This week marks the 15th anniversary of Kenny’s Commentary. As a result, I will be taking a break from the note for a week or two. However, you will have the good fortune of reading Marc Sutin’s market narrative in my place. As you know from previous notes, Marc is a very highly regarded technical analyst, founder of Intuitive Analysis LLC, former partner of mine at Knight Capital Group, and dear friend for many years.
Perception is not always reality, but price is and prices for bonds fell sharply last week extending their acceleration phase which began on February 16. The interest rate markets have worked themselves into a frenzy over concerns that inflation and economic growth will increase faster than the Fed thinks forcing the Fed to react with a tighter policy stance.
Whether these concerns are warranted or not the yield on the 10-year T-Note has gone parabolic in the near-term.The recent sharp rise in the yield of the 10-year T-Note is now weighing on the equity market sending prices there lower as well. Although the yield of the 10-year T-Note had been rising since last August it was the sharp acceleration, a 41-basis point rise since February 12, that finally spooked the stock market. It seems that the bond market holds the key to the stock market’s performance in the near-term.
It was the acceleration of the rise of the yield of the 10-year T-Note the past two weeks that finally took a bite out of equities. For perspective, the S&P 500 fell 4.1% from its mid-February peak into last week’s low. The growthier/higher multiple areas of the stock market suffered the most. A good example is the ARK Innovation ETF which fell 21.1%. The NYFANG index fell 10.1% the Technology Select Sector SPDR ETF (XLK) fell 7.6% while the NASDAQ 100 index lost 8.1%.
As last week progressed the weakness within the stock market became more broad-based encompassing issues more leveraged to the economic recovery like the S&P Metals and Mining SPDR ETF XME which fell 10.6% from Wednesday’s high into Friday’s low.
Recent stock market volatility appears to be the result of a near-term overbought condition, an extreme in market sentiment which was logically accompanied by heavy positioning in equities and a rapid rise in yields across a large segment of the yield curve. Once sentiment cools, equity positioning is adjusted, and the bond market calms down we expect the stock market to resume its advance. The stock market’s fade into the close on Friday was not particularly encouraging suggesting the current setback may not have run its course. Given that the stock market has shown so much internal rotation we would take advantage of the weakness on a stock-by- stock basis to add to positions as we see this as a buying opportunity.
Given the current importance of the behavior of the bond market to the behavior of the stock market let’s get some perspective.
My approach to analyzing the markets combines technical analysis with macro-fundamentals. So, let’s dig in, discuss Fed policy, and review the bond market’s technical position as it is the epicenter for the volatility spreading throughout the markets.
In Congressional testimony this past week, Fed Chair Powell’s comments that the current bout of inflation would not be sustained and that risks to the recovery still warranted an easy monetary policy stance did little to calm the bond market.
It is reasonable to acknowledge that investor concerns about the path of growth and inflation are not unwarranted. We have never emerged from a pandemic before and both monetary and fiscal policy are positioned to lend perhaps the most support ever to economic growth. On the macro-fundamental side Fed policy and the Fed’s perspective on the economy are important determinants of the path of interest rates. There will always be bouts of short-term volatility around that path.
In this period of uncertainty, I encourage you to read Lael Brainard’s speech delivered at Harvard University last week entitled ‘How Should We think About Full Employment in the Federal Reserve’s Dual Mandate?’. It explains in the clearest terms I have read yet the Fed’s new monetary policy framework.
As some of you may recall the Federal Reserve recently concluded a review of its monetary policy framework. It made several important changes which will influence its policy path as the economy recovers from the effects of the pandemic. Ms. Brainard explains the changes clearly and her explanation is calming in the sense that it helps an investor understand the Fed’s intended policy path as the economy recovers.
We think the following comments taken from her speech encapsulate what is most important for investors seeking to understand Fed policy.
For nearly four decades, monetary policy was guided by a strong presumption that accommodation should be reduced preemptively when the unemployment rate nears its normal rate in anticipation that high inflation would otherwise soon follow.
But changes in economic relationships over the past decade have led trend inflation to run persistently somewhat below target and inflation to be relatively insensitive to resource utilization.
With these changes, our new monetary policy framework recognizes that removing accommodation preemptively as headline unemployment reaches low levels in anticipation of inflationary pressures that may not materialize may result in an unwarranted loss of opportunity for many Americans.
Instead, the shortfalls approach means that the labor market will be able to continue to improve absent high inflationary pressures or an unmooring of inflation expectations to the upside.
Brainard noted that “Today the economy remains far from our goals in terms of both employment and inflation, and it will take some time to achieve substantial further progress.”
Our take on this is not that interest rates will not rise, as the Fed seems willing to let the economy run ‘hotter’, but that the rise in rates will be driven by increased economic growth and not increased economic growth and not increased inflation.
This is the type of interest rate rise that is likely to prove less of a constraint to rising equity prices. Our conclusion is that the Fed’s new policy framework is supportive of higher economic growth and higher equity prices. We acknowledge that bouts of near-term volatility will occur as markets question the Fed’s ability to stay on the path it has laid out.
Given the stock market’s near-term sensitivity to moves in the bond market we need to understand the technical position of the bond market. We are going to use the TNX Index in this analysis. The TNX index is the CBOE 10-Year US Treasury Yield Index.
The first thing that jumps out to us from a chart of the TNX index is that it has gone parabolic to the upside in recent weeks. Such moves are unsustainable and unlikely to be maintained in the near-term. In our view this suggests a high probability that the upside momentum that is unnerving the stock market is likely to see a respite shortly. This should have a calming effect on the equity market.
Next, we need to understand what yield levels are likely to provide resistance or act as a limiting factor to the current uptrend in rates. To get the proper perspective it is necessary to look at a 10- year chart of TNX. We can see that in 2012, 2016 and September 2020 yields bottomed in the 1.34% to 1.43% area. Price activity in September 2019 thru January 2020 appears to provide resistance in the 1.43%-1.97% area.
Our conclusion is that the current technical position of the TNX index is likely to result in a slowing of its upside momentum leading to a consolidation as it encounters resistance in the 1.40%-1.97% area. While this takes place the stock market is likely to become oversold as investors become less bullish and positioning unwinds.