Weekly Economic Update 06-22-2018

Are the Russian’s Pushing Treasury Yields Higher?

After 35 years of disinflation and with the election of President Trump as our 45th President, inflation fears dominated the mainstream media—almost overnight. For some reason, analysts deemed President Trump’s policies as inflationary, even though past Presidents have implemented similar policies without creating inflation. The shift in mindset isn’t about economic policy at all, rather how the public perceives the term ‘inflation’.

In the past, inflation was defined as a general increase in prices due to an increase in the supply of a fiat-based currency, such as the U.S. dollar. Today inflation is defined as an increase in consumer prices. However, the new definition of inflation doesn’t make much sense to me. If a business chooses to raise their prices above their competition, it is not inflationary, nor does it lead to inflation. It might spark a price-war between competitors but it’s certainly not inflationary.

In the United States, money can only be created and destroyed by the banking system due to what is called fractional reserve banking. Fractional reserve banking allows banks to create money out of thin air. By regulation, banks are required to hold a specified amount of money in reserve to meet the cash demands of their customers. For each dollar in reserves, banks can lend out approximately nine times that amount. Inflation is created when a borrower spends the money and the new recipient deposits the proceeds at a different bank.

When a deposit is made at a bank that is borrowed from another bank, the receiving bank can count this new deposit towards their reserves. The receiving bank is allowed, per regulations, to lend nine times against this new deposit. This process of borrowed money moving from one bank to another is referred to as the “money multiplier.”

Inflation can only be created when the money multiplier is working and money is flowing between banks. As I have pointed out in prior updates, the money multiplier is a function of the number of commercial banks. The fewer commercial banks in the system, the less money can multiply. Around the time of President Trump’s inauguration, the belief was that the Federal government was going to borrow huge sums of money, even more than they are now, which would flow into the banking system and be multiplied, which would create inflation.

With investors fearing a sudden and steady increase in the money supply, they decided to sell and short U.S. Treasuries. There is no evidence in modern society that President Trump’s proposed policies will lead to inflation. The Bank of Japan has been pumping money into their economy for thirty years without creating inflation. The European Central Bank has been buying government and corporate bonds since the Great Financial Crisis without creating inflation.

The Federal Reserve bought nearly $4 trillion in U.S. Treasuries during three rounds of Quantitative Easing without creating inflation. We now know, as I covered in last week’s update, the Federal Reserve cannot print money; they can only encourage the banks to lend, but they cannot force the banks to lend or the public to borrow.

We also know, based on famed American economist Dr. Milton Friedman’s research, that periods of monetary decelerations, such as we are going through now, lead to lower long-term yields. We also know, based on research from the St. Louis Federal Reserve, that the Fed can only control short-term yields, whereas long-term yields are based on economic fundamentals. We also know, based on Dr. Lacy Hunt’s research which validates Dr. Friedman’s research, seventeen out of the last twenty-one periods of monetary declarations in the M2 Money Supply have led to a recession and caused long-term Treasury yields to fall.

Most financial professionals understand how stocks are priced, but few understand how bonds are priced. I have sought out every expert on bonds and studied their research to better understand what drives bond prices and interest rates. My research, and that of other experts indicate Treasury yields should be falling. Yet many highly educated and respected money managers have been pounding the financial media with news of rising Treasury yields. I assume these financial experts have access to at least the same information I have, which has forced me to ask the question: What is their motivation for higher Treasury yields?

One obvious explanation is the need to get the public to sell their bonds to buy stocks. Ninety percent of all stocks are owned by a mere ten percent of the population, so for the big players to sell, they need small investors to buy. For reasons unknown, American’s are fearful of inflation, although few truly understand the definition of inflation. The propaganda campaign of the big players worked – the public now has ninety percent of their investible assets allocated to stocks.

Another explanation has to do with Russia. The U.S. Treasury discloses the amount of Treasuries held by foreign investors on a monthly basis. In April, Russia sold off half of their U.S. Treasury holdings which amounted to $47.4 billion of U.S. Treasuries. Assuming Russia began floating this idea shortly after President Trump got elected, it is logical to also assume that hedge-fund managers wanted to buy them at the lowest possible price.

With the inside knowledge that Russia was planning to unload half of their U.S. Treasury holdings, it is logical to assume those same hedge-fund managers were trying to manipulate the market price of Treasuries to force Russia to sell their holdings at a lower price. If forcing Russia to sell their U.S. Treasury holdings at a discount was the goal of these hedge-funds, it appears it worked. In April hedge-funds increased their Treasury holdings by $15 billion. The rest of the Russian-owned Treasuries went to American investors, which explains why Treasury yields stopped rising in May.

