Bonds and Currencies Leading Markets Higher

Sometimes it seems like the financial news world is rooting for the next big correction to blow up equity markets. In article after article, it's almost like the industry wants a meltdown, or at least spark a little bit of market volatility. It's good for headlines, it draws in the readers. Set aside the business case for media: this is simply not the right time to be talking about market corrections. Just last week, we discussed fundamental reasons why a correction is not likely, including higher analyst earnings estimates and a shift toward growth in expectations for economic expansion.

There are plenty of ways to analyze equity markets and confirm what they are actually saying. Currently, they are predicting economic growth. How do you confirm this prediction? By exploring what other markets are saying. Let's look at the bond and currency markets. After all, both the bond and currency markets are sensitive to interest rates and economic growth.

(Mott Capital Management, LLC)

The chart above tracks the evolution of U.S. treasury yield curve since last July. It shows the curve has been slowly been shifting higher over the last eight months. In fact, the 10-year yield has risen nearly 1% since July, from around 1.5% to roughly 2.5% today. A rising yield curve implies expectations of higher future inflation and economic expansion. One could make the argument that bonds began to expect a turn in the U.S. economy sometime in September. Which was also of course around the time the Federal Reserve began preparing the market for its December rate hike

(Mott Capital Management, LLC)

The chart above shows that the spread between the 10-year yield and the 2-year yield started widening around September 28th, 2016. A widening spread between these two treasury bills is a key indicator of improving economic conditions. The spread continued to expand right through the middle of December and has leveled off since then. Based on this chart, you could make the argument that the equity market has lagged the bond market by about two months.

(Mott Capital Management, LLC)

The chart above tracks the spread between the U.S. 10-year Treasury yield against the German 10-year Bund yield on the left and the Japanese 10-year JGB yield in the middle. On the right, you have the spread between the 10-year German bund yield and the 10-year Japanese JGB yield, which has remain relatively stable. The widening spreads between U.S. yields and the benchmark European and Asian bonds suggest the global bond market is anticipating higher US interest rates, which is indicative of higher US inflation rates and faster economic growth.

(Interactive Brokers TWS)

Currency markets are picking up the cues from bond markets. The chart above tracks the EUR/USD currency pair since July 2015. The U.S. Dollar has clearly strengthened against the euro over the same period of time as my U.S. yield curve chart, with the pair falling from around 1.12 in late July 2016 to around 1.06 presently. The stronger dollar is one sign of a stronger U.S. economy.

(Interactive Brokers TWS)

The chart above shows the USD/JPY currency pair since July 2015. Since late July 2016, the yen has weakened by approximately 12 percent, with the pair rising from around 100 to 112 currently. Not to reiterate, but rising U.S. bond yields and a stronger U.S. Dollar are indicative of improving U.S. economic fundamentals. Reading into these charts, you could argue that U.S. equity markets have actually been lagging behind not only bonds but also currency markets, by about two months in each case.

Going a step further, the equity market risk-on mentality is clearly visible when looking at sector rotation. Using SPDR ETFs as proxies for industry sectors, you can see risk appetite is high and anything but complacent.

(Mott Capital Management, LLC)

The biotech, healthcare, tech and financial sectors are leading the equity market higher in 2017. Biotech and tech are considered risk-on sectors offering the highest growth rates and the highest beta. Additionally, financials would be the biggest beneficiaries of a rising and steepening yield curve, given that banks borrow short and lend long. Simply put, this means that as the spread between short-dated and long-dated bonds widen, the banks make more money. Don't be surprised that utilities, materials, and energy are the worst performing groups in 2017. Utilites are typically higher-yielding investments, and a rising interest rate environment hurts higher yielding equities. Meanwhile, a strengthening dollar gives commodities and materials a significant head wind, since commodities are priced in dollars. As the dollar strengthens, it takes fewer dollars to buy a unit of a given commodity.

Lastly, let's look at inflation. In the chart above, you can see that CPI inflation has been surging on a year-over-year basis. Remember what was happening with oil at this point last year? Oil futures were trading in the $30 dollar range, up slightly from the mid-20's. By June, oil prices peaked and the commodity has traded sideways since then. CPI has been surging because the price of oil last year at this time was so low. When you strip oil and food out of the CPI data, inflation levels have been pretty much flat for quite a long time. Come June, it is likely the spike in inflation will abate.

Stable inflation coupled with pro-growth policies should allow for moderate and steady economic expansion supportive of current market valuations. If the bond and currency markets are correct, the closest thing to a correction we should see in equity markets is sideways trading. If you believe valuations are stretched and the big market meltdown is coming at any moment, don't hold your breath.