It was going to happen sooner or later.  Real estate developers are all about leverage.  And, leverage is all about the cost of capital.

The FOMC is trying to create some headroom for the next time they need to rescue the stock market economy — apparently not as important to Trump as are the midterm elections.

Though it hasn’t broken down just yet, the US dollar is taking it on the chin… … and USDJPY is circling back for the backtest we’ve been expecting.Futures, which nailed our initial downside target during the yesterday and our second overnight, are off modestly — especially given that VIX broke out.

Bottom line, Trump’s latest outburst threatens to undo Powell’s market-calming, algo-goosing testimony.

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Everybody’s talking about interest rates — mostly fears about the yield curve.  Even the most vocal market cheerleaders have been seen publicly fretting about the flattening yield curve.  Will it invert?  What will it mean?  Will the market crash?

Since our forecasts are pretty much on autopilot at the moment, let’s take a fresh look at where we came from, where we are, and where we’re likely going.

Remember this chart [see: The Yield Curve May 3, 2018], warning of the repercussions should the 10s2s bounce off the white TL?

It didn’t.  But, what’s interesting is why it didn’t.  At the time, SPX was struggling to break out of a downtrend which began in late January and back above the important Fib extension at 2703.

By continuing below the trend line connecting the former lows, the yield curve contributed to SPX’s breakout instead of continuing breakdown.It’s the sort of thing which has kept the rally alive, on a macro level and even day-to-day, as happened lately with VIX.  Note ES’ breakout above the purple TL came at the same moment that VIX broke below its rising red TL.And, it’s happening right now with USDJPY, which broke above the top of a falling white channel and is pushing above a backtest of the rising channel from which it broke down in January.  New highs, made to order.Indices are generally only allowed to correct when there’s a trend line, moving average or Fib level to backtest.It wasn’t always this way, of course.  During the two major crashes of the past 20 years, interest rates and equities moved very much in tandem.  This was true of the 2Y and the 10Y.But, things changed dramatically after central banks took over the bond market.   Rates, which had been driven lower by the flood of equity monies into bonds during the crash, were driven even lower.

The Fed bathed financial markets in trillions in fresh liquidity, boosting all financial assets.  In the process, it also tilted the tables of the relative attractiveness of bonds versus equities.  A 10Y that exceeds 3% is a problem with $22 trillion in debt.   From Feb 23’s Why Rising Rates are a Problem This Time.  The solid black line shows plunging average interest rates across US borrowings, while the orange line shows soaring net interest expense resulting from the massive growth in debt.

As much as they would like to raise long-term rates, the Fed has done the math and knows it would be a knockout blow from which the economy might not recover (Japan anyone?)

But, the Fed needs to create some headroom on the short end of the curve for the next time they have to bail out the markets.  So, we’re left with a curve that gets flatter and flatter, approaching inverted.If they’re paying attention, the Fed knows that they can’t allow it to actually invert — as this would send the signal that a recession is in the offing.  But, they need to get it as close as possible, meaning another hike or two while the 10Y continues to go sideways (over 5 months since reaching our 2.856 target.)

So far, equities are on board with rising short-term rates.But, what happens when the Fed is done painting itself into a corner, when the choice is either to invert or allow the spread to widen?

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Housing starts collapsed 12.3% in June, the 4th worst report in the last 5 years.  Permits dropped 2.2%.

Futures barely budged on the news……as the 4% GDP growth narrative continues to dominate the headlines (Kudlow takes the mic at Delivering Alpha) and algos continue to be well-supported by favorable currency moves……and, conveniently timed dips in VIX.It remains to be seen whether or not carbon-based investors will read the tea leaves and determine that high interest rates and crashing housing starts might affect the actual economy.  It certainly used to — until 2009-2016 when the Fed began injecting trillions into the money supply.  Is it just possible that tightening might have the opposite effect?

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One of the most interesting charts to float across my desk this morning was this one from FactSet, citing currency factors and cost increases as companies’ top concerns on their Q2 earnings calls.With oil, gas and the dollar up significantly over the past several months, it’s not a huge surprise.

Nor is it a surprise that we’ve seen oil and gas decline sharply — a thesis we lhatched months ago when it became apparent that inflation would rise to problematic levels.

The currency question is a little more complicated.  USDJPY is threatening a major breakout… …and EURUSD a major breakdown… …all against the backdrop of a yield curve which is threatening to invert.What does it all mean, and how might Powell address it in his testimony to Congress?  Can the FOMC find a sweet spot where interest rates, dollar strength, and inflation can all be kept in check?

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Futures are flat at the moment, despite sizeable moves in WTI (-2.14%) and RBOB (-2.62%) and a sharp pop in rates.  While we wait for oil and gas to reach our downside targets, I thought it would be a good time to revisit our yield curve charts.

Many of you will remember this chart from May 3 [see: The Yield Curve – An Update.]

