Yield Curve Flattens As Stocks Near Record High

Yield Curve Flattens Again

Yield Curve - Even though the stock market is within 1% of its record high, the 10 year yield fell 4 basis points to 2.82% on Monday as it is following my prediction. Growth probably won’t get much higher than where it was in Q2 and inflation will decelerate after it peaks in August.

The 2 year yield fell 2 basis points to 2.59%. This means the difference between the 10 year yield and the 2 year yield is only 23 basis points which is the lowest of this business cycle. This flattening is right before the Fed raises rates again at its next meeting on September 26th.

Ultimately, this means nothing for a recession yet, but it implies growth will follow the trajectory the ECRI leading index predicts. There is a sharp difference between what the 10 year sees in the future and what stocks see.

I think the future is somewhere in the middle as growth will decelerate, but still be decent.

Yield Curve - S&P 500 Closes In On Record High

We have been watching the S&P 500 try to reach a new record high for weeks. It took a strong step in that direction on Monday as the S&P 500 increased 0.25% to 2,857.05. The VIX fell 1.19% to 12.49. The CNN Fear and Greed index is at 56, showing us that there is room for stocks to increase.

I think technical resistance, global economic slowing, and fears of a trade war are preventing the market from reaching a record high. Ultimately the technical resistance will be broken. Stocks will increase during the trade skirmishes and crash if there is a major tariff announcement. They will soar if there is news of the skirmishes ending.

I’ll discuss more about trade later in this article.

Yield Curve - Sector Weighting

The best sectors on the day were materials, industrials, and consumer discretionary, which were up 0.72%, 0.64%, and 0.62% respectively. Macy’s stock was up 6.05% even though it had bad earnings last week. It has recovered close to half of its losses from the crash on Wednesday.

Nordstrom was up 4.02% as it continued its rally from Friday.

The chart below shows the sectors fund managers are the most overweight. As you can see, fund managers love healthcare, technology, and consumer discretionary and loathe consumer staples, telecom, utilities, and real estate.

This isn’t a surprise because Amazon and Netflix are in the consumer discretionary sector and Apple, Alphabet, and Facebook are tech firms. This will change in September when the indexes change, but the stocks managers own will stay mostly the same.

The chart shouldn’t make you short tech and buy utilities because this is exactly the weighting you should expect in a bull market. The stocks in the bottom sectors don’t have many firms that will quickly grow their earnings.

They have slow and steady firms which will outperform when there is a risk event. Fund managers who buy momentum names do well and get more investors who then expect the managers to invest more in what has been working.

It is a snowball effect which eventually crashes and burns when the economy falters.

I don’t necessarily think stocks will crater, but the momentum names will definitely have a big correction when the cycle ends. This explains why you shouldn’t short risky stocks and buy the defensive names.

You need to believe the cycle will end soon to make that trade. This is a foolish projection based on the economic data and earnings projections.

Yield Curve - Does President Trump Hate Rate Hikes?

It’s not a surprise President Trump doesn’t seem to like Powell’s rate hikes. But it’s always news when the President  discusses monetary policy. Trump said "I'm not thrilled with his raising of interest rates, no. I'm not thrilled. I should be given some help by the Fed."

If the Fed raises rates 2 more times this year, it’s fair to say the economy will be dragged down by the global deceleration, hawkish monetary policy, and potentially a trade war. Trump’s hope is probably that he negotiates a trade deal before tariffs start to impact the economy.

The President will never like rate hikes if they slow the economy. That’s especially true now because the Fed could hurt Trump’s negotiating power when making trade deals.

The latest Fed funds futures market shows there is a 93.6% chance of a hike in September and only a 60.7% chance of at least 2 hikes this year. Even though it’s good news for the yield curve that the Fed could be hiking less, it doesn’t matter much if the 10 year yield crashes like it has recently.

Yield Curve - Not Great News On Trade

Last week there was news that mid-level American and Chinese officials would be meeting to discuss trade; stocks rallied on this report. Interestingly, stocks rallied on Monday even though it doesn’t seem like these talks will go far. The market is ignoring the risk of a trade war for now.

President Trump said Europe and China are manipulating their currencies. Trump said he doesn’t “anticipate much” from the discussions between the mid-level officials that were announced last week.

Furthermore, he has “no timeframe” for ending the trade skirmish with China. He added “I’m like them, I have a long horizon.”

Part of these statements is posturing for negotiation in this game of chicken. However, there isn’t much evidence to suggest that the talks will lower the heat in this trade skirmish.

I don’t see why stocks would maintain their gains when the positive catalyst from last week was proven to be nothing. If Trump announces a major tariff, which ends up being the first strike in a trade war, the stock market will fall by potentially 2%-3% in one day.

Yield Curve - Takeaway & Conclusion

I remain neutral on stocks because of the risk of a trade war, but mainly because I expect an economic slowdown. I won’t be bearish until we see a trend of disappointing economic reports.

It seems likely that the tariffs America has planned for August 23rd will go into effect. The only questions are when President Trump will announce another tariff and what its size will be.

 

 

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2 Comments

  • Terrence

    August 21, 2018

    I enjoyed the article and appreciate the work you put in. I look forward to the next one.

  • CAROLYN HARPER

    August 22, 2018

    Good thoughtful stuff. It clarifies the current market condition. Give me more.