This is probably one of the most exciting stock market (NYSEARCA:SPY) weeks we have coming up. The Fed's key inflation metric, PCE, reports this week. Nonfarm payrolls, the (not really) blow-out report that broke markets out, updates this week. Plus, we have the spillover effects from the Fed and BOJ reaction. This week is jam-packed with trading fun. We had key hints last week of changing investor perspectives on upcoming key metrics. We think data will start to matter again.
We are about to show you how the dollar move last week can predict the US stock market move this week with PCE. This is key because while there are many market pundits expecting stocks to go up or down, the key is identifying the catalyst. We've been saying inflation is that catalyst (bubble popper).
Here's what investors want: "Line it up for me, Elazar, and make my job easy, tell me why, when and how it's going to happen, and then you'll get a coveted "Follow" from me."
Great point, we need a catalyst. Let's line it up! That catalyst we think is inflation, and now we think (based on the dollar) investors are finally paying attention.
If inflation reports higher than expected, investors are finally ready to pay attention.
Inflation has been the most underfollowed metric for risk. It's about to go front and center. While everybody was thinking deflation, inflation has been picking up. Now that investors are telling you that through the dollar post-Fed meeting, you have an important metric that could do damage to markets.
The dollar said a lot last week. Here's what it said:
"Investors sold me last week because they think the Fed is behind the curve. They think it's going to take more of me to buy things, as inflation is out of the cage after no more rate hikes."
You've now heard what the dollar was saying last week.
This is hinting to you that foreigners are showing early signs of getting restless. Bad inflation news (PCE this week) could confirm their greatest suspicions that the Fed is now behind the curve (thus the dollar drop last week).
Let's go step by step.
The US in real terms also has negative rates
We think the US is quickly going to be seen as "sporting" (our new favorite analytical word) the LOWEST interest rates in the world.
Elazar, how can it be? They are rip-roaring at 1.5%. All other economies are "sporting" negative rates?
Great question. Let us explain.
Right here you see the US 10-year Treasury yield at about 1.5-1.6%. Right?
Above you see the US 10-year Treasury at 1.6%.
How do we calculate real interest rates? Real interest rates are rates minus inflation.
Let's do the math.
Rates are 1.6%. Great.
What is inflation?
The Fed's Core PCE inflation is 1.6% currently on an annual basis. CPI top line is running about 3% in the last 3 months on an annual rate.
PCE reports this Tuesday and will update us where the Fed's favorite measure is for inflation.
Real rates negative in the US
If you take 1.6% yields minus 3% inflation, you are at negative 1.4% real rates. Because of building inflation, holding US bonds is worth less, because price inflation erodes the future value of cash flows.
The dollar is whispering to us that foreign investors are finally paying attention that the US may be "sporting" the lowest rates in the world.
The dollar move last week tells us that investors are worried that the Fed is behind the curve on inflation. We are going to walk you through why foreign investors are about to pay attention to negative real US interest rates.
What did the dollar do after the Fed decision on Wednesday?
All that safe-haven status since Brexit's spike June 24th is out the window.
What's the dollar telling you?
We gave the dollar a call, and this is what it told us:
"Elazar, foreign investors are worried about me now because they think the Fed might be behind the curve. I know you guys have been talking about this for forever, but nobody wanted to listen. Now you see immediately after the Fed, people are finally starting to catch on and they are selling me. They think that I'm going to go down in value because US goods are going to go up, inflation. I'm so sad now."
Cheer up, dollar. Even though we love you we have a "Sell" rating on you too. No offense.
The dollar is crying because people see that the Fed may be behind the curve. We finally saw someone else say publicly that the Fed could be behind the curve. We did not see that before. That is an inflationary term. (As you know, we've been expecting inflation for some time.)
Please say this in a sing-song: "PCE reports this wee-eek"
Now that the dollar is showing a negative reaction after the Fed, it means investors are telling you they are worried the Fed is BEHIND THE CURVE. It means investors caught on that a lack of rate hikes could let inflation "out of the cage," as we've been saying.
Any key inflation number that reports badly now will be another confirmation of that dollar move post-Fed meeting.
Hmm, is there any major inflation indicator coming up right after that dollar-hint move?
Yes, PCE reports on Tuesday. It and CPI have been moving higher.
If PCE reports .3 inflation is a risk and could see bonds sell off. A .3 X 12 would mean 3.6% annualized inflation. That would mean: 1.6% yields minus 3.6% inflation = a negative real interest rate of 2% in the US.
I can't believe what I am about to say, but... I'd rather buy a bond with a negative yield!!
