How solid is the current economic recovery? In late April I argued that the recovery was faltering and that cracks were starting to appear in the “Trump rally” in US equities.
I wrote then that a stock market can rally on promises – in the case of the Trump presidency, promises of lower regulation, tax cuts, and infrastructure spending. But it takes concrete results to sustain it, and those results aren’t being delivered.
US equity markets have continued to grind upwards. The S&P500 is up another 2.1 percent since I raised the idea that the Trump rally was sitting on a shaky macroeconomic foundation in late April. And it’s up 8.5 percent in 2017 so far.
The CBOE S&P 500 Volatility index (or VIX), which measures the expected level of equity market volatility has fallen back below 10. This means investors are not bracing for a sharp decline in US equity markets any time soon.
Meanwhile, US economic data continues to be weak.
Last weeks’ US nonfarm payrolls (NFP) data were not encouraging. NFP data provides month-on-month changes in US employment. It’s a key barometer for overall economic health. In May data showed that 138,000 jobs added that month versus expectations of 182,000. That’s a 25 percent miss.
Cracks show in the bond market first
More interesting is what’s going on in the US treasury market.
In the aftermath of Donald Trump’s electoral victory in November, 10-year treasury yields shot up from less than 1.8 percent to 2.6 percent in the space of a month.
When bonds prices fall, yields rise.
This was all part of the “Trump rally” in equity markets. The view was that a Trump presidency would lead to faster growth, higher inflation – and therefore faster interest rate rises. (If the economy grows faster, the U.S. Federal Reserve would likely boost interest rates faster .
As a result, the market sold US treasuries (which perform poorly in a rising interest rate environment). (For bonds, a higher yield equates to a lower price.)
The chart below shows the Commitments of Traders (COT) report on net US treasury futures positions in 2016, up to the end of February 2017. Treasury futures are contracts to buy or sell US treasuries for a specific price at some point in the future. They are extremely liquid instruments used by traders and asset managers to hedge or bet on US treasuries.
This COT data is published weekly and shows to what extent the market is long or short (i.e. betting against) the price of the 10-year US treasuries.
A positive number means the market is generally long US treasury futures contracts, which means traders think bond prices will rise (and hence yields will fall).
A negative number implies the market is betting against treasuries and expects the price to fall (and hence yields to rise).
As soon as Trump was elected, the net futures COT numbers went negative. That is to say, the market began betting heavily against US Treasuries.
The market was anticipating that the price of Treasuries would fall. And it did. Treasury yields increased and bond prices fell.
The graph above shows data from January 2016 up to the end of February this year.
You can see in November 2016, when Trump won the election, that 10-year yields rose quickly, and the net COT postion went negative i.e. traders began betting heavily against the US treasury market.
But take a look at the next chart below. This shows you the COT numbers up the end of May, and in the context of the past decade.
You can see that in recent months traders have suddenly switched from betting heavily against treasuries, to betting heavily on treasuries. It’s the largest and fastest swing ever recorded (in data going back to 1993) in such a short time period.
The reality is, if the US economy is in such good shape, and interest rates are likely to rise as a result, then the market wouldn’t be betting so heavily on treasuries all of a sudden. If the bond market is boss, then right now it’s saying you better look out… the Trump rally and economic recovery aren’t a ‘given’. Traders are now positioned more bullishly on the US treasury market (i.e. betting bond prices will rise and yields will fall) than any time since 2007.
Let me be clear: if the market was optimistic on the US economic outlook, you simply would not see so many people betting on the US treasury prices rising.
Because of US economic frailties, I suggested earlier that investors look at shifting some of their US equity exposure to Chinese equity markets. I cited a relatively strong economic foundation and stabilisation in the renminbi, the Chinese currency.
Specifically I said “We are bullish on H-Shares.” (H shares are Chinese companies listed in Hong Kong.)
It’s early days, but since then H shares have outperformed the S&P500, with A shares (Chinese companies listed in China) not far behind.
We’re still bullish Chinese equity markets. And in our most recent edition of The Churchouse Letter, Peter makes his case why…