Reading Between the Lines of the FOMC Minutes

The Yinzer Analyst has been on a journey these last few weeks; first a series of interviews with firms in Pittsburgh and beyond and then a journey of self-discovery, learning more about himself, plumbing his depths and mostly discovering how much he hates shoveling snow every freaking day. I’m sorry it’s been so long since the last post, but after a powerful two week rally and with volatility dying down before tomorrow’s FOMC minutes release, now seems the time to get back in the swing of things and take the pulse of the market.  And tomorrow is also Ash Wednesday; a perfect time to stop and reflect on what’s going on around us and what lessons we could be taking in but one nice thing about coming back after two weeks off is getting a chance to revisit my last post and see if my charts came to anything or not. And this week, the Yinzer Analyst is doing a serious victory lap.

In my last post I talked about how the market seemed to have reached new extremes; Treasury yields had plummeted in January and were at levels not seen even at the worst of the Lehman crisis while domestic equity momentum was close to the lowest levels of the 2009 bull cycle. As much as I hate using labels like Treasury Bear/Equity Bull, I had to face up to the fact that yields had dropped way too quickly and were more likely to move higher while equities were likely to continue consolidating around a sticky level of 2030. The thesis behind that logic was simple, I like to call it my “Cleveland Brown” system because it’s so simple that anyone can get it…”S$%T got too damn expensive.”

Since that post, TLT has dropped 8.5%, going from overbought to nearly oversold in two weeks while sisters in the “hunt for yield” trade like utilities (XLU -6.6%) and REITS (IYR-1.42%) followed it and the S&P 500 made a 5.28% gain. Let’s start our investigation by looking at the extremes and in February, nothing has been more extreme that the major shift in the sentiment towards Treasuries.

We asked the question then of whether Treasuries had come too far, too quickly and we got it right almost to the day. After plunging in January, the ten year yield has not only pushed its way back into the 2014 downtrend channel but is threatening to break out of it to the upside. The thirty year yield is telling a similar if not quite as extreme a story.

$tnx

$TNX2

So what gives? Is this all due to the major shift in equity sentiment that began in late January? Wasn’t it just last month that “global deflation” was the buzz word everyone was spewing? While there’s been some improvement in the economic outlook in Europe and here at home, it certainly hasn’t been substantial enough to completely erase the “global deflation” scare. Or was it the fact that the economy is still on enough of a solid footing for rate hikes to be a serious concern later this year?

The answer is that human sentiment or if you prefer, behavioral finance, has more to do it with it than anyone would really like to admit to. I remember in 2013 the conversation was “well of course rates are going up, so get out of Treasuries (or bonds all together)”, then 2014 it was “well rates are going up, but we don’t know when so it’s back to Treasuries” and so far we’ve had both extremes in 2015. I know one local manager who in mid-January decided to REDUCE duration because he felt rates had come too far too quickly and got an unholy amount of S$#T for it. Guess who’s laughing now?

But the problem for us now is to figure out whether Treasury yields have gone too far in the other direction and what that could mean for the equity outlook going forward. For the technicians let’s start with a few charts.

Starting with TLT, we’re back to prior support but there doesn’t seem to be any sign of a momentum reversal in the immediate future. We could continue drifting lower back to the $122-$123 before a base begins to form. Moving to long-term charts, TLT looks like it could have been in a classic “bump and run” formation meaning a move back to prior support at $122.50 or even below that at $120 could be a best case scenario. But what it could really mean is that the worst of the bond sell-off might already be behind us.

TLT

TLT2

Moving to equities, the S&P 500 has gone from some of its worst momentum readings since the start of the bull cycle to some of the strongest of at least the last year. Given how weak equities have been over the last few months, we would just drift and consolidate for the next week or two and allow some of the buying pressure to cool off which has already been dissipating. Look at the weak volume since the start of the rally; the improving CMF score was more about weak days dropping off than strong buying pressure pushing the market higher. Again, I have to wonder if the best has already come.

SPXD

SPXW

Going to a fundamental case on bonds, the battle royale is going to be between economists who feel that there’s a strong likelihood for a rate hike as early as this June and traders who continue to hold large Treasury positions because they feel the Fed will use the weak global economy to justify holding to the ZIRP for even longer. Fortunately tomorrow’s release should shed some “light” on the Fed’s thinking, but given the surge in imports and personal consumption, the economists “might” be right this time.

One of my major mistakes in my past life was confusing what I thought the Fed should be doing with what they were actually signaling their intentions were and while it’s an extremely common fallacy among financial professionals, it doesn’t absolve me of the sin. While the Fed’s statements and commentary will remain obtuse because their function is to obscure, investors need to keep an eye on a few key trends that should determine how likely the Fed is to raise rates:

  • Value of the Dollar: As long as Uncle Buck stays strong and keeps commodity prices under check, the Fed should be reluctant to raise rates. Long-term, the textbooks say that the difference in interest rates should lead to a falling dollar and eliminating any arbitrage opportunities, but it could take years for that to adjust. What’s more likely is that after the initial run-up in rates, Treasuries could stay attractive relative to low global yields and led to a further run on the dollar as more money finds its way to our shores. Worst case, you could get a mini-repeat of the mid-2000’s where foreign credit flooded the U.S. and helped fuel the housing boom…and bust.
  • Real Incomes: As inflation remains low and commodity prices continue to fall, real disposable incomes have continued to expand even while the average workweek and take home pay have remained static. Real DPI in 2014 increased as its fastest rate in December and was up 2.3% in 2014 compared to -.3% in 2013. With unemployment already low and U-6 falling, the Fed is terrified that this increased in real DPI will get translated into more consumer spending and rising imports (a real possibility as the value of the dollar rises.) Personal consumption expenditure contributed more to GDP in 2014 than in any year post-Lehman while the Federal gov’t almost added to GDP for the first time in years.
  • Employment: Seems like a no-brainer to keep your eye on unemployment, but with the headline number falling steadily over the last few months, the FED might become reluctant to raise rates right away…especially with a rising participation rate. If more workers come back into the workforce just as the FED raises rates to slow economic growth, the unemployment rate could skyrocket and cause a major credibility crisis.

Tomorrow every trader in the world is going to be picking through the FOMC meeting minutes looking for clues including comments about those three bullet points above to figure out which way the FED might be preparing to tack. And a lot of traders are putting their money where their mouths are, look at the chart below from the COT Report; open interest in the 10 year has fallen and the rally in January led some to close out short positions but with a whole lot of nothing between tomorrow and the March meeting, why would you want to have a strong position going either way.

COT

So if the FED keeps up the chatter and the market comes away with a strong belief in a June rate hike, we could see more selling pressure in TLT. If Yellen doesn’t really deliver anything new, the market will turn its focus back to Greece and TLT could get a chance to bottom out.

What does that mean for you patient investor? It means get turn on Bloomberg, get out your red pen and be prepared to go through the transcripts with a wary eye!

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