Note: Due to technical difficulties this article is being posted one day later than originally planned; charts are therefore as of  Friday's close. Alas, no major noteworthy  new developments have occurred since then, so we decided to leave it as is.



1. US Government Bond Market

A bullish looking weekly candle developed in TLT, t-notes, t-bonds, etc. last week – a weekly inverted hammer, exactly the type of candle that was seen at the major low in 2009 that formed after the 'QE1' induced sell-off.


There is of course no guarantee that this reversal candle will produce a similar outcome, but generally weekly reversals have more technical weight than daily ones, so it should probably be heeded (see also the chart comments further below). In addition, sentiment on the government bond market continues to be quite bearish, a contrarian sign.

We briefly want to address the various reasons that have been forwarded for the preceding sell-off in bonds. The optimistic version is that the rise in yields reflects increasing optimism about economic growth. The problem with this account is inter alia that it is at odds with the Fed's continued pursuit of 'QE2'. As we noted before, the performance of the US economy at present is mixed, i.e. in terms of official economic statistics there are signs of growth in some areas, while others still look very depressed or appear to be weakening once more. Furthermore it is questionable if the signs of growth represent sustainable growth. Still, even if market perceptions were more optimistic than is warranted, such a shift in expectations would likely have an impact on yields.

The pessimistic explanation is that the recently announced agreement on extending both the Bush era tax cuts and unemployment insurance payments mean a higher prospective budget deficit than previously assumed, allegedly goading the so-called 'bond vigilantes' into action.

In terms of what can actually be observed objectively without having to resort to an opinion, we note that market based inflation expectations have risen. They have done so ever since Ben Bernanke's Jackson Hole speech that foreshadowed 'QE2'.



10 year US inflation breakevens: in a clear uptrend since August – click for higher resolution.



The TIP-TLT ratio shows the same trend, if less pronounced. SPX and gold comparison added – click for higher resolution.



In short, what we do know for certain is that 'QE2' has succeeded in one respect so far, namely in raising inflation expectations – as odd as this seems for a central bank to do, the Fed has in fact enunciated this is one of its current policy goals. It can of course not at the same time succeed in holding nominal bond yields down.

The chart below shows a time line of the QE announcements and the bond market behavior following them, using TLT as a proxy.



TLT weekly – QE related expectations create big rallies, but the bond market begins to sell off every time even before the actual announcement is made – thereafter, it continues to sell off as inflation expectations increase. The 2009 sell-off ended with a weekly inverted hammer candle, with the low retested later. A similar weekly candle has just put in an appearance – click for higher resolution.



2. Stock Market

The stock market marked time near its recent highs last week, with numerous divergences continuing to be noticeable. Meanwhile, nothing has changged on the sentiment front – option traders, fund managers, Rydex traders and surveys all continue to show very high degrees of bullishness. Worth noting is that the NAAIM survey of fund managers, which gives managers the opportunity to describe their positioning as ranging from '200% short' to '200% long' plus asks them about how much confidence they have in their own positioning, last week continued to stand at a very high level of net bullishness, with confidence crossing above the 'high confidence' line. What's remarkable is that apparently even the most bearish quartile of managers was on average 73% net long – a level of bullish conviction last seen in October of 2007 (which was not exactly a propitious time for having such conviction).



The S&P 500 index remains near its highs of the recent move, but this is accompanied by weak internals, divergences and very high bullish sentiment regardless of the methodology used to measure it – click for higher resolution.



Naturally the stock market continues to be supported by the Fed's extremely loose policy stance. Monetary pumping can often overrule certain alarm signals, but it is per experience the case that in mature trends the buying becomes ever more selective (i.e., rallies tend to become narrower and narrower). More on this further below.


3. Gold

    Momentum divergences similar to those noted in the stock market have appeared in gold as well, but the recent sideways action in this market looks more and more like a running correction – a type of correction that usually tends to resolve in some sort of blow-off move. Provided of course that this is in fact the correct interpretation – it may not be.

    A bearish alternative would be that the next move higher is the final leg in an ending diagonal. It should be possible to make that determination by noting whether the next move exhibits more vigorous momentum than the ones preceding it (bullish alternative) it or if momentum continues to wane (bearish alternative).



    The RSI and MACD divergences visible in gold denote a loss of momentum, but this is something we would actually expect to see during a running correction. If that is what it represents, then the next move up should immediately show strong momentum. A labored rise that continues to exhibit waning momentum would indicate that perhaps some sort of ending diagonal was under construction (in which case 'B' would be labeled '1', 'C' would be labeled '2', etc.) – click for higher resolution.

