The recent bond market sell off came on the heels of Bill Gross' comments regarding the German 10-year Bund as, "The short of a lifetime." We had already noted the negative yield situation in mid-March along with the increasingly negative tone that commercial traders were taking. Positioned accordingly, the bond sell off was a profitable experience. Over the last two weeks, however, there has been more and more talk about inflation and frankly, I just don't see it coming. Therefore, the generational bond rally may not have come to the screeching halt that the media is leading us to believe.
Prices are falling everywhere I look except the stock market. There is no shortage of capacity in any industry. Money is still cheap. There are certainly no personnel shortages. Meanwhile, the media appears to have taken Janet Yellen's remarks that the interest rate hike expected by year's end and the first since 2006, spells the end of this giant cycle. In fact, the recently released minutes of the Fed's April meeting showed four of its board members argued that rates should be bumped by a quarter point at the next meeting to begin normalizing the relationship between the Fed Funds rate and the discount rate which has been stuck at 0% - .25% since the economic collapse. While I agree with the reasoning at hand, I disagree with the pace at which bond yields have risen to match the media's inflationary noise.
The following composite chart shows nine different markets that are responsible for much of the world's commodity usage. Each chart shows today's position and change relative to one year ago.
|These nine charts show just how deflationary the commodity markets are at this point.|
The only two markets that are higher over the past year are the U.S. Dollar and the 30-year Treasury Bonds. The combined behavior of these two markets in and of themselves is deflationary. The stronger the Dollar becomes, the more it depresses commodity prices. The more depressed commodity prices become, the less inflation the Federal Reserve Board feels they have to contend with. This cycle is not over just because the first of the rate hikes appears to finally be visible on the horizon. Also, note that the recent bond sell off still leaves the market priced higher than one year ago to reflect even lower yields than we saw this time last year.
Furthermore, the issues depressing the other markets are nearly the same. The grain markets have had a perfect planting season on top of record harvests. This has left many newly constructed bins full to the brim financed by low rates and paid for by the high crop prices of a few years ago. This line of logic continues through the cheap money that financed the fracking boom which has led to the current energy glut. Finally, the same low rates and expanding monetary base that led to inflation insurance purchases of gold simply have not materialized. As a result of nearly a decade's worth of cheap money, any durable good that has needed to be purchased or built, has been. Cheap money has created an overhang of supply that will simply take time to work through.
Acknowledging the slack in our own economy due to the Federal Reserve Board's actions over the last 8 years should help put the European Central Bank's (ECB) anticipated actions into perspective. The ECB is just beginning to enact their own version of Quantitative Easing along with their own Zero Interest Rate Policy (ZIRP). Here at home we've finally quit adding new stimulus even though we've yet to pull the first dime to tighten. In fact, the minutes from the Fed's last meeting revealed very little along the lines of inflationary economic growth projections. I view the included table as benign while the talking heads will exclaim that, "The Fed predicts that the Personal Consumption Expenditures index could DOUBLE in the next two years!" Don't buy the hype.
|The minutes from the Fed's April meeting show little to mild inflation over the next two years.|
Shifting from the macro focus of the global economy and focusing on forming a trading thesis going forward, I believe it's still too early to think inflation. We track the commercial traders' positions in 35 commodity futures markets. Twenty-five of these markets can be considered more or less, tied to current and expected inflation levels. Of these 25 markets, 18 are facing bearish pressure by the commercial trader group. This includes entire sectors of inflation sensitive markets like interest rates, energies and metals as you can see on last night's discretionary COTSignals nightly email. Note that the positive commercial trader momentum in the interest rate complex suggests higher instrument prices which equates to lower yields.
|Commercial traders are bearish on 18/25 inflation sensitive markets including entire sectors like precious metals, energies and interest rates themselves.|
Our specialty within the commodity markets is examining the behavior of the futures markets' participants via the Commodity Futures Trading Commission's (CFTC) weekly Commitment of Traders (COT) report. This report breaks down the actions of the market's traders into a few key groups; small speculators, index traders, managed money and commercial traders. Briefly, the small speculators are just what their name implies; small speculators. Index traders follow a rigid program designed to manage exposure and leverage which means buying more on the way up and selling on the way down. Managed money covers the large commodity trading advisers and institutions. Finally, the commercial traders are the market participants that have a physical need for the commodity being traded. They're either the producers or, end line consumers of a given product. For example, Archer Daniels Midland (ADM) supplies the grain seed to the farmers that grow it for General Mills (GIS) .
Now that the bias has been established, let's look at how this plays out on a trading chart. We'll close with the last year's worth of discretionary trading signals generated by the commercial traders in the 30-year Treasury Bond futures. Each circle represents a trade entry and the corresponding stop loss level. These are short to mid-term trades with discretionary exits of no more than 10 days after entry. It's safe to say that 7/11 trades over the last year could've exited profitably.
|Commercial traders in the 30-year Treasury Bond futures generated 11 trading signals over the last calendar year. Seven of these were profitable.|
The rapid buying by the commercial traders is highly indicative of higher prices and lower yields ahead. This is the type of direct evidence that leads us to believe that the bond market bubble has yet to be pricked. Of course, if Greece is finally unable to make their debt payment next month we could see a huge rise in the U.S. bond market as fear of contagion sparks a massive flight to quality which will show up in the U.S. Dollar Index and Treasuries sectors. Either way, the forecast is not inflationary domestically.
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