Temptation Island

“I gotta get off this rock Chuck. Get back to the mainland. Whatever the hell is going on here, it’s bad.”

—Shutter Island

No absence of war news on Memorial Day, but why are markets not observing?

Key takeaway: Waller’s analysis of the neutral Fed funds rate uncovers darker implications about investors’ views of Fed credibility and the 10-year long-term rate path. News about the Rafah invasion, Egypt exchanging fire with Israel, Russia successfully neutralizing American missiles, China encircling Taiwan, Iran’s near bomb-grade uranium inventory growing 17% and North Korea firing a missile toward Japan: What’s next, Trudeau invading Buffalo? Meanwhile there was barely a ripple in risk markets. In my Variable Dimensionality framework, geopolitics is now at the top slot. Fed Governor Waller warned of economic weakness last week despite his reluctance to cut rates soon. Stocks affirmed their bullish trend but see Equity section regarding vulnerabilities.

Wall to Wall Waller Dept: Governor Christopher Waller spoke twice last week. I have noted that there has been a firehose worth of Fed speak recently, and to have Waller prepare two speeches in the same week is yet another example. In his speech on Tuesday May 21, he said that progress toward the Federal Open Market Committee’s (FOMC) goal of 2% “has likely resumed.”

The market focused on his comment that he would need to see “several more months of good inflation data” ?before voting for a rate cut, and that caused the curve to flatten along with his comments on the economy (see Fixed Income section).

What I found notable in his speech was that he mentioned two moderating themes for the economy. He pointed out that the institute for Supply Management (ISM) data had moved below 50 for both manufacturing and non-manufacturing businesses. An ISM reading below 50 indicates contraction, and he emphasized that the survey of services businesses, which represents “the lions share of U.S. output” fell below 50 for the first time since December 2022. His concern is that if it continues, “it would be indicative of slowing economic activity beyond manufacturing.” ????

Secondly, he mentioned flat April retail sales after February and March were revised down, and listed credit card and auto loan delinquency rates back above their pre-pandemic levels as indications of consumer stress.

The following chart of US real retail sales adjusted for CPI supports Waller’s concern

:Any further weakness and it will be flashing a recessionary signal. Waller followed up by saying that labor demand has eased relative to supply, emphasizing the weakness in the voluntary quits rate, something I have stressed. Another point I have been making that firms are less in need to fill vacancies was also mentioned by Waller on Tuesday.

One final note on that speech—he said that we can rule out that inflation is no longer accelerating. That is again communicating the asymmetric view of rate cuts, meaning there is only a pause out there before a rate cut, with no chance of a hike. That can come back and bite the Fed.

When You Wish Upon R-Star

Waller’s second speech, on Friday May 24 centered on the long-term equilibrium Fed Funds rate, r-star (r*). It is generally defined as the neutral funds rate that neither boosts nor dampens economic activity when inflation and employment have hit the Fed’s equilibrium target. As policymakers (and the markets) adjust their view of r*, it colors perceptions about the degree of monetary policy restriction. As it becomes clear that r* is on a rising path, it will mean that monetary policy is not as restrictive as was assumed, and the market will need to reprice its view of future rate cuts to assume fewer expected rate cuts.

There was a mention of the neutral rate in the May 1 FOMC minutes showing it is being actively debated at the Fed: Some officials think long-run rates may be higher than previously thought. Additionally, last night BoJ Governor Ueda mentioned that the challenge is to determine the neutral interest rate, showing that all the major central banks are grappling with how heavy government debt may impact the long-term policy rate.

Waller used the 10-year real yield as a suitable real-world proxy for r* and here is a monthly chart going back 10-years provided by the Cleveland Fed

:One can also use the 10-year TIPS yield, which is currently at 2.15%, after being negative for two years following the pandemic (It started to go negative at the end of 2019 as economic data began to signal a recession even before COVID). There are many good arguments against using the 10-year real yield, but it does seem better than the models coming out of the NY Fed that estimate r* at 1.25% after peaking at a 16-year high of 2% in Q4 2021.

Key to the discussion is what he said was driving r*. Waller mentions that r* has fallen over the last 40 years, which strikes a chord with me, because I strongly believe in the 40-year inflation cycle that peaked in the early 1980s and created a backdrop of deflationary growth that helped fuel stock market gains. He examines what forces could increase the neutral policy rate but dismissed all of them.

We can use his arguments for why r* had fallen, and use them to show why r* has most likely troughed:

First, he explains the decline in real yields over the past 40-years to have been driven by the demand for Treasuries outstripping supply, and he attributes that the “safety and liquidity of U.S. Treasury securities was actually increasing” making Treasuries even more attractive.

This is a critical point, because as fiscal policy becomes unhinged, investors will demand a higher real rate to be compensated for the fact that the very “safety and liquidity” of Treasuries that made them attractive over the last 40 years is likely reversing. Waller asserts that default risk “has and will be zero” yet the market may question that in coming years.

Second, he looks at the “significant decline in the level and volatility of U.S. inflation that drove a more stable monetary policy. The historical harbor, or island of low beta monetary policy as I would describe it may be over. I can understand the temptation to linearly extrapolate what has been in place for decades, but I did not expect that from Waller.

Waller’s own chart on the term premium hints at the potential that the COVID flush of fiscal policy may have unhinged monetary policy stability

.The chart above is the Kim and Wright three-factor arbitrage free term structure of 10-year Treasury yields. It should not go unnoticed that as the term premium rises, so does the chance of recessions (shaded areas are the last four recessions).

