Summing up the pieces that have lead us to the strange "here and now" in global financial markets may produce a different result for each market practitioner, yet there are truths agreed upon by most worth mentioning. The purpose of this article is to identify some truths and un-truths, which will provide a fresh slice on Treasury bonds, the US dollar and crude oil assets.
To begin talking about Treasury bonds we must first identify the balance sheet strength of the U.S. Treasury. Treasury debt issued in 2009 to pay for the current government bailouts and stimulus will total almost $2 Trillion, while financing interest on the current deficit will put the total amount of debt issued over $3 Trillion for the year. Total U.S. debt was $9.4 trillion on June 14 of 2008 and one year later is just above $11.4 trillion (21.36% yoy). Tax revenues slumping on the state and federal levels by nearly 35% makes economic growth extremely important to the future strength of U.S. credit. GDP should finish the year at $14 trillion for 2009 providing that there is no net negative growth for the remainder of the year. Similar policies abroad have quickly led Standard and Poors to downgrade the credit rating of the United Kingdom as their debt combined to nearly 100% of GDP (see Britain Solvency Questioned).
Unfortunately, neutral estimates of 2009 GDP at $14 trillion may easily be surpassed by the federal deficit this time next year, suggesting that a downgrade of America's credit rating may be imminent. While most won't agree that the U.S. will suffer a downgrade, Treasury market yields suggest the U.S. is far less credit worthy at best. The yield curve below shows the shift which has occurred in Treasury yields in the past 30 days.
The basic assumption suggests that a steepening yield curve and higher long term Treasury Note yields ensure that inflation must be occurring in the marketplace. We have seen evidence through commodity prices rising and 10 yr Treasury yields increasing significantly as the U.S. dollar index becomes weaker. Could we have forgotten to consider the domestic and foreign demand for American goods? The "hope" trade has catapulted the recovery into the hearts and minds of all who watch and participate in financial markets, yet the economic data theme has shifted from "green shoots" to "dead and brown" on falling demand for American goods domestically and abroad.
The following three charts depict the cycles of the U.S. dollar index, 10 Year Treasury yield and the WTI crude oil spot price. The current theme of treasury yields and crude oil moving higher opposite the U.S. dollar is synonymous with an economic recovery and is contrary to the relationship seen earlier this year in November. At that time fear engulfed the market and Treasury yields fell with crude prices because Treasuries represented security while crude oil became cheap in anticipation of a deep recession. The dollar was strong during the bottoming periods due to high demand for U.S. Treasuries in a time where there was "nowhere to hide."
Many believe the global economic recovery and suggest that China's stimulus has saved their country from collapse, causing such great domestic demand for goods that they are aggressively buying commodities. The story sounds awfully familiar to rhetoric heard during the oil bubble in July of 2008. The truth of the matter, described by consultant to the Chinese government Charles Nenner, is that China has been buying commodities as speculative investments given historically low prices. Higher energy prices due to speculation don't translate into inflated consumer prices and can't manipulate the underlying currency's value. It is important to also realize that consumer prices fluctuate based on the U.S. dollar and foreign currency exchanges as well as the demand for goods. The current account data has shown that consumer demand continues to fall for domestic and foreign goods, but that the foreign demand for American goods is falling less fast and strengthening the dollar.
Extremely low volume and tepid buying have defined the equity trading environment throughout June and suggest that equity markets are losing momentum to top out in a slow but persistent defeat. The pain felt by consumers throughout the recession has been drastic when compared to previous lifestyles, yet the wealth of our country is so great that true pain has been forgotten. Consumer demand has dropped substantially, yet true fiscal responsibility and humility have still not been attained. Once the true destruction of inefficient firms occurs and prices stabilize, the trend seen recently in the dollar, crude oil and treasuries will make sense.
In the near term, expect for the S&P 500 to trend downward followed by crude oil while de-linking the commodities from movements in Treasury yields. Only when demand returns to the market will there be a sustained move higher in commodities. The move in the stock market suggested that the economy has turned the page and resumed growth, yet economic indicators suggest the opposite. Treasury yields will continue to rise over the long term, adding fear to the equity market, yet commodities and the dollar will de-link from the treasury yields and resume a November-esque relationship until CPI and PPI indicators confirm that inflation has arrived. Wednesday's intra-day bounce off of 905 resistance on the S&P 500 will create more momentum for a deeper dive below these levels on Thursday or Friday.
Disclosure: Long SKF, Long DXD, Short USO, Short SCC