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Tom McClellan

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Why Are Bond Yields Staying Low?

 

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July 21, 2017

There is a 60-year cycle in bond yields which has existed since bonds first came about in the 1700s.  It says that bond yields should have ideally bottomed in 2010, and by now we should be well into a 30-year rise in yields lasting until 2040. 

But that is not how it has worked out.  Bond yields have stayed low 7 years beyond the ideal bottom date.  So is something wrong, or is the cycle broken?  Or perhaps is this just an normal sort of anomaly?

We have seen prior examples of bond yields bottoming a bit off schedule.  There was supposed to be a yield bottom in 1890, but bond yields waited until 1900 to finally bottom.  Wars, ship sinkings, and other human events have also skewed the cycle a bit.  So this current delay could just be another example of a delay in this cycle bottom’s arrival.

Or there could be a deeper explanation.  We tend to think of the Fed as the authoritative controller of interest rates, something which I debunked at this link.  A study of long-term historical data shows that another agent is more powerful than the Fed.  Sorry if that last sentence sounds like economic heresy.  But do you want to believe what your econ professor taught you, or what the data say?

The 60-year cycle also appears in global climate data.  One place where it shows up best is in a bit of data known as the Atlantic Multidecadal Oscillation (AMO).

Atlantic Multidecadal Oscillation and interest rates

According to this 60-year cycle, global average temperatures should have turned down by now, and made for a cooling planet like we had in the 1970s.  Cooler temperatures mean more freezing events, poorer crop yields, and thus higher prices and inflation rates which bring higher interest rates.  But temperatures have not turned down, which means that former Vice President Al Gore still has a complaint, and thus a business model. 

And it also means that interest rates have remained low (show as high readings on this inverted scale chart).  The movements of global temperatures, as modeled by the Atlantic Multidecadal Oscillation, tend to lead the movements of long term interest rates by about 6 years.  If we are going to see a rise in interest rates, we should expect to see a drop in temperatures beforehand. 

There is a lot of noise in the (monthly) temperature data, but this is a long enough chart to see the trend.  And we see that the AMO data tend to lead the interest rate trends by about 6 years.  The AMO data do not go back to before 1856 (reliable thermometers were still being perfected), and so we cannot see what it would have said about the little ice age in the late 1700s and early 1800s known as the Dalton Minimum.  

As for why this relationship between temperatures and interest rates works, my hypothesis is that it is because cooler temps are bad for crop yields, causing higher food prices which trickles into other price data, and thus pushing up interest rates.  I cannot fully explain the reason for a 6-year lag. 

As for the 1890 cycle low not arriving until 1900, the 1890s were pretty warm.  But then colder temps (and a quiet sunspot cycle) in the 1900s led to rising wheat prices, the creation of the Fed, and WWI.  This latest sunspot cycle has been the quietest one since that Dalton Miminum.

Cumulative Sunspots per cycle

Eventually that lower solar output that the planet is receiving should start to matter in terms of cooler temperatures, poorer crop yields, and thus higher inflation and interest rates.  Delaying an event that the cycle says should happen does not necessarily negate the cycle; it can instead postpone the work to be done, forcing the commodities markets to work extra hard to make up for lost time.  And that should lead interest rates to start the delayed rise toward a top in yields due in 2040.

Tom McClellan
Editor, The McClellan Market Report

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Tom McClellan

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A Different Sort of Presidential Cycle

 

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July 14, 2017

 

It is by now an overused phrase to say that we are in a different sort of presidency right now.  And befitting that theme, we are seeing a really different sort of behavior of the market relative to the Presidential Cycle Pattern.

This week’s chart shows a version of our Presidential Cycle Pattern that is constructed by averaging together the stock market’s performance only in periods when there is a new president from a different party than the last one.  We have found that the market’s personality differs quite a bit according to whether there is a new sheriff in town from a different group than the last one, versus a status quo type of president. 

Normally a new president from a different party brings a market rise, at least until May of the first year, just on hope that everything is going to be better.  Then as investors realize that all of their hopes are not getting realized right away, that hope turns into disappointment, and the market declines during the summer and into autumn. 

What we are seeing this time is a rise, all right, but it is continuing now into July, and investors are not yet showing disappointment.  That’s a verbal story.  But if you look closely at the chart, you can see that the SP500 has been zigging and zagging all at the wrong times, according to the Pattern.  In other words, the correlation has been inverse.

