Business Cycles are usually categorized into 3 distinct phases: Early Cycle (Recovery/Expansion), Middle/Late Cycle (Peak) and Recession (Contraction). Predicting recessions and expansions is difficult due to the irregularities present in the business cycle.
Background on Business/Debt Cycles:
In general, the business cycle is governed by Keynes' idea of aggregate demand (total spending) within the economy. Credit is the most important part of the economy because it is the most volatile. Lenders and Borrowers both benefit from credit. Credit Creation is the main force driving the monetary supply of an economy. Increased income, leads to increased borrowing, which, allows increased spending then, more income, borrowing and spending. A cycle. When you borrow money, you borrow from your future self. So, there will be a time in the future where you will have to save more to pay off the money you borrowed in the past. A cycle. Thus it is important that the debt you took on was used efficiently/productively. As economic activity increases, spending increases fueled by credit causing prices to rise. As inflation increases discount rates move higher to negate inflation. Raising rates cause a credit contraction putting downward pressure on the M2 money supply. High rates cause less borrowing and higher debt repayment.This leads to less spending, less income, less borrowing and lower prices. As a result, The fed reacts by lowering rates to stimulate the economy. The economic cycle is based on credit (debt) cycles! This cycle repeats and fluctuates in volatility. The economy booms when there is a surplus of credit because, borrowed money is used to buy goods and financial assets. The economy busts when debt grows faster than income, debt burdens/repayment cause a decrease in spending and income. Uncertainty surrounding the virus and the state of the economy combined with high unemployment levels has resulted in decreased consumption and increased saving rates. Reopening and stimulus expectations have propelled markets upwards through speculation of future economic growth and larger amounts of spending. Interest rates have been creeping up behind, the success of the markets and are changing investors' behavior.
Keynes' book General Theory of Employment, Interest and Money argued that the volatile and ungovernable psychology of markets would lead to periodic booms and crises(busts). Keynes introduced concepts that supported the behavior of a cyclical market through the multiplier effect, marginal effectiveness of capital (discounted cash flow is effected by Interest rates), the consumption function (disposable income is linked to consumption), liquidity preference (demand for assets considered liquid), and effective demand (demand is affected by the purchasers constraint). Despite your thoughts on Keynesian Economics, it has heavily influenced Modern Monetary Theory - the leading economic growth strategy facilitated by Central Banks around the world. Keynes was wrong in believing that fiscal policy could regulate business cycles. But, Economists today have reached the consensus that business cycles go through phases due to changes in corporate earnings, interest rates and inflation causing economies to eventually go through boom - bust cycles. It is no surprise that Economies navigate through cycles but, what part of the cycle are we in? The velocity at which Interest rates are rising have affected the way the world does business. Expectations of an economy returning to normal have heightened the cost of borrowing. The steep increase in rates could be enough to propel the economy into another phase of the business cycle. Since, September, Value stocks have outperformed Growth stocks and relative weakness is prevalent across the tech sector. The tech sector has propelled markets upward since 2009. Are investors no longer as willing to buy tech companies at these valuations?
1. Early Cycle (Recovery/Expansion)
After, a recession has ended; markets usually experience their most successful run. The economic environment is characterized by low rates, low inflation, monetary policy is accommodative and the yield curve is steep. Economic Policy is designed to stimulate the economy and push inflation higher. Since, June 2009 (the last trough present in the business cycle) its been 135 months of an "expansionary economy". Cheap borrowing enables Consumer Discretionary, Financials, Real Estate, Information Technology and Industrials to thrive during these times. As these economical sensitive sectors succeed the defensive sectors (Value, Materials, Utilities, Energy) underperform.