At the time, I considered it one of the most important charts to keep an eye on.  Previous bounces off the TL connecting those previous lows correlated strongly with the 2000 and 2007 crashes.

With the 10s2s spread approaching negative territory, we wondered whether or not we’d see a repeat.  Here’s where things stand now.  Note that the curve has not only reached the TL, but has dropped beneath it.

As we’ve discussed many times, a flattening curve is typically positive for stocks.  It’s those sharp spikes higher that do most of the damage.

Back in January [see: China – It’s Not Me, It’s You] I pegged the upside for TNX at 28.56.  I considered the rise above it February an overshoot, convinced that it wouldn’t last. I was partially right. As expected, the pop up to 31.15 in mid-May didn’t last.  But, TNX has clung stubbornly to our target range.  The purple TL from Sep 7 held until May 25, at whit point TNX broke down and tagged our initial downside target — but, not further.In fact, it experienced a strong backtest that lasted through mid-June, and is still hanging around 28.56.

One might wonder why, with the Fed so involved in “managing” interest rates, TNX has been so hesitant to reverse.  That’s where the yield curve comes in (and, a little currency manipulation.)

With the short end of the curve rising in conjunction with the FOMC’s rate hikes, a bigger drop in the 10Y could easily produce an inverted curve — generally considered a precursor to a recession.

10s2s is presently positive by only 25 bps.  So, there is precious little room for the 10Y to drop — at least until the Fed stops hiking rates.  Glass-half-full analysts see rate hikes as appropriate, given the economy’s strong performance.  Cynics see them as a maneuver to create more headroom for the next time the Fed has to step in and save the markets.

Whichever the case may be, the Fed will prevent an inversion for as long as possible.  If/when one does occur, they will be even more cautious about allowing it to unwind rapidly.

If things go according to plan, oil and gas will drop just enough to dissipate the recent inflation pressure — allowing DXY to settle lower along with 10s and 2s.  If they don’t, things could get ugly.

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As we discussed yesterday, USDJPY has reached a critical line in the sand.  As one of the primary drivers of equity algos [see: Yen Carry Trade] this creates a potential headwind for stocks.

Over the years, oil and the USDJPY have mostly offset each other – with one bolstering stocks while the other resets (or, moving in tandem if the situation is dire enough.)  The most significant such event was in July 2014, when WTI’s crash began on the very same day that the USDJPY broke out to new highs.

This enabled Japan, which had recently seen inflation near 4% as a result of soaring oil prices, to withstand even further yen depreciation.  It also enabled SPX to remain above the critical resistance (1823) through which it had recently pushed.

As oil crashed, Japan’s inflation rate settled back down to the level at which the BoJ could justify continuing an insane amount of QQE (which continues to this day.)  And, SPX went merrily on its way to its next technical resistance at 2138, backtesting 1823 another 4-5 times (in case there were any unconvinced bears left standing.)Why the history lesson?  The huge white channel that has carried USDJPY higher since 2010 broke down on January 24, two sessions before SPX topped out and began a 340 point (11.8%) correction.

When SPX finally bottomed out at its 200-day moving average on Feb 9, it was because USDJPY was making noises about rejoining the broken white channel and because oil took the opportunity to bottom out and begin a 29% rally (yep, the same day.)

While CL did the heavy lifting, USDJPY reset for the next six weeks.  It bottomed on Mar 23, the very same day that SPX tagged its SMA200 for the second time.  USJDPY has since supported SPX’s slow, tortuous climb back above a key Fib at 2703 ever since.

But, yesterday, it reached a critical line of resistance — a backtest of the huge white channel from which it originally broke down and instigated the Jan-Feb correction.Normally, backtests mark reversals. So, when we talk about reaching “critical resistance” we’re not just talking about the currency pair.  If USDJPY doesn’t push through resistance, stocks will not be amused.

We’ll take a look at the various scenarios and the likely outcome of each.

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We’ve been beating the inflation drum for months, wondering when the folks behind the curtain would finally pull the levers to reign in energy prices.  Yesterday was a good start, as gasoline and WTI futures were both off sharply.

Ordinarily, we’d expect to see stocks suffer in tandem.  But, as we discussed yesterday morning:

So far, [VIX] has put the brakes on at a backtest of the recently broken straw-man trend line.  If it can remain below the red TL and the SMA200, and USDJPY keeps ramping, stocks will suffer a mild pullback.

That’s exactly what happened.  Another VIX pullback this morning……coupled with a breakout by USDJPY……has futures in the green by 15 points.But, of course, CPI isn’t out just yet.

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USDJPY reached our upside target this morning, tagging the top of the falling white channel from 2015.  This is the terminus of a move which began in late March [see: Algos to Markets – All Better.] This is a pivotal point for the pair, particularly since ES reached its IH&S target overnight.continued for members… (more…)