Yield Curve Speaks, Commodities Listen

August is just getting going, but it’s already proving to be far from a vacation month for markets. A number of complicated and consequential dynamics are in play. This week, the bear market rally in major stock indexes persisted, commodities continued to slide, the dollar gained ground again, and bonds tumbled as yields headed higher. Expectations for the size of future Federal Reserve rate hikes increased, as did expectations for the terminal fed funds rate for the current hiking cycle. Meanwhile, the inverted yield curve deepened dramatically to multi-decade extremes, evolving from a cautionary red flag to a blaring warning siren presaging an impending crisis.

By June’s market low, extreme bearish sentiment, extreme bearish positioning, deeply oversold technicals, and negative news flow saturation set the stage for the current bear market rally. These ingredients were potent enough to wrest the driver’s seat from fundamentals in dictating market price action. At this point, however, the bear market rally dynamics are getting mature. Shorts have been painfully squeezed, many skittish bulls have started to chase prices higher on fear of being left behind, technicals have migrated from oversold towards overbought, and market sentiment has begun to reemerge from the bomb shelter.

Despite the fact that the technical basis for the relief rally has eased, the counter-trend move higher in stocks recently got its second wind. Weakening economic data coupled with comments interpreted as dovish from Fed chair Powell at July’s FOMC Fed meeting sent stocks still higher on speculation that a dovish Fed policy pivot and an end to the hiking cycle were imminent.

Regardless of the bear market rally, a crucial underlying fact remains. The radiation poison that comes from exposure to higher interest rates for our credit-based, debt-laden, structurally fragile financial system continues to sicken the underlying economy.

At present, indexes are facing their first major technical resistance. As a result of news this week, the market narrative has shifted away from “the pivot is upon us,” to a new narrative suggesting “more hawkish hikes, no pivot in sight.”

So, what does all this mean for the bear market rally in equities? A breakout above current resistance may extend the rally further. The S&P 500 could go as far as testing the now falling 50-week moving average above 4,300, but the clock is ticking. The bear market internals are reloading, and the hammer appears cocked and ready to fire the next bearish bullet at any time. To channel Churchill, it may not be the end of the rally, it may not even be the beginning of the end, but it is perhaps, the end of the beginning.

As for the significant news of the week, ISM and PMI data sent very mixed economic signals, while Friday’s non-farm payroll report absolutely blew away estimates, adding over half a million new jobs.

This week, it was a tale of two very different services sectors. S&P Global US Services PMI fell from 52.7 to 47.3 in July. This latest reading depicted the weakest data since Covid, and before that the Great Financial Crisis. The contraction was also broad-based. On a completely different page, ISM Services actually reported an increase from 55.3 to 56.7 in July, well above the 53.5 estimated. Very tough to know exactly what to make of the divergent reports. Chris Williamson, Chief Business Economist at S&P Global, offered color on the S&P PMI data:

US economic conditions worsened markedly in July, with business activity falling across both the manufacturing and service sectors. Excluding pandemic lockdown months, the overall fall in output was the largest recorded since the global financial crisis and signals a strong likelihood that the economy will contract for a third consecutive quarter…with a further steep rise in interest rates from the FOMC since the survey data were collected likely to intensify the downturn. Higher interest rates, alongside the ongoing surge in inflation, have meanwhile spilled over to the consumer sector, meaning the surge in household spending on goods and activities such as travel, tourism, hospitality and recreation seen in the spring has now moved into reverse as household spending is diverted to essentials.

Williamson continued, “Although employment continued to rise in July, the rate of job creation has also slowed sharply since the spring and looks set to weaken further in the coming months as firms cut operating capacity in line with weakening demand.”

Furthering the conflicting data, on Friday all attention turned to the July non-farms payroll report. The release showed the labor market remaining very strong despite other signs of economic weakness. The U.S. Bureau of Labor Statistics (BLS) reported that non-farm payrolls increased by 528,000 in July, whipping expectations of 258,000. The number lowered the unemployment rate from 3.6% to 3.5%, while wage growth rose 0.5% for the month. It was the strongest payroll report since February.