Another reason large money managers and speculators are shorting Treasury yields is to prevent the yield curve from inverting. The yield curve is the difference between 10-year Treasury yields and 2-year Treasury yields. When 2-year Treasury yields move higher than 10-year Treasury yields, the curve becomes inverted and signals a recession is likely to occur within 6 to 12 months.

With 10-year Treasury yields near historic lows, it won’t take much action on behalf of the Fed, who has control of short-term yields, to push 2-year Treasury yields above 10-year Treasury yields. Since most money managers follow the yield curve on a daily basis, the potential inversion of this curve will cause money managers to begin selling their equity positions. To prevent the yield curve from inverting and to keep money managers buying equities, the simple solution would be to drive 10-year Treasury yields higher.

Due to the aggressive actions by the Fed, who is simultaneously unwinding their balance sheet and raising rates, had 10-year Treasury yields not been pushed higher, the yield curve would have likely already inverted. Six months ago speculators began shorting 10-year Treasuries, which has pushed 10-year Treasury yields to 2.9x%. When factoring the Fed’s unwinding of their balance sheet, the implied Federal Funds rate is 2.63% and in three months will be 3.13%. While the yield curve may not actually invert in the near-term, short-term interest rates are rising faster than long-term rates.

We know the Fed is in the process of raising the Federal Funds rate and reducing the monetary base, both of which are disinflationary and will lead to lower long-term bond yields. We know Russia’s bond sale only made a minor impact on Treasury yields and the effects on yields have largely been negated. We know if it wasn’t for the speculators shorting Treasury yields that the yield curve would likely have inverted in the first quarter of 2018.

Treasury yields have been rising because market participants have been manipulating them to keep investors focused on buying more stocks. Meanwhile, the “Smart Money” continues to buy U.S. Treasuries as they see a recession and lower bond yields on the horizon. Treasury yields have the potential to drop significantly when those who are short either willingly exit their position or are forced out. When long-term yields fall we will likely see the yield curve inverted, but this time we may not have to wait 6-12 months for a recession, because the curve may already have inverted.

Q&A with Steve – Your Questions Answered

  1. What happened to the stock market on Monday?

While foreign markets sold off on news of an escalating trade war, U.S. indices largely ignored the risks. Over the weekend I read an article published by one of the major investments banks showing 70% of all U.S. stocks are being traded by machines. Those machines are currently targeting short sellers. Anyone who is short this market has a target on their back. As the machines flush out the short sellers, stock prices rise.

Treasury yields were mostly flat for the day as short sellers tried to drive yields higher. Looking at Treasury bonds, there has been a strong volume on intermediate-term Treasuries, which is a buying signal.

Today’s 6-month Treasury auction saw weak demand as investors turn their back on short-duration Treasury bonds. There is growing concern that the U.S. Treasury may have trouble selling short-dated Treasuries going forward. This shouldn’t come as a surprise considering the Fed’s rate hike path. It does present a risk that the U.S. Treasury could see a failed auction in the future, which would create a problem as to how our government will fund their short-term needs.

After Friday’s selloff, physical gold failed to rally, which suggests prices will fall into my last target buy zone. The large gold miners failed to hold their 100-day moving average again, which also suggests prices are headed down. Large silver miners are down and are at risk of a larger move down, which would be good as we look to buy in before the gold rally kicks off.

Traders are no shorting soybeans as China enacts a tariff against them. Other traders are quick to point out that there isn’t enough supply to meet global demand without U.S. soybeans. In the short-term, this has led to lower prices, but tariffs always lead to higher prices. With agricultural commodity prices at their 15-year low, it remains a long-term buying opportunity.

  1. What happened to the stock market on Tuesday?

The big news was in overnight trading as Asian and European markets were all down, and Treasury yields also fell in overnight trading. In the past 5 trading days, the U.S. markets have opened below the prior day close and buyers have been fighting to push prices back up, which are mostly due to corporate share buybacks. Over the past five days, prices have run into a wall before close. Either liquidity is thin or there are sellers. Based on trading volumes, it appears liquidity is thin. When the “dip” buyers get tired of buying the dip, prices will start to fall.

