Yesterday we talked a little to importance of the yield curve.
It’s a proven indicator when it comes to forecasting when an economic slowdown is on the way.
Today things look good and there is no cause to sound alarm bells (as many like to do).
Banks are lending and are happy to. And they will if it’s profitable to do so (opposite the risk taken).
But there are often times when this isn’t the case…
For example, we demonstrated yesterday with this simple chart:
The 2-year Treasury yield is in red. Notice how it trades opposite the 10-year Treasury yield in blue.
What banks don’t want to see is these two lines converging… or worse… the red-line rising above the blue-line.
If that happens – lending freezes (as it’s no longer profitable) and recessions normally follow.
That’s called credit contraction.
It’s normal for credit to both expand and contract as a function of the business cycle.
However, over the past four decades this has been exasperated by central banks as they strove to drive rates lower.
For example, today we require around $4 of credit for just $1 of economic output.
That’s a bad equation.
It’s not a sustainable in the long-run… however in the near-term it gives the perception of working.
Juicing the Market
Central banks have been on a mission the past decade (or so) to drive interest rates below zero in real terms.
Real terms (for those less familiar) is the offical cash rate less inflation.
This has the net effective of creating favourable lending conditions and an abundance of cash.
So what happens when you stuff more (free) cash in the pockets of Mums and Dads?
Typically they speculate; ie asset prices rise.
Australia is a perfect example.
My basic thesis is if interest rates were not allowed to fall below say 6% (in real terms) – there is no way we would have seen the speculative bubble in housing (another discussion)
By driving nominal interest rates below nominal growth rates, pushing real interest rates on cash negative, and driving real bond yields down to near zero percent…. this created a system structured on an enormous amount of leverage (evidenced by what we see with both public and private balance sheets).
But this era of effortless easy money will come to an end.
The problem is most folks don’t realise it.
For example, borrowing say “$600,000+” on income of less than $200,000 has been commonplace. Folks don’t think twice.
And that’s easy when interest rates are the lowest they have ever been.
But try borrowing the same $600,000 and income of less than $200,000 with interest rates at 8%?
Or almost 20% as we saw in the late 1980s?
The equation looks very different.
I’m here to say that this era of ez-money (ie rates at zero) is now approaching its final years. And that’s going to leave a lot of uneducated (housing) speculators high and dry.
Timing Your Exit
Central banking language over the past year is in stark contrast to what we have heard over the past decade.
They are telling us the era of ez-money will be tapered rather than increased.
In other words, the accommodative monetary policy we have enjoyed post 2008 (ie the setting of interest rates) is shifting.
And whilst that is expected (and from my lens welcomed) — what’s also of interest is where we are in the business cycle.
You see, business cycle expansions generally last around 7-8 years.
The current cycle kicked off shortly after the GFC of 2008… enabled via access to more credit.
As such, it too will come to its inevitable slow-down.
Now when you consider that:
(a) monetary conditions are set to become a little tighter (ie in order to maintain the right balance between growth and inflation); and
(b) a business cycle slow-down — we need to be more mindful of our environment.
For the purpose of clarity, the “dance” is not over.
The music is still playing and alcohol is still being served. As such, continue to enjoy it.
And it’s been a “hell of a party”!
But all parties come to a close. Drinks stopped being served.
And whilst we don’t want to be the last person leaving at “3am”… we are now dancing just a little closer to the exit…
It’s fun trying to choose the right language to describe the financial environment (for lack of a better term).
I don’t try and scare people unnecessarily (unlike many other publications). However, I try to be shed as much light on what is happening to allow people to make better (more informed) decisions.
That’s the fundamental purpose of this blog – sharing what I know for others to benefit.
With that.. let’s update our weekly charts for both the S&P 500 and XJO.
Markets enjoyed a topsy-turvy week – but as I will show below – nothing has changed.
“The party” is still happening and as such – we continue to enjoy it.
But like our 40-year credit party — all trends end.
The key (as I often say) is knowing when they end. And we have a pretty good system (and track record) for identifying when that is.
S&P 500 – Still Bullish
It’s now an incredible 67-weeks for our weekly bullish intermediate trend.
That’s how long we have been “long” this market… and continue to be until we are told otherwise:
Not much to add from last week….
That is, we are experiencing the expected (forecast) resistance in the 61.8% zone outside our (tight) 20-week distribution.
For six consecutive weeks the market has tested – and failed – to break through the level of 2450.
My read (from a few months ago) was this was likely to be overhead resistance (so far so good).
We are also seeing some weakness with the weekly-MACD – which tells me the “zest” has come out of the buyers (ie they can’t push it higher).
And whilst it is not a sell yet… we should not be surprised to see further profit taking over the coming weeks/months.
From mine, the area of 2300 and 2350 will be a good buy-zone (on the basis our trend remains bullish).
That is, a similar pattern to what we see in June and November of last year – where the 35-week EMA acted as strong support.
XJO – Trend Lines Converging
Last week we warned the party is ‘slowing down’ for the XJO…
For example, we cited the convergence of the 10-week EMA as it trades in relation to the 35-week EMA:
A few things:
First, our trend is still bullish therefore it’s premature to be aggressively short this market. And whilst the trend looks like coming to its inevitable end – remain patient.
Second, the 35-week EMA is doing a great job of acting as support. We have seen this level tested for six straight weeks and it has held firm.
Third, the weekly-MACD continues to issue caution for those who are bullish. It shot its first warning in the first week of May… ie when we alerted traders to take partial profits.
It was a prudent move for those who listened.
So far there is nothing with the weekly-MACD to indicate there is buying pressure.
Now one final technical observation for the keen student…
There is a second (smaller) distribution playing out with the XJO. Let me illustrate:
I have marked this structure A-B… established by the pull-back we saw after the run higher from November through to January
Today, the price action is gravitating towards its midpoint – which is around 5700.
That is where the bulls and bears essentially fight for control.
If this is to breakout to the downside – I would be looking for targets of 5600 initially (bottom of the structure); and then 5450 as 61.8% outside this distribution.
Putting it All Together…
All credit cycles come to an end (as do trends).
We are now in the final stages of one of the greatest (and most aggressive) credit expansions ever experienced.
It has been going on for so long – many financial managers would not know any different (eg if you were born in the 1970s)
The party is still going on and there is money to be made.
However, in terms of our “dance floor” analogy… we are a little closer to the exits (ensuring we will not be last ones to leave).
Trust me, when everyone is looking for the exits at the same time, it’s not fun.
Finally, with respect to both the S&P 500 and XJO, whilst the weekly intermediate trends are bullish, expect profit taking over the coming weeks and months folks…
The XJO is showing considerably more weakness than the S&P500 — not surprising given the weakness in our economy (and concerns around the overly extended Sydney and Melbourne property markets).
Tomorrow we will look at the weekly smackdown for gold and silver. I hope you listened to our warnings… as the move was in the charts.
… trade the tape
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