A. SMH/SPY (Semiconductors vs. SPY)
The Semiconductor sector has been a fantastic leading indicator of broader markets. In todays technology age, semiconductors are the lifeblood of all logic based technology. Automobiles, computers, phones, household appliances and medical devices use semis in the first phases of their supply chain. Anyone starting or maintaining a business today will need the extra computing power enabled by semiconductors. It really does dictate the path of the economy. There is a strong positive correlation between semiconductor growth and economic expansion. One could argue that the semiconductor manufacturing process is expensive and involves large amounts of capital making it more sensitive to changes in interest rates. Looking at the chart for SMH/SPY, we see that this ratio is approaching the highs its made in the Dotcom bubble and that semiconductors have been outperforming the broader market since 2008. A strong bull market is reliant on semi's outperformance.
B. Tesla
Another leading indicator which has dictated the markets meteoric rise in recent months has been Tesla. Tesla has been an incredible indicator of market sentiment. Investors are willing to speculate that Tesla will grow tremendously in value over the years. Tesla delivered close to 500,000 vehicles in 2020 compared to Toyota and VW at 10 million. Every car Tesla sold added 1.4 million to their market cap compared to 80,000 for Toyota and VW. This risk tolerance displayed by investors has dictated the amount of risk investors are willing to take in other parts of the market. Stocks are a uncertain call on future earnings and the base case for the amount of future earnings to expect has been set by Tesla. If Tesla makes new highs or lows the stock market will follow. Tesla had some product issues arise in February which did not deter stock holders. The National Highway Traffic Safety Administration told Tesla to recall 134,951 of its 2016-2018 Model X and 2012-2018 Model S to replace the 8GB eMMC in the MCU with newer ones with a longer life span. When the MCU were designed, no automative grade ones were available on the market to source. Tesla would either have to spend time and money to create their own or use consumer grade embedded MultiMediaCards. The design of the 8GB eMMC to have only a finite amount of write-cycles and excessive data logging resulted in too low of a write limit. Because, Tesla mainly relies on software and the MCU for necessary driving functions they were forced to recall and repair their vehicles.
C. XLY/XLP (Consumer discretionary vs. Consumer staple)
As financial conditions are eased spending becomes more abundant, borrowing is cheaper ultimately leading to economic growth and increases in sales and revenue.
D.XLI (Industrials)
When credit is easily available, large capital orders are made. A weak dollar and low rates lead to higher revenue and earnings comp (profit) in future quarters. However, if the dollar is strong and yields are high analysts will cut estimates resulting in lower stock prices. A strong dollar will not help many companies that export their products or sell products overseas.
E. GOLD (King)
When the economy is growing and consumers have large amounts of disposable income Gold usually appreciates in price along with inflation. ~50% of Gold is used in jewelry, 20% is used in coins and personal investment and the remaining ~30% is used in industrials and technology.
F. XLF (Financials)
Financials have not done well in recovering their losses from the the great financial crisis. In the early parts of a business cycles financials are expected to succeed due to the large amounts of lending because of low rates. Low rates cut into their profitability however, the increase amount of lending usually offsets this.
G.M2, M2-M1 (Money Supply and Bank Lending)
Credit Contraction puts downward pressure on M2. Credit Expansion puts upward pressure on M2.
2009-2015 was known as a period of a struggling recovery due to the persistent liquidity crisis which was present. In 2016 rates increased due to a more "normal" economy but, were quickly reversed. Rates moved up to quickly and in 2018, 2019 the fed started to enable cheap borrowing again. 2020 Covid hit, rates plunged even further down and 2021 we are seeing rates rise.
It was hypothesized that prior to Covid the economy was in the Late Cycle of the business cycle. However, Covid 2020's economic landscape mirrored an Early Cycle environment. The ten year rate is increasing at very high velocity so, the business cycle is accelerating quickly to latter phases.
2. Middle/Late Cycle (Peak)
As, the economy recovers: moderate growth is present, interest rates begin to rise, corporate earnings are strong and the fed sets inflation expectations. This stage is usually the longest and market corrections are experienced here. As this phase reaches the tail-end; the economy eventually reaches a saturation point, economic indicators start to top, prices peak and consumers restructure their budget. Defensive and Inflation resistant sectors perform better than, cyclical sectors (economically sensitive). The Consumer Discretionary and Technology sectors start to underperform. Materials, Consumer Staples, Healthcare and Energy all start to outperform. Commodities were at their lowest point in 2020 and were able to catch a bid in September when Interest Rates signaled a move higher. Commodity prices play a huge role in the cost of living and our spending behavior as well. The basic input costs that run our lives. When commodities increase in prices, corporate profits decrease and consumers pay more for goods. Everything we consume started as a commodity transaction. A "weakening" dollar has made commodities more "expensive".
