Does the Yield Curve Matter?

Bear Rally Over? Yield Curve and VIX Turn Higher

It has been a long and winding road in this bear market. Yes, I still believe a bear markert is underway until new highs are made. I haven't been tactically bearish on the market over the preceding months, onyl taking some small swings when setups looked good. Until those old highs are taken out, my bear market call from November 2021 remains intact.

First, the classic bubble chart pattern hasn't been violated:

A double-top is a valid expression of the "return to normal" phase. Bullish sentiment and speculative behavior return to near peak levels, propelling the major indexes or stocks into double-tops. Anecdotal, but cryptocurrency speculators believe a new bull market is underway. Bitcoin BTC has a pattern that is consistent with the classic top though:

Tesla, Google, Amazon and Meta all sport the classic pattern with no hint of an imminent double-top. The paradox stocks are Apple and Microsoft. Both have achieved new all-time highs. Their massive weight in the S&P 500 technology sector (nearing 50 percent at times) propelled that sector to a new all-time high in July. If I'm correct in my assessment, this will turn into an overthrow of a double-top pattern and not an extension of the bull market.

Industrials also achieved new all-time highs this year. Energy and materials made new highs in the second-quarter of 2022 and remain within striking distance of new highs.

I'll digress here and give the bullish argument over the longer-term. Assume for a moment the U.S. was primed for a recession around the time the coronavirus hit. The government then wrecked the economy and then flooded it with far too much stimulus. Even though there's no official recession in 2023, the U.S. government is running deficits on par with the fallout from 2008:

There's nothing bullish about that chart long-term. Growing deficits will increase inflationary pressure. Falling deficits could trigger deflationary pressure. Since stocks are priced for perfection, deviation out of the Goldilocks Zone will trigger price declines in all sectors at least for a time, barring an explosive move higher in energy as we saw in early 2022.

I don't want to belabor the valuation topic, but here is the price-to-earnings ratio divided by the growth rate (PEG) and the spread between investment grade corporate bonds and the Federal funds rate.

Going back the to the bull thesis: what if the government front-loaded stimulus and the bear market/recession doesn't materialize? In that case, either an extension of the bull unfolds or the transition occurs without the bear move. Both EFA and EEM, the developed and emerging market ETFs, bottomed in October 2022, with EEM having a little overthrow this year:

To wrap up the bull case: the government flooded the economy with stimulus, triggering a temporary inflation surge. Inflation settles back into the Goldilocks Zone, as does GDP growth, sub-2 percent for both. In the short-term bull scenario, stocks enjoy an extension with tech and other speculative assets resuming leadership. In the longer-term scenario, the transition to new leadership such as industrials, energy, commodities and foreign markets takes place without a major bear.

Back to the bear scenario, one of the strongest signals for a recession has been the inverted yield curve. It doesn't indicate an imminent recession, rather it signals the pre-recesesionary stage. The actual recession comes when the yield curve steepens. Going back the past four decades, this has always occurred when the Federal Reserve slashed rates. Right now, the yield curve is steepening because long-term bond yields are rising faster than short-term yields. It is a small move at the moment, but the spread has made a higher low, indicating the final low might be in.

The 10-year treasury yield has a bullish formation that may or may not complete. If it completes, then higher long-term rates will sink financial asset valuation and could indicate a stagflationary recession. The 30-year mortgage would be on its way towards 10 percent, a level that would almost assuredly kill home prices too. On the flip side, a traditional steepening via Fed rate cuts would be another bear market and recession like we've seen in 2000 and 2008.