Responding to the report, Peter Boockvar, chief investment officer at Bleakley Financial Group, noted, “This was a great number…but when this is happening at the same time GDP is declining, it means productivity is plunging… As the pace of firings is at the highest level in nine months, this pace of hirings is just not sustainable.”

Steve Sosnick, chief strategist at Interactive Brokers, added that the jobs report, “really disrupts the market narrative of expectations for a Fed policy pivot… The data is very market-unfriendly.” Liz-Ann Sonders, chief investment strategist at Charles Schwab commented that, “For the economy, this is good news… It’s not positive from a market or Fed perspective.” This week’s non-farm payroll report, along with recent consumer price inflation reports, is the latest data point locking the Fed onto its aggressive rate hike path. This week, Fed speakers affirmed their hawkish intentions.

As recently as last summer, Minneapolis Fed head Neel Kashkari said he wanted to keep interest rates at near-zero “at least through the end of 2023.” Forty-plus-year highs in inflation, a tight labor market, and all-time record low consumer sentiment (despite the strong labor market!) will change a thing or two, however. Fast forwarding to this week, Kashkari offered a slight tweak to his preferred policy position. On the policy outlook through 2023, he said the likely scenario is, “given what I know about the underlying inflation dynamics…we would continue raising [interest rates] and then we would sit there until we have a lot of confidence that inflation is well on its way back down to 2%.” Talk about leaping from one side of the Titanic to the other.

Kashkari’s views were echoed by other Fedspeakers this week in a rare, unified front. St. Louis Fed President James Bullard confirmed a similar stance, saying, “I think we’ll probably have to be higher for longer in order to get the evidence that we need to see that inflation is actually turning around on all dimensions and in a convincing way coming lower, not just a tick lower here and there.” San Francisco Fed President Mary Daly also carried the hawkish torch and said the Fed’s work to bring down inflation is “nowhere near” done. She warned there’s “a long way to go… The number of people who can’t afford this week what they paid for with ease six months ago just means our work is far from done.”

It’s worth reemphasizing the impossible-to-ignore elephant in the room. In an already slowing, debt-laden, credit-based economy more structurally dependent on loose financial conditions than ever, a Fed on a rate-hike warpath is a recipe for disaster. 

Meanwhile, according to Nobel Laureate economist Joseph Stiglitz, “it takes about 18 months for the full effects of monetary policy to be felt.” Other estimates suggest a 6–9-month lag for policy to bite. Either way, the point remains: Given the 225 basis points of tightening in just the last four months, with more on the way, the economy has already endured heavy radiation exposure and is still being subjected to ionizing radiation. At the same time, the impact of quantitative tightening (Fed balance sheet reduction/liquidity withdrawal) has barely even begun.

Crucial questions remain. How far will the Fed go with increasingly restrictive policy? How much economic damage will be wrought? Under what conditions, and to what degree, will the Fed eventually pivot back to an outright “accommodative” policy stance?

The depth and breadth of the inverted yield curve and the violence of the “kink” in the curve suggest the bond market expects the policy pivot point to revolve around some crisis event. As highly respected economist Mohamad El-Erian put it following Friday’s jobs report, “you saw what happened to the inversion of the 2s10s [yield curve], now beyond 40 basis points, it’s saying that they’re going to have to somehow break this economy to bring inflation under control.” Given how woefully behind the curve the Fed already is on inflation, along with the further inflationary fuel of a tight labor market, El-Erian says tighter Fed policy “is having to catch up frantically, and nobody likes to see a central bank catch up frantically.” In other words, the bond market sees a policy error culminating in crisis.

So, from the vantage point of the bond market, every tick higher in the equity bear market rally looks like an even better opportunity to step aside. Despite the recent weakness in commodity prices, Bloomberg estimates for next week’s CPI inflation reading are for 8.8%. That would be the second highest print in 40+ years, and blisteringly hot. Even a significant miss of the estimate would still leave inflation in the critical red zone. Adding the hot jobs data this week on top, it’s clear that the challenging dynamics for the Fed, the economy, and markets are firmly in place and more elevated than ever. What a mess.

