Bonds In the Spotlight

The most significant piece of news this week is that the Fed hinted more rate hikes may be needed in their minutes from their July meeting. This is nothing new but the reaction in the bond markets was certainly noteworthy.

If you look at the adjacent chart of the US yield curve you can see the large shift higher over the last month (blue line vs grey line). The front-end is pegged by the Fed so the rise is longer tenors signals inflation will continue to be persistent and that the journey back to a steep curve may be underway.

Wage growth and inflation in services remain a concern and are now dividing the Fed so another hike of 25bps is now a coin flip. And if the 10Yr keeps rising then I suspect the market is doing the Fed’s work and they will stand at no change at the September meeting.

The flip side of fighting inflation is that something breaks as the sharp move higher in interest rates squeezes the consumer. Despite items like food costs coming down, mortgage rates are the highest since circa 2000 at 7.58%. Also, credit card interest is at 20% and the moratorium on student loan payments conclude this month. Not a great prospect for consumption despite the strong job market (which the Fed wants to break).

Higher Yields Everywhere

You may not have realized but bond yields are rising across the globe. The rise in US yields this week kicked off a similar move in Japan, Australia, South Korea, New Zealand and Europe. So the swell in yields is ubiquitous and I think we are heading into a credit cycle where defaults are more commonplace over the next few years.

Higher interest rates will also pressure weaker companies that have relied on cheap debt for growth which will now pressure cash flow and earnings for years to come. Not to mention, commercial real estate is very challenged which affects bank balance sheets as they are the biggest lender to this sector. Overseas we are seeing similar concerns with commercial real estate as Hong Kong stocks entered¬†a bear market over concerns of China’s stuttering economy as several large Chinese commercial real estate developers defaulting on large swaths of debt.

The Long-Term S&P 500 Chart

I am showing a “monthly” chart of the S&P 500 Index (SPX) that goes back to the financial crisis (each candlestick represents 1-month of price movement). The chart reveals two things: First, is the Relative Strength Index (RSI) at the bottom has a negative divergence brewing since 2018 (white line). One can infer that this means long-term investors have not bought the market with much fervor since the last time the Fed tried to raise rates in 2018. The Fed failed at this effort and lowered rates just by the end of the year as the high-yield market was unable to issue any new deals which may have foreshadowed the risk of rate hikes to equity markets.

The second point is to show a Fibonacci extension starting from the 2007/2009 peak and bottom. You can see these extensions or “echoes” of this time period (2165/3100/4600) mark areas of significant peaks. Most notable, is that the most recent rally (upper far right) from the October 2022 low rebounded up to the 423.6% extension and was rejected this month (so far). Also, the 21/55EMAs at 4100/3750 have contained most pullbacks on this chart so those are some trend following levels to watch if we continue to decline in the coming weeks.

The Chart for 2023

The daily chart of the S&P 500 ETF (SPY) is below and shows the decline from the all-time high down to the October low of last year and the subsequent rebound. Most of what you see below looks corrective which means the rebound this year may be a bear market rally that fell short of reaching the March 2022 high of $462. The decline has left the S&P now in the vicinity of the August 2022 high at $432 which should act as support as the RSI on the bottom of this chart is close to registering an oversold condition.

What to watch now will be significant for the reminder of 2023. A continued decline would warn the bears are taking over and a break of $415 will show the 2023 rally was a rebound within a longer-term downtrend. For the bulls, a rebound from here needs to be impulsive and take-out $462 to re-establish the uptrend. Right now, it looks as though this is a bear market rally given that the yield curve is acting as a worldwide wet blanket (catalyst) and we will probably get more answers next week.

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Paul McCarthy, President of Kisco Capital, LLC

Paul J McCarthy III

President, Kisco Capital

Paul McCarthy

Mr. McCarthy is the President and founder of Kisco Capital.