[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.

[This blog post is a modified excerpt from a commentary published at TSI in April of 2022. The main changes are updates to the chart and the numbers.]

The US monetary tightening commenced in February of 2021– the month that the US monetary inflation rate peaked at the extraordinary level of 40%. The monetary inflation rate has since collapsed to around 0% and if the Fed has its way will fall even further over the months ahead. Why is this important?

The overarching reason it’s important is that changes in the monetary inflation rate, that is, changes in the rate at which new money is created out of nothing, drive the economy’s boom-bust cycle. More specifically, large increases in the monetary inflation rate result in periods during which the economy is superficially strong and optimism abounds (the boom phase), while subsequent reductions in the monetary inflation rate lay bare the ill-conceived boom-time investments and usher in the bust phase.

Associated with the major trends in the monetary inflation rate that drive the boom-bust cycle are major trends in the yield curve.

A discussion of the relationship between the monetary inflation rate and the yield curve, including a full explanation of why an inversion of the yield curve has preceded all US recessions of the past sixty years, can be found HERE. The bottom line is that trends in the monetary inflation rate drive trends in the yield curve, with a yield curve inversion being caused by a decline in the monetary inflation rate from a high level to a low level. That is, both a flattening of the yield curve to the point where it becomes inverted and a shift in the economy from boom to bust are eventual effects of a downward trend in the monetary inflation rate.

The strong positive correlation between the US monetary inflation rate and the US yield curve is illustrated by the following monthly chart. On this chart the yield curve is represented by the monthly average of the 10year-2year yield-spread and is shown in red. The monetary inflation rate is the year-over-year percentage change in True Money Supply (TMS) and is shown in blue.

One difference between the current cycle and previous cycles is that monetary conditions in the current cycle became sufficiently tight to drive parts of the yield curve into inverted territory when the Fed was just STARTING a monetary tightening campaign.

Does the Fed have any idea what it is doing?

Before answering the above question it is worth reiterating that the Fed is a Keynesian institution. Within the Keynesian framework the economy can be viewed as a bathtub filled with an amorphous liquid called “aggregate demand”, and it is the job of the central bank and the government to add or remove liquid to keep the level of the tub in a range deemed desirable. In the real world, however, there are millions of individuals making production, consumption and investment decisions for myriads of reasons. Consequently, in the real world there is no such thing as the Keynesian “aggregate demand” and it is ridiculous to view the economy as a bathtub that can be filled/emptied by policymakers to optimise performance.

Returning to the above question, the Fed seems to believe that it can make up for the recklessness of its actions during 2020-2021 by becoming excessively ‘tight’ during 2022-2023. At least, that’s the only plausible explanation for why it started reducing its balance sheet by up to US$95B per month, thus removing up to $95B of money from the economy every month, after the monetary inflation rate had already dropped far enough to bring on the bust phase of the cycle.

Also, the Fed seems to believe that it can address rapidly rising prices resulting from supply shortages by engineering a further tightening of monetary conditions, as if reducing the availability of money will remove the constraints on supply caused by COVID-related policies and anti-Russia sanctions.

The reality is that after an inflation problem has been created via a large increase in the money supply, removing money from the economy cannot help. Actually, it will lead to additional distortions of relative price signals and thus greater economic weakness. What’s desirable is money-supply stability.

So, the answer to the question is no. Even taking into account the limitations imposed by the fatally flawed Keynesian framework in which it operates, the Fed appears to have no idea what it is doing.

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

Market interest rates always lead Fed-controlled interest rates at important turning points. Therefore, when trying to figure out whether interest rates have peaked or troughed, don’t look at what the Fed is saying; look at what the markets are saying.

The above statement is illustrated by the following chart comparison of the Fed Funds Rate (the green line), an overnight interest rate totally controlled by the Fed, and the 2-year T-Note Yield (the blue line), a short-term interest rate that is influenced by the Fed but ultimately determined by the market. The chart shows that at cyclical trend changes since the mid-1990s, the 2-year T-Note yield always changed direction in advance of — usually well in advance of — the Fed Funds Rate (FFR). For example, focusing on the downward trend changes we see from the chart that a) the 2-year yield reversed downward in Q4-2018 and the FFR followed in mid-2019, b) the 2-year yield reversed downward in mid-2006 and the FFR followed in mid-2007, and c) the 2-year yield reversed downward in Q2-2000 and the FFR followed in Q4-2000. When the 2-year T-Note yield reversed downward in 2018, 2006 and 2000, the Fed had no idea that within 6-12 months it would be slashing the FFR.