A. IVW/IVE (Growth vs. Value)
In the first expansion phase, Economically sensitive sectors such as growth grow rapidly in value because, growth stocks are the highest benefactors of a high growth economic environment. When interest rates, start moving higher, growth companies no longer have access to the same cheap credit and will have less money to put toward investing in their growth. However, during the beginning parts of Middle/Late Cycle tech companies do well because, the economy is in good shape so, they will have consumers willing to spend on their products. However, soon as inflationary pressures become too great to sustain growth expectations, profit margins get worse and investors move away from economically sensitive sectors. Value names with financials that don't rely heavily on large amounts of economic growth and those companies with stable cash flow/income start becoming more attractive to investors. Since, September there has been a move away from Growth names and into Value. Any "healthy" bull market is characterized by strength in growth stocks. At least since 2008, Growth has propelled markets. One can argue that a cyclic change is occurring and now is the time for Value to outperform Growth and propel markets upward (Not as easy as it seems). Berkshire Hathaway sold Apple and bought into Pharma and Energy stocks. Apple is trading at over 30 times net profits and over 8 price/sales (investors are paying 8 dollars for every 1 dollar in sales) which is an incredibly high valuation for even a giant like Apple. Growth stocks are so overvalued investors are starting to realize that they need another place to store their money. As the economy has plans of reopening many of these value names have garnered speculative attention. This caused the rotation from growth to value to occur. The questions is " Is the rotation into Value real and will it be sustained?" It is important to keep in mind that a large part of "value stocks" are debt laden, zombie companies like airlines, cruises, casinos, brick n mortar stores and banks. The "pent-up" demand, enthusiastic reopening targets and high inflation expectations seemed to of convinced speculators to front-run the supposed rotation and pile into value names with subpar fundamentals.
B. SPY/CRB ( Stocks vs. Commodities)
Since 2009, we have seen an outperformance of stocks vs. commodities. We saw a peak in this relationship near November 2020. Commodities have been outperforming ever since and I expect this ratio to reach its Pre-Covid levels. It is also very possible that this relationship may of peaked. Higher commodity prices are not good for the economy as it hurts producers and consumers. Producers of goods that use commodities as, inputs will need to pay higher prices. These higher prices effect their profit margin. The higher prices are also carried on to the consumer who must pay more. This hurts corporate earnings and slows down consumption. A decline in oil and many metals would slow the big run in the equity market's energy, material and industrial parts. By looking at the pre-covid levels of this chart you can get an idea of where this ratio is supposed to be. Commodities are still not performing as well relative to SPY as, they were pre-covid. Spy has room to underperform in the short term.
B. IWM (Small Caps)
The Russell is a good indicator of market breadth (the number of stocks participating in the gains/loses of an index). Relative strength in IWM was the precursor to the end of the past three bear markets. A large amount on Small Cap names such as Macys, BBBY, GME, PLUG, PENN have experienced that their stock prices/valuation have deviated from their fundamentals. A lot of these companies carry a lot of debt and were at the brink of bankruptcy. The success of broad markets will be reliant on the performance of Small Caps.
C. HYG (High Yield Bonds / Corporate Bonds)
The High Yield Bond Market has held up well during recent market down turns. It has not yet broken the Feb 2020 highs but, it also has not fallen with the market the past weeks. Corporate Bonds usually are based of short term treasury rates and those rates are still plastered to zero. A very bullish leading Indicator would be a break to new highs in HYG and JNK. I am watching closely, banks too. It is important to note that HYG is exceptionally resilient to these market fluctuations because expectations for rate hikes in the next two years are not very high. It is the expectation for 7 year or 10 year duration bond that have high interest rates pegged to them.
