[This blog post is an excerpt from a TSI commentary published on 12th March 2023]

The financial markets have been fighting the Fed since October of last year and especially since the start of this year, in two ways. The first involves bidding-up stock prices in anticipation of a ‘Fed pivot’, which we have described as a self-defeating strategy. The second involves factoring lower interest rates into bond prices, which we thought made sense. What is the current state of play in the battle between the markets and the Fed?

Just to recap, we wrote in many previous commentaries that stock market bulls would get the monetary policy reversal on which they were betting only AFTER the SPX plunged to new bear-market lows and the economic data had become weak enough to remove all doubt that a recession was underway. In other words, a very weak stock market was one of the prerequisites for the policy reversal. That, in essence, is why bidding-up prices in anticipation of a policy reversal was/is viewed as a self-defeating strategy. Also worth reiterating is that previous equity bear markets were not close to complete when the Fed made its first rate cut. This implies that if we are still months away from the Fed’s first rate cut then we could be a year away from the final bear market low.

Regarding the other aspect of the Fed fighting, we have written that interest rates probably would move much lower over the course of 2023 due to an economic recession, an extension of the downward trend in inflation expectations and a collapse in the year-over-year CPI growth rate. This meant that from our perspective the financial markets were right to be factoring lower interest rates into Treasury securities with durations of two years or more. However, in the 16th January 2023 Weekly Update we cautioned: “…the recent eagerness of traders to push-up asset prices in anticipation of easier monetary policy has, ironically, extended the likely duration of the Fed’s monetary tightening. Therefore, while the markets probably are right to discount lower interest rates over the coming year, ‘fighting the Fed’ has created a high risk of interest rates rising over the next 1-3 months.”

Partly due to equity traders attempting to ‘front run’ the Fed, the monetary tightening has been extended and interest rates rose markedly from mid-January through to the first half of last week. The 10-year and 30-year Treasury yields have remained below their October-2022 cycle highs, but the 2-year Treasury yield, which had signalled a downward reversal late last year, made new highs over the past fortnight.

The following chart shows the surge in the 2-year Treasury yield from a multi-month low in mid-January to a new cycle high during the first half of last week. It also shows that there was a sharp decline during the second half of last week. Will the latest downward reversal stick?

We suspect that it will. It’s likely that 10-year and 30-year Treasury yields have reversed downward after making lower highs, and that the 2-year Treasury yield has made a sustainable downward reversal from a slightly higher high for the cycle. This is the case because other markets are signalling the start of a shift away from risk.

There’s a good chance that within the next few months stock market bulls will get the Fed pivot they have been betting on. However, they probably will get it with the SPX at 3000 or lower.

[Below is an excerpt from a commentary posted at TSI on 19th February. Subsequently there have been no significant changes in the data, so the conclusion remains the same.]

Cutting to the chase, the short answer to the above question is no. Here is the longer answer:

Banks becoming suspicious of each other is one of the early signs that a banking crisis is brewing. This suspicion is indicated by a rise in the average interest rate that banks charge each other for short-term financing relative to the interest rate paid by the US federal government for financing of similar duration. For example, under normal (non-crisis) conditions the spread between 3-month LIBOR, a widely used interbank interest rate, and the yield on a 3-month Treasury Bill oscillates between 0% and 0.50%, but when some banks start becoming concerned about the financial strength of other banks the spread breaks above 0.50%.

The following daily chart shows the performance of the aforementioned interest rate spread since early-2006. The Global Financial Crisis of 2007-2009 sticks out on this chart and was signalled by an initial surge above 0.50% during the second quarter of 2007. During the period covered by this chart the only other move to well above the top of the normal range occurred during the March-2020 COVID crash, but it was very short-lived as the Fed acted immediately to ensure that the economic shutdowns perpetrated by governments did not create problems for the commercial banks. Also worth noting is that there were minor signs of banking-system stress in Q4-2011, Q3-2016, Q1-2018 and the first half of 2022 that did not develop into crises.

Importantly, the chart shows that the current spread is close to zero, which means that the interbank market is as calm (lacking in suspicion) as it ever gets.

Another interest rate spread worth monitoring is the Secured Overnight Financing Rate (SOFR) minus the yield on the 1-month Treasury Bill. The SOFR is the interest rate that banks and hedge funds pay to borrow overnight money in the US Repo (Repurchase Agreement) market. It has a much shorter history than the LIBOR, but it is gaining in popularity. Like the LIBOR-Treasury spread discussed above, a substantial and sustained rise in the SOFR-Treasury spread would indicate increasing suspicion/stress in the banking system.

The following chart shows that the SOFR-Treasury spread has been far more volatile during the past 12 months than it was during the bulk of 2020-2021, but that it has oscillated around zero and currently is slightly below zero (a level indicating a general lack of concern).

Note that the huge upward spike in the SOFR-Treasury spread in 2019 was due to the “Repo Crisis” in September of that year. The Fed circumvented this crisis very quickly via emergency liquidity injections.

Unusual increases in the above interest rate spreads would warn that a banking crisis was brewing. Also, prior to a banking crisis there would be persistent and pronounced weakness in bank equities relative to the broad stock market.

The lower section of the following chart shows that there was significant weakness in the Bank Index (BKX) relative to the broad stock market (represented by the SPX) during February-March of last year, but that the BKX/SPX ratio is in a short-term upward trend and is at roughly the same level today as it was in early-April of last year.

