The stock market continues to try and resolve the technical wreckage from the sell-off that occurred in February after a top in late January. In many cases, you will see stocks test a bottom twice before finding a base and continuing to move higher – a double bottom. Will we find a bottom or is a larger sell-off at hand where the stock market goes bust and ends a larger uptrend from the 2009 low? How did we get here? Well, after a better than expected jobs report earlier this month, we had a nice move higher which failed to manifest into a larger recovery among all the major indices. Only the NASDAQ has made a new high since January – which ended abruptly on Monday. This week’s open was foreboding as stocks gapped lower indicating the run-up after the payroll report was one big head fake. What was left was a topping pattern called an “Island Reversal”.
Let’s take a look at the NASDAQ ETF ($QQQ) to understand how this all fits together:
I expect to see the 200 day tested next week as the selling accelerated into the close and the big red bars in this chart come in sets of three many times so perhaps we bottom by Tuesday.
Alternatively, the S&P 500 closed below its 200 day moving average (a key level it needs to hold). Let’s take a look:
The DOW has been the weakest index these past two weeks (making a lower high) and closed right on its 200 day, see the chart below:
So why is this happening? Big picture, the end of ultra-low interest rates and debt. Speaking of which, the Federal Reserve had its first meeting under new Fed Chair Jerome Powell on Wednesday where the committee continued its policy of raising rates into a recovering economy. However, many economists have been downgrading the prospects for growth in Q1 from what was 3%+ in January to now 1.8% as we near the end of the quarter. This is where the fundamentals may fail the stock market. This economy needs to see 3%+ growth because the Fed is going to raise interest rates in 2018 3-4x.
Are there any fundamental warning signs out there?
Corporate Bond Spreads are widening which signifies rising default risk. Or, maybe spreads are coming off an all-time low and are widening in tandem with the Fed’s normalization policy. All the same, the spread widening is significant and can’t be ignored taking into consideration how much debt has been created as a by-product of the Fed’s ultra-low interest rate policy. Take a look:
The Libor-OIS Spread – what is it? The LIBOR-OIS spread represents the difference between an interest rate with some credit risk one that is risk free (like a T-Bill). When this spread widens, it’s a warning sign that there is growing credit risk within the financial sector. Prior to the financial crisis, the spread between the two rates was as little as 0.01 percentage points. At the height of the crisis, the gap jumped as high as 3.65% and acted as an early warning detector. This chart illustrates what happens when the credit risk of banks come into question:
So, what is happening to this spread now?
The spread widening may be attributed to technical factors such as funding pressures from increased T-Bill issuance from the Treasury, balance sheet reductions by the Fed and reduced demand from US corporations that are now re-patriating their cash due to reduced tax rates. Nonetheless, increased borrowing costs hurt everybody all the same so this spread can’t be ignored. Is this increased cost being factored into the stock market?
I’ll keep digging for details and report back what I find but keep in mind that interest rates are a powerful force that affect how stocks are valued. The stock market action will be very telling next week so hang on and keep liquid!
Chart of the Week!
Economic & Central Banking Snippets
- The Federal Reserve lifted short-term interest rates by a quarter-point and forecast that rates will rise higher than expected in the coming years as its new chairman Jay Powell responds to strengthening growth at home and abroad. The US central bank raised the target range for the federal funds rate by a quarter point to 1.5-1.75% as it predicted inflation would accelerate in the coming months. The Fed’s median forecast for interest rates at the end of 2018 was left unchanged, but its projections pointed to an extra increase in 2019.
- Brazil’s central bank cut interest rates to a new record low on Wednesday, saying the reduction was driven by the need to stimulate the economy and benign external conditions. Even as the US Federal Reserve raised rates and warned of more increases, Brazil’s central bank cut the benchmark Selic interest rate by 25 basis points to 6.50%.
- The Nikkei-Markit flash manufacturing purchasing manager’s index edged lower to 53.2 in March, down from 54.1 in February and closer to the 50-point line separating growth from contraction. Job creation also eased amid the softest pace of output growth since July last year.
- Durable goods orders jumped by the most in eight months for February as the rise was led by a 7.7% increase in transport orders. Even with the volatile transport category stripped out, orders were up by 1.2% in February which topped estimates for 0.5%. Orders for non-defence capital spending excluding aircraft, which are seen as a proxy for business investment, rose 1.8% to $67.83B, recovering from two straight months of decline.
- Britain and the EU have agreed to terms for a 21-month transition after Brexit. However, the transition relies on a final agreement on the complete withdrawal agreement later this year, including the question of the Irish border, which was only partly addressed in Monday’s talks. (FT)
- Prosecutors in Munich raided BMW’s headquarters on Tuesday and said they have launched a preliminary investigation into suspected diesel emissions fraud at the luxury carmaker. The prosecutors said they have reason to believe that 11,400 cars may be equipped with “inadmissible defeat devices” that understate emissions during laboratory tests. Since Volkswagen was caught using cheat software to bypass emissions tests in September 2015, all carmakers have been under close scrutiny by the authorities. Until now BMW has had a squeaky clean image.
- The Trump administration plans to impose new tariffs on $50bn in annual imports from China, targeting products such as robots and high-speed trains as it also ramps up efforts to block Chinese investment in strategic sectors. In what White House officials on Thursday billed as a historic move against Chinese “economic aggression”, President Donald Trump was set to order US officials to levy tariffs against China in response to a finding that Beijing has for decades pursued a strategy of unfairly acquiring US intellectual property. (FT)
That is all for now until next week’s Market Update. If someone forwarded you a copy of this report, you can sign-up directly at www.kiscocap.com.
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Paul J. McCarthy, III
President – Kisco Capital