D. USOIL (Cash Settled Texas Light Sweet Crude Oil Contracts)
IYE, OIH and other Oil etfs have seen a surge since September due, to many investors looking for a sector rotation. Oil in general has made quite the comeback due to reduced supply, increased demand due to reopening and stimulus. Also, Saudi Arabia production cuts to keep prices propped up. Changes in energy prices, diverse energy supplies and demand dynamics, and government regulations could pose as obstacles. $40 a barrel is the breakeven cost (profitability) for oil companies so, the current price of $65 allows for some nice profits. Will this economy be able to sustain these high gasoline prices.
E. WOOD (TIMBER ANDD FORESTRY)
Wood goes into buildings, toilet paper, furniture, etc. A thriving housing market relies heavily on wood for construction, remodeling and interior decor. The current price for a 1" by 12" wide board of pine wood costs you $8.83, in February this peaked at $10.21. In March 2020 that same piece of pine wood would of cost you $2.63. I imagine about 4,000 to 7,000 amount of wood goes into building a house so, in March 2020 4,000 boards would of cost $10,520 vs. $40,840 in Feb 2021. That is heavy cost difference for consumers.
F. SILVER
Silver and Gold are not feeling the effects of inflation. Precious metals will suffer in a liquidity crisis. Looking back at every crash, metals usually started declining before stocks, crashed with stocks and rallied before stocks rallied.
G. S5INFT (Info Technology Stocks)
I imagine this subset of tech stocks will do well because, they are detached from the stay-at-home type stocks and tech stocks with absurd valuation. I expect some outperformance here. These are also the type of tech stocks that gain more from an economy experiencing high amounts of growth than from low interest rates.
3. Recession (Contraction)
As credit becomes less available, spending is lowered and lower prices soon follow. Debt overhang and debt burden eventually cause assets to be sold, flooding the market. Spending falls, income falls and borrowers become less credit worthy. Interest rates are already relatively low. If the economy starts falling into this cycle, rates will need to be lowered again and negative rates may be needed. Some debts may not be able to be repaid so, savings will need to increase, debts are restructured, increases in taxes and "Money Printing". One could argue that we are around this phase of the business cycle: the deleveraging. Quantitative easing and stimulus are not tools a government wants to rely on for economic growth because, the fed is a reactionary force. The economy must be really bad if these tools need to be used. "Printed money" needs to be released into the real economy through bank lending, this is the only way reserves can be used. The rate of interest needs to be lower than the rate of income. Low rates are important for an economic recovery. Health care, consumer staples, utilities and other sectors where revenues are tied to basic needs outperform other asset classes. Consumer staples have outperformed every other sector during every recession.
A. XLU (Utilities)
XLU has underperformed the broader stock market since the last recession, it seems like Utilities could potentially start outperforming sectors such as tech, consumer discretionary and industrials. Investors like utilities because they pay a high dividend yield which is needed during a recessionary environment where share prices don't rise much. Utilities have mainly been following interest rates and preforming well at lower levels. Not to mention it has mainly been carried by NextEraEnergy, without it their chart would look much worse.
B. Inverted DXY and SPY (pictured)
The chart of the dollar inverted matches very closely with the SPY chart. DXY has risen a lot more than SPY has over the past 2-3 weeks and the dollars strength can be attributed to rising rates. If the dollar does not get weaker, I wouldn't expect markets to move too much higher. As the dollar moves higher, commodities and commodity-linked sectors of markets will see weakness. Wider spreads and rates (compared to German,Japan bonds) help bring capital inflows back to the US for investment. The ECB and the BOJ would welcome a weaker euro and yen. It eases deflationary pressures from a strong currency and helps boost growth rates.
