Financial Review

Flattening

…Stocks struggle to bounce off long-term support. Amazon under attack. Tesla’s debt problem. The bond market’s yield curve problem.

Financial Review by Sinclair Noe for 03-28-2018

DOW – 9 = 23,848
SPX – 7 = 2605
NAS – 59 = 6949
RUT – 0.54 = 1513
10 Y – .01 = 2.78%
OIL – .60 = 64.65
GOLD – 20.10 = 1325.40

 

Let’s start with the good news. The S&P 500 managed to close above its 200-day moving average. That support level has held for four straight days. The 200-day moving average stand at 2588 – just 17 points shy of today’s close. Any movement below the long-term trend line would trigger selling, and it could get ugly, fast. There is a good chance the S&P will continue to hover just above support heading into the end of the quarter. Next week, the calendar flips to April. The first three weeks of April are a popular time for companies to preannounce their earnings results and given the number of issues investors are looking for clarity on — including the impact from the recently passed tax bill, the prospect of protectionist trade policies and whether management teams are seeing any sign of inflation or impact from higher interest rates — such announcements could prove pivotal for traders. The technology sector, which has recently been in focus due to the massive swings it has seen, could be particularly susceptible to volatility. About one-third of April preannouncements are done by companies in the tech sector.

 

Currently, the S&P 500 is about 9.3% below a record high hit earlier this year, while the Dow Jones Industrial Average is down 10.4% and the Nasdaq Composite Index is down 9%. Both the Dow and the S&P 500 are in correction territory, meaning they’ve dropped 10% from a peak and haven’t recovered; the Dow’s correction was one of its fastest such drops from a record in history.

 

Facebook managed a small gain today but it has been pummeled over the past 2 weeks, but it is not the only FANG stock feeling the pain. Today, Amazon dropped 4.4% today, and it is down 11.5% from its high just 2 weeks ago; which means that Amazon is now in correction territory. Despite the selloff, the stock has still run up 20% over the past three months. Axios reported that Trump wants to “go after” Amazon with antitrust enforcement or by changing tax rules. Whether that happens or not, only time will tell. It’s no secret that Trump hates Amazon. He has repeatedly tweeted how much he dislikes the company. White House Press Secretary Sarah Sanders said today that the administration is not considering action on Amazon “at this time.”  It’s far from certain that Trump would be able change laws to retaliate against Amazon. Now, remember that just 2 weeks ago this was the company that’s growing so fast that cities across America are throwing billions of dollars in tax breaks at it to lure its second headquarters. The company that muscled its way into the grocery business, dominates cloud computing, lords over online retail and wins Emmy awards. In some ways, Amazon might serve as the canary in the coal mine. Will the stock continue to decline, or was this just a buy the dip moment for a market leader?
While much of the market attention has been focused on big tech and the FANG stocks, it has been easy to overlook the bond markets. The yield on the 10-year note has dropped to 2.78%, which seems like a long way from the redline of 3%. Bonds moved higher as a safe haven play as money moved out of the high-flying tech stocks. But that does not mean all is well in the land of debt. Case in point – Tesla. Last summer, Tesla sought to raise $1.5 billion in the bond market. Demand to invest in the debt was so high for a company that was losing money, burning through cash and falling behind on its production targets that it was able to raise $1.8 billion. The coupon rate was 5.3 percent, a record low for a bond of its rating and maturity. Now, barely seven months later, those bonds are fast becoming the poster child for excesses in the credit markets.

 

Along with Tesla’s shares, those eight-year bonds are slumping, falling to about 86 cents on the dollar and helping to drag down the broader corporate debt market, following questions about the company’s business and finances following a fatal Model X crash in California. The cost to insure junk bonds such as those issued by Tesla against default has risen to the highest level since 2016. In hindsight, it’s easy to criticize investors oppressed by a world of near zero interest rates who participated in the offering and allowed Tesla to raise so much money at such cheap rates for a junk bond issuer. But the real issue is how vital confidence in the credit markets is to the financial system, and right now there’s little doubt that Tesla’s troubles are contributing to a repricing of corporate bonds. Cheap financing for the really mediocre credit stories is not available, at least nowhere near the way it was as recently as the end of the summer.

 

And don’t forget the Federal Reserve is tightening at a slightly faster pace and sounding just a smidge more hawkish under the guidance of new Fed Chair Powell. We haven’t really seen corporate borrowing costs rise high enough to force businesses to rethink their borrowing costs. We’re not there yet, and the Fed might continue to plug along with all the excitement associated with drying paint. There is a good chance that the recent pullback was slightly exacerbated by a squeeze on short sellers, overly anxious for 3% yield on the 10-year Treasury. Those positions have been unwinding over the past week. The selling pressure in the bond market looks like it is under control, for now. There is little doubt that Powell would prefer to fade the “Fed Put” – the idea that the Fed will always act as a backstop to the markets. So, all we’ve really heard from the Fed is not much more than jawboning the market. For now, the economy looks strong, so a hawkish tone is easy. More difficult is tightening policy further without inflicting real damage.

 

And that brings us to the yield curve, which is flattening. Let me explain. In general, short-term bonds carry lower yields to reflect the fact that an investor’s money is at less risk. The thinking behind this is that the longer you commit funds, the more you should be rewarded for that commitment, or rewarded for the risk you take that the borrower may not pay you back. This is reflected in the normal yield curve, which slopes upward from left to right on a graph as maturities lengthen and yields rise. Since 1990, a normal yield curve has yields on 30-year Treasury bonds typically 2.3 percentage points (also known as 230 basis points) higher than the yield on 3-month Treasury bills, according to data from the U.S. Treasury. When this “spread” gets wider than that—causing the slope of the yield curve to steepen—long-term bond investors are sending a message about what they think of economic growth and inflation. When the spread narrows, or flattens, it means that we might be getting closer to a recession. The flattening yield curve signals concern that the Federal Reserve could be hitting the brakes on the economy so hard that it inadvertently puts the United States into another recession.

 

The yield curve narrowed to nearly the smallest point since before the Great Recession. The 10-year bond is trading at only 50 basis points more than the 2-year bond. People are worried the Fed will keep tightening us into an accident. An inverted yield curve, in which longer-duration bonds yield less than short-term ones, often signals a coming recession. We’re not there yet. It might not happen. But the flattening of the yield curve is sending a message. Usually when the bond market and the stock market disagree, the smart money sides with bonds. And the message from the bond market is that the economy is not quite as robust as the stock traders might imagine. The yield curve is not a great predictor for recessions. The yield curve went flat in 1998, more than two years before the next recession. The same thing happened in early 2006. Relatively flat yield curves are not terrible for stock market returns, but flat-line and inverted ones are. Even if that’s not the case this time, the flatter yield curve is bad news for banks, which pay interest on short-term rates and lend at long-term rates. Investors are betting that the yield curve won’t be a problem, but if it continues to flatten, the stock market’s recent bumpiness will most likely continue.

 

And late word that Veterans Affairs Secretary David Shulkin will resign soon, Trump will likely nominate his personal physician, Dr. Ronny Jackson, to succeed Shulkin.

 

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