Higher elevations and steeper slopes?

Higher elevations and steeper slopes?  Equity markets closed slightly higher yesterday well off of their morning lows in a relatively calm trading session.  The S&P gained the most ground yesterday as the other indices did their best to maintain their neutral to constructive positions.  Though the technology sector has been a factor the sector that has been doing most of the pulling over the past week has been a sleeper for a while.  That sector is none other than the financial sector, having been left behind as the ne’er-do-well sector, has stood out so far in this earnings season and it is being rewarded.  Chart 1 in my chartbook tells the story in pictures. This chart represents the returns of each sector over the last week and the winners are Financials, Technology, and Industrials.  Industrials have earned the bronze due to a lack of scary trade news over the last week.  There is another interesting story developing on this chart in one of the also-ran positions.  Utilities, which was a sector that has performed relatively well in the last quarter as longer term bond yields remained in the lower end of their range.  Remember that utilities are an equity-based bond proxy because of their relatively safe and higher dividend yields.  Because of these characteristics utilities tend to trade in a positive correlation to bonds.  This brings us to the real story that is emerging in the overall markets and it is in the recently-quiet back half of my chartbook.

Let’s start with bonds.  The story has been relatively repetitive for much of the summer as longer maturity yields have been held down by buyers betting on the potential for a future recession as well as foreign buying.  A high 2% yield for a 10 year maturity treasury is really attractive to foreign buyers as similar maturity sovereigns elsewhere have significantly lower yields.  OK that was the story until last Friday when President Trump turned his gaze to the Federal reserve in an attempt to keep rates lower longer.  It started with an interview on CNBC and was followed up by… you guessed it… some tweets.  That was enough to cause a selloff of longer maturities starting on Friday and continuing yesterday as yields climbed to levels seen earlier this summer pushing them though the Fibonacci resistance at 2.94% (see chart 20).  If you are a regular reader of my market note, you probably know where I am going next.  We all know that the Federal Reserve is supposed to be independent from political pressure.  This is true for the most part but occasionally pressure from the executive branch has found its way into rate policy – Nixon made a mess of things by pressuring his Fed and is credited for causing the high inflation era that followed in the 1970s.  Anyway, traders today believe that the Powell Fed will exact integrity and stay their course of tightening 1 to 2 times this year despite the jawboning.  Hold front-end rates steady and get a back-end yield rally and you get a steepening curve.  Yes folks, you heard it here for the first time in a while.  You can see it on chart 17 on the Fixed Income cheat sheet.  The thicker black line on the top panel is yesterday’s yield curve and the thinner black line is the yield curve a week ago.  The green bars on the bottom represent the change, so it is clear that 10 year yields went up more than 2 year yields in the past week.  Really the last 2 trading sessions, but whose counting?  So what does this mean?  Well if you are of the belief that long rates will continue to go up and the curve continues to steepen, then you would expect the recent rally in financials to continue.  Remember lenders like a steep yield curve – they make money borrowing short term and lending long term.  The weakness in utilities should continue as well.  Oh did I forget to mention that the Treasury is auctioning off 3, 7, and 10 year maturities this week.  The increased supply will also continue to put pressure on longer yields.  I want to make a quick mention of the fact that the Chinese Yuan continues to decay against the Dollar (see chart 14).  FYI, this is by design as the PBOC has made no attempts to support it.  The President is also unhappy with the strong dollar.  Can you say trade war?  More on this in the days to come.  Today we start the session with Alphabet/Google having knocked the ball out of the park in yesterday’s post-market earnings announcement.  Google is a big part of the S&P500 and this should provide some upward pressure today (remember my pie chart from yesterday).  10 year yields are at 2.95% and the 2 year / 10 year swap is pick 31.96 basis points.  The Tour de France will enter the treacherous Pyrenees Mountains today and the riders will climb their way up the steeper slopes and reach new high elevations today.   Similarly the markets will attempt higher highs and steeper slopes today as well.  Hopefully its legs will hold up!  Please call me if you have any questions.

daily chartbook 2018-07-24