Investors watching the financial market as the 2018 New Year opens are most likely fixated on the rapid, almost Bitcoin-like move up in stocks. Granted it is a good show currently.
But I am more interested in what is brewing in the markets that will eventually knock the juggernaut down. And in looking at the markets over time, the ingredients of a market meltdown, as opposed to the current melt-up, usually have two common ingredients – a changing price in energy that is simultaneously subject to a change in the cost of money. Energy and the cost of money are basic elements in the functioning of a capitalist market system. When these two markets move rapidly in the same direction, simultaneously, as they are at the present time, I take notice.
Energy is the lifeblood of the US and world economy. Since mid-2014 one important energy market, crude oil, has been depressed – great for energy consumers, but not so good for energy investors.
The market first broke down from over $100 per barrel in late summer of 2014 to a trading range of $50 to $60 thru July of 2015. Then in August of 2015 the market collapsed again, pushing prices to extreme low points on a relative historical basis during the winter of 2016. By February of 2016 the front-month contract was trading as low as $25 per barrel, and the average contact price for WTI crude oil during the month was $30.32.
The downward shift in the oil market reflected a world market that became oversupplied during the 2012 through 2016 time period, thanks in large part to shale exploration and production in the US. Many have attributed the oversupply phenomenon to technology. To some extent this is true. It is unlikely that the US market would be able to produce the oil it is today without massive investment in horizontal drilling. However, I would add that it also was driven, possibly even to a greater extent, by Central Bank QE around the world. The very low cost of money during this time period pushed investment in new production, not only in the US but worldwide, well beyond normal bounds. This resulted in an industry massively oversupplied by 2016.
Oil Makes a Break-Out Move above $60 at the end of 2017
The collapse of the oil market in August of 2015 and the subsequent bottom in February of 2016 are two very important points in recent oil market history. In the graph below, you can see what the market expected prices today to be in August of 2015 and February of 2016. Through time I have been tracking the movement of market expectations about the price of oil. And, as you can see by the orange line in the graph, the market is currently in a classic downward sloping backwardation position. This position usually discourages investment in new supply discovery as the long-term fundamentals still show expectations of an amply supplied market. In the case of the US market, the shale drillers have shown a propensity to violate the laws of rational economics, continuing to drill and run perpetual losses as capital continues to flow, albeit on a slowing basis. Elsewhere in the world however, capital constraints have been more evident.
Since 2016, the oversupply created during 2012 through 2016 has been drying up. Capital expenditures have been more disciplined even though interest rates have remained low because a market price of $50-60 per barrel is economically at or below break-even for most exploration projects (assuming the dollar index is at 100). As a result, the front end of the oil curve has periodically been bouncing upward to encourage oil supply in storage to be brought to market. Meanwhile, the back end of the curve has remained lower to continue discouraging new investment.
Through the fall of 2017 and then really noticeable in early January 2018, there has been a shift up in the WTI crude oil curve on the front end. These front end spikes have occurred several times in the past 2 years since oil bottomed in 2016, June and October of 2016, only to be knocked down. The recent spike, however, is much stronger. As shown in the graph, the curve on the front end is now well above the line drawn in the sand by the futures market in August of 2015. Part of the reason for the move currently being experienced is a better demand-supply balance. However, there is a new dynamic in the latest market move. The WTI crude market is being pulled higher by Brent Crude, which closed on Friday at $69.87 per barrel.
Why is Brent Crude trading so much higher than the WTI contract? I have a couple of observations. One, the world market for crude is much tighter than the US, and the risk of an onslaught of new supply from shale drilling is not great given export constraints from the US, and the fact that the US is still a net importer of oil. The second relates back to the cost of money from the perspective of the world market. The US Dollar (DXY) has gone down almost 10% since May of 2017, closing at $90.91 on Friday January 12, 2018. And recently the USD slide downward accelerated, falling over 5% since November of 2017.
Could it be that US Tax Reform fiscal policy and a slow roll tightening of monetary policy being initiated by the Federal Reserve is changing the market dynamics for oil? In my analysis, the answer is a resounding yes.
In addition, the impact of the US policy shift will be much more wide reaching than just making oil more expensive in USD terms. It will also simultaneously raise the overall cost of money, and this impact is currently greatly underappreciated, much less understood by average investors in the world financial market today.
10-Year Treasury Moving Up, Trend Different this Time
The US Treasury Yield curve has also been moving progressively higher since lows recorded during the first half of 2016. And, since Trump was elected in November of 2016 there has been a noticeable march higher on the short end of the curve, aided by interest rate increases implemented by the Federal Reserve.
But the 10-Year yield, which shot up almost 100 basis points from July of 2016 through the Trump inauguration, remained stubbornly anchored in a range of 2.30% to 2.50% throughout much of 2017. The actions by the Fed to tighten rates on the short end of the curve during 2017 were not being transmitted to the long end, and therefore the yield curve flattened over 100 basis points during the year. Currently, the spread between the 30-Year bond and the 2-Year Treasury note stands at 90 basis points (TLT) (SHY) (IEF) (IEI) (GOVT) (SHV) (TBT) (SCHO).
