by Kevin Klombies, Senior Analyst, TraderPlanet.com
As of the close of trading yesterday the Fed funds futures were trading at levels that suggested that following next month’s Federal Open Market Committee meeting the funds rate would be lowered to either 1/2% (36% odds) or 1/4% (64% odds). In other words the markets continue to expect that the over night funds rate is headed lower. Fair enough.
Our view is that a new cycle begins with economic weakness and falling short-term interest rates and ends with sharply rising cyclical asset prices and rising interest rates. At times the tail end of the last cycle will over lap the leading edge of a new cycle as interest rates decline even as asset prices move upwards.
In any event we have argued from time to time that either the Fed funds rate is way too low or 3-month eurodollar yields- currently around 2 1/4%- are too high. The idea was that the long end of the bond market tends to peak in price some time after the yield for 3-month eurodollars moves below the Fed funds rate. To the extent that the markets still believe that the Fed funds rate is going lower this argues- to us, at least- that short-term and long-term Treasury prices are going to resolve higher.
The point is that the markets are in the very early stages of forging a recovery. To explain we show at right a chart of, from bottom to top, 1-month LIBOR futures, the U.S. 2-year T-Note futures, the 5-year T-Note futures, and the 30-year T-Bond futures.
To get from crisis to recovery the markets have to work through a certain sequence. First the Fed has to cut the funds rate. Second, the banking system has to calm to the point where 1-month LIBOR futures prices are actually rising. Third, the markets have to expand the process so that 2-year, 5-year, 10-year, and eventually 30-year Treasury prices move upwards. Fourth, the markets have to gain enough confidence to start to start squeezing in the various spreads. Fifth, the equity markets have to resolve upwards, and sixth… real asset prices- including commodities should start to strengthen.
In any event… we are encouraged by the recent action in 1-month LIBOR futures as prices pushed above the September highs. We can also see that 2-year and 5-year T-Note futures are now at new recovery highs as the 30-year T-Bond futures work slowly upwards. We will argue that this suggests that the markets are some distance down the path that leads from crisis to eventual recovery.
Below we show two comparisons between the S&P 500 Index (SPX) and the CBOE Volatility Index (VIX). The top chart is from 2002 while the lower chart is from the current time frame.
The VIX tends to rise during periods of markets-related stress so the basic relationship is VIX up and SPX down. Fair enough.
The VIX peaked in July of 2002 when the SPX made its first bottom. When the SPX returned to the lows in October the VIX had been trending upwards but had yet to reach new highs.
While the current situation stretches over a much shorter time frame the charts are actually quite similar as the SPX bounces along support around the 850 level while the VIX grinds higher. Our point is that a sustainable recovery rally for the SPX will require enough weakness in the VIX to break the rising trend line. In other words an intraday move below 60 by the VIX concurrent with enough strength in the SPX to push it back above 900 would most certainly be encouraging.
Below and below right are two comparisons based on the SPX and the product of commodity prices (CRB Index) times bond prices (U.S. 30-year T-Bond futures. The idea is that the equities are one part financial asset and another part ‘real’ asset. They tend to trend with the bond market and the commodity market so if both are falling the trend for the SPX is typically lower.
In 1982 (below right) the SPX turned sustainably higher once the CRB Index times T-Bond futures was ready to move above its 200-day e.m.a. line. In the current situation (below) we have recently seen a bit of strength in the long end of the bond market and some tentative indications of a bottom in the commodities markets. Perhaps not quite enough to call this encouraging but these days we will take what we can get.