The decline in the VIX has been a hallmark of this bull market. The VIX has fallen below the level reached at the November 2021 peak, indicating fear is gone. Here's the VIX overlaid with the 2s10s spread:

VIX isn't a great indicator in that it tends to be coincident with the 2s10s, but a rising VIX indicates rising fear, likely because there's bearish action in parts of the market ahead of the full-blown bear. Here's a look at when the VIX bottomed ahed of prior bearish periods:

There will be bearish trades emerging very soon if the yield curve has finished inverting and moved into steepening. Ditto if the VIX follows it higher. With September and October coming up, the calendar supports a market top scenario here. New highs on the major indexes will invalidate the bear scenario, as will a falling VIX. If the 2s10s inverts further or moves sideways, it will indicate no imminent economic pressure. If the 10-year yield fails a breakout for instance, the yield curve might invert further while the broader stock market interprets the falling yield as disinflationary and therefore bullish.

Take the Quiz

Social Awareness poll: Without cheating, what was the inflation-adjusted capital gain in the US equity market for the 75 years following the 1906 peak. Recall how much wealth was created in that window.

— Dave "Rent this Space" Collum (@DavidBCollum) April 12, 2023

After checking the result, I looked up dividend yields and calculated the compounded return. Then I looked up historic dividend yields versus bond yields.

Good-bye Again Great Britain, Bond Market Dictatorship Begins

The market popped to 3700 this morning on news the bond markets are back in control of Western governments.

ZH: Truss To Fire Kwarteng, Make Major U-Turn On Tax Cuts

Shades of the 1970s:

Instead of tax cuts, rumor has it there will be tax hikes. Various sides of the political circus will have their say about spending and policy, but lets be perfectly objective about deficit spending. Credit growth fuels economic growth as measured by GDP. We can debate up and down about the quality of that GDP, but we cannot argue that higher credit growth generates higher GDP. Even in extreme situations where the government is imploding the economy via hyperinflation, stopping that inflation will cause incredible short-term deflation. Slower credit growth will cause slower growth in the short term. Lower deficit spending will in the longer-term generate higher quality growth as government shrinks in the economy, but that will take time.

Politically speaking, one doesn't want to take office ahead of this collapse unless you have campaigned on doing it. Reagan survived a major recession early in his first term because he unleashed massive deficit spending at the same time inflation had finally peaked and the public was in the mood for reform. Thatcher came into power after the cuts had been made. Truss will end up like Kwarteng.

Only "revolutionary" leaders can handle the current situation. Almost the entirety of the ruling class wants to preserve the existing order. Most of the supposed outsiders are empty suit pretenders or losers who cannot handle the situation. I even include Trump in here because he surrounded himself with clowns and toadies. He came in with a good cabinet and strong advisors, and most were gone within a couple months of his election. Then he put some good people in at the last minute after losing the election. In between was a clown show with warmongers like John Bolton.

High Yield Debt Still in Positive Divergence

Amazing that high-yield is diverging positively from investment grade bonds even as it has been moving lower. Positive divergence the past few days as well.

Ragnarok

Apple is having trouble this morning after a news drop last night. The Bank of England restarted QE today. We're into the "this is serious" phase of the downturn where bad news and policy intervention start driving markets. For its part, the U.S. government and central bank remain on course. U.S. officials up to Janet Yellen have said there's no problem in financial markets, there's no need to slow the rise in the dollar. The Federal Reserve acknowledges what's happening, but hasn't changed its rhetoric one bit. Powell speaks today though...

Stocks were overdue for a rally. Bonds are rallying for a similar reason and probably because traders are thinking, "if the BOE is doing QE again, the Fed won't be far behind." If 2008 is a template, there is only one to two days of rally possible. I will become aggressively short above 3700 if the ES should get there. BTC is hanging on. I don't want any spare capital when BTC breaks that trendline. I want to be 100 percent in short positions.

Yawning Yen Chasm

If U.S. long bonds break out, how long until the yen moves towards the closing yield spread?

Market Prices in 25bps

Will Fed Reduce Balance Sheet by $70 Billion This Week?