The demand for Cash/US dollars causes selling in assets. Short-term moves in the US dollar are driven by changes in US systemic liquidity flows (changes in current and capital account). When looking at the US exchange rate, the factor which determines its movement are long term yields. Long Term yields are effected by changes in systemic liquidity. There is a huge short interest on the US dollar , when it becomes apparent that DXY has bottomed, shorts will start to get unwound. Higher rates are causing the dollar to break out and go higher. If that happens, what is left to push equities up?
C. US10Y-US02Y (Yield Curve)
A steepening yield curve is usually associated with an equity market peak. Where the yield curve peaks is the real question. When the yield curve is steep it means investors are severely discounting future cash flow this happens under strong economic conditions with positive returns on capital and investments. When the yield curve is flat, the future economic outlook is questionable. As the yields curve steepens, higher rates of unemployment occur shortly after. This is because of the decrease is spending, borrowing and an increase in prices results in lower amounts of profits. The short end of the curve or "policy rates" will stay plastered to zero. The capacity of the market to borrow cheap and continue to spend will not change however, this has ushered in an era of mania. If yields get to high investors may get spooked and a sell off will ensue. The Yield Curve hit its local minimum on Sep 2019. Usually there is a 15 month gap for the yield curve to hit the local max. Since Sep 2019, the yield curve has been continually steepening, for 15 months!!! Could we see a local max in the yield curve here. I would not be surprised if the yield curve continues to rise for a couple more months but, it is approaching "high" levels. The yield curve was technically negative at its local min bottom in Sep 2019, usually we look for a one point increase in the yield curve which has historically signaled a drop in equities. We are at 1.4 right now. The yield curve is giving the signal that markets are close to peaking. Every inflationary period was characterized by yields at around 4% we still have a while to go until we reach real inflation.
D. TLT/XLF (Long Term Bonds vs. Financials)
This chart is one of the scariest I have ever seen. This ratio has made its way back down to the 2008 levels. Over the last few weeks as rates have increased banks have risen but, higher rates caused bonds to plummet. Looking back at history, when TLT rises faster than XLF, it is a bad sign for markets and an indicator of systemic risk. There is not much room for Financials to continue to outperform bonds. A reversal in this ratio could signal a market top.
E. GDX
GDX is a proxy for liquidity and a leveraged position on Gold. GDX does not lie. The price action exhibited by GDX is very bullish for bonds and the dollar. I believe Gold and GDX have already experienced their episode of inflation expectations. GDX peaked at 3 times its March 2020 price and started a decent down in August. GOLD and GDX are usually the best leading indicators because they are a proxy of liquidity and liquidity drives markets. People are selling their Gold for cash. I am waiting for Gold to bottom and start trending up because at that time interest rates will begin to fall. Miners are as vulnerable as tech stocks are to credit market swings and economic shifts. A healthy market should see GDX rising with it.
F. EURO
Foreign governments that require US dollar reserves will end up paying relatively more to obtain those dollars. Europe has a lot of headwind and it is hard to make a bullish case for European Equities. Prior to Covid, Europe was in a lot worse place than the US. As US financial conditions tighten, Europe's conditions will as well. Europe cannot afford this because, they do not have the very juicy 1.9T fiscal stimulus package, US has to help offset these higher rates. The stimulus package the US is receiving has resulted in many very high growth forecasts. On CNBC someone came out and said 8% growth in 2022. WHAT?!?!? Never the less, Europe doesn't even have a stimulus package that results in any significant growth forecasts. A lot of money in emerging markets are flooding back to the US. The downside to the dollar is very limited due to growth outperformance. Because, the value of the dollar is reliant on a basket of other currencies(Yen,Euro); the dollar will most likely rise in value.
G. FXI
A lot of the worlds manufacturing flows through China and a large part of America's bank reserves end up in China. China's PMI is now tipping downward at 50.6. China's non manufacturing PMI for the last month was 51.4 which is one of the lowest in China's history. China's expected gdp target growth rate is 6% which is lower than many people expected. If China's economy is headed for a downturn then, the world economies will eventually join them. China is a good leading indicator because, the issues that affect China manufacturing will be felt by the United States, Europe.
H. ISM Manufacturing PMI
A bottom in the PMI signals a bottom in the dollar.