General Electric will be removed from the DJIA on June 26 and replaced by Walgreens. General Electric’s stock is potentially on a cliff that could send prices to a very attractive level, especially with its dividend. The last time GE bottomed was an incredible buying opportunity. I’ll be watching to see if prices continue to fall. If GE’s price falls below $10/share, and it’s at $13/share today, it will likely head down to ~$7/share where it bottomed in 2008. I’d be very interested in GE at that price.

Treasury yields closed down, but short-sellers tried to push yields higher. Treasury short-sellers are also long stocks and short volatility, all of which moved in opposite directions. It’s becoming clear that Treasury short-sellers are fighting an uphill battle. Momentum inches closer to triggering a buy signal.

Physical gold, the large gold miners, and the large silver miners were all down for the day. This is excellent. Prices are headed towards the last buy zone!

Agricultural commodities got clubbed last night by short sellers. I don’t understand why traders want to short something that is already between its 15 to 20-year bottom. How low do they think it can go? Buyers stepped in a pushed back hard today, because they know tariffs lead to higher prices. With agricultural commodity prices this cheap, it’s a low-risk opportunity in my opinion.

  1. What happened to the stock market on Wednesday?

As quick as fears of a global trade war hit the global equity markets, a few days later the news has faded, and worries subsided. Keep in mind, when equity markets rise on news of trade wars and Fed rate hikes, it’s just a signal to politicians and policymakers to do more.

The S&P 500 is slightly up for the year, with the Dow slightly down. Tech stocks continue to rise as tech companies dump billions of dollars into share buybacks and as investors now believe tech companies are immune to economic downturns. I believe we saw this once before going into the dot-com bubble. Trading volumes across the three major indices remain very light, meaning there aren’t many buyers or sellers.

On news of home sales sliding due to high-interest rates, Treasury short-sellers resumed shorting bonds to push interest rates higher. Perhaps one day these short sellers will realize long-term interest rates are a function of supply and demand. Clearly, demand continues to slide as yields stay elevated.

The U.S. dollar seems to have a found a ceiling at $95 – symbol DXY. Suggests another move down before the next move higher. I’d like to catch that last move if momentum in Treasuries can turn positive, which I believe they will soon.

Physical gold, the gold miners and silver miners all slid today. It appears gold has a date with our target buy zone. We’ll be looking to see if physical gold holds the $1,250-65/oz level or if it’s going to visit $1,200/oz. We’re ready to roll either way. This should be the last move down before we find out if the chart patterns are right and we are on the cusp of a much higher move in gold.

Agricultural commodities found some buyers. The move down is nearly entirely due to the Soybean market. A heat wave is headed towards the growing region and if tariffs hold, prices should rise. What I do know is short-sellers are shorting the July contracts, which will roll into the next contract once expired. With trade wars brewing and supply equaling demand, prices should rise over the long-term.

  1. What happened to the stock market on Thursday?

On very little news equity markets were in the red today. While many have reasons, the simplest one is the Monetary Base. The Monetary Base is back to its early July and February 2017 levels, and since stock price lag the monetary base, the S&P 500 and DJIA are back where they were in early 2018. Asset prices shrink with the Monetary Base.

In overnight trading, 10-year Treasury yields tagged their 50-day moving average, then fell today as the Monetary Base shrinks. A decelerating money supply and monetary base lead to lower long-term yields. Yields closed right above their 100-day moving average, which has been a prior level of support and where yields were back in February.

Physical gold tagged the upper end of its buy zone today, but I don’t believe the move down is complete. We are close to making our move in once physical gold settles its next move down. We’ll then look at the associated mining stocks to enter our position.

Agricultural commodities were mostly flat for the day, but a heat wave is headed to the farming regions and precipitation is expected to be below average.

  1. What happened to the stock market on Friday?

Stocks tried to rally early this morning but faded by close, again on weak trading volume. The Monetary Base shows the tax cut has flowed through the system but may continue to show in the economic data for the next couple months due to the lagged effect of fiscal stimulus. I expect stock prices to continue to weaken as the Fed plans to increase the pace of monetary tightening next month.

Treasury short-sellers continue to try to push yields higher but are finding no traction. It’s almost as if Milton Friedman’s research that shows periods of monetary tightening lead to lower long-term yields.

Gold is hovering above my targeted “Buy Zone” and it just flashed a death cross, where its 50-day moving average pierces its 200-day moving average to the downside. This should cause people to exit positions and bring prices down to our target zone. I’ll be looking for the last move down and prices to hold before we start buying into the gold and silver miners.