The Federal Reserve's balance sheet has grown by $20 billion in June. It was supposed to reduce by $47.5 billion. These balance sheet readings come on Wednesdays. The Fed is already about $70 billion off course with one week to go. We can debate whether the Fed should or should not be doing this much QT, but there's no debate on this: the Federal Reserve is destroying the last shreds of its credibility when it contradicts its own policy statements.

Buy Bonds

I bought eurodollar calls yesterday. I shut my screen at the regular close, but was filled overnight. Up about 40 percent on those calls so far.

Wild Close Incoming: Japan Govt Bond Yield

There is a lot that can happen between today and Tuesday's open. My main worry is that Japan experiences a surprise in the bond or currency market.

Looking Bullish

I went long the yen, small position and won't stick around if I'm wrong. A gut feel that all the attention on Japan is a squeeze moment rather than the crisis. The horiontal above is the get out of dodge line for yen longs.

If ZB (above) can recapture the higher horizontal, that would be bullish for bonds. If that happens, the corresponding move in TLT is a climb above $114 area.

Technical Capitulation Time, But Nothing Good Otherwise

Looking back at 2008, the most recent bear market, there is an analog. The 2008 market bottomed in January and then tested that level in March when Bear Stearns collapsed. The test held and there was a rally into May. This time, the low came in May and the bounce is a few weeks later. I don't place a lot of confidence on this analog except that in both cases it was a rather clean h-pattern. Failure to move lower from here would be bullish.

If going lower, there is a trendline around 3700 formed by the 2011 and 2016 lows, mapping to $370 on SPY

The "target onn break" is where there is major support. I think that is a very viable target here for one reason only: it makes sense for the big picture. A plunge down towards 3400 would allow for a massive bounce back up to aroud 4300 (a 25 percent rally), although I think something like the 4100 makes more sense.

That's the big general direction. There can be ping pong action between levels, but eventually 3400 will be hit and that should mark the end of round one for this bear market. There will be a big rally and then round 2, wave 3 in Elliot Wave terms, will begin.

While there are signs of capitulation such as the roaring VIX this morning and short-term indicators will scream "oversold" today, nothing is improving. The bond market broke down. We are in free fall territory now and every time bonds drop, the valuation of stocks drops. This may or may not be important in the present, but it matters for the question of "Is this a bear market?"

Similarly, crude oil hasn't cracked yet. How does the stock market's long-term outlook improve with rising commodity costs? Only by become much cheaper.

Finally, I have seen people still expect a Fed pivot, or that stocks will drop until the Fed reverses. Same thing I've said going back to last year: the Fed won't change until at the very least, crude oil tumbles. Until then, there will be no change in policy. If crude rises and bonds fall, then the Fed is trapped and must contiue raising rates until it inflation comes out.

Bond Troubles Could Resume on Stock Slide

The spread between the 2s10s, 10yrs in US and China, and 10yrs in Japan and US, plus the 10yrs for Germany and the US for laughs.

Another Yen Chart

Here's the spread between Japanese and U.S. 10-year bonds along with JPYUSD. It isn't always correlated, but it has been highly correlated this year.

Bonus: same charts for China.

30-Year Bonds Beat Stocks for 20 Years

Granted I'm cherry-picking a bit here, but an investor who put everything into long-term treasuries after the 2000 bubble had burst would not have underperformed stocks on their return until January 2018, and they would not have underperformed consistently until January 2021. This underperformance is up for debate since we haven't completed the cycle yet. It's possible this outperformance won't end for a few more years.

How many people know that long-term treasury bond funds beat stocks for 20 years?

It would make sense if stocks beat bonds over the coming years, but here's the scary thought for anyone holding financial assets: this ratio goes up if stocks lose less than bonds. Stocks will lose a lot if bonds go down. If the 10-year yield gets back to around 5 to 6 percent, the 30-year bond should be 6 percent or higher, which would approximate (ballparking it for simplicity) to a 50 percent drop in the price of the bond.

ZB Inverted

The H&S bottom hasn't been invalidated yet...as QT kicks off.