But in my analysis of the chain of recent events in the credit market, the tide has definitely turned. In early September 2017, the 10-Year Treasury spiked higher, driven by a borrowing binge by the US Treasury after it had been cut off from new public debt issuance (not to be confused with re-financing maturing debt) because the National Debt ceiling had been reached when Trump took office in January. Basically, supply had been limited, and the market had bid the price lower over the summer.
On December 8th, 2017 the Treasury was sidelined again from new issuance as the 2018 budget approval was punted by Congress into January 2018. However, so far since the Treasury has stopped increasing the US Public Debt, which currently stands at $14.8T (Total National Debt is $20.4T, see here), the long end of the curve has continued to trade higher in yield, lower in price. The primary change in this time period was the passage of the Tax Reform bill in December 2017. The reason this is a big deal to investors is the amount of new issuance the Treasury must flood the market with going forward in order to pay for the corporate and to a lesser extent individual tax cuts approved in the Tax Reform Bill.
In total, the US Treasury is projected to issue new debt of over $1.2T in 2018, up from less than $0.5 T in 2017 and much higher than any of the previous 4 years. And the borrowing need is only expected to get larger through 2021. If the projections materialize, and they could be worse if the Tax Bill does not produce the economic growth expected, then the US Public Debt will be over $20T by 2021, and the National Debt will stand at $28T. It is noteworthy as a relative comparison that the Treasury financing need was less than $0.5T in 2017, and interest rates on the long end of the curve remained anchored, although higher than the previous year.
It looks like a safe call that interest rates are going to be moving up, and possibly very quickly as soon as the Treasury hits the market with its “huge” borrowing need to finance the “massive” tax cuts and absorb the Fed balance sheet reduction program now getting underway. The only offsets to dampen the blow on the long end of the yield curve will be the following:
1) The Treasury has already put the market on notice that it intends to borrow more on the short end of curve and less in the long end over the near future.
2) Excess reserves of $1.99T continue to be shown in the Fed balance sheet which may migrate from cash to Treasuries in the financial system as new Treasury collateral becomes available.
3) The Tax Reform Bill was jointly constructed by Wall Street and the Treasury. Both are fully aware of the financial gap that has been created by Tax Reform. It appears that structurally the creators of the “deal” fully expect a higher valued market to be used as a means of absorbing the government need through institutional portfolio re-balancing. This market, made up of insurance companies and pension funds, favors longer duration investments. This would explain the strong, but totally inappropriate in my observation, cheer leading section from the Oval office (which for those of you who have forgotten, the Treasury is controlled by the Executive Branch).
These technical dynamics aside, the upcoming 3 times order of magnitude change in debt issuance by the Federal government is going to be felt across the financial markets, and soon. Add the prospect of an ECB and JCB wind-down of bond-buying programs, which the prospects for are already tightening interest rate markets overseas, and you have a recipe for a bond market meltdown of potentially epic proportions over the next 6–18 months, and beyond.
Oil USD Price and 10-Year Yield Pattern Conspicuously Correlated
Many investors already see the pattern. Oil is surging, so the Energy ETF (XLE) and large integrated producers like BP (BP), Exxon (XOM) and Royal Dutch Shell (RDS.A) (RDS.B), are all rallying. Additionally, shorting Treasury credit duration is also on the rise (TBF) (TMV) (PST) (TTT) (DTYS). I pointed investors to this opportunity back in September of 2017 in an article entitled National Debt Explodes Higher - Good Time To Be Short Duration. The article remains very pertinent to current market conditions and is worth a read for those interested.
But what do the changing interest rate pattern and surging oil price have to do with the broader stock market? First, take a look at how the oil and 10-Year Treasury markets are currently tracking each other in recent daily trading.
On a relative basis, oil is trading up and down in the past week almost in lockstep with movements up and down in the yield on the 10-Year Treasury. The exception was the brief time period before the 10-Year Treasury auction on 1/10/18 which was preceded by strong rumors of China lowering Treasury buys in the future. After the auction completed, the pattern returned. The rumor is, in my opinion, a good forewarning sign of the financing difficulties facing the Treasury going forward, but it should be old news. China has been “diversifying” away (politically correct code for don’t expect new money from us) from the US Treasury market for years now since QE began:
I chuckle when I read stories about China having no choice but to step up and finance the Tax Reform bill. Wishful thinking can lead to preposterous conclusions and undue risk-taking. This leads to the reason why the torrid run-up in stock prices has entered the jeopardy zone in my assessment.
Correlation Not a Random Coincidence
The front-month oil price relative to 10-Year Treasury yield pattern is not a random coincidence, it is just one that happens only periodically in the market. And when the correlation strengthens, as it is currently showing signs of doing, stock investors need to become much more vigilant.
Currently, the correlation using the past 2 years of month-end close data (my analytical metric) stands at .69. Over a 3-year span the correlation is .57. Looking back over a much longer time frame, such as the beginning of 1997, the correlation is negative. The analytical point for investors to understand is that this correlation is not always evident in the market. In a balanced market, the correlation is most likely close to 0 or negative.