Right now, J. Powell thinks that the Fed is going to hike its targeted interest rates 2-3 more times and then hold them at 5% or more until well into 2024. However, that’s nothing like what the Fed will do if the stock market, the GDP growth numbers, the CPI and the employment data do what we expect over the next few quarters.

Our view is that the US stock market and economy are about to tank due to the decline in the monetary inflation rate that has already occurred, causing market interest rates to fall across the yield curve. Furthermore, the longer it takes for the Fed to wake up to what’s going on, the worse it will be for both the stock market and the economy and the more rapid will be the decline in market interest rates.

The Fed is asleep, but the market has begun to discount the “inflation” collapse and the negative economic news to come. Evidence is the pullback in the 2-year T-Note yield from its high in early-November to below its 50-week MA (the blue line on the following chart). This is the first sustained break below the 50-week MA since the upward trend was established in 2021. A break below the 90-week MA (the black line on the chart) would be a definitive signal that the 2-year yield’s cyclical trend has changed from up to down.

Based on the leads and lags of the past three decades, if the early-November high for the 2-year yield proves to be the ultimate high for the cycle, which it very likely will, then the Fed has made its last rate hike and will be cutting rates by the final quarter of next year. Our guess is that the Fed’s first rate-cut will occur during the second or third quarter of 2023.

[This blog post is an excerpt from a commentary published at TSI on 4th December]

At least one of two things should happen to warn that an official US recession is about to begin. One is a decline in the ISM Manufacturing New Orders Index (NOI) to below 48 and the other is a reversal of the yield curve’s trend from flattening/inverting to steepening. For all intents and purposes the first signal triggered in July-2022 when the NOI dropped to 48, whereas the second signal probably won’t trigger until the first half of next year.

The following monthly chart shows that the NOI dropped to a cycle low of 47.1 in September-2022, ticked up in October and returned to its cycle low in November, leaving the message unchanged. The NOI is signalling that a recession has started or will start soon.

The following chart also shows that the NOI dropped below 40 during the recession period of the early-2000s and dropped below 30 during the 2007-2009 Global Financial Crisis and the 2020 COVID lockdowns. We expect that it will drop below 30 next year.

The first of the two daily charts displayed below shows that the 10yr-2yr yield spread, our favourite yield curve indicator, plunged well into negative (inverted) territory during July and remains there. The second chart shows that the 10yr-3mth yield spread, which apparently is the Fed’s favourite yield curve indicator, finally followed suit over the past two months and is now as far into inverted territory as the 10yr-2yr spread.

One of our consistent messages over the past few months has been that a more extreme inversion of the US yield curve would occur before there was a major reversal to steepening. There were two reasons for this. First, the monetary inflation rate (the primary driver of the yield curve) was set to remain in a downward trend until at least early-2023. Second, it was likely that declining inflation expectations would put downward pressure on yields at the long end while the Fed’s rate-hiking campaign supported yields at the short end. For these reasons, we wrote over the past few months that by early 2023 both the 10yr-2yr and 10yr-3mth spreads could be 100 basis points into negative (inverted) territory.

As recently as two months ago our speculation that the 10yr-2yr and 10yr-3mth spreads would become inverted to the tune of 100 basis points (1.00%) by early-2023 looked extreme, especially since the 10yr-3mth spread was still above zero at the time. With both of these spreads now having become inverted by around 80 basis points, that’s no longer the case.

We doubt that the aforementioned yield spreads will move significantly more than 100 basis points into negative territory, because we expect that during the first quarter of next year economic reality (extreme weakness in the economic statistics and the stock market) will hit the Fed like a ton of bricks. This should bring all monetary tightening efforts to an abrupt end, causing interest rates at the short end to start falling faster than interest rates at the long end, that is, causing the yield curve to begin a major steepening trend.

Our conclusion over the past four months has been that the US economy had commenced a recession or would do so in the near future. Due to recent up-ticks in some coincident and lagging economic indicators, we now think that the first quarter of 2023 is the most likely time for the official recession commencement.