Another Narrative Change Underway?

I’ve used this analogy before, but on days like today, one can’t help but feel like investors are nothing more than Pavlov’s dogs, salivating for the inevitable treat they’ve been conditioned to expect. As for Pavlov, he is of course played by Fed Chairman Jerome Powell, also known as the Wizard of Oz.

Pavlov’s main contribution to the field of psychology was the idea of classical conditioning, in which a neutral stimulus can, over time, come to elicit a response similar to that of a potent stimulus. In this case, the potent stimulus is lower interest rates (easier monetary policy), and the neutral stimulus is Mr. Powell’s words, which bait investors like a jar full of peanut butter.

To give you an idea of how powerful this conditioned response is, take a look at the chart below, which shows the yield on the 10-year Treasury. That big reversal you see toward higher rates (lower bond prices) occurred as the text of Mr. Powell’s speech today in Chicago was published.

10-Year Treasury Yield

During the speech, Mr. Powell made a few key statements. In particular, regarding the escalating trade tensions, he said, “We are closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion.”

Translation: Markets … we got your back.

To be fair, the reversal in Treasury yields actually began yesterday when St. Louis Fed President James Bullard became the first Fed official to suggest a rate cut “may be warranted soon.” Among other comments, one of the more telling things he said was that “signals from the Treasury yield curve seem to suggest that the current policy rate setting is inappropriately high.”

The Fed’s acknowledgement of the inverted yield curve as an indication that their policy decisions are out of whack is somewhat refreshing … it signals that someone is flying the plane, and that critical sensors are working (no offense, Boeing).

Now, this shift towards a more dovish outlook was largely expected by the markets. Inflation has been running well below target and Fed funds futures have been suggesting a high probability of one or more rate cuts by year end.

Here’s what the Fed funds futures market currently look like for the December meeting this year. As you can see, market participants are betting that the Fed will cut rates two to three times this year (assuming quarter point cuts). Current pricing suggests a 0% chance of a rate hike, and only a 3% chance of rates staying at current levels.

Target Rate Probabilities for December Meeting

Now that the Fed has officially endorsed the idea of lower rates, and the use of monetary policy to balance out economic problems caused by trade disputes, investors seem to be feeling a lot more comfortable. At least that’s the takeaway I get from watching the Dow climb 500 points and the Nasdaq jump by over 2%.

All of this speaks to another potential narrative shift. Back on May 14th, shortly after trade talks with China broke down, I mentioned that the market’s narrative had shifted (away from expecting a soon-to-be-announced trade deal) and that this would take some time to get priced in.

Markets did indeed head lower in the interim, but now it appears another narrative shift is underway – one orchestrated by the Federal Reserve. And as mentioned above, the Fed has a powerful ability to make investors salivate simply by rustling their bag of treats.

So what should we expect moving forward?

Ultimately, we know that economic fundamentals underpin asset prices, at least over the long-term, if not the short. Thus, the primary trend of the market will be determined based on incremental changes to the outlook for growth, especially with regard to corporate profits.

On that front we now have two primary competing forces: trade disputes, acting to suppress economic growth and corporate profitability, and the Federal Reserve, acting to stimulate economic growth and profitability.

Of course, there are a multitude of other variables involved, including things like good old fashioned labor force growth and productivity growth, which ultimately determine economic growth, but there’s something important to remember …

And that is the two most powerful decision makers in the world – President Trump and Fed Chairman Jerome Powell – both have a vested interest in making sure this economic expansion continues: Powell so that he and the Fed don’t go down in history as the cause of another recession, and Trump so that he gets reelected in 2020.

That’s an awful lot of firepower to have on the bullish side, but incumbent presidents and Fed Chairmen are always incented in this way, and they don’t always get what they want. Sometimes outside forces are too strong and overwhelm the system, as we saw with the last two asset bubbles.

As a result, we’re going to have to continue monitoring incremental changes to incoming data and reacting appropriately. With that in mind, let’s take a look at some of the more recent developments.

First, a quick look at inflation. Below is the Fed’s preferred inflation gauge and as you know it’s well below target. This, combined with the Fed’s evolving view of their inflation target, and an inverted yield curve, suggests dovishness as far as the eye can see.

Personal Consumption Expenditures

Part of the reason financial conditions appear tight right now is due to the strength in the dollar. As you can see below, the longer-term trend for the buck has been up over the past year. This is harming exports, dragging down corporate profits, and is itself a form of monetary tightening.

U.S. Dollar Index

We’re also seeing signs of lackluster global growth in both oil and industrial metals prices. Below is a chart of light crude, which has taken a beating in recent weeks.

Light Crude Oil

The industrial metals complex is also under pressure and has been in a downtrend for quite some time. Notice that industrial metals peaked at around the same time the trade war began.

Bloomberg Industrial Metals Subindex

Switching gears a bit, one area that I feel is really key to validating big price swings ahead is junk bonds, as well as credit spreads in general. The chart below of JNK – a junk bond ETF, shows that even amidst all the challenges to growth, investors remain comfortable owning the debt of companies with questionable balance sheets.

JNK - High Yield Bond ETF

Warren Buffet is fond of saying that, “Only when the tide goes out do you discover who’s been swimming naked.” Well … if you want to get a peek at some naked investors, keep watching the junk bond market; that’s where you usually see them first. But at least for now, investors don’t seem to be scared.

That’s the same message we’re getting from other measures of the credit market as well, as you can see below.

Credit Spreads

Moving on, let’s take a quick look at some of the major averages. First up is a chart of the S&P 500. As you can see, the S&P recently fell below its 200-day MA, but has popped back above it in today’s rally.

S&P 500 Index

I had previously suggested that the 200-day MA may a good area for those trading around a core position to add to their holdings, and the rally today seems to send a similar message. But it’s important to point out that we’re back below the major support/resistance line we’ve been playing with for the last year, and we just completed what looks like a head-and-shoulders pattern.

As a result, I’m a bit hesitant to commit capital here, especially without seeing if today’s rally has any legs. It’s possible a lot of what we’re seeing in today’s action is headline driven trading combined with short covering.

I also don’t think the market’s going to run away from us anytime soon. There are simply too many unknowns right now for investors to bid up the market’s multiple substantially, and we know that profit growth is essentially flat.

The Nasdaq is also back below its 200-day, and fighting to get above it. Tech has been especially hard hit lately due to increased regulatory threat.

Nasdaq Composite

As for the Dow Jones Industrials and Transports, they too are back below their respective 200-day MAs, though both are bouncing today as expected. Overall, I think we need to be patient here and see if the short-term downward momentum really is reversing.

Finally, the last two charts I want to show today are of gold. The precious metal has bounced sharply over the past two sessions and is now well above both its key moving averages.

Gold - Daily Chart

On a longer-term basis (chart below), the metal still has tremendous resistance around 1375, but also continues to trace out an ascending triangle pattern. This is considered a bullish price pattern, and would be validated upon a breakout of the upper horizontal trendline.

Gold - Weekly Chart

On the other hand, a break below the lower blue rising trendline would invalidate that pattern, suggesting more months/years of sideways or lower prices. As you know I don’t always rely entirely on technical analysis, but with gold we have nothing else to go off since it can’t be intrinsically valued (no cash flow or dividends). As a result, I would keep watching those key trendlines.

Wrapping things up, I believe there’s a good chance we remain in a rangebound market, held hostage by trade negotiations. The economy remains on firm footing for now, but with so many moving pieces, things could change quickly.

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