Third, Waller emphasized the importance of globalization and liberalized capital markets as a secular force in dampening real yields that has been in place since the 1990s. I do not think many would argue that globalization will remain a beneficial factor going forward.

He also listed the rise in Sovereign Wealth Funds globally and the aging demographics as a driving factor behind the demand for Treasuries. No doubt, but the question remains whether these forces on the margin will be sufficient to dominate the first three I list. I would expect that Sovereign Wealth Funds would also demand a higher real yield to compensate for the risks of the expected rising supply of Treasuries based on the oft-quoted view coming out of the Fed Chair and the Treasury Secretary that the “U.S. is on an unsustainable fiscal path”.

The path of the 10-year will begin to be determined by the term premium. It is a matter of when, not if.

How Badly Tempted is China to Invade Taiwan?

The markets seem to assume that China’s military actions last week will coax newly inaugurated President Lai Ching-te to open diplomatic channels with the mainland. That remains to be seen. All I can say is the equity market tone for now is quite bullish in the face of China’s actions and all the other military news over the weekend that has all ratcheted geopolitical risk at least one notch higher.

We must not forget that the Taiwan issue is not just a headline—it is an existential issue for China.

Opportunity is the gap between price and value in any market. I believe there is an opportunity that the risk premium is now too low, but there needs to be some movement in price toward that lower value before I feel comfortable committing capital. However, all I can say is in looking at the news is that “this is not a positive.”

Markets:

Equity Market: Oscillator flipped, new highs, but three problems?

Weekly Trend: Bullish

Last week I mentioned the S&P 500 Index weekly chart had shown bullish signs but was not confirmed. The oscillator shown below has now confirmed the bullish trend with its fourth crossover since the major October 2022 low. There is a twist, however

.I am using a more traditional candle chart above to show that last week opened and closed at the same level, forming a potential topping formation. When a market opens at a certain level, moves to a new all-time high, and then fails to close above where it opened, it can mark a top. Not all tops have this formation, and the chart shows that same formation well before other market tops, but the conditional exists. It needs confirmation, and the fact I am seeing some problems in the daily charts below is the only reason I am giving this any weight.

The daily chart also shows a lack of follow-through, despite the bullish weekly oscillator signal. There was a second attempt at retouching the channel that was hit from below a week ago. This time it failed just short of my 5350 target when it opened on Thursday at 5341 and failed:

A third potential issue is a momentum tool I have relied on in the past and it is flashing a warning sign in the form of a divergence. The S&P 500 hit a high at the end of December 2023, but this indicator did not confirm those highs, and coincided with a selloff. The index closed at new all-time highs at the end of March 2024, again there was a breakdown in the momentum indicator below, and then a strong selloff. Last week’s all-time highs flashed the same warning.

Any break in the indicator below 64 would be a signal to start becoming defensive. I will monitor and send it out if it happens this week, because I believe it would mark a significant reversal.

Even more concerning is that the indicator is showing successive lower lows as the index is making higher highs. Again, price trumps all, so unless and until there is a break below last week’s low, and a subsequent close below 5255 in the cash S&P index, there is nothing substantial to say the bull market is vulnerable.

Software Chart

This is the third week I am featuring the software ETF IGV. Its price action is critical. It retouched support at 82.20 and bounced. I have not touched any annotation on this chart

:I will not be able to lean bearish on stocks until a closing break below this 82.20 level.

Fixed Income: Watch curve in front of heavy Treasury supply

Weekly Trend: Bullish ?

Weekly 10-year notes are bullish below 4.50% as seen by this weekly chart

Because the 12-month correlation between 10-year yields and the S&P 500 is back in positive territory, a move above 4.50% in the 10-year will be significantly negative for stocks.

Focused on the yield curve

Based on the chart below, I had mentioned weeks ago that the 2-year vs. 10-year yield curve spread between -15 and -40 basis points was noise. The curve just moved beyond that range this week. The black and red horizontal lines were the original ones from when I first mentioned that range:

Why is the curve important? If the curve reflects Waller’s worry that production weakness may be spreading into the larger services sector, and/or his concern over a weakening consumer, then that is something that could cascade into the equity markets.

The curve is sitting on -48 basis point support. Below -61 basis points would go below the cloud and could see Japanese institutions among others moving out on the U.S. Treasury curve. The flattening has occurred as expectations are moving back from two rate cuts to one. We will be watching how the curve reacts to the heavy Treasury auction schedule that packs in over $200 billion in 2-year and 5-year (Tuesday) and 7-year (Wednesday) coupons, including $28 billion in floating rate notes, and Friday’s PCE inflation data.

Warning coming out of the junk market?

The percentage of BBB bonds on negative outlook has more than doubled since February to 5.7% and now exceeds the share of BBBs on positive outlook for the first time since the pandemic

.Once again, this is not a positive.

Crude Oil: Biden releases one million barrels of gas in an attempt to drop prices

Weekly Trend: Bearish

Inventory data came in higher than expected, keeping a lid on Crude below $80

:Getting back above $80 this week would be very bullish in front of Saturday’s OPEC meeting. Otherwise, a move toward $75 could represent a good risk/return buying opportunity.

Best,

Peter Corey

Pave Pro Team

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