The big news this week revolved around all the comments coming from different Fed personalities. On Tuesday St. Louis Fed President James Bullard and New York Fed President William Dudley set the table nicely for Federal Reserve Chairman Ben Bernanke’s appearance on Wednesday at the congressional Joint Economic Committee. They clearly stated that the Fed wasn’t yet ready to tighten. What they say matters because one of the main transmission methods for this whole quantitative-easing thing is trickle-down economics — build up the stock market, and let people who own those stocks spend money, and this will supposedly feed the rest of the economy. Aside from that you keep rates as low as possible thereby maximizing the proceeds from mortgage refinancing and providing support for housing and car sales.
Then out came Mr. Bernanke on Wednesday in an apparently coordinated message contained within his prepared text — saying that a premature exit risks not just hurting the stock market, it even risks the entire recovery! “A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further,” he said. That is, the U.S. economy, growing around 2%, could entirely grind to a halt depending on what the Fed does. In Fed Chairman Ben Bernanke‘s opening comments on Capitol Hill Wednesday, he says that despite recent advances, the job market remains weak. So far, so good!
He should have stopped right there as the Dow was up more than one hundred and fifty points when he finished with the prepared text. Then came the clinker! It came in response to the following question from Rep. Kevin Brady, the Texas Republican who heads the Joint Economics Committee, “So, are you going to tighten by Labor Day?” After a few hems and haws, Bernanke replied, that depending on the data, the rate of bond purchases could slow “in the next few meetings.” So much for towing the party line, and the Dow fell right back down to earth in a heart beat. What’s the point? The point is that even the mere thought of easing off on QE at some point down the road is enough to unravel markets, so what happens when they actually do pull back? Better yet what happens if the Fed is forced to stop altogether?
So Bernanke spoke and then the market spoke. Bernanke said maybe he’ll cut back on QE, and the market said don’t you even think about it! I can’t remember the last time all three major markets staged reversals on the same day, and it’s a clear warning for anyone invested. These markets are completely dependent on QE and the current rise in stock prices has little or nothing to do with valuations or earnings. That’s why I told my clients of exit their stocks on Wednesday morning even before Bernanke began to talk. What happened on Wednesday may have been a game changer, and even if it wasn’t it’s still a coming attraction.
A lot of people labor under the false belief that the Fed will be able to ease its way out of QE without suffering consequences. In order to see the fallacy in that logic all you have to do is look at how the markets behaved in the hours that followed Bernanke’s off-the-cuff remarks. The Dow, Transports, S & P 500, NASDAQ and the bond market all staged downside reversals while the US dollar staged an upside reversal. I can’t recall a time when all three of the paper markets (stocks, bonds and the US dollar) all staged reversals on the same day. That’s the market’s way of saying, “Not on your life.”
I was particularly interested in the behavior of the US dollar since it is the world’s reserve currency and most of the debt in the world is dollar denominated. Aside from the upside reversal we can see the previous breakout above the top band of the trend line. Additionally, we see a new higher high and it broke out above the 83.31 Fibonacci resistance. Finally, you have to go all the way back to July 2010 to find a close above the 84.35 close posted on Wednesday.
The talking heads will cheer the rise in the dollar, claiming its proof the US is a safe haven and it’s all part of a strong dollar policy, but the Fed does not want to see a stronger dollar. Also, most of our industrial base in now located overseas, earning in a foreign currency, and it takes more of that currency to buy dollars when repatriated and that cuts into corporate profits. Then you have commodities priced in US dollars and they’re now more expensive for the rest of the world. Finally, Bernanke knows that the only way the US can ever pay off its debt is to inflate the debt away, and that means the dollar must depreciate over time. All in all, a rising dollar spells trouble for Bernanke and the money crowd.
In the US we have three paper markets, stocks, bonds and the dollar, and I believe that all three are headed for trouble. In fact I’ll go so far as to say that the bond market has already topped and is now heading lower. I believe the bond topped back in July 2011 and then turned lower. Below you’ll see the first leg down that took it to the March 2013 low of 141.41:
The March low was followed by a rebound that retraced almost exactly 61.8% and then turned down for the second leg that will produce a lower low.
The more the bond price falls, the higher the interest rate goes. Now think about the trillion dollars of new debt coming out every year, and the half a trillion or so of debt that has to be rolled over, all at higher rates. The US has US $100 trillion in debt if you include unfunded obligations, so imagine what just a 1% increase in interest rates would cost the US per year. Right now the interest rate is at historical lows and it would have to jump 4% just to get back to the historical average. Such a jump would cost the US several trillion more a year just to service existing debt. Finally, it’s worth remembering that we have over US $700 trillion in derivatives floating around and more than 50% is tied to the interest rate! Can you see a problem?
Finally, for those of you looking for ‘confirmation’ there is another outside indicator that demonstrates interest rates are on the rise. As you can see in the previous chart, the Dow Jones Utility Index has broken down. This is important because the Utilities Index is extremely interest sensitive and you generally see a break down in the Index once the bonds have topped.
Stocks have better luck than bonds, but they still suffered a
downside reversal on Wednesday on a big jump on volume. The Dow, Transports, S & P 500 and even the NASDAQ all posted downside reversals on Wednesday and all but the Dow continued that decline on Thursday and Friday. The Transports weakened more than the others as you can see and it came close to testing good support at 6,305. What’s more the Transports appear to be faltering as you can see a break below the original trend occurring back in early April, and RSI failed to confirm any of the new all-time closing highs.
If you look at individual stocks you’ll see there is something to worry about as companies like Caterpillar:and Apple:
have experienced significant breakdowns. It’s common at a top to see that the market leaders have turned down several months before the general indexes finally exhaust themselves. Aside from the two above I could have posted charts of FedEx, Facebook, IBM and Intel since they’re all in the same boat.
On the positive side of the ledger we still had the Dow posting a new all-time closing high as recently as Tuesday although it was not confirmed by the Transports. Also, as you can see below, the number of companies trading above
their respective 50-dma is holding at a high percentage. Personally I don’t like what I see and that’s why I advised my clients to exit all their stock positions Wednesday morning as Bernanke was preparing to speak. I just don’t see the value in this market and I see no reason to play a game of financial musical chairs.