Thank you for reading!
Background on Business/Debt Cycles:
In general, the business cycle is governed by Keynes' idea of aggregate demand (total spending) within the economy. Credit is the most important part of the economy because it is the most volatile. Lenders and Borrowers both benefit from credit. Credit Creation is the main force driving the monetary supply of an economy. Increased income, leads to increased borrowing, which, allows increased spending then, more income, borrowing and spending. A cycle. When you borrow money, you borrow from your future self. So, there will be a time in the future where you will have to save more to pay off the money you borrowed in the past. A cycle. Thus it is important that the debt you took on was used efficiently/productively. As economic activity increases, spending increases fueled by credit causing prices to rise. As inflation increases discount rates move higher to negate inflation. Raising rates cause a credit contraction putting downward pressure on the M2 money supply. High rates cause less borrowing and higher debt repayment.This leads to less spending, less income, less borrowing and lower prices. As a result, The fed reacts by lowering rates to stimulate the economy. The economic cycle is based on credit (debt) cycles! This cycle repeats and fluctuates in volatility. The economy booms when there is a surplus of credit because, borrowed money is used to buy goods and financial assets. The economy busts when debt grows faster than income, debt burdens/repayment cause a decrease in spending and income. Uncertainty surrounding the virus and the state of the economy combined with high unemployment levels has resulted in decreased consumption and increased saving rates. Reopening and stimulus expectations have propelled markets upwards through speculation of future economic growth and larger amounts of spending. Interest rates have been creeping up behind, the success of the markets and are changing investors' behavior.
Keynes' book General Theory of Employment, Interest and Money argued that the volatile and ungovernable psychology of markets would lead to periodic booms and crises(busts). Keynes introduced concepts that supported the behavior of a cyclical market through the multiplier effect, marginal effectiveness of capital (discounted cash flow is effected by Interest rates), the consumption function (disposable income is linked to consumption), liquidity preference (demand for assets considered liquid), and effective demand (demand is affected by the purchasers constraint). Despite your thoughts on Keynesian Economics, it has heavily influenced Modern Monetary Theory - the leading economic growth strategy facilitated by Central Banks around the world. Keynes was wrong in believing that fiscal policy could regulate business cycles. But, Economists today have reached the consensus that business cycles go through phases due to changes in corporate earnings, interest rates and inflation causing economies to eventually go through boom - bust cycles. It is no surprise that Economies navigate through cycles but, what part of the cycle are we in? The velocity at which Interest rates are rising have affected the way the world does business. Expectations of an economy returning to normal have heightened the cost of borrowing. The steep increase in rates could be enough to propel the economy into another phase of the business cycle. Since, September, Value stocks have outperformed Growth stocks and relative weakness is prevalent across the tech sector. The tech sector has propelled markets upward since 2009. Are investors no longer as willing to buy tech companies at these valuations?
1. Early Cycle (Recovery/Expansion)
After, a recession has ended; markets usually experience their most successful run. The economic environment is characterized by low rates, low inflation, monetary policy is accommodative and the yield curve is steep. Economic Policy is designed to stimulate the economy and push inflation higher. Since, June 2009 (the last trough present in the business cycle) its been 135 months of an "expansionary economy". Cheap borrowing enables Consumer Discretionary, Financials, Real Estate, Information Technology and Industrials to thrive during these times. As these economical sensitive sectors succeed the defensive sectors (Value, Materials, Utilities, Energy) underperform.
A. SMH/SPY (Semiconductors vs. SPY)
B. Tesla
C. XLY/XLP (Consumer discretionary vs. Consumer staple)
D.XLI (Industrials)
E. GOLD (King)
F. XLF (Financials)
G.M2, M2-M1 (Money Supply and Bank Lending)
2009-2015 was known as a period of a struggling recovery due to the persistent liquidity crisis which was present. In 2016 rates increased due to a more "normal" economy but, were quickly reversed. Rates moved up to quickly and in 2018, 2019 the fed started to enable cheap borrowing again. 2020 Covid hit, rates plunged even further down and 2021 we are seeing rates rise.