But that statement is only true when one looks at a certain time frame.  The overall path of the SP50 has been higher like it was supposed to, but the minor pattern has been inverse. 

This revisits a point I wrote about in August 2010, under the headline of “Correlations May Not Be What They Seem”.  The point is that having a trend in the data makes an inverse correlation seem positive, both visually and quantitatively.  Here are a couple of charts from that article.  The first shows a perfect inverse correlation:

sine waves inverse

But if we add an artificial uptrend to that inversely correlated data, the calculation of a correlation coefficient flips to a strongly positive one:

sine waves in uptrend

The point in reviewing these principles is to see past the 8-month uptrend in the first chart, and notice the inverse relationship in the smaller movements, even as there is an overall uptrend.  That overall uptrend can disguise the inverse movement on the shorter time scale. 

With that point firmly in mind, we can see that the SP500’s movements have been backwards from what the schedule says.  There is your different sort of presidency, and different sort of price response.  The SP500 bottomed at the end of June, just when this Presidential Cycle Pattern said that a minor top was supposed to be seen.  And now the market is rising at a time when the Pattern says prices should be falling.

All of this inverse behavior would be concealed from those who look just at quarterly or monthly returns data.  You have to look at the chart closely to see the insight.  And the immediate message is that prices should continue higher for much of the rest of July.  A longer term chart shows that this autumn will get even more interesting, assuming that the inverse correlation of the minor patterns remains inverse.

presidential cycle first term presidents

If it does remain inverse, then the Pattern’s decline into late September should mean a strong advance for stock prices then.  But here is the caveat: If you ever count on a relationship remaining inverse, that’s when it can flip again and fool you.  So you must keep a watch on it, and notice if it “disinverts”.

Tom McClellan
Editor, The McClellan Market Report

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Tom McClellan

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Phillips Curve Is Not Even Wrong

 

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July 07, 2017

To paraphrase Wolfgang Pauli, the whole idea behind the Phillips Curve is “not even wrong”. 

A.W.H. Phillips studied the relationship between inflation and unemployment in the United Kingdom, and noticed that they were usually moving in opposite directions.  He therefore theorized that when unemployment is low (and it is hard to find workers), prices of things rise because employers have to pay more to hire qualified employees.  That led 2-3 generations of economists to undertake an effort to determine what is the exact tradeoff between inflation and unemployment, thinking that if a government or central bank changed one factor, there would be an equal and opposite reaction in the other factor.

The problem is that neither Dr. Phillips nor the generations who came after him understood the real relationship.  It is not one of opposition, but rather of lead-lag.

In the chart above, the plot of the CPI-U Inflation rate is shifted forward by 2 years (24 months) to reveal how the U.S. unemployment rate follows in the same footsteps.  That is important because the inflation rate bottomed in early 2015, and so the echo of that bottom is coming due right now for the unemployment rate.

This is not a perfect relationship, though.  Sometimes exogenous events put a thumb on the scale.  We saw that especially in 2008, when the commodities bubble sent the inflation rate up to an unnatural high, which was followed by a crash of equal magnitude to the downside.  Two years later, the unemployment rate did not exactly match those dance steps.  But after a few months, the relationship got back into step again. 

The CPI-U inflation rate rose from the low in April 2015 to its high in February 2017.  Add two years to those dates, and we get a low for unemployment due in roughly May 2017 and a high in February 2019.  But it does not appear to be as big of a rise as some of those we have seen in the past, so don’t worry too much.  But do brush up your résumé.

Tom McClellan
Editor, The McClellan Market Report

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Tom McClellan

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Treasury-Bund Spread Gives Early Warning of the End

 

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June 30, 2017

The 28-year record high spread between 10-year T-Notes and German 10-year “bunds” is finally starting to narrow just a bit.  This is a warning that the great bull market in stock prices from the 2009 low is in its last stages.  But it is not done yet.

Ever since June 2009, the yield on the US 10-year T-Note has been higher than its German counterpart.  It turns out that this is a pretty bullish condition, at least for as long as the spread between the two is rising.  As a bull market ages, though, this spread shows the wearing out by displaying a divergence relative to prices.  It can take many months for the divergence to finally matter, and bring a meaningful price decline.  We are just now starting to see those first signs of such a divergence.