Banking crises don’t come out of nowhere. Enough people inside and outside the banking industry see them coming and take steps to protect themselves or profit from the fallout that early warning signs emerge. Currently there are no such signs.

[This blog post in an excerpt from a recent TSI commentary]

It is clear that Russia’s invasion of Ukraine has escalated into a major war. It is also clear that the conflict has evolved into a NATO proxy war against Russia. We don’t know how it will end and the extent to which the shooting will expand beyond Ukraine’s borders, but it’s very likely to result in the near-complete destruction of Ukraine. This almost certainly means that during the years following some form of peace agreement, there will be an effort to rebuild Ukraine funded by…you.

At the moment there’s no point attempting to analyse the ramifications of the Ukraine rebuilding in detail, because there’s no way of knowing when the war will end. It could end within the next two months or it could drag on for another two years. The issues we want to address in brief today are that the rebuilding effort will 1) be colossal (probably trillions of dollars), 2) cause a large and sudden increase in the demand for industrial commodities, and 3) be funded mainly by the citizens of the countries that provided military assistance to Ukraine. The entire episode will be a Keynesian stimulus program writ large. You destroy an entire country and then pay to bring it back to the way it was, creating a veritable tidal wave of “aggregate demand” in the process.

Regarding how the rebuilding will be funded, the key is that under the current monetary system anything that is paid for by the government initially will appear to be free. For example, since the start of the Russia-Ukraine war the US government has spent or committed to spend about US$105B to assist in Ukraine’s defence. This spending, which equates to about $800 per US household, has widespread support within the electorate, but how much support would it have if every household had received a bill for $800 for “military assistance to Ukraine”? Undoubtedly a lot less.

The reason that the Ukraine assistance and many other large government spending programs are either supported or ignored by the general public is that from the perspective of most people there is no cost. Nobody gets a bill or immediately has to pay higher taxes to cover the spending. Instead, the government just adds more debt to the ever-growing pile. Furthermore, sometimes the debt is purchased by the central bank with money created out of nothing, in which case there isn’t even a need for private investors to part with any money to fund the government deficit-spending.

Almost regardless of how high the cost of supporting Ukraine’s military efforts, it will be minor compared to the cost that eventually will be incurred in the rebuilding of Ukraine. However, for the reason outlined above, the huge cost initially won’t appear to be a major problem because it won’t adversely affect the personal finances of most people. There simply will be an addition to the existing pile of government debt. It won’t be until a year or two later, when the large demand for scarce resources resulting from the debt-financed rebuilding has caused interest rates and the cost of living to sky-rocket, that the adverse effects will be apparent to the general public.

Industrial metals such as copper, zinc, and nickel, and specialty metals such as lithium and the rare-earths, are among the resources that should have the greatest increases in demand relative to supply once the Ukraine rebuilding gets underway. This is because shortages of these commodities are already in the works due to the “energy transition” to which the political world is committed. An implication is that having investments linked to the production of these commodities will be a way for people to profit from or protect themselves against the “inflation” that will be unleashed after the fighting stops and governments set about trying to repair what they destroyed.

That reconstruction will follow the destruction is something to be aware of. Urgent action is not required, however, because at this time there are no signs that the destruction is about to end.

[This blog post is an excerpt from a TSI commentary published on 22nd January 2023]

It goes without saying that the early stage of every large rally contains a break above resistance and the early stage of every large decline contains a break below support. However, most upside breakouts are not followed by large rallies and most downside breakouts are not followed by large declines. More interestingly, it is not uncommon for the best rallies to begin shortly after breaks BELOW obvious support and for the largest declines to begin shortly after breaks ABOVE obvious resistance. The reason is that breaching obvious resistance/support shakes out many weak-handed speculators and in doing so can create a sentiment platform capable of launching a substantial move in the opposite direction.

There are countless examples of the phenomenon described above, including gold’s performance over the past several months. Last September-October the US$ gold price breached important and obvious support defined by the lows of the preceding two years, but the breach of support did not have bearish implications. Instead, it marked the END of a 2-year bearish trend and in all likelihood ushered in a cyclical bull market.

We are revisiting this topic today because the S&P500 Index (SPX) is positioned such that it could soon generate a misleading signal in the form of a break above obvious resistance.

The potential upside breakout is associated with the downward trend-line drawn on the following daily SPX chart. Every chart-watcher and his dog are paying close attention to this trend-line and many of them undoubtedly would interpret a move above it as evidence that the bear market is over. However, the historical record suggests that the bear market won’t end until many months after the monetary trend becomes favourable, which probably means no sooner than the final quarter of this year.

There are fundamental differences between the present day and any previous period, but in price-action terms the current equity bear market has, to date, been similar to the equity bear market of 2000-2002. Both bear markets followed spectacular bubbles that were focused on tech stocks, involved stair-step declines rather than liquidity-driven collapses, and contained signs of internal strength after the initial multi-month declines.

Interestingly, during the course of the 2000-2002 bear market the SPX broke above a downward trend-line that is not unlike the trend-line drawn on the above chart. As illustrated below, about a week after the ‘bullish’ upside breakout in March-2002 the SPX commenced its largest decline of the bear market.

We don’t know that the SPX will break above its downward trend-line in the near future, although it stands a good chance of doing so. The point we want to stress today is that if the trend-line is breached it will not imply that the bear market is over or even that there will be significant gains over the weeks immediately ahead. On the contrary, an upside breakout could lead quickly to the best opportunity to date to enter bearish speculations.