Why the Correlation is Worth Watching Now
As the price of oil and the 10-Year yield start to dance, history shows that stock market trouble is brewing (SPY) (DIA) (IVV) (VTI) (VOO) (IWD) (IWF) (IJR). In the graph below, I have plotted the points in time since 1980 that the stock market has experienced a major setback of 10% or more, and how the oil spot price relative to 10-Year Treasury yield 2-year lag metric performed. As you can see, if the correlation approaches and exceeds .8, meaning the two markets are almost in lockstep on a % change basis over a 2-year period of time, the stock market implodes, and in every case violently unless there is massive Central Bank pre-emptive intervention as in 2011. The big market moves happened in 1981, 1987, 2001-2003 and 2008, and in every case the metric touched or exceeded .8 as the market breakdown approached.
The signal is very useful because it works whether the absolute price of oil is hitting extreme high points as in 1981 and 2007, or is trading at relative low price levels like in 1987, 1998 in early 2016. Likewise, the absolute level of 10-Year Treasury yields is also not a factor in driving the signal. The 10-Year Treasury rate was at high levels in the 1980s and declined to historical lows in 2016. The metric forewarned of stock market trouble regardless of the absolute level of rates and prices in the market.
The underlying information sent by the correlation is that the cost of energy and the cost of money are rising or falling simultaneously. When this happens for too long, stocks have a history of being relatively overvalued. Today the metric is at .69 and rising, a level I see as on the warning track, and the pattern month over month is likely to continue to move the metric toward and above .8 over the next 3-6 months. After that, it will very likely remain elevated until the stock market bursts like an overfilled water balloon.
A break-down in the metric would be a welcome relief for equity investors who are chasing the market like a crazed dog after a car at the present time. The signal would break down if either the cost of oil or the 10-Year Treasury becomes less correlated in the near term. However, I don’t foresee this happening presently. The market seems to be locked into a higher rate, higher oil direction at the present time.
Back Testing the Signal
Every signal has its potential false positives or misses, but in retrospect since 1980, this one has very few. The year 1990 might be considered a miss, but it was a very minor correction, and a study of the data shows that the market at the time was still having difficulty surpassing levels it set before the 1987 crash. Additionally, the warning zone levels reached in the mid-1990s never produced an actual stock meltdown. However, the time period was very volatile and produced low returns for stock investors. The market move down in the 10-Year Treasury in late 1995 broke the synchronization with oil enough and a deep stock crisis was averted prior to the dot.com boom that followed.
There was also big warning signals sent in May of 2002, but it is not considered a market peak break-down point because the market was in a continuous breakdown at the time. If you study market returns during this time frame, you will see that the stock market underwent a secondary fall during the summer of 2002, and did not really bottom until February of 2003 from the peak in the year 2000. Additionally, there is an auspicious peek in the signal in the first half of 2010. Taking a look at the data in this time period you will see that this was the point in time the Fed really began adding Treasuries and MBS securities to their balance sheet in large quantities. The result was a significant lowering of the cost of money relative to the cost of energy, averting a relapse in the stock market after the 2008 crash. The Fed “put” came to the rescue of stocks in the nick of time at this point in history.
Stock Market Expectations Now – Large Downside Risk Escalating
Stock investors are currently being set up for a cathartic market event in my assessment. My expectation is that the tech sector (QQQ) (XLK) (VGT) (IBB) (XBB), which has led the move higher in the markets (FB) (AMZN) (NFLX) (GOOGL) (GOOG), will be the sector that signals when the party is over. Once the mighty Apple Inc. (AAPL) begins rot, the DJIA will stumble, and the rest of the market will follow. After the market deflating trend is realized by momentum investors, the feedback loop will be reinforced by the increasing cost of money and higher price of oil (inflation). A large portion of the 42% run-up in the DJIA over the last 14 months will likely disappear much faster than it took to build up.
How will the Wall Street wizards, Washington and the Fed maneuver to try to avoid this evolving predicament – one where the bond and oil vigilantes from the Middle and Far East are returning after long hibernation to extract value for their oil and Treasury IOUs precisely when the Federal government needs a lot more money? Will the Fed punt on balance sheet reduction and try to keep rates from moving higher as the Treasury enters the market to finance the “massive” tax cuts? Would such a move even work now, or would it signal market desperation? Or, is the “smart money” on the other end of this trade again, like Goldman Sachs (NYSE:GS) was in the mortgage crisis in 2008?
The current fast-moving market is a fascinating reality TV show to watch. But if you are an active show participant, I say make sure you have a sure exit path to become a spectator when market chaos happens once again, lest you get left holding all the losses.
Daniel Moore is the author of the book Theory of Financial Relativity. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.
Additional disclosure: I manage a large, diversified primarily fixed income portfolio. I have been shortening credit duration for the past six months, and I plan to continue to do so. Stock positions in technology were recently liquidated. Exposure to oil was recently increased.