It was hypothesized that prior to Covid the economy was in the Late Cycle of the business cycle. However, Covid 2020's economic landscape mirrored an Early Cycle environment. The ten year rate is increasing at very high velocity so, the business cycle is accelerating quickly to latter phases.
2. Middle/Late Cycle (Peak)
As, the economy recovers: moderate growth is present, interest rates begin to rise, corporate earnings are strong and the fed sets inflation expectations. This stage is usually the longest and market corrections are experienced here. As this phase reaches the tail-end; the economy eventually reaches a saturation point, economic indicators start to top, prices peak and consumers restructure their budget. Defensive and Inflation resistant sectors perform better than, cyclical sectors (economically sensitive). The Consumer Discretionary and Technology sectors start to underperform. Materials, Consumer Staples, Healthcare and Energy all start to outperform. Commodities were at their lowest point in 2020 and were able to catch a bid in September when Interest Rates signaled a move higher. Commodity prices play a huge role in the cost of living and our spending behavior as well. The basic input costs that run our lives. When commodities increase in prices, corporate profits decrease and consumers pay more for goods. Everything we consume started as a commodity transaction. A "weakening" dollar has made commodities more "expensive".
A. IVW/IVE (Growth vs. Value)
B. SPY/CRB ( Stocks vs. Commodities)
B. IWM (Small Caps)
C. HYG (High Yield Bonds / Corporate Bonds)
D. USOIL (Cash Settled Texas Light Sweet Crude Oil Contracts)
E. WOOD (TIMBER ANDD FORESTRY)
F. SILVER
G. S5INFT (Info Technology Stocks)
3. Recession (Contraction)
As credit becomes less available, spending is lowered and lower prices soon follow. Debt overhang and debt burden eventually cause assets to be sold, flooding the market. Spending falls, income falls and borrowers become less credit worthy. Interest rates are already relatively low. If the economy starts falling into this cycle, rates will need to be lowered again and negative rates may be needed. Some debts may not be able to be repaid so, savings will need to increase, debts are restructured, increases in taxes and "Money Printing". One could argue that we are around this phase of the business cycle: the deleveraging. Quantitative easing and stimulus are not tools a government wants to rely on for economic growth because, the fed is a reactionary force. The economy must be really bad if these tools need to be used. "Printed money" needs to be released into the real economy through bank lending, this is the only way reserves can be used. The rate of interest needs to be lower than the rate of income. Low rates are important for an economic recovery. Health care, consumer staples, utilities and other sectors where revenues are tied to basic needs outperform other asset classes. Consumer staples have outperformed every other sector during every recession.
A. XLU (Utilities)
B. Inverted DXY and SPY (pictured)
The chart of the dollar inverted matches very closely with the SPY chart. DXY has risen a lot more than SPY has over the past 2-3 weeks and the dollars strength can be attributed to rising rates. If the dollar does not get weaker, I wouldn't expect markets to move too much higher. As the dollar moves higher, commodities and commodity-linked sectors of markets will see weakness. Wider spreads and rates (compared to German,Japan bonds) help bring capital inflows back to the US for investment. The ECB and the BOJ would welcome a weaker euro and yen. It eases deflationary pressures from a strong currency and helps boost growth rates.
The demand for Cash/US dollars causes selling in assets. Short-term moves in the US dollar are driven by changes in US systemic liquidity flows (changes in current and capital account). When looking at the US exchange rate, the factor which determines its movement are long term yields. Long Term yields are effected by changes in systemic liquidity. There is a huge short interest on the US dollar , when it becomes apparent that DXY has bottomed, shorts will start to get unwound. Higher rates are causing the dollar to break out and go higher. If that happens, what is left to push equities up?
C. US10Y-US02Y (Yield Curve)
D. TLT/XLF (Long Term Bonds vs. Financials)
E. GDX
F. EURO
G. FXI
H. ISM Manufacturing PMI
Thank you for reading!