Morning Market Brief — Tuesday 9/11/18

Yesterday’s attempt to push stocks higher failed, but today’s hammering of volatility appears to be working as stocks are effortlessly moving higher. The financial media reported this morning that long-term Treasury yields were headed higher due to today’s upcoming three-year Treasury auction. I don’t think so…

There is a record short position on long-term bonds, which indicates speculators believe long-term bond yields are headed higher. The argument for this has to do with the record amount of debt being issued by the U.S. government to fund its deficits. Long-term bond yields are correlated to large budget deficits, but not to the upside.

Since the 1980’s, which Reagan began deficit spending, yields have fallen. The notion that long-term bond yields need to rise to offset large government deficits is false. The problem for the speculators, who are holding the largest short position in history, is rising short-term bond yields.

The Fed is raising the Federal Funds rate, which affects short-term bond yields. The Fed is also unwinding its balance sheet, which causes long-term bond yields to fall. The risk to the speculators is when the yield curve inverts.

An inverted yield curve is when short-term yields are higher than long-term yields, which indicates something is wrong with the financial system. Banks borrow against short-term yields and lend against long-term yields, so as the yield curve approaches inversion, banks cut bank on lending.

Less lending means less money entering the economy. As less new money is created, the economy risks falling into a recession as the money supply decelerates towards zero. To keep the game going, speculators need to make sure the yield curve doesn’t invert.

The only way to do that is either to get the Fed to stop hiking, which isn’t going to happen, or continue to push long-term yields higher until the economy breaks under the weight of tighter financial conditions.

Interest rates rise due to demand or due to a perceived increase in the money supply, which leads to increased demand. Let’s say a bank has $5 million they want to lend out to customers who want to buy a new car. After running a marketing campaign to find new borrows, the bank receives applications for $10 million in potential new car loans. Due to the unexpected demand, the bank raises interest rates until they have $5 million worth of new loans from their customers who are willing to pay a higher interest rate for their new car. That’s how interest rates can go up.

On the macro front, wholesale inventories are rising at a rate of +0.6% MoM, which is a sign of increased confidence by wholesalers who believe demand is increasing. At the same time, wholesales sales were flat. Demand is starting to slow.