Treasuries Rally Nearly Historic

Big Stock Market Decline On Geopolitical News

The stock market sold off significantly on Monday as investors feared the 10-2 year yield curve inversion and the bad geopolitical news. Specifically, in Argentina’s primary election President Mauricio Macri did much worse than expected which caused the S&P Merval Index (Argentinian stock market) to fall 48% in US dollar terms which was its second biggest daily decline in 70 years. Since 1950, only Sri Lanka’s stock market has fallen more in one day. The S&P Merval fell 45.2% in 2002.

The Argentinian peso initially fell more than 30% and the central bank’s interest rate rose from 63.7% to 74.8%. Mauricio is a center right politician who is seen to be pro-business. He lost to leftist Alberto Fernandez who has a nationalist running mate. Voters were angry about the economy, so this was somewhat of a protest vote. Macri lost by 16 points in a big trouncing. The Fed’s rate hike cycle has boosted the dollar and made it very tough on many emerging market economies. The good news is a new cutting cycle is upon us.  

The other negative geopolitical news event that hurt stocks is the ongoing protest in Hong Kong. This is the worst protest since Great Britain handed off Hong Kong to China in 1997. The protest has been going since early July and has been getting more violent. It originally started because of a bill that would allow people in the city to be extradited to mainland China. That bill has been suspended, but the protest has kept going. The protest has evolved into calling for full autonomy, full democracy, and the ousting of Hong Kong chief executive Carrie Lam. The protest is economically driven as small and medium sized businesses haven’t seen the same growth as multinational firms. There has been no income growth in 30 years. This inequality growth is similar to that of America.

Review Of Monday’s Volatile Action

The stock market correction isn’t over. The Hong Kong protest could keep a lid on stocks in the near term especially since the trade situation between America and China is tenuous. On Monday, the S&P 500 fell 1.22%, the Nasdaq fell 1.2%, and the Russell 2000 fell 1.19%. This was the 5^th back to back Monday decline of over 1% in the S&P 500 since the bull market began. The next 4 days have averaged an increase of 3.24%, but I don’t see a similar performance coming this week. Uber stock fell 7.6% to $37 which is a new all-time low. Investors are still processing the enormous loss it took last quarter. I see no reason to buy the stock in the intermediate term.

The VIX rose 17.36% to 21.09. It’s once again mildly elevated. The CNN fear and greed index fell 2 points to 23 which is extreme fear. This signals stocks should rise in the near term. However, if the protest continues and other negative geopolitical news comes out, stocks won’t rebound. Every sector fell on Monday as the decline was broad based. The 2 worst sectors were materials and the financials which fell 1.58% and 1.92%. The financials obviously fell because of the massive decline in treasury yields and the flattening of the yield curve which I will get to next.

Almost Historic Rally In Treasuries

The rally in treasuries was almost historic because as you can see from the chart below, the 30 year bond yield nearly fell to a new record low. The 30 year yield fell 13 basis points to 2.13%. Its 52 week low is 2.12% and its record low in July 2016 was 2.0882%. It’s very likely to hit a new record low this summer. The 10 year yield fell 11 basis points 1.64%. Its 52 week low is 1.59%. Finally, the 2 year yield fell 7 basis points to 1.58% which is 8 basis points above its 52 week low. As you can see, the longer the maturity date, the more the yield fell. That tells you the curve flattened.

The difference between the 10 year and 2 year yields is just 6 basis points. If it flattens at the same rate as Monday, it will be inverted by Wednesday. If this spread inverts, it will be the top news event of the day and could catalyze a selloff. It’s a similar negative catalyst to the non-manufacturing ISM PMI falling below 50 or the monthly BLS employment report showing negative job creation.

It’s no surprise that the Fed funds futures market expects either 2 or 3 more cuts this year. There is a 49.7% chance of at least 3 more cuts. It used to be that if the Fed kept rates the same, the curve would invert. Now if the Fed cuts rates 2 times in 2019, the curve will definitely invert. One hawkish statement from anyone at the Fed can easily invert the curve. I see the Fed cutting rates in September. I can’t make a prediction on where rates will go by the end of the year because trade policy is uncertain.

On Tuesday, the CPI report comes out. It’s almost impossible for the report to show enough inflation to dissuade the Fed from cutting rates in September. Since the market is pricing in such a large decline in inflation, there’s a possibility this report causes yields to rise if inflation is above estimates. Yearly headline CPI is expected to rise to 1.7% from 1.6% and core CPI is expected to stay at 2.1%. I wouldn’t be surprised if it fell slightly.

Conclusion

My main focus is on the treasury market because the 30 year yield is near a record low and the 10-2 year spread is near an inversion. I don’t think this guarantees a recession within the next 18 months, but it probably will cause stocks to fall below their recent low. I could see a full 10% correction from peak to trough. The markets are more unpredictable than usual because of the number of geopolitical factors in play. There is Brexit, the Argentinian election, the U.S. presidential primary, the trade war with China, and the Hong Kong protest