Oh My, I cannot believe that I just said that.
Inflation of -1% and bond yields of -1% is a real rate of 0%.
Here's the math: Yield minus Inflation, remember?
Yield of -1 minus a -1 = 0% (-1 +1)
Which is better, -2% yields or 0% yields? 0% yields right? Therefore, I'd prefer (if you held a water gun to my head) to own a 0% real rate than a -2% real rate. I don't want either, because I expect inflation, but you held a water gun to my head...
A negative-yielding bond is outperforming the US Treasury by at least 2% if PCE price comes in at .3%.
The reality is that at some point, PCE may be that catalyst that wakes investors up to that fact.
The US Treasuries, if inflation continues, will be sold
If investors get a whiff of negative real rates, they will sell those bonds.
As bonds get sold, what happens to stocks??
Uh, Elazar, they have to go up, right, they can never ever go down.
No, we disagree. As bonds get sold, yields will spike. As yields go up the Fed Model comparison trade to earnings yields (which, by the way, are declining) will also get sold, because higher-yielding bonds will become a better relative deal.
Equity investors will sell based on bonds being sold.
We have said inflation is the bubble popper, and now you see why.
Japan and European bonds are a better deal because they don't have the inflation that the US has.
We thought the Fed had the GDP number in hand when they made their decision. We did not think they had this week's PCE number in hand. That is a market risk now, especially since the dollar tells us everybody is now paying attention.
Other key data this week
Nonfarm payrolls report this week too (more fun). This is the report that broke out the markets. We showed here that the market likely had record short interest from Brexit. Here's the number of options that traded in June:
Going into the last jobs number, there was likely a record short position that "got squeezed."
With the weak GDP number Friday, we think the economy is staying slow. We didn't think the last nonfarm payrolls number was so strong. In fact, it was the weakest all year if you take the two months combined (Which smooths the Verizon (NYSE:VZ) strike).
Here's nonfarm payrolls that will report on Friday.
May and June combined to average 149. 149 and 144 the month before were the slowest reports all year.
Just like GDP, it's slow. Here's GDP from Friday.
We have record amounts of quantitative easing still in the system, record low rates, and all we can get is an annual rate of 1.2% GDP. The expectation was for 2.6%.
If we continue to get slow GDP and fast inflation, we think the economy will suffer. Higher prices will crowd out consumer budgets from buying discretionary purchases.
Higher rates will slow spending, because credit spending has far outpaced the GDP. The economy has been driven by credit.
Compare this next chart showing consumer credit growth with the above GDP growth. Which is faster, credit spending growth or GDP growth?
Growth rates of credit have been MUCH faster than the GDP growth.
Is that sustainable?
If inflation raises rates, it will be more expensive for consumers to buy on credit. They may miss payments or default.
Inflation is the bubble popper (we'll say it again) for many reasons. Inflation will do the job of slowing the economy that the Fed has been scared to do.
Now, let's go to the BOJ (Bank Of Japan)
We have a song for them, and we want you to sing along.
Please sing to the tune of Sheryl Crow's "All I Wanna Do."
This is what the BOJ is now singing now that none of their extreme policies are working.
BOJ is now singing:
All I want to do is sell some yen (because nothing else worked)
I have a feeling I'm the only one
Until the (land of the rising) sun comes up on US Treasury Currency Manipulator alerts.
Catchy song, right? (But did you sing along?)
Let's look at the 10-year chart on dollar/yen.
You see an amazing chart above. If we break down below the 100 dollar/yen, we'll be breaking a 10-year support/resistance line. That will be a major market event.
What happened since the BOJ disappointed the street on Friday (as we expected)?
Oh my! The dollar/yen is fast approaching 100.
We think if it gets through 100, the BOJ is going to be singing our song above, which will cause major market risk.
Why? If Japan intervenes and sells yen:
- Other countries will follow. It will be a currency war. Currency volatility accompanies down markets.
- The US will call Japan a currency manipulator, which will hurt Japan's already weak economy with tariffs and penalties.
- Japanese investors will sell US assets as their investments go negative based on crossing that 10-year dollar/yen price level.
That's the world right now. There was too much fun last week, and we expect too much fun this week. Economies are slowing, inflation is picking up. Central banks are getting restless, and foreign investors have reason to sell the US. One reason is inflation, as the dollar's post-Fed move hinted to us. The other is the yen crossing over a key 10-year support/resistance line at 100.
We think the market hinted at readiness to sell a higher inflation number or a weak jobs number this week, based on the dollar move last week.
We are bearish.
Please be safe.
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Disclosure: I am/we are short SPY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.