Countertrend Quarter-End Games

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by: Ivan Martchev

When I sat down to write this column and went through major developments last week in stocks, bonds, commodities, and currencies, a peculiarity jumped out at me – last week’s moves were predominantly counter-trend (or against the prevailing trend in the second quarter). Stocks, which had been appreciating in 2Q, were down last week. Ditto for bonds. Oil and commodities in general had been weak in 2Q but then had a rebound last week. Only the dollar kept on sliding last week – as had been the case all year.

One explanation for the counter-trend moves in many financial markets is that last week was not only the last week in June but the last week of the second quarter. It is not inconceivable that many managers simply were involved in more quarter-end window-dressing than usual. For example, mutual funds are obligated to disclose the top 10 positions at the end of the quarter to their investors. Other funds have similar policies, even though they may not be a requirement. The need to reposition portfolios in the last week of the quarter may be much bigger. Still, window dressing, by definition, is not a phenomenon that is long-term in nature. Unless fundamentals drive those moves, markets usually revert to the mean.

The oil market was up five days in a row last week, which may have been just a necessary rebound after a $10 per barrel slide from the May highs to the June lows ($42) in the August WTI futures contract. The crude oil market has been hard to read in the sense that it has not delivered any seasonal strength. This is also true for other commodities, which translates into a poor performance for the CRB Commodity Index.

CrudeOil.jpg

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

In the past, I have often heard that such gyrations are more likely to happen as high-speed computerized trading systems have dominated the futures market for commodities, so the machines are just pushing the market around and leading traders by the nose. While this is not an implausible explanation, what does one say about iron ore – which has no futures market but is priced in forward over-the-counter markets? China is the #1 producer and consumer of steel, but iron ore careened down from $90/ton to $55/ton in the second quarter (see chart, below), indicating a sharp slowdown in industrial demand last quarter.

IronOre.jpg

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

I have my doubts about China, but rather than go on another “China rant,” I will say that the economic situation there seems more like the eye of the storm, rather than any meaningful economic stabilization. I am watching with great interest to see if this peculiar weakness in commodity prices is indeed China-related. We should see evidence in secondary indicators like third-quarter foreign exchange outflows.

Meanwhile, the U.S. bond market was down for the week, sending the 10-year note yield to 2.30%. We may have more Fed rate hikes in store– this is what the Fed has telegraphed – so seeing some back-up in long-term interest rates is to be expected. Still, the bond market is telegraphing a mature economic expansion in the sense that the difference between the 2-year note yield and the 10-year Treasury note yield (dubbed the yield curve slope) had been shrinking all quarter, even though it rebounded last week.

TenYearGovernmentBond.jpg

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Last summer, after Brexit (June 23, 2016), the 2-10 spread was as low at 76 basis points and then went as high as 136 bps after the U.S. election in November. A steeper yield curve forecasts a stronger economy and vice versa. Since we have been down to 78 bps on the 2-10 spread in June, the bond market is no longer forecasting the acceleration of the U.S. economy that was initially forecasted after the November election. I expect that by the time President Trump’s first full term in office ends in January 2021, the 10-year Treasury yield will have declined below 1%, as I have mentioned previously, as the likelihood that we will have a recession by then is high, based on the statistical distribution of recessions over 240 years.

How ‘Bout that Euro?

I have repeatedly pointed out that the dollar is not as weak as the U.S. Dollar Index would have you believe, since the euro comprises 57.6% of the U.S. Dollar Index. As the eurozone breakup risk is being priced out with pro-EU election victories in The Netherlands and France, the euro has strengthened more at a time when the Fed is accelerating its rate hikes, which is typically supportive of the dollar.

EuroDollarExchangeRate.jpg

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Not to diminish the importance of the rebound of the eurozone economy, the strength in the euro is somewhat political, too. We know that because the action is confirmed by the German bond market, which had been acting as the ultimate safe haven. The yield on the “bundesschatzanweisungen,” dubbed the 2-year “schatz notes” to avoid tongue injuries, closed on Friday at -0.56%, a great improvement, since the schatz notes were yielding -0.96% earlier in 2017 before the pro-EU election victories.

SchatzVersusBondYield.jpg

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The 10-year bund yields closed at 0.47% Friday, as Europe still has a deflationary problem despite the smaller chance of a eurozone breakup (for the time being). Ironically, faster rising 2-year schatz yields mean a shrinking schatz/bund differential – which is like the U.S. 2-10 spread for Germany. In this bizarro world of negative interest rates, less political risk in Europe means a flatter yield curve in Germany, which in this case is a good thing as a eurozone breakup would have been a disaster for the EU economy.

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