Remember that inflation was already going to trip up this economy. Even if you have a strong labor market, it is not keeping up with inflation. The 70% consumer-driven economy still has to reckon with the fact that real “inflation adjusted” wages are negative and that, more broadly, real disposable income is negative. This is forcing the consumer to draw down savings and increase credit card debt, both of which are exactly what is happening. Second quarter credit card debt, out this week, increased at the fastest rate in 20 years, and the savings rate is at a 12-year low. That means that, despite the job market, consumer spending is in the late rounds to continue punching above its weight. In fact, spending has already started to trend negative in real terms. Meanwhile, the Fed is held hostage by hot inflation and labor data. Its policy must therefore remain on a hawkish trajectory. The dynamics square with the picture the bond market inversions are painting: a Wile E. Coyote Fed sprinting off a cliff and scrambling furiously in mid-air before falling far, far below to the valley floor.

For the time being, commodity markets are siding with the bond market on the risk of a crisis “event.” Almost all subcomponents are, to greater or lesser degree, being negatively impacted by the looming threat of crisis. According to JPMorgan, at the market lows in June, base metals were signaling a 65% chance of recession. That signal has since increased to 84%. 

Meanwhile, oil was crushed again this week despite a much smaller than expected, almost miniscule, 100,000 barrel per day production increase by OPEC+. The shockingly small increase, along with the implications that spare capacity is nearly nothing, should have been bullish for black gold. Instead, its price dropped by nearly 10%. In addition, bullish oil demand news also emerged on reports that European nations are moving towards aggressive gas-to-oil switching as a means to cope with stiflingly high natural gas prices. Technically, oil now finds itself precariously testing trend-line support for the entire rally off Covid lows. If support meaningfully fails, the breakdown could turn violent. Even copper’s attempts to recover from its recent collapse have been exceedingly muted and unimpressive as the metal languishes under the threat that crisis dynamics will trump demand.

Precious metals have rallied nicely off their lows, but gold still sold off on Friday and failed to close the week above $1,800. The rally may continue to the upper $1,800s in coming weeks, but the complex has so far remained relatively subdued given the context of an exceedingly bullish set-up. All sentiment indicators are supportive of a significant bottom in the complex as capitulation occurred over the recent selling washout. For example, gold COT futures-market positioning is now at contrarian bullish extremes reached only two other times in the last 20 years. Those other occasions were major bottoms in 2015 and 2018. Nevertheless, the gold complex remains uneasy. The likely culprit is lingering concern that further collateral redemptions will negatively impact gold should a crisis event trigger a broad market liquidity crunch. No doubt, we are nearing dramatically better weather in the gold market as soon as the looming storm breaks or the risk diminishes, but for now all commodities, like the bond market, are skittish. 

At present, the Fed is reacting to the immense building pressure to stop inflation. When the full negative impact of its policy path becomes more apparent in the economy, the Fed will really be put to the test. As former Treasury Secretary William E. Simon said, “the American people have a love-hate relationship with inflation. They hate inflation, but love everything that causes it.” As the inflation fight causes ever more economic pain, the Fed’s minefield may fully encircle them as Americans paradoxically demand a stop to inflation while at the same time insisting the Fed and fiscal policymakers dole out record amounts of everything that causes it. In such an impossible situation, policymakers will be mightily challenged. History suggests, however, strong odds that inflation concerns will eventually take a back seat as pragmatic policy calculus yields a stimulative pivot as the least bad option.

Weekly performance: The S&P 500 gained 0.36%. Gold was up 0.53%, silver was down 1.78%, platinum was higher by 3.92%, and palladium was nearly flat, down 0.05%. The HUI gold miners index shed 1.26%. The IFRA iShares US Infrastructure ETF was lower by 0.83%. Energy commodities were volatile and lower. WTI crude oil was crushed by 9.74%, while natural gas lost 2.01%. The CRB Commodity Index was down 3.77%, while copper was down 0.56%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 0.76% on the week, while the Vanguard Utilities ETF (VPU) was up 0.13%. The U.S. Dollar Index gained 0.67% to close the week at 106.49. The yield on the 10-yr Treasury jumped 16 bps to end the week at 2.83%.

Best Regards,

Morgan Lewis
Equity Analyst & Investment Strategist
MWM LLC