    Note in this context that heretofore all major gold rallies had mid point corrections and that tops in gold have generally tended to be 'spiky'.



    If the 'running correction' interpretation is correct then rising gold and commodity prices may continue to lend support to stocks in the short term (due to the asinine 'risk on'-'risk-off' modern method of trading that tends to treat all markets as one in the short term).


    4. The Nasdaq blow-off of 1999/2000

    There may be some parallels between the current time period and the year 1999/2000 blow-off in the Nasdaq. At the time some pretty wild sentiment extremes were established as well. For instance, unusually large amounts of call options in internet/optical equipment and similar market darling stocks were well in the money at the time, with prices easily vaulting over the resistance normally posed by large call open interest. The only really significant put buying/hedging at the time was done in NDX jumbo options.

    The Rydex overall bull/bear asset ratio went to 92:8 at the March 2000 top, still an unbeaten record. The Greenspan Fed engaged in massive monetary pumping in the final months of 1999 – the 'Y2K bug' fear was in the air and the Fed was afraid the payments system may become dysfunctional, so it stuffed the banking system with extra liquidity.

    The Bernanke Fed is no slouch in the monetary pumping department either of course, currently adding some $100 billion gross ($75 billion net) to the size of its balance sheet per month. Consequently there could be similar effects in train. What was notable about the stock market's behavior in in 99/00 – the rally also became ever more narrow and concentrated in speculative favorites, while the broader market was lagging noticeably in the final months of the advance.

    A few prominent value investors simply gave up at the time, because they had to watch as worthless stocks like '' or the aptly named 'VerticalNet' went to the moon while their value stocks sagged concurrently. It was in fact a great contrary indicator – over the years that followed, value outperformed tech and other growth names considerably.

    The lesson: in this type of situation it has actually paid in the short term to buy whatever was already inflating the most – alas, one had to prepare diligently for the transition from what was in favor to what was out of favor and would eventually replace the favored sectors. Also, the transition period was marked by a mini-crash that followed on the heels of the narrow blow-off rally. The mini-crash in turn was followed by a brief rebound before downtrend became clearly manifest.

    Of course every situation is unique, as there are many more factors in play than just the ones we have highlighted in the foregoing.

    One thing that is for instance different about the monetary policy backdrop at the moment is that although the Greenspan Fed pumped liquidity into the system, it had already embarked on a rate hike campaign. So once the Y2K scare was revealed as a harmless hoax, it gradually removed excess liquidity and implemented more rate hikes. As we noted before, next year the FOMC will have more hawks in voting positions than this year. This could bring about a change in Fed policy earlier than currently anticipated, but as yet no such change is imminent.


    5. Euro Area Credit Market Indicators

    Below are the charts of our usual suspects, with CDS spreads on euro area sovereign debt once again heading a bit higher last week , while continuing to remain bounded by the recent corrective trading range. All prices in basis points, color-coded. We will have more to say on the recent negotiations regarding the disposition of the EU's bailout fund in a future commentary – once we have seen the market's reaction to it.


    1. CDS:


    5 year CDS spreads on Portugal, Italy, Greece and Spain. Heading slightly higher again within triangular corrections – click for higher resolution.



    5 year CDS spreads on Ireland's sovereign debt, Bank of Ireland, France and below Japan. The European spreads are increasing again, Japanese ones have built a triangle (it looks bullish to us) – click for higher resolution.



    5 year CDS spreads on Belgium, Hungary, Austria and Romania. Somewhat ironically, only Romania's look well-behaved at this time – click for higher resolution.



    The Markit SovX index of CDS on 19 Western European sovereigns. A slight pullback within a still bullish looking trend. The crisis just doesn't want to go away – click for higher resolution.



    2. Euro Basis Swaps


    3month euro basis swap – still heading in the wrong direction. This indicates that dollar funding for euro area banks is facing some difficulties – click for higher resolution.



    One year euro basis swap – a similar picture. Here the lateral support from May's low has not yet been reached, but it's obviously getting close – click for higher resolution.



    5 year euro basis swap – a small bounce in this one on Friday – click for higher resolution.



    Charts by: Bloomberg,



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    One Response to “Market Observations, December 20”

    • spagetti:

      agree re the charts on the 10yr TY. Im also more in the deflation camp, hence another argument to agree with a bottom in Trsy bonds

      BUT …

      it does feel like the market is now severely damaged. and the short term correlations now suggest that Trsy’s have now the feel of a ‘risky asset’ going up when stocks and commods go up and down when those are down

      maybe this is just short term .. on the other hand it makes me somewhat nervous still that another leg in the selloff is ahead of us. which will then likely puncture the whole ‘risky asset’ universe and bring everything down with it

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