As expected, the Fed's 'extended' easy money meant trends 'extended' as well, as even govvies rallied in the face of an extension of the up trend in equities. And as far as the govvies go, this has happened before, and there is even more reason to allow that they can rally along with equities this time. This has been part classic govvies 'hostage to fortune' rally (i.e. anticipation of equities stalling out into a downside correction) and part yield curve comfort now that the FOMC and Mr. Bernanke have signaled no risk of a rate hike for at least four months.

While that doesn't make the govvies a bull market, it allows for near-term buoyancy. But it comes with a lot of risk. In a nutshell, we see attempts to monetize the annualized yield spread between Federal Funds and the 10-year T-note as a fool's game. Accepting a 75 basis point nominal profit per quarter for holding longer dated govvies is pretty reckless. That's on two fronts. In the first instance, the major bullish cycle in govvies which proved so tenacious and more robust than most people might've imagined across many years has very likely reversed into a major bearish part of the cycle.

Those owning the 'flattening' trade (i.e. long the long-end on short-money borrowing) are risking that the primary trend might hit them at any time; even if there is zero chance for a Fed rate hike. Let's face it, if any strong equities activity should foment near term weakness in govvies, an immediate loss of quite a bit more than potential earnings on the trade for a full quarter could occur at any time.

That said, there is nothing wrong with owning a bear market for a limited potential, as long as that is also for a limited amount of time. Yet, any profits in this case are more likely to be related to the equities and govvies returning to more classical counter-trend activity from their recent mutual rally. And there are good reasons that is likely to occur fairly soon; either for better or worse in each asset class.

The psychology behind these sporadic govvies 'hostage to fortune' rallies is worth reviewing. Rather than simply an academic exercise, as in previous seasonal phases this may also be critical to near-term trend analysis. This is due to the divergent focus of the govvies and the equities. Except under the worst of economic conditions, earnings season is a classically buoyant time for equities. Previous quarterly corporate performance may be a 'rearview mirror' indication, but typically better than expected figures still have the power to drive the equities.

The extra benefit in this quarter is the upbeat guidance based upon better overall economic expectations by corporate executives, reinforced by successive previous quarters' outperformance. That shows up in higher corporate borrowings from banks, even though consumer borrowing for things like mortgages remains very weak. Of course, that latter bit flies in the face of the upbeat corporate expectations.

As such, equities are rallying on anticipation as much as the sheer positive previous results. Govvies on the other hand are more focused on real world implications of underlying economic data trends. US housing is in a definitive double dip that already includes new lows in quite a few markets, employment is still spotty to weak (witness last week's Initial Jobless Claims and today's ADP figures), and energy and commodity prices are weighing heavily on consumers' future ability to engage in expansive discretionary spending.

They are also raising input and transportation costs for most businesses. Hence, there is some rational foundation for govvies to suspect equities will have more headwinds than previous. The question ultimately becomes which of these divergent expectations dominates as earnings season comes to an end? As that is going to occur into the middle of this month, it will become more important to assess current economic data and market responses once again. Any further weakness in the data on top of today's weakish developed country Services PMI's will be more important, both as an extension of recent soft figures, and the factor which might finally cause the equities to stall and reverse.

In spite of the commodity boom and weak US dollar being good for some of the very large multinationals (glaringly obvious in DJIA upside leadership), there is a point of diminishing returns. That is all part of the moderately perverse perspective on why the govvies have been able to counterintuitively rally along with commodities: the prospect that all those higher input costs will slow rather than spur the developed economies. If the Fed's easy money policy were occurring into a robust employment situation with rising wages, a case could be made for demand-pull inflation. But in the current weak jobs and wages context, it is more likely companies will run into price resistance that significantly crimps profit margins.

Read more...

As noted previous, the Fed's 'extended' easy money policy meant trends had 'extended' as well after the last FOMC 'no-action' and very accommodative press conference communication from Mr. Bernanke. First and foremost that meant equities could continue their sustained rise. That included the June S&P 500 future push above key resistance in the 1,334-27 range, which also left and UP Break above the higher end of that range. However, that is all coming into question in a more significant way than any time since the late-April FOMC meeting on the early week slippage back below that area this week. It has shifted the psychology significantly this week: whereas previous the challenge was on the bears to knock the market below it, the burden of proof is now on the bulls to reinstate the upward momentum back above the June S&P 500 future 1,334-27 range.

And it goes without saying that quite a bit of the continuing equities psychology is dependent upon continued dovish sentiment and accommodation from the looser central banks in the UK and US. This is partially a situation unto itself in the current fraught environment, where various problems and programs might weigh upon the equities. Those include everything from the ongoing risks in the peripheral European Debt-Dilemma, a decidedly hawkish stance of the emerging market central banks which are cooling economies to combat inflation (some would say driven by the easy Fed policy), the potential for conservative US politicians to get too aggressive with fiscal retrenchment that might directly hit the US economy (note the current fiscal shortfall in Greece in spite of draconian cuts), the headwinds from a still very elevated energy prices, etc., etc., etc.

Yet, the one other factor which may not be prominent in most market participants' minds is that this particular phase is so very similar to a previous critical juncture. While the Bank of England minutes released this morning were a bit more dovish than previous due to sustained UK economic weakness, that means the further key rests solidly on the FOMC meeting minutes release this afternoon. That is because it was the less than fully accommodative central bank minutes back in May of 2008 that encouraged the significant failure of the key UP Break at the top of a major rally back at that time. That brought about the end of the early 2008 recovery, and reinvigorated the bear market that became so vicious later that year.

Read more...

There was an excellent recent Financial Times broad perspective by their credit market supremo Gillian Tett on US Tarp program history and real world implications. In addition to a very concise, well-informed view on that, the column was ultimately attempting to illustrate the title claim that “Tarp shows that US can break political deadlock” (insight column, May 13, 2011) through a bit of history and series of well-thought points. Not the least of which is the fact that it usually takes a crisis for US politicians to take obvious necessary steps.

As Winston Churchill once observed, "Americans can always be counted on to do the right thing...after they have exhausted all other possibilities." In the current circumstances that now applies to not throwing out the baby with the bathwater while addressing daunting fiscal challenges. As both sides of the political divide rapidly shift between accommodation and antagonism, we are not hopeful about a reasonable resolution.

Regardless of how the specific negotiations unfold, the obvious risk would seemingly be to the US government bond market (possibly along with other sovereigns.) Yet, on recent form any problems with the US fiscal reform negotiations have hit equities even more so than govvies.

Read more...