This spread peaked in May 1999, 7 months ahead of the DJIA’s Dec. 1999 peak, and 10 months before the SP500’s March 2000 top. 

The lead time was even longer ahead of the 2007 top.  The Treasury-Bund spread had its highest reading in Oct. 2005, but started downward from a slightly lower top in June 2006.  That was still more than a year ahead of the stock market’s October 2007 top, so there was plenty of warning if one had listened to this indicator. 

Another peak in the Treasury-Bund spread arrived in April 2010, which was just a month ahead of the infamous Flash Crash, but 12 months ahead of a more significant top which came in April 2011. 

Now most recently, we have a peak in this spread in Dec. 2016, and only now in May and June 2017 is it really starting to decline.  So we are likely still a year or more away from a final price top for the stock market.  A top in mid-2018 fits well with the expectation offered by crude oil’s 10-year leading indication

It is important to understand when using these insights that this relationship between the Treasury-Bund spread and stock prices has really only worked for about the last 30 years.  Prior to the 1980s, it did not work at all.  Here is a longer term chart:

Treasury-Bund Spread 1956-2017

We should remember that in the decades after World War II, Germany was still a rebuilding country, divided in two by the postwar agreement with the Soviet Union, and definitely not a favorable risk in terms of its sovereign debt.  So its yields were understandably higher than those of U.S. debt.  Then in the late 1970s and the 1980s, the Federal Reserve was fighting inflation that began with the 1973-74 Arab Oil embargo, using higher interest rates.

Only in the late 1980s did things settle down, and with the fall of the Berlin Wall in 1989, Germany came to be seen as a legitimate financial and industrial power, and a good risk in terms of its sovereign debt.  And that is when this leading indication for stock prices began to work. 

I was stationed with the US Army in Germany at the time the Berlin Wall came down, and the two Germanys reunited.  It was obvious that it was a transformational moment in history, but I could not have known then that it would mean this change in how the yield spread would work as an indicator.

If we ever see a time when the yield on German bonds is higher than that of U.S. 10-year T-Notes, making a dip below zero in these charts, that will mark a great buying opportunity for the stock market, if the past 30 years’ experience is any guide.  And a few months from now, we should see a major price top for the stock market, which the current divergence is just now starting to foretell.

Tom McClellan
Editor, The McClellan Market Report

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Tom McClellan

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Narrow Range for McClellan Oscillator

 

Chart In Focus

June 23, 2017

A quiet market is one of the hallmarks of a price top, when no one seems to care enough about risk to move the market very much in either direction.  The NYSE’s McClellan A-D Oscillator has recently been displaying some of that quietness, trading only a few points above and below zero until just the past couple of days.  That quietness in Oscillator readings is telling us something about that very complacency I was talking about.

So to look at it more quantitatively, this week’s chart looks at the 15-day high-low range of Oscillator values. It’s calculation method disregards at what point level that range occurs; it is just looking at the highest minus the lowest readings over the past 15 trading days.  What we can see in this chart is that the high readings occur near inflection points, usually as prices are turning up. This makes sense. Think about a nice oversold (very low) Oscillator reading, which is then followed a few days later by a crossing of zero to a nice high reading. That is going to increase the magnitude of the readings for this 15-day range indicator.

But it is the low readings for the 15-day range that I find even more interesting, because they tell us more about what is going to happen, as opposed to what just did happen. These low readings, below around 120 points, seem to give pretty good signals that a price top is at hand.  This is similar to several other types of indicators that portray market calmness, such as Bollinger Bandwidth (AKA standard deviation), VIX, and Average True Range. Calmness of prices and investor complacency go together, and usually appear together at market tops.

A low reading like what we have just seen does not necessarily have to lead to a big price decline.  But it does say that traders are feeling complacent, and thus that those who are going to be buying have likely done so, and thus there is little immediate pressure left to help push prices higher.  Waiting for a fearful event, with its associated volatility and oversold readings, will get a better short term entry point. 

This is a newfangled way of looking at McClellan Oscillator interpretation.  For some of the more longstanding methods, check out our Learning Center chapter on the McClellan Oscillator.  And to see a chart of the McClellan Oscillator updated every trading day, visit our Market Breadth Data page.

Tom McClellan
Editor, The McClellan Market Report

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