I think this is what's really driving the hesitancy in the C suite. In turn, it helps explain the weakness in both corporate investment and wage growth, both of which are directly tied to the executive suite's belief about future profits.

Loose financial conditions and falling yields have gone a long way to cushion the equity markets. Unless there's a surprise later this week, credit markets will have gotten their way, receiving the three interest rate cuts that have been priced into a greater or lesser degree for months. It's not surprising bond traders consider themselves the alpha dogs. Why shouldn't they, when they keep getting their way?

The next meeting isn't a quarterly one, unlike the last two times the Fed cut rates. That means we'll get less information about what FOMC members currently think the rate trajectory will be over the next 12-18 months. We'll get a rate decision announcement that the market will go through with a fine-tooth comb but little else. I'm expecting Powell will try and walk a fine line and keep the Fed's options open. I don't expect him to promise or imply too strongly we should expect another rate cut.

Will a refusal to promise more monetary crack top the market? Not necessarily. Because Santa Claus is coming to town. Everyone knows about the "Santa Claus rally" on Wall St. Many think it starts in December. It actually starts a lot earlier most years, right about now in fact.

The chart above showing average seasonality for the past 44 years shows that a big chunk of the average year's gain comes between the beginning of November and year-end. If you're the Fed chair and plan to mildly disappoint traders, this is the time of year to do it.

That's not to say that this year is completely "normal". Trading volumes on the big board are extremely light and market breadth isn't impressive either. For a rally that has taken Wall St to new highs, it doesn't feel like it has any real momentum behind it.

Much of the recent strength can be attributed to optimism on the trade front. Consumer-centric economic readings continue to be better than corporate ones, though there have been more misses, notably in retail sales. Q3 GDP growth is expected to come in at 2% or less, not a disaster but not what you'd expect to accompany all-time highs either.

While there still aren't many details on the "mini agreement" that China and the US have apparently reached there is widespread agreement the deal actually exists this time. There is some evidence that China is stepping up its agricultural imports which is supposed to be a major feature of the deal. That combined with the US pushing back tariff increases accounts for much of the recent market optimism.

My expectations for a deal continue to be low. It's now going to address any of the major trade frictions. I don't think that will matter though. Wall St will cheer anyway.

The updated US 10-year yield chart below is a good measure of that optimism. Yields have been rising since stories about a trade deal surfaced-even as the market-based odds of a rate cut this week also increased.

The combination of higher long-term yields and expected rate cut has led to a steepening of the yield curve. It's still very flat by historic standards but looks healthier than it has in months. Medium-term rates are still inverted but the longer end of the curve no longer is.

The expected cut in short term rates and some macro weakness put at least a short-term top on the US Dollar index. That seems to fly in the face of concerns about "dollar shortages" though I think those shortages are real and could still come back to haunt us all.

Some traders at least continue to be concerned about the Fed's need to do large cash injections into the repo markets. That's not making me too comfortable either. I'm not pulling the fire alarm just yet though, as there are real structural reasons for it. Bank's lack of "excess reserves" is as much a legislative issue as it is a financial one. But I also agree–to a point–with commentators who ask, "why now?".

I think part of the reason may lie in the broader financial picture of the US government. Most of the main actors in the repo market are also the primary dealers in the Treasury market. Washington's spending deficit is climbing fast. That situation will get worse before it gets better, even under the most optimistic economic growth scenarios. The Treasury Dept is selling a lot of paper and Primary Dealers have to eat it. That may be making the situation in the repo market worse. In a rational world, that might have some wondering if the deficit should be addressed, especially as all those Treasury sales are draining Dollars from the system. Don't hold your breath on that, unless something ugly happens and forces the issue.

All this uncertainty and an overall weaker USD must be good for gold price though, right? Not so much. While the gold chart below doesn't look full on terrible, it does look weak and gold's threatening to break some important support levels. A falling USD earlier in the month didn't help the gold price and now rising longer yields, and a short term (?) USD bounce are hurting it.

I think the bigger issue right now is shown in the bottom pane of the chart above. Gold has maintained a negative correlation to Wall St since early August. That is a good measure of gold's attribute as a "risk-off" asset, as opposed to its "currency" attributes.

That doesn't bode well for the near term at least. It's not a secret I think Wall St is overvalued. The market doesn't care what I think though. It's all FOMO and liquidity flows for now. Unless the Fed manages to really disappoint markets or the trade deal falls apart, gold's correction looks set to continue.

I don't think we've seen "the" top for gold prices. I still think broader macro issues, negative real interest rates and decelerating growth will turn things around. But we may be in for a bit more short-term weakness that helps build a base for the next leg up. Generalists piled into bullion funds like GLD and I think we need to see some of them shaken out before the bull resumes. That's taken longer to happen than I expected, but the current weakness should accelerate that process. We'll be fine.

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