Notes From Underground: Is the Yield Curve Taunting the Fed?

There were many responses to last night’s post regarding one of my favorite topics: the yield curve. The airwaves have been filled with opinions about the impact of the 2/10 curve on bank stocks and other financial asset valuations. Long-time readers know that I often note the significance of the shape of the curve for hinting at possible investment opportunities. Last year the 2/10 curve FLATTENED (a relative term) to long-term support levels at 74.8 basis points and then steepened out to about 150 basis points as the market feared a Trump inflation scenario.

Today the 2/10 curve closed at 85 basis points and is approaching that critical 75 basis point support level  again. Reader ROB SYP posted an interesting article in last night’s comments, which correlates regional bank stocks with the yield curve. While the correlation exists, does it indicate that the regional banks are weakening because lending activity is slowing, which is what the 2/10 flattening always indicates (a tightening of monetary conditions in relation to the underlying economy)? In my opinion, IF THE FOMC RAISES RATES NEXT WEEK AND THE 2/10 CURVE closes the week below 72 BASIS POINTS it will signal that the FOMC is out of step with the real economy. It is difficult to judge this in the ERA of MASSIVE QE but this indicator has weathered the test of time.

For example: In 2007, the 2/10 yield curve actually inverted while the equity market continued to make new highs, and we know very well what happened a few months later. But I caution yet again that the 25-year average of the 2/10 is roughly 120 basis points so while Tuesday’s close represents a flattening bias it is not inordinately flat but the direction could be ominous. I must emphasize again, the influence of the massive QE programs from Japan, Europe, Switzerland, England etc. could be “corrupting” the market but it is something to watch. If the FED is paying attention it should provide some concern and prompt some questions about raising rates at next week’s FOMC meeting. We will continue to monitor other asset classes for a hint of confirmation to the yield curve:

1. Tuesday’s trading action saw the YEN move above its 200-day moving average as did SILVER, gold/euro and gold/Swiss, 30-year Treasuries (the 10-years have been above for a few days) and many other assets. Very importantly for the currency traders, prices on the EURO currency are approaching the November 9 high and this level is in step with the DOLLAR INDEX low of that night (95.88). These levels have significance as they were spiked highs and considered one-off irrational prices. This gives us perspective. All of my technical work is based on futures prices derived from daily, weekly, monthly continuation charts.

2. The ECB meeting and British elections take place on Thursday. The election polls in the U.K. are predicting a Conservative victory but not an outright majority for Prime Minister May. She has been slipping in the most recent polls but is still expected to handily defeat the Labour Party candidate Jeremy Corbyn, who seeks to nationalize some parts of the U.K. economy. A loss for Theresa May would send the FOOTSIE cascading down and would lead to a retest of last years low in the POUND. A Corbyn victory would signify a low probability, high impact event. The ECB will do nothing on Thursday and yet again the snake-oil salesman Mario Draghi will be peddling his cache of EUROS in an effort to enhance the ECB‘s balance sheet.

Some analysts on Wall Street are expecting Draghi to hint at a TAPERING of QE but with THE EURO IN RALLY MODE THE ECB PRESIDENT WILL NOT WISH TO ADD A SENSE OF TIGHTENING TO AID AND ABET RECENT EURO STRENGTH. DRAGHI WILL DO ALL HE CAN TO FAN THE FLAMES OF CONTINUED LARGE SCALE ASSET PURCHASES. If the euro sells off in response to Draghi’s dovishness I would look for low-risk support levels to purchase the EURO in an effort to test the theme of recent DOLLAR WEAKNESS.

The Germans and Jens Weidmann will be mildly placated with the recent euro strength so Draghi should have an easy press conference. He will maintain that the European economies are in recovery mode as equity and currency markets will attest. BUT HE WILL NOTE THAT THE ECB’S INFLATION MANDATE OF 2% REMAINS AN ELUSIVE TARGET. After Thursday’s events the markets will be on alert for the French elections on Sunday. (No rest for the weary.) For the market followers and traders this week’s closes will be of great interest. Intra-week prices are important but weekly closes are significant. The markets are calm but the calm belies the price violations we experienced today. Who is taunting whom?



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8 Responses to “Notes From Underground: Is the Yield Curve Taunting the Fed?”

  1. Rohr (Alan Rohrbach) (@MacroMeister) Says:

    Excellent insight Yra, especially that the Fed may be in an overly anticipatory upbeat mood once again.
    In addition to the yield curve there is a distinct divergence of the asset classes from the classic stronger equities fomenting US dollar strength and govvies weakness. It’s been exactly the opposite.
    This can likely be explained by the degree to which equities are still trading on the benefit of Trump’s regulatory rollback (especially the Paris Agreement last week) and ignoring Trump’s self-inflicted Twitter wounds. That is while the govvies and US dollar are trading on the current economic influences.
    Both the self-inflicted Trump wounds and economic reality of Wednesday morning’s OECD Global Outlook are explored in the latest post for anyone who is interested.
    Also appreciate your spot on comments on the other aspects, as we already know the ECB/Draghi remained as accommodative as expected at this morning’s press conference, and UK PM May is indeed likely to have working coalition majority if not outright Tory dominance for the contentious Brexit negotiations.
    Looking forward to your next thoughts-

  2. Gideon Says:

    News being reported by WSJ that Santander buys Banco Popular over night for $1.00USD resulting in the wiping out all but senior notes along with CoCo’s. Resulting in the first losses for such bonds, which we all know are converted to shares once capital falls below a threshold. I personally am excited to see what the resulting losses does to the rest of the CoCo’s yield and bond pricing. Interesting times we are living in here as I wonder how much of this debt is being held and by who? Time will tell.

  3. Chicken Says:

    Good call on May’s blunder, GBP gets hammered

  4. Arthur Says:

    Don’t know how much credibility Jim Rogers has to you: The worst crash in our lifetime is coming…

    • yra harris Says:

      Arthur–very interesting

    • yra harris Says:

      Arthur–also Jimmy Rogers i have a great deal of respect for–thinks out of the box and supports his views with solid arguments—-I hold him in very high regard

  5. Rohr (Alan Rohrbach) (@MacroMeister) Says:

    WOW! Hard to believe it’s only a week down the road from your prescient observations. Did you KNOW the US economic data was going to tank since early last week?!!
    And while 2-10 curve NOT below your critical 72 BASIS POINTS level, the entire context is suddenly getting that ‘good ole 2015-2016’ feel back.
    The serial weak US data is daunting in the face of the nominally more hawkish FOMC stance… 3 hikes in 2018??
    Just put up a fresh politico-economic post on why US reforms (if Trump manages to not derail them) that the Fed says it has NOT factored in as yet may ironically rescue a Fed that is leaning ‘way out over the tips of its skis’ again right now.
    Have a great weekend-

  6. Average Joe (@JosephMackie) Says:

    This might be a dumb question but where are you watching the 2/10 yield curve? I went to FRED and only see the 10 Year Treasury Constant Maturity Minus 2-Year. It shows .8 as the lowest level. I couldn’t find 74.8 that you were mentioning. Thanks!

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