The Rally Got Mugged

By March 22, 2019 Weekly TGIF

“The Rally Got Mugged”

That was the title of an article I saw this morning. It was an attention getter. The Market always has our attention. This was one of those weeks we will be referencing for a while, I suspect.

The Federal Reserve reversed course. The central bank just made its most dovish shift in outlook since the Financial Crisis. In addition to keeping rates unchanged this week, Fed Chair Jerome Powell surprised the Market by announcing they plan to keep rates unchanged for the rest of the year. Wow. The year is still young. The Fed also downgraded its forecast for US Economic growth to 2.1% for 2019 from a prior estimate of 2.3%. They also lowered estimates for next year.

Why are they doing this you might wonder. Well, they have clearly acknowledged the global slowdown which has finally reached the US. They also acknowledge that inflation remains a non-threat, continuing to stay below that targeted 2% level.

The most significant news was that the Fed has decided to abruptly taper and end the renormalization of its balance sheet. The Fed had been reducing its balance sheet by up to $50 Billion per month, consisting of $30 Billion in Treasury securities and $20 Billion in mortgage securities. In May, the Treasury portion will be cut in half to $15 Billion per month, while mortgage securities will continue rolling off at the current pace. But starting in October, the Fed will no longer reduce its Treasury position at all, but will instead take up to $20 Billion per month in maturing mortgage securities and roll them into Treasury debt. The Fed made a complete 180 from its December meeting, and the Market is now pricing in the next move will be a rate cut, not another hike. That’s new.

This change has our attention. The yield curve had already inverted in various maturities, suggesting caution. This week, both the 10-year and 30-year Treasury yields undercut their January lows, which came in the wake of the December Market crash. That is significant. At 2.4%, the yield on the 10-year is now below the Fed’s overnight rate. The Bond Market has been signaling trouble all year, and the volume just got elevated. Things are much worse overseas. German 10-Year Bunds went negative for the first time since 2016. That means lenders are paying the government to hold its bonds. That’s not good. Global growth is slowing. Europe is fighting off recession already.

We pay close attention to the Bond Market. We always have and always will. The Bond Market is the Smart Market. Right now, it’s telling us that growth is slowing fast, and the Fed has been slow to act. The Bond Market forced the Fed’s hand in January and did it again this week. It is essentially calling the bluff of the Fed by front running them and lowering rates for them. This does not happen often, in fact, the last time this happened was in 2008.

In simplistic terms: Why would one purchase a 2 yr (2.31%), 5 yr (2.24%), 7yr (2.34%), or 10 yr (2.44%) Treasury NOTE today at below the yield of the Federal Funds rate which is 2.50%?

Answer: You expect rates to not only remain very low for a good amount of time, but also that short-term rates are likely to head lower, hence the reason to own some Duration (or a maturity date out in the future vs very close in).

After basically shooting straight up to start the year after a free fall to end last year, stocks have been due for a breather. The S&P flew much faster and further than we expected. Stocks are no longer cheap. The question in our minds is whether this will be a shallow sell-off, or one much deeper to correct this overbought situation and perhaps retest the December lows. We’re studying this very closely. We trimmed some of our holdings again this week.

Have a nice weekend. We’ll be back, dark and early on Monday.

Mike

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