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Friday, March 29, 2024

READING THE TEA LEAVES

READING THE TEA LEAVES

Mint Tea

By Rom Badilla, CFA – Bondsquawk.com

Last week, equities rebounded as we entered earnings season with the hope that pleasant surprises and positive guidance will ultimately lead to a sustainable economic growth.  State Street led the charge with a bang by posting better than expected earnings which the bulls used as an indicator of the health of the financial sector and as stimulus for a stock market rally.  The S&P 500 thundered its way back from the lows by rallying 5.4 percent over the week.  Bonds sold off 7 basis points during the same time frame as evident of the yield on 10-Year U.S. Treasury closing at 3.05.  If we look at trough to peak, bonds sold off even more as the yield increased 13 basis points after it bounced from a low of 2.92 percent.  While impressive by its own right, not all asset classes were convinced that the U.S. economy is out of the woods.

The dollar sold off during this time frame suggesting that the U.S. economy is still on slippery footing.  The Dollar Index which is a measure of value against six major currencies tumbled 0.6 percent and closed the week at 83.947.  Since the release of the first disappointing payrolls in number in early June, which suggested stagnant employment growth (if we can call it at that), the Dollar Index has dropped a staggering 4.9 percent.

So the relative lack of noteworthy economic developments coupled with extreme bearishness as evident by the AAII Sentiment index, which is more of a contra-indicator, suggests that the recent gains in equities may be little more than a short term correction following the onslaught of declines over the past two weeks.

The same can be said of the bond markets after posting lower yields and tremendous gains over the last few weeks.  Despite the recent breather, the 10-Year had declined more than 30 basis points since June’s payroll number.  During that time, we had significant economic indicators suggesting lower inflation expectations which should be the predominant theme for awhile.

Easing price pressures in the various economic activity indicators are evident.  The Prices Paid component for Philadelphia Manufacturing Activity released on June 17 dropped from 25.5 points to a reading of to 10.0.  On July 1, the ISM Manufacturing Prices Paid component dropped to a reading of 57.0 from 77.5 in the prior month.  Similarly, the ISM Non-Manufacturing Prices Paid component released several days afterwards went from 60.6 to 53.8.  While both the Philly Fed number and ISM numbers still represent “expansionary” indicators (positive reading for Philly Fed and above 50 for ISM), the violent drop is a concern as it edges closer to contraction.  PPI and CPI are set for this week and barring a major surprise uptick, should reinforce the view of weak pricing power.

As far as market inflation expectations go, the yield differential between nominal 10-Year Treasury yields and 10-Year Treasury Inflation Protected Securities is still lower in recent weeks.  Inflation expectations aka the breakeven rate, dropped 24 basis points from early June which includes a back up of 10 basis points late last week.  Though, the recent increase experienced on Thursday and Friday can partially be attributed to technical factors as the U.S. Treasury came out with new TIPS supply.

On Thursday, the U.S. Treasury auctioned off $12 billion of 10-year Inflation Protected Securities at a yield of 1.295 percent.  With very low price pressure expectations, demand for securities, whose design is to insulate investors in the event of rising inflation, was lackluster.  Demand was lower as evident by the bid to cover ratio, which compares the number of bids with the amount of securities sold and is a gauge of demand. The ratio was 2.88, compared with 3.43 at the previous auction.

To sum up, stocks and bond yields advanced in recent sessions in what appears to be a “dead cat bounce”.  The height of the feline bounce is difficult to say.  It is my belief that in the absence of fundamental data or stimulus, technical analysis reigns supreme.  So it makes sense to defer to that type of analysis which is beyond the scope of this post (Insights on tea leaf readings go only so far.  Now, if we had a live rooster…).  I will say, not suggest, that the 50 day moving averages, which can be viewed as resistance points and are below the 200 day in a “death cross” pattern, are at 1100 and 3.27 percent for the S&P 500 and 10-Year, respectively.

In addition and as mentioned at the onset, it is earnings season which as State Street displayed, can surprise to the upside and lead the market higher in the short term.  I am sure mainstream media and bottom up analysts, whose expertise puts them in a vacuum, will have grins on their faces, ear to ear, and start proclaiming the recent decline as nothing more than a “healthy” correction to a recovery if and when we get a good string of positive surprises.

Having said this, I am far from convinced since the tidal waves of recent economic data suggesting weaker growth, will ultimately engulf any attempt of a sustained bull run.  While the ECRI Growth Rate Index edges closer and closer to the abyss, the fact remains that federal stimulus is waning with little signs of renewed appetitie to spend.  Furthermore, consumers have to deal with higher taxes set for next year which act as another drag.  News across the pond has been quiet as of late but the fact remains that the European debt crisis is far from over.  Economic data and the macro theme of high unemployment, weak real estate, and debt deleveraging, still calls for a suspect economic “recovery” and easing price pressures.  So, keep your eye on the ball until the tea